Inflation outcome alone too narrow to gauge RBNZ policy decisions

Monday 2nd November 2015

The Reserve Bank says its policy decisions can't be judged solely on the level of inflation in the country, as it has to maintain the credibility of its operating framework and can be trumped by new information, according to a research paper published by central bank officials.

Governor Graeme Wheeler's framework in finalising monetary policy decisions has attracted criticism in recent months, with legislation putting him in sole charge even if the practice is to set the benchmark rate through committee. In September, Wheeler defended his decision to hike rates last year, saying they were the right ones to make with the data the bank had at the time given New Zealand was the only country in the world running positive output gaps.

A Reserve Bank bulletin paper by officials Dean Ford, Elizabeth Kendall and Adam Richardson on evaluating monetary policy says gauging decisions on inflation alone isn't sufficient, as it misses how unexpected events affect consumer prices, and that the central bank's flexible target grants it scope to influence the speed of bringing inflation back to target.

The bank has to make its assessments before the event, based on a credible forecast, which its board will review to see whether reasonable processes have been followed.

"Given the uncertainties, it is not expected that the bank will always get its forecasts right, but that it will respond in a reasonable manner as new information becomes available, especially if this new information differs from earlier expectations," the research paper said.

That means the way it communicates is important to maintain the credibility of the framework, and keeping the market appropriately informed.

Using the 2014 rate hike cycle as an example, the paper says the outlook for New Zealand's economy was "very positive" with inflationary pressures mounting, and it was seen as prudent to embark on tighter policy.

"However, several unforeseen circumstances led to inflation being weaker than expected - including significant falls in the prices of oil and our commodity exports, a stronger-than-expected exchange rate, weaker-than-expected capacity pressures, and weaker-than-expected non-tradables inflation," it said.

The paper says the RBNZ responded reasonably to the new information, "progressively" easing its tightening bias with reductions in the forecast track for the 90-bank bill rate, often seen as a proxy for the official cash rate, ahead of an eventual cut in June of this year.

That move was seen as being effective because it led to lower retail interest rates, and upheld the system's credibility because medium-term inflation expectations are still near the 2 percent midpoint target, despite falling over the past six months.

"Continuous learning about the state of the economy is important to ensure that monetary policy is set appropriately," the paper said.

BusinessDesk.co.nz

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