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Beating the bank

By Donal Curtin

Friday 24th March 2006

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Who'd be a central banker? For every Alan Greenspan, retiring from the Fed showered with honours and respect, there's a hundred Alan Bollards dodging a hail of incoming tomatoes.

The tomatoes are flying thick and fast at our Alan right now. After a clutch of particularly gloomy business confidence surveys around the turn of the year, the Reserve Bank Governor stands accused of engineering a business slump. In addition, people have been quick to make the comparison between the Reserve Bank of Australia (years and years of steady economic growth, lower interest rates than here, and a steady-as-she goes coolness under fire) and ours (a cyclical rollercoaster, higher interest rates, and over-energetic use of brake and accelerator). While it's a thankless task at the best of times - all the interest groups squeal when rates go up, but there's no corresponding public vote of thanks from the country's savers - the volume of the criticism has risen sharply in recent months.

So, has the Reserve Bank lost the plot? Has it needlessly brought the economic expansion of the past three years to a halt, or even left us looking down the barrel of a recession we don't need to have?

There's no doubt that the bank has been running a very tight monetary policy, and the best way to see that is to resuscitate a measure of policy stance that has fallen into disuse - the Monetary Conditions Index, or MCI. This is an attempt to measure the combined impact of exchange rates and interest rates, and time was, pre the Monetary Policy Statement of March 1999, the bank framed its policy stance in MCI terms. It would explicitly say what sort of level of MCI it thought was appropriate to keep inflation on track.

The MCI is particularly relevant right now because both legs of it have tightened: both exchange rates and interest rates are high. The combined effect has been dramatic. In December, the MCI reached an all-time record level, higher than it was when the Reserve Bank first set out in the early 1990s to bring inflation under control, and higher than it was in late 1996 when the economy was bursting at the seams.

The guts of the criticism has to be, then, that this unprecedented degree of squeeze is disproportionate to any inflationary risks. We know, for example, that the headline rate of inflation (3.2%) is only modestly above the bank's 3% target, and we know, too, that it's been temporarily boosted by world energy prices (inflation 'ex transportation', which is the nearest Statistics NZ does to an 'ex energy' measure, is only 2.8%). Other ways of dicing the data could also leave you underwhelmed about runaway inflation. Take out central and local government charges, which have been rising faster than other costs (there's a surprise), and inflation is only 3%. Or take out housing, which we know is going to cool anyway at some point, and inflation is 2.5%. For this, we risk a recession?

Personally, I look at the data in a different way, and I think the bank is, broadly, right to be worried, and for three reasons.

One is that it's easy (especially if you have a sectoral axe to grind) to take out transient factors that reduce the 'headline' inflation rate to some lower 'underlying' rate. But it's just as easy to point to factors that have artificially lowered headline inflation - most notably, the exchange rate. If the Kiwi dollar hadn't appreciated as it did over the past few years, we could have been looking at a headline rate well over 4%.

The second is that there is a domestic nuggety core to inflation that would worry me, too, if I were in the bank's shoes. It's particularly obvious in the 'non tradables' measure of inflation, which is defined by Statistics NZ as "goods and services that do not face foreign competition" - the likes of the school 'donation', the visit to the dentist, the meal out. That measure of inflation has been running at over 4% for some time, and sometimes nearer 5% (it's currently 4.3%). As a sweeping but probably correct generalisation, where sectors aren't being constrained by import competition, they've been using the good times and the tight markets to jack up prices.

And the third is the state of the housing market. It's still a hot and unsettled debate amongst academic economists whether central banks ought to intervene in asset markets when there is a real or potential 'bubble'. Some argue a central bank is likely to be no better at spotting one than anyone else, and in any event who asked them to stick their nose into the sharemarket or the housing market? Others argue that a central bank ought to be interested in preventing the fallout from asset price booms and busts, and some would argue that, as a minimum, an asset price 'bubble' could be signalling that you've accidentally got policy 'too loose'.

Even if it was reasonably agnostic on the various debates, a central bank observing house prices up 15.8% in the year to December, and this after months and months of trying to 'jawbone' the market down, could well be forgiven for keeping rates at today's levels till there is some sign of response in the housing market.

No central bank gets things right all the time: by common consent ours tightened too late in response to the mid-1990s surge in growth, and didn't ease quickly enough in response to the Asian crisis of 1998. While there's a lot of finger-pointing going on right now, I wouldn't be too quick to conclude that the bank's made another blooper.

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