Why the Reserve Bank could be forced to shelve its inflation target

Tuesday, 7 March 2023

Inflation is expected to stay above target for 3 year and three months, raising questions about just what the government-set target means.

Tom Pullar-Strecker is a senior business journalist at Stuff.

ANALYSIS: If the Reserve Bank is right, we’re about halfway through a period of just over three years when inflation will have been sitting outside its 1% to 3% target band.

Inflation has been above 3% for 20 months and, based on the bank’s projections, it won’t drop back under that bar until September next year.

Can the bank get inflation down by then, and if it took longer, would that really matter?

Economic forecasts shift like the sands, but the current concern is that global inflation is getting a second wind.

* Reserve Bank hikes official cash rate to 4.75%

* Reserve Bank's inflation mandate unlikely to survive Covid

Figures on Thursday showed annual inflation in Europe slipped only slightly to 8.5% in January, from 8.6% in December, with “core” inflation, excluding food and petrol, rising to 5.6%.

The situation in the US is similar.

Annual inflation there dropped from 7.2% to 6.4% between December and January, but the 0.5% monthly increase was the highest rise since June and far above expectations.

Waikato University honorary professor Leo Krippner, who accurately sounded the alarm bells over the possible extent of looming inflationary pressures in April 2021 when annual inflation had last been measured at just 1.4%, fears interest rates may not have risen enough to reduce demand.

ANZ chief economist Sharon Zollner says inflation is a “pain in the neck” but if it was entirely predictable, then its costs would be minimal.

“Central banks have tightened interest rates to try and bring inflation down, but, at present, ‘real’ interest rates are still at negative levels,” he notes.

ANZ chief economist Sharon Zollner also believes stubborn global inflation may prove more than just a pothole.

“If inflation doesn’t obediently fall all the way back to target like we're all forecasting it to – and I certainly see the risks as tilted in that direction –then I think at some point there will be questions asked by politicians about whether the ‘pain is worth it’, or whetherwe should settle for getting inflation down to some more middle-sized number for a few years,” she says.

“I fully expect that to become a very loud debate over the next year or two and I wouldn't rule out that some countries’ politicians might decide to change their inflation targets.”

If major economies decided to live with higher inflation, that could make getting inflation under 3% here a tougher exercise, and arguably not even a sensible one, Zollner suggests.

New Zealand's traditional model has been that domestic inflation runs at 3%, “tradeable” inflation caused by inflation overseas runs at 1%, “and that gives you a consumer price index at 2%”, she says.

“If tradeable inflation is going to run at 4% or 5% and there's nothing that you can do about that, would it be reasonable to drive your domestic economy to deflation, in order to achieve average inflation of 2%?”

Zollner says she isn’t predicting politicians will abandon the inflation target. “But I think it's going to come under pressure in the next few years in a way it hasn't before.”

“I wouldn't say New Zealand would necessarily be the first place to let inflation go, but if everyone else did, then it would be very hard to hold the line.”

Reserve Bank governor Adrian Orr may have been mulling that when he observed at the NZ Economics Forum hosted by Waikato University on Friday that the bank needed to bring inflation back down to target “over a reasonable horizon” so as not to unnecessarily crash the economy.

Or perhaps, having already issued a monetary policy statement and raised the official cash rate by 0.5% the previous week, he had nothing else much to put in his speech beyond a run down on the trade-offs always in front of the central bank.

The question of why it might matter if the Reserve Bank did take longer to bring down inflation is trickier than it seems.

While out-of-control, spiralling, and even just strong, unpredictable variations in inflation (either up or down) do have clear economic costs, there are few reasons in theory why inflation sitting at, say, 5% is much “worse”, as such, than inflation at 2%.

People would be paying higher prices for goods and services they bought over time but, collectively, they would be getting more money for those goods and services also – the two have to add up.

“If inflation was 5%, give or take 0.5%, year after year, then people could just live with it and that'd be fine,” Zollner says.

“If it was predictable, then the costs of inflation are minimal, because everyone can build it into their decision-making.”

But the experience of the past couple of years shows that is not how most people see inflation, she observes.

“Inflation is a pain in the neck. Unemployment is an existential threat. Unemployment is definitely more painful than inflation. Yet – maybe it’s not rational – but people really hate it.”

It would also be fair to say that the easiest way to make inflation predictable is for a central bank to set a target band for inflation and then show it is prepared to defend that through thick and thin.

Abandoning an existing target and starting again from scratch would reset a central bank’s credibility at zero.

Krippner believes the current targeting regime can be salvaged and perhaps even strengthened by the current testing times.

If central banks bring inflation back to target in a reasonable timeframe, then there is no reason think their current miss would be tremendously detrimental to the credibility of their targeting regimes, he says.

“If anything, it would enhance central banks’ credibility that they had taken higher inflation seriously; they might have ‘got it wrong’, but then gone on to show they were prepared to correct that.”

If on the other hand, New Zealand’s current inflation-targeting regime can’t be resuscitated, as Zollner observes, “it has had a pretty good run”.

In that scenario, don’t expect an admission of defeat to come easily or early, she suggests.

“Central banks have got every incentive to talk super-tough on inflation, until they decide the job is done, just like a politician will ‘deny, deny, deny’ they’re resigning until they suddenly quit. There’s nothing to be gained from expressing uncertainty.”