Inflation and Reputation: Did the Reserve Bank Slow the Economy Down?

Listener 15 June 2002.

Keywords: Macroeconomics & Money

In the 14 years when Don Brash was Governor of the Reserve Bank (RBNZ), consumer prices rose a total of 40 percent or about 2.5 percent a year. However the early part of his term was a period of disinflation. …

… In his the last 10 years the prices rose by 1.8 percent p.a, a lower rate than that of the rich OECD countries. This compares with the inflation performance of the early part of the post-war era, say from 1954./5, when New Zealand’s consumer prices also rose more slowly than the OECD’s. However in the ten years after 1954/5 the volume of GDP (the total output of the market economy) rose 4.2 percent a year, while in the last ten years the GDP rose only 3.1 percent p.a.. Brash can be satisfied with his inflation record, but he leaves unhappy with the growth rate. Is it possible that his governorship slowed the economy down?

The RBNZ argues that its monetary policy does not effect the long term growth rate on the economy. This seems to be a theoretical postulate rather than an empirical finding, for the only research the RBNZ has done on the growth rate is mechanical and not very informative. (You may have thought that they had a body of research, the policy implications of which Brash wants to implement if he becomes the National Minister of Finance. However the policies he has talked about have never been addressed systematically by the RBNZ and, indeed, the empirical evidence for their having any effect of the growth rate hardly exists.) What this lacuna means is that the RBNZ has no account of the sustainable growth rate of the economy other than it will chug along at its past trend growth rate.

So the RBNZ sets its interest rates by looking at the degree to which inflationary pressures are building up, notably by assessing the cost push elements that appear to be rising, and the size of what it thinks is the output gap. The first element is that if everyone says they are soon having to push up prices then there is a worry about inflation. The second element assumes that a narrowing of the gap between what the economy is actually producing and what it is capable of producing, shortages will lead to prices and wages being hiked to deal with the bottlenecks. But assessing any output gap involves some notion of the sustainable growth rate of the economy. That is where the RBNZ’s thinking is primitive.

Suppose the sustainable growth rate were to rise from 3.1 percent to 4.2. percent p.a. (I dont think it has jumped by that amount, but it may have risen a bit in recent years, for reasons that I will have to write about in another column.) How would the RBNZ respond? The short answer is its approach means it could not. Using the old trend rate, the output gap would seem smaller than it was, and the RBNZ would take monetary measures to slow down the economy. If it was successful that would constrain the economic growth rate to the 3.1 percent p.a. of the economy. Businesses would conclude that if they would be unwise to plan on the basis of a growth rate of the economy any higher than 3.1 percent p.a. Thus the outdated RBNZ trend growth rate assumption could become a self-fulfilling prophecy.

This may be happening. In March and May of this year the RBNZ faced conflicting evidence about the inflationary state of the economy. Almost all the price setters were saying there was not much pressure to up their charges, and the wage setters were showing restraint too. So the cost-push elements in the economy were not strong. But in the RBNZ’s judgement the output gap appeared to be narrowing dangerously. The RBNZ, cautious over the dangers of inflation, has tightened monetary conditions, interest rates have risen.

There is one small caveat to the story. There are some cost-push pressures, but mainly in those sectors which are sensitive to higher interest rates. They are expecting them to rise, presumably because of an expectation of the RBNZ to tighten monetary conditions. Perhaps the self-fulfilling prophecy is on.

Of course, I am not sure. Perhaps the sustainable growth rate has not risen. What I am sure is that the RBNZ is not thinking sufficiently about this issue. My bet is that with the next Governor of the Reserve Bank, there will be a change in the Policy Targets Agreement which sets out the goals of monetary policy. It is likely to ask her or him to pay more attention to the impact of the RBNZ’s actions on the sustainable growth rate.

Incidentally, I dont know who will be Brash’s successor, but there is one characteristic the new Governor should have. Brash spoke widely and vigorously to business groups but in his 14 years he never once spoke to a conference of the Council of Trade Unions, even though the RBNZ assessments pay attention to wage pressures. Does that make sense in a modern economy, in the post-ECA environment?