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Will relaxing the inflation target increase our wealth


Friday 23rd August 2002

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Will relaxing the inflation target make us richer?

That is the nub of the debate Finance Minister Michael Cullen is leading while renegotiating a new Policy Targets Agreement (PTA) with Alan Bollard, the replacement for Don Brash as Reserve Bank Governor.

The surprise appointment of the Treasury Secretary seems to be the first step on the path to a less doctrinaire, more pragmatic path towards achieving price stability.

Dr Bollard, in his 4-1/2 years as head of the Government's financial advisory department, has steered it away from a free market, ideologically driven body towards more open thinking.

There is unsubstantiated talk he has been frustrated at No 1 The Terrace -- that growth has been repeatedly squashed by the bank and that's why he is moving across the road. He wouldn't comment yesterday on that or whether the RB's 0-3 percent inflation target should be modified.

Dr Cullen was also coy, but he gave some pretty broad hints that there would be change. And the changes would be more concrete than those made to PTA in 1999 or those made by NZ First leader Winston Peters in 1996.

Mr Peters required the bank to take note of New Zealand's need for sustainable growth, while Dr Cullen asked the bank to avoid unnecessary market and output volatility when setting monetary policy.

Both essentially wanted the bank to be more flexible and both were blithely ignored by Dr Brash, who never wavered from his original mantra that "a stable price level is the only enduring contribution monetary policy can make to our economic well-being".

Dr Cullen said yesterday he did not want to widen the 0-3 percent inflation target. But he wanted "monetary policy outcomes to move closer to those of Australia".

The Australian central bank is directed to keep inflation within a 2 to 3 percent band on average over the business cycle. That is interpreted as not necessarily slamming on the brakes if inflation over 3 percent but the economy is back-pedalling.

Other options Dr Cullen is mulling include abandoning a target band in favour of a single point target or simply narrowing the band to 1-3.

The change in the band would force the bank to aim at a higher mid-point than the current 1.5 percent bull's-eye. The bank argues there would be no practical difference, that it has been operating policy flexibly as evidenced by the 2.5 percent average inflation rate over the last three years.

A single point target was recommended by Professor Lars Svensson of Sweden in his independent review of monetary policy last year, but was then rejected by Dr Cullen.

The debate has been consistent since the inflation target was formally introduced in 1990. Almost no one advocates higher inflation, but critics of the narrow target, including farmers, business and unions, want the bank to look at a wider timespan to smooth the peaks and troughs.

Some, such, as Council of Trade Unions economist Peter Conway, argue squeezing the last drop of inflation from the economy has greater costs than benefits.

"No-one wants to see it persistently above 3 percent. The issue is if you're driving down below 2 percent too hard then what effect does that have on growth," he said.

Business New Zealand does not want the target changed but agrees the time focus should be moved out from 12 months to the "medium-term".

Dr Brash believes the alarm bells should be clanging with Dr Cullen's proposed changes. To lift the target floor would encourage the perception of greater tolerance to inflation.

"Dr Cullen must avoid even the perception of being more tolerant of inflation because of the adverse impact this would have on long term interest rates."

This whole debate has arisen from the frustration that New Zealand cannot achieve a stronger growth rate -- having fallen well behind Australia through the 1990s and rapidly slipping down the OECD ladder.

The RB believes New Zealand's non-inflationary growth cannot exceed 3 percent without substantial productivity growth.

There is a widespread feeling that every time the economy gets some momentum the bank stomps on it by raising interest rates.

But achieving per capita growth of 4 percent a year for 20 years to achieve the Government's goal of getting New Zealand back to the top half of the OECD is no easy task. Blaming monetary policy for not getting there may be easier.

It is interesting to note that during the first half of the 1990s when the inflation target was 0-2 percent, economic growth averaged 4 percent-plus. Since the target was relaxed in 1996, it has averaged under 3 percent.

However, even the Business Roundtable does not draw a relationship between the two sets of numbers. It blames backsliding on the economic reform process and increased government spending for the growth slowdown.

Roundtable executive director Roger Kerr said there is no evidence that a more relaxed approach to inflation targeting produced faster growth.

He warns that if inflation averaged 2.5 percent over a decade, the Consumer Price Index would rise 28 percent -- far short of stable prices.

Mr Kerr said there was no solid analysis that Australia's superior growth rate was down to a difference in the operation of monetary policy. Indeed, he argues there has been virtually no difference in how the two central banks have operated over the last three or four years.

Economist and former RB board member, Suzanne Snively, now a partner at PriceWaterhouseCoopers, agrees evidence is lacking but she said the RB should provide it.

There was no issue with the single objective of price stability, but there is more than one pathway to it, she said.

It comes down to the sophistication of the RB's economic modelling.

"I don't believe that we currently have the analytical ability to have tested that and I think it's the Reserve Bank's job and responsibility to test those things."

It all comes down to what is meant by long-term and how the adjustment process was conducted.

Ms Snively said the real thing that should be targeted in the economy is the wellbeing and welfare of the people who live in it.

New Zealand had slipped from fourth in terms of wealth in the OECD in 1972, to ninth in 1984, and 26th by 1996.

"If you are perpetually telling people to tighten their belts and the economy is going backwards, then you have to ask yourselves, `are we doing it the right way?' Certainly in the 1990s our growth rates relative to the rich countries fell back dramatically," she said..

"Given than we didn't ever look at the inflation targeting in relation to these measures, my hypothesis is we need to understand that better and analyse it."

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