Dialogue: Why can't our central banker be more brash?

By BRIAN FALLOW

When we see interest rates being cut aggressively in Washington, but cautiously in Wellington, it is natural to ask why Don Brash can't be more like Alan Greenspan.

The usual answer is that he can't afford to and doesn't need to.

New Zealand is at a different phase of the economic cycle to the United States, or for that matter Australia, with both more growth momentum and more inflationary risk than they have. In their cases the great 1990s expansion is only now coming to an end. In our case it ended in 1998 and we are now in the upswing stage of a new cycle.

New Zealand's easings this year have been portrayed as insurance against the risk that the global slowdown will bring that export-led recovery to a shuddering halt.

But does the difference in cyclical circumstances fully explain the difference in monetary policy stance between the Reserve Bank and the Federal Reserve? Or is there an underlying difference in the way the two banks approach their task?

In explaining its policy decisions, the Federal Open Market Committee typically talks about risks. Which is the greater risk, inflation or recession? Right now it is clearly the latter.

Announcing its decision to ease another 50 basis points yesterday, the Fed said: "The committee believes that, against the background of its long-run objectives of price stability and sustainable economic growth ... the risks are weighted mainly towards conditions that may generate economic weakness."

How different is that in practice from the Reserve Bank's approach?

The Reserve Bank's allotted task is not just to maintain price stability, but to avoid "unnecessary instability in output, interest rates and the exchange rate."

Underlying those instructions is research showing there is a tradeoff, not between inflation and growth per se but between variability in inflation and variability in output.

So if you can tolerate bigger swings in inflation, you can expect less fluctuation in growth, interest rates and the dollar.

Central to the way the Reserve Bank seeks to fulfil that task is the output gap.

It must figure out what the potential (sustainable) growth rate is - that is, how fast the economy's productive capacity is growing. That reflects basic factors like growth in the workforce and its productivity.

Then it looks at how fast demand is growing. If the economy is heading towards a period of demand outstripping the economy's capacity to supply, warning bells sound. That excess demand is not going to buy a sustainable increase in output, but only inflation or a blowout in the trade balance and current account. In which case the bank should tighten monetary policy to extinguish that excess demand.

Conversely, if the economy seems headed towards a negative output gap, with not enough demand to take up the capacity to supply, then the bank should ease, because too little demand is potentially deflationary.

Lars Svennson, the Swedish monetary economist who reviewed the operations of the Reserve Bank, says there is general agreement that inflation-targeting central banks in industrialised countries conduct policy in this way. "That is, they aim to stabilise inflation around the inflation target, but also to some extent to stabilise output around potential output - acknowledging that because of the trade-off, unpredictable shocks, uncertainty and unavoidably imperfect control, there will always remain some variability in both inflation and the output gap.

For a small, open and less diversified economy like New Zealand, the remaining variability is likely to be substantial," he said.

Viewed in that light, the Fed's rhetoric about weighing the risks to price stability against the risks to growth could just be seen as the dilemma all central banks face.

But that leaves the question of whether there is a difference between the Fed and the Reserve Bank - not in their intellectual framework, but in their nerve.

Dr Brash has more room to manoeuvre than he used to. Expectations that inflation will remain low appear to be secure. The inflation target band has been widened from 0-2 per cent to 0-3 per cent. And the most recent policy targets agreement mandates a more flexible, Australian-style approach.

The question is whether Dr Brash is using that extra freedom to its full extent, says Adrian Orr, WestpacTrust's chief economist and former chief manager of economics, at the Reserve Bank.

If the risks are either that it might take a quarter or two longer to bring inflation back into line, or that the economy might be tipped into a tailspin, the course of action is obvious.

But the difficulty is always how to weight those risks.

Something like the output gap is a very useful construct, but it will not automatically answer the policy question for you, Mr Orr says.

He argues that, at present, the interest rate-sensitive sectors of the economy are not firing. It is the external sectors, the ones most at risk from a global slowdown, which are propelling the economy.

The tight labour market does present a risk of wage inflation, but in the present competitive environment that is more likely to affect firms' profits than to be passed on to consumers.

Given that asymmetry of risks, he says, Dr Brash could have chanced a more Fed-sized rate cut.