Reserve Bank's inflation mandate unlikely to survive Covid

Saturday, 9 October 2021

What does the official cash rate mean?

OPINION: The Reserve Bank kicked off its first series of interest hikes in seven years on Wednesday amid the most inauspicious of circumstances.

Some businesses owners questioned whether it made sense for the Reserve Bank to lift the official cash rate at the same time that the Government was losing its grip on the spread of Delta.

Bank economists, on the other hand, rightly assessed that the central bank had no real choice.

Even with the rise in the official cash rate to 0.5 per cent, the Reserve Bank would not appear to be chasing down inflation.

The Reserve Bank is, after all, mandated by the Government to try to keep inflation “between 1 per cent and 3 per cent on average over the medium term”, with a particular focus on the mid-point.

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It has historically interpreted the “medium term” as the second-half of a three-year forecast horizon.

That has the convenient upshot that no action the bank takes can be proven a failure until at least two years after that action is taken.

Already inflation has risen above the upper band, hitting 3.3 per cent in the June quarter, and the Reserve Bank tips it will soon top 4 per cent.

Britain is currently looking like a canary in the coal mine when it comes to global inflation; Bank of England governor Andrew Bailey explains why it lifted its inflation forecasts in August.

But ANZ chief economist Sharon Zollner notes that even following the 25 basis point rise, the OCR remains “extremely stimulatory” at 0.5 per cent.

“We have still got really negative real interest rates.”

The Reserve Bank forecasts inflation will return “towards the 2 per cent midpoint over the medium term”.

But it has to say that – given that is the outcome it is obligated to achieve.

Reserve Bank governor Adrian Orr voiced concern in August about the situation recent home buyers might soon be in, and since then prices have risen rather than fallen. (Video first published August 19, 2021)

If the Reserve Bank was forecasting anything different, it would in effect be admitting it was already ignoring its inflation mandate.

The question is whether its forecast is believable.

Realistically, if New Zealand sees an inflation rate of 2 per cent in the next couple of years that is only going to be as a result of the economy tanking.

Inflation is currently running at 3.2 per cent (and rising fast) in the UK, 3.8 per cent in Australia and 5.4 per cent in the United States.

Like tectonic plates colliding, powerful forces are pushing New Zealand and global inflation higher.

The most intractable is the huge increase in the money supply caused by quantitative easing.

The US Federal Reserve, the European Central Bank, Britain’s Bank of England and the Bank of Japan have spent US$9 trillion on QE since the start of the Covid alone and now have US$25t sitting on their balance sheets.

Loose monetary conditions have increased people’s sense of wealth and fuelled demand by pushing house prices and share investments to precipitous levels.

The latter figure is more than a quarter of the value of all the companies listed on all the share markets in the world.

QE and loose monetary policy in general have helped inflate asset prices – principally house prices and share prices – making their owners better off on paper and giving them a false sense of their collective, future spending power.

That can only resolve itself in the long-term through inflation, asset-price crashes, or sustained increases in productivity.

At the same time, Covid and snags including Brexit and the Evergreen snarl-up, have played havoc with supply chains around the world.

ANZ chief economist Sharon Zollner says inflation targeting is going to cease being “nearly so much fun”, but there’s no point only doing it when it’s easy.

Some of those supply-chain problems may be only short-term, as the Reserve Bank suggests.

But others, including a shortage of computer chips that has knee-capped a variety of industries, look more gnarly.

Productivity growth is unlikely to ride to the rescue.

Covid has encouraged e-commerce and made it more acceptable for people to work remotely, both of which could increase productivity.

But the overall impact of Covid may be to slow productivity growth, in part by limiting labour-market mobility and because of the health-related overheads it imposes on businesses.

There are other chill winds blowing.

Climate change – and the efforts to mitigate it – are likely to constrain the supply of many goods, and some services, globally.

Rising geopolitical tensions with China can be expected to have the same effect in so far as they affect international trade and the normal conduct of business.

Under these circumstances, central banks around the world may only be able to keep inflation in check by repeatedly throwing buckets of ice over their economies.

But the Reserve Bank is now also obligated by its government mandate to “support maximum sustainable employment”.

Something is going to have to stretch or snap. Common sense, the weight of history, and especially politics all dictate that it is likely to be the inflation target.

Asset prices, including house prices and share prices, are unsustainable and are going to need to fall in real terms, one way or another, after all.

Asset prices, including house prices and share prices, are unsustainable and are going to need to fall in real terms, writes Tom Pullar-Strecker.

Tolerating a higher rate of inflation over a period of some years would arguably be a less disruptive means of bringing asset prices and wages back into balance than the alternative, which is for steep falls in nominal asset prices, otherwise known as a market crash.

Inflation may be somewhat helpful too, in whittling down the large sovereign debts that governments around the world are sitting on – in fact many are probably counting on it.

Zollner cautions against the Reserve Bank waving the white flag on inflation too early.

Central banks were made independent of governments because politicians were not prepared to do the hard yards tackling ’stagflation’ in the 1970s and instead opted to support jobs and growth, she says.

She argues the current economic situation is “looking a lot more like the 1970s shock”.

“There is no question it's getting harder – inflation-targeting is not going to be nearly so much fun.

“But if the first time you see a similar shock, you say ‘well, let's rethink the inflation-targeting regime’, then you're basically saying you only want the inflation-targeting regime when it's ‘easy’.

“In that case, you haven't actually achieved the aims of inflation-targeting in the first place, which is to anchor inflation expectations through thick and thin.”

Leo Krippner, a fellow with the economics department at Waikato University, notes that raising the 1 to 3 per cent inflation target in anticipation that it was not going to be achievable would inevitably increase inflationary expectations and to some extent become a self-fulfilling prophecy.

“I think the inflation mandate of 1 to 3 per cent remains appropriate, even when the environment might make it difficult to achieve”, he says, accepting this is one of those times.

“That gives the public confidence that inflation will not become a dominant issue to account for when they make economic and financial decisions in their daily lives.

“Once people realise the ongoing costs of higher inflation on their behaviour and the economy, history shows that it takes an economically painful and prolonged effort to bring it back down again.”

But there does come a point at which pretence becomes pointless, and shortly after that there’s a point at which it becomes counter-productive.

Shifting the goal posts on inflation could contribute to inflation getting out of hand.

But that risk will need to be balanced against the corresponding danger that bending the posts or repeatedly missing the goal entirely risks negating inflation-targeting as a credible monetary tool.

The Reserve Bank was the first central bank to be required to target a specific inflation rate in 1990, initially targeting a rate of between zero and 2 per cent.

The softer 1 to 3 per cent mandate it has been operating under since 2002 is equally arbitrary.

No-one should get too attached.