Thursday, May 04, 2006

Brian Fallow: Oil putting heavy pressure on Bollard

Will Alan Bollard trust us to trust him to keep the lid on inflation? As much as anything that is what will determine how long we continue to labour under a policy interest rate of 7.25 per cent, exceeded within the OECD only by Turkey and Iceland.

It's all about inflation expectations.

In his review of the official cash rate last week, the Reserve Bank Governor said the drop in the exchange rate and the rise in world oil prices would keep inflation above 3 per cent for longer than previously projected.

He would not try to counteract the one-off boost to prices from the exchange rate and oil price shocks.

"However, monetary policy must remain vigilant against these price shocks spilling over into inflation expectations and price and wage-setting behaviour."

Resisting that spillover is a bottom line for any inflation-targeting central bank.

There is a justified dread of returning to the bad old days of the wage-price spiral, the cost-plus mentality and the self-fulfilling expectation among businesses that their costs would keep rising relentlessly, so their own prices had better too.

Squeezing that mindset out of the system was a painful business. No one wants to go there again.

But how much risk of that is there, really?

True, confidence that we live in a low inflation environment is being sorely tested.

Annual consumer price inflation has been above the top of the Reserve Bank's 1 to 3 per cent target zone since the middle of last year.

In a recent Reuters survey of 10 economic forecasters all but three expect it still to be over 3 per cent at the end of this year - and two of them have it at 2.9 per cent. Indeed two forecasters expect inflation still to be outside the bank's comfort zone at the end of 2007.

Which raises the question of what it takes for the Governor to be in breach of his job description - the policy targets agreement with the Government. The problem is he is judged by an elastic tape measure. The agreement was amended in 2002 so that the target is no longer to keep inflation under 3 per cent in any 12-month period but only "on average over the medium term".

If "the medium term" is long enough, or if inflation is really low the rest of the time, then even 18 months or two years outside the zone can be arithmetically consistent with that.

And Bollard has another out: oil.

Without the increase in petrol prices, inflation would be 2.5 per cent not 3.3 per cent.

Ever since the inflation targeting regime was introduced in the late 1980s it has been clear that the bank should be allowed to disregard the direct effect on prices of supply shocks, such as a sharp rise in the international oil price.

Such a rise sucks spending power out of the economy.

First NZ Capital economist Jason Wong has calculated that if petrol and diesel prices stay where they are for the rest of the year then an extra $1.5 billion will be spent on those fuels compared with last year, and all else being equal $1.5 billion less will be available to spend on everything else.

For the bank to raise the cost of borrowing as well, in response to an oil-fuelled rise in headline inflation, would perversely compound the activity-sapping effect of the oil price hike.

So although Bollard has some explaining to do, to his board in the first instance and then the rest of us through monetary policy statements, he is unlikely to lose his job.

Don Brash, after all, spent two years at or above the top of the inflation target range, then 2 per cent, with impunity.

But there is perhaps a deeper sense in which Bollard has departed from the spirit, if not the rather fuzzy letter, of the policy targets agreement.

The charge is that he runs monetary policy in a manner more reactive than pre-emptive, basing decisions on current conditions when he should be focused on a medium-term horizon.

In theory he should focus on the likely balance of supply and demand in the economy two years ahead, since that is what he can influence through interest rate moves now.

In practice, the official cash rate tends to rise and fall closely in step with the headline inflation rate - the consumers price index (see graph above). When inflation is high, so is the policy interest rate.

This suggests the Reserve Bank is not so much looking ahead as looking sideways.

What might account for this is a preoccupation with inflation expectations and the need to keep them "anchored".

Some recently published research by senior Reserve Bank economist Bernard Hodgetts on the way the inflation process has changed notes that inflation expectations two years ahead have remained relatively stable over the recent economic cycle. They did not for example jump in response to the steep drop in the exchange rate in 2000, as the bank might have feared.

This makes the bank's task much easier.

"However we have been extremely wary of simply assuming that inflation expectations are 'anchored' and taking policy risks based on that assumption," Hodgetts wrote.

Bollard's warning to wage-setters last week is also somewhat at odds with the bank's own research, which suggests that the days when wage rises drove inflation are long gone.

While wages led prices in the 1980s, the relationship reversed in the 1990s, with wage movements tending to scamper along behind inflation, struggling to keep up.

Adjusted for productivity, wage settlements were often lower than inflation over much of the past 10 years, and rarely exceeded significantly, Hodgetts said.

But again the bank seems reluctant to trust this conclusion: "Helpful as this has been ... we have remained wary of the potential for wage inflation to reassert itself as a direct driver of inflation."

Which begs the question: why would Bollard expect business people setting prices to be any less wary than he is?

Bank of New Zealand economist Craig Ebert says that when firms ask him and his colleagues what inflation they should be budgeting for, "The academic reply is that we should all trust the Reserve Bank when it says don't worry, inflationary pressures will be drifting back down again before too long. But we can understand the disbelief of companies, employees and savers alike already burned as inflation has risen above the 1 to 3 per cent target band."

Businesses are dealing with real inflation pressure and their expectations inevitably reflect this, Ebert says.

Their inflation expectations right now, as recorded in the National Bank's monthly business outlook, average 3.07 per cent.

It is still above the top of the Reserve Bank's target band, of course.

But historically those expectations are closely aligned with actual inflation at the time or in the previous quarter - and no guide at all to inflation a year to two ahead.

Both Bollard and the companies themselves can take comfort in that.


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