Bollard defends inflation targeting as economy shrinks

Wednesday 30th July 2008

New Zealand's economy, teetering on the brink of recession, has been well-served by the central bank's policy of targeting inflation, though it has little ability to influence global price surges, according to Governor Alan Bollard.

"Even in the current very difficult circumstances, the flexible inflation targeting framework positions us well to manage the ongoing shocks impacting the New Zealand economy," Bollard said in notes for a speech today.

The central bank cut the official cash rate (OCR) a quarter point to 8% this month and said further cuts are likely, provided inflation peaks as expected and the local dollar doesn't decline too far. The kiwi fell as low as 73.47 US cents earlier today, a 10-month low.

Soaring prices for fuel, food and raw materials has added to Bollard's challenge in managing inflation in a slowing economy. He predicts inflation will peak at 5% in the September quarter and slip back within the bank's 1% to 3% target band in the medium term.

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New Zealand was the first nation in the world to adopt an explicit inflation target in 1990, a policy that is now standard for most central banks. Concern that the Policy Targets Agreement may need updating or rethinking as the economy faces stagflation, prompted Parliament's finance committee to initiate an inquiry into the framework.

"When shocks are persistent, as with oil and food prices currently, it is difficult to judge the appropriate response," Bollard said. "The extraordinary oil price rise in particular has left New Zealand poorer and we all need to recognize this."

Associate Finance Minister Trevor Mallard this month said the central bank's policy tools haven't been able to address the impact of record high prices for fuel and food, and the government is "open to looking at alternatives."

The comments were cheered by the New Zealand Manufacturers and Exporters Association, which said the bank's inflation battle has had a devastating impact on their returns. High interest rates drive up demand for the Kiwi, which erodes returns for exporters.

Bollard today warned that companies have to avoid passing on higher costs to customers as the central bank must ensure inflation shocks don't translate into so-called second-round inflation.

That may be the toughest ask for companies. The most businesses since 1987 expect cost increases over the next three months and they're preparing to pass them on to customers, according to the New Zealand Institute of Economic Research's Quarterly Survey of business opinion this month.

By Jonathan Underhill

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