Pity Dr Bollard
One can only feel sympathy for the awful position the Reserve Bank Governor has been placed in. Part of the solution to getting inflation down (domestic inflation is at over 4%) is to reduce expectations of future inflation. It isn’t just about house prices and the level of government spending. If people expect 5% inflation then they ask for 5% pay rises and then employers put prices up by 5% etc etc. Some people say the RB Governor’s most powerful weapon is his megaphone.
The problem is the Government is undermining this. When the Foreign Minister says he wants to change the law away from targeting low inflation, then expectations are affected – especially when the Government says they won’t vote against it at first reading. Even worse, when the Finance Minister publicly muses about using the emergency powers to suspend the agreed inflation target range, that is a massive signal regarding inflation expectations.
I am surprised that Dr Cullen is blundering so badly, as generally he has been a fairly solid performer. But it reminds me of something I blogged six weeks or so ago. This Government has never faced a really tough economic issue. They have never had to confront a $5 billion deficit or an Asian Crisis. They have never had to deal with doing something very unpopular but economically necessary.
You see the current level of the dollar is not a crisis. Yes there are sectors which will be really hurting. But the country is not about to go into recession. Home owners are not going to be defaulting by the thousands. There is no emergency which comes closes to justifying the Finance Minister musing abous suspending monetary policy. All we have is a Government which can’t handle the pressure and is undermining the Reserve Bank in its task to keep inflation low.
The Herald reports that most economists are saying the Reserve Bank must now raise interest rates next week, or be seen not to be independent.
Brian Fallow reviews what is causing the inflation and why the Governor must increase the cash rate. He quotes Westpac chief economist Brendan O’Donovan as sayign he expects a hike not just next week but also in September. If this is the case, I wonder if Dr Bollard would be better to do a 0.5% hike next week instead of the minimum 0.25%. This would be a very clear signal that the RB remains dedicated to pushing inflation down and would help reduce expectations of higher inflation. That way it might then be his last rise.
John Armstrong reviews Dr Cullen’s actions:
If he does not suspend the Reserve Bank’s primary focus on controlling inflation, he will be accused of making empty threats and his credibility will take another knock among those suffering from the high dollar and interest rates. And more so should the bank’s governor, Alan Bollard, again hike the official cash rate next week.
Alternatively, if Cullen does follow through, he risks his credibility being completely ravaged if it creates more problems than it solves – as many economists fear would happen.
In threatening to override the bank’s priority of price stability and require it to avoid damaging the exchange rate, Cullen has shaken monetary policy to the core.
Suspending the priority on tackling inflation for 12 months may be fine in a recession. In an overheating economy, it is a recipe for disaster.
Uncertainty about the direction of economic policy might see lenders add a premium to interest rates, while the tight labour market would likely provoke a wage-price spiral upwards. Labour’s record as a credible economic manager would correspondingly spiral downwards.
Don Brash was on Agenda this morning. He agreed with Fallow that Cullen’s intervention means that Bollard almost has no alternative to increase rates. Brash also made the point that so many have missed – the real solution is to make changes which will increase productivity which will allow the level of non inflationary growth to increase.
Brash also made the point that high inflation does not help exporters in the long run. He reminds us that once the NZ$ was $1.12 vs the US yet today exporters struggle at $0.80. The reason is because over time our inflation has been higher than our trading partners. The Zespri CEO agreed 100% that relaxing the inflation limit would not help exporters. He said the dollar goes up and down but once inflation goes up it never goes down (in terms of the price level).
Fallow on Agenda stressed the point I made above, that Cullen’s statements may lead to an increase in pricing expectations and undermine Bollard’s job to reduce them.
While most of the focus has been on Cullen for his foolish talk of suspending monetary policy, I should also say that I think John Key should resist the temptation to say whether or not he thinks Dr Bollard should or should not increase the cash rate. If he gets into a habit of saying what he thinks the RB Governor should do as Opposition Leader, then he may find it hard to not comment if he is Prime Minister. This is not to say he shouldn’t comment generally on monetary policy, where he thinks the dollar is heading etc. He has considerable expertise in these. But politicians are best not to specifically state what they think the Governor should do with the cash rate.