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Don't do it, Don

Tuesday 2nd May 2000

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Back in the heady days of our oh-so-cutting edge and deregulating economy, the newly-appointed Don Brash couldn't have made tighter-than-a-ducks-bum monetary policies look more chic. Lifted to a high place beyond the petty meddling of the pollies, he was the smart-dressing guru of the new monetary black-box - and clearly the most powerful man in the economy.

But it's time he changed suits. Brash's "better throttle all growth over 3% a year" approach has not served our economy well. As we head for the best growth for some time - CS First Boston is forecasting a 5.8% boost in GDP this year - let's not ramp up interest rates straight away and spoil the party.

The Australians have joined the push for change. "Brash is a nightmare. He has an appalling record as head of the Reserve Bank. Yet he still behaves as if he's God's gift to central banking," wrote the Australian Financial Review back in January. The AFR's outburst followed one of the bank's most embarrassing moments: on January 19, in an attempt to curb supposed rising inflation, it increased interest rates, expecting the December quarter consumer price index (inflation's best measure) to rise to just under 1%. Two hours later, the official CPI numbers came out at a paltry 0.2%. Almost zero inflation.

Why does the bank think the economy can't grow faster than 3%? Its doctrine is the outdated, "output gap" methodology.

It's not the first whoopsie for the governor. He's had to virtually abandon his Monetary Conditions Index - a structure whereby a fall in interest rates triggered monetary conditions to push exchange rates up, and vice versa. The MCI was invented by the bank, was used nowhere else in the world and was rigidly and clumsily applied throughout the 1990s. In fact, countering a falling currency with rising interest rates during the 1998 Asian crisis pushed us into recession. The bank has raised rates three times in the past six months, despite the economy being in recession twice in the past two years, and overall inflation being only 1% in 1999.

GDP growth versus inflation
You don't have to kill the goose

NZ  Australia  USA  France  Canada  
GDP growth
(2000 anticipated)
5.84.34.53.24.7
CPI inflation
(2000 anticipated)
1.32.13.21.42.7
Source: CS First Boston, The Economist, OECD, Bloomberg, Consensus Forecasts

The last rate rise, in March, pushed the official cash rate to 5.75% and caused uncharacteristic jeers from the business community - the sort reserved for a Jonah Lomu knock-on. Critics included the northern division of the Employers and Manufacturers Association, the Bureau of Economic Research, Merrill Lynch economist Mark Benseman and yours truly in the National Business Review. What's our beef? Just like in January and in the whole of 1999, there's no evidence inflation is about to rise.

Why does the bank think the economy can't grow faster than 3%? Its doctrine is the outdated, "output gap" methodology. This measures overheating by focusing on the difference between actual growth and the sustainable potential capacity of an economy.

Other countries, notably Australia, show they, too, can sustain high growth with low inflation. Australia did raise rates last month, the third increase in five months.

Brash isn't alone in liking the model, but some of the best practitioners, like US Federal Reserve governor Alan Greenspan, see it as just one part of the mix. They abandon it when it doesn't suit. If Greenspan had been slavishly following the theory, he'd have raised interest rates in 1997 to slow an economy barrelling along at 4% growth. In fact, he kept rates low to soothe the Asian crisis. The longest boom in US history resulted and the economy is now growing at the blistering rate of 7.3%. Note Greenspan is thinking of taking action only now, while our bank has promised stern action to pull our growth back to 3%. Other countries, notably Australia, show they, too, can sustain high growth with low inflation. Australia did raise rates last month, the third increase in five months. But, then, it does have 4%-plus growth and rising consumer spending. Latest retail figures from Statistics New Zealand show our retail spending is down 2.3%.

Fact is, inflation is far less a bogey than the old model proposes. The latest thinking in economics shows the New Economy is creating genuine productivity gains that are offsetting inflationary pressures. Really it's the "nude economy" because the Internet makes it easier for buyers and sellers to compare prices. This is good for a small economy, without resources to scatter researchers and marketers around the globe. It also cuts out middlemen, reducing transaction costs and barriers to entry.

The Bank underestimates the productivity this is creating. Its model shows an erratic picture - productivity up 5% between mid-1996 and mid-1997 and then down sharply over the next 12 months. But this is contradicted by Treasury's Diewert-Laurence study that indicates productivity gains consistently higher than Australia's, recently accelerating to 2.4%. Basically, Treasury is saying we can grow at the sustainable rate (say 3%) plus the productivity rate (2.4%) - close to the anticipated 2000 rate of 5.8%. But the Reserve Bank uses its graph as a basis for its argument for continuing caution on monetary policy.

The Reserve Bank is fully aware of the new "strong growth doesn't have to mean high inflation" argument. The issues are discussed in some detail in its March 2000 mone-tary policy statement, (from which the accompanying graphs come). But, says the bank, there isn't yet enough evidence that New Zealand will follow this "new paradigm". Reserve Bank corporate affairs manager Paul Jackman makes a convincing case (National Business Review, March 31) for acting now to anticipate expected inflation. My argument suggests we wait and see before taking what could be precipitate action. I believe the economy can grow at more than 3% without overheating. Can't we at least give 5% growth a try?

In the US, productivity is trending at 3%. The country is reaping the rewards of its investments, particularly in comp-uters. There is no reason why New Zealand cannot closely follow the US lead, especially as comp-uter costs diminish.

But Don Brash may spoil the party, once again, using an outmoded methodology holding a low view of New Zealand's product-ivity and growth potential.



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