Excellent Editorial from the New Zealand Herald Today

The Editorial from the Herald is spot on:

Eyebrows were raised this week when the Reserve Bank Governor castigated banks, oil companies and food manufacturers for not bringing down prices as much as they should. In a speech entitled "Everyone needs to play their part," Alan Bollard also told power companies not to keep pushing up prices and chastised local bodies for not keeping rate rises under the level of inflation. It was a sweeping assault aimed specifically at ensuring inflationary pressures continue to be dampened. More broadly, however, it was a welcome marker in a time of extraordinary economic stress.

Some of those criticised by Dr Bollard were quick to fire back. One or two had more reason than others. But the response from the Auckland City Council and the banks suggested that, at least in their cases, the governor's attack had been witheringly accurate. Most lamentably, councillor Doug Armstrong suggested Dr Bollard was wrong because Auckland City had managed to keep its rate rises within the "council rate of inflation". The only problem is that this year's council rate, the basis for rates and water bill increases, is 5.1 per cent. Over the past three years, the official rate of inflation has averaged just 3.2 per cent. As Dr Bollard suggests, councils have got into the habit of passing on big increases and not thinking too deeply about it. It is not, after all, their money.

The banks, also, had no valid comeback to the governor's surprise at not seeing more "pass-through" from the Reserve Bank's slashing of the official cash rate. Short-term mortgage rates have been cut but not by as much as the OCR reductions. The banks, variously, attributed this to the increased cost of borrowing overseas, a wish not to reduce deposit rates by a similar rate, and Government charges for the bank deposit guarantee scheme.

To heap blame on a scheme funded by the taxpayer for the good of the banking sector is ungracious, to say the least. So, too, is the lack of any acknowledgment that banks happily extracted huge profits before the United States sub-prime mortgage crisis bit. According to accounting firm KPMG, the big banks made combined profits of $4.8 billion before tax last year. Dr Bollard says they cannot expect to maintain high profit margins in the current environment. Asking them to come to the party seems particularly reasonable, given the underpinning they have received from the taxpayer.

Other industry sectors have not received such largesse. Some also point to an inherent conflict between Dr Bollard's wish and their responsibilities to their shareholders. But most companies will, in any case, be wary of lifting their prices for fear of losing out to competitors. Those who do and suffer for it will, ultimately, have served their shareholders badly. Dr Bollard has, of course, spent the past few years delivering stern and unpalatable messages. His entreaties to householders about their ongoing spending spree went largely unanswered. So, too, did his message to banks that some of their lending practices were rash. Now, his cutting of the official cash rate seeks to prise open people's chequebooks. There may be difficulties there, too, because many are worried about losing their jobs.

It will take even longer if the councils and companies targeted by Dr Bollard do not pull their weight. He will find it hard to keep cutting interest rates if there is no evidence that inflationary pressures are reducing significantly across the board. If such were the case, a vital stimulus would be lost. That would hinder not only economic recovery but the profitability or performance of each of the enterprises targeted by Dr Bollard. They have a vested interest in playing their part.

They should heed the governor.

BNZ on the inflation menace and the Reserve Bank

From the BNZ Strategist dated 14 August 2008

"Unrelated to the cycle but of significant importance to New Zealand’s medium term prognosis is the approach that the Reserve Bank of New Zealand takes to containing inflation. Recently inflation has burst through the top end of the Bank’s target band. The RBNZ can be excused for much of this as the major driver has been a global supply shock, the first round impacts of which the Bank has no influence over.

What concerns us more, though, is what the Reserve Bank is doing in terms of its inflation target. We can’t help but feel that the RBNZ has gone soft on inflation. There no longer appears to be any great desire to get annual inflation back to the mid point of the target band. Rather, anything under 3.0% seems to do.

We might well be wrong in jumping to this conclusion but this increasingly appears to be the accepted view of folk in financial markets.

There is a large body of research that says if you are to be an effective central bank

(a) inflation expectations need to be anchored and

(b) there needs to be a clearly identified and understood target.

We would contend that there is increasing uncertainty about both. It should thus be of no surprise that inflation expectations seem increasingly to be headed for 3.0%. While, so far, this is an adaptive response to rising headline inflation, there is a real danger that they get stuck there which will ensure that the central bank’s job gets harder and that the neutral nominal interest rate will be higher than would otherwise have been the case.

If this is so, start getting used to higher interest rates, on average, for longer than has been the case. And for the populace as a whole remember that the higher is inflation, the harder the hit to those on fixed incomes and the less well off. " Unquote

Exactly my point, see earlier post on inflation - KT

The inflation menace is up and running.

Inflation is the world’s major menace, and it hasn’t gone away, just been asleep for a few years. Global inflation is back, and this will be the theme for some years, perhaps into the end of 2010, as central banks grapple with resurging inflationary pressures.

The problem is, they are not tackling inflation the way they should be.

There are two schools of thought on what a central banks job should actually be in setting monetary policy.

One is that central banks should go for growth (and other more nebulous targets) and try to kick start the collapsing growth in their economies by lowering interest rates.

This ignores the reality that Japan has had low to zero interest rates for 10 years, and sadly, no resulting growth.

Equally it ignores the fact that New Zealand has had the highest interest rates in the western world for a number of years and has had reasonable growth, only slowing this year as global growth tumbled on the back of the credit crisis.

So it is plain that the level of interest rates is not necessarily a driver of the level of growth in an economy. Growth is a function of many elements; the relative level of interest rates does not solely drive it.

Consumer confidence, wage rates, tax rates, government policies, property values, exchange rates, the level of productivity, these and many other factors all contribute to drive growth pressures. Central banks who ignore inflation and change interest rates to target growth do so at their peril.

Recent examples are the US, New Zealand and maybe, Australia.

The second school of thought, and my preference, is that central banks should solely focus on inflation and nothing else. The level of interest rates is set to control inflationary pressures, be they primary as in oil and food shocks, or secondary in transport cost increases and plastic prices increases, to name but a couple of obvious ones. In my view, the job of a central bank is to control inflation, even, if necessary, through a recession. (By the way, a recession does NOT necessarily mean no inflation).

Example: The European Central Bank: probably the best CB in the world.

The US has the excuse in being willful on inflation because of the sub prime disaster and their property meltdown, flowing into the credit crisis. The reality remains that banks lent money to people who could not repay it, over properties that were vastly over priced. It is not the role of a central bank to bail out bad lending decisions. With US inflation at close to 6% and US interest rates at 2%, they have negative real interest rates. This is madness. The price is higher inflation, with recent US data being the highest in 17 years and set to go higher yet.

Here in New Zealand, The Reserve Bank of New Zealand has no such excuse, and lowering interest rates when they are forecasting higher inflation is worse than madness, it is simply not doing their job.

Governor Alan Bollard is gambling that the slow down in the economy will compensate for the higher (one off) prices feeding through from (principally) higher food and oil prices. He is right to look through these one off impacts.

But he is wrong that secondary inflation pressures will not result. Every company I have spoken to is seeing price increases across the board. Bollard thinks they will not be passed on because of the pressures of falling sales.

I have news and its all bad for the Reserve Bank. Companies would rather sell less at a profit than more at a loss. Everyone is putting up prices to recover margin, and what is worse, people expect prices to go up, so inflationary expectations are rising quickly.

The very thing he is there to defend against is happening, inflationary expectations are rising, and once that rabbit is out of the hat, there is no catching it again without a huge amount of pain.

No growth and high inflation is the fear of any government but sadly, that is where we are headed again.

Excellent article by Brian Fallow

Brian Fallow: Keep focus on targeting inflation

5:00AM Thursday August 07, 2008 By Brian Fallow

It has been as long in gestation as a baby rhinoceros, but the outcome of the finance and expenditure select committee's inquiry into the monetary policy framework is expected soon.

If a week is a long time in politics, 15 months is an eternity.

The inquiry was launched against a background where the Reserve Bank had driven interest rates sky high in a bid to deflate a housing market bubble and rein in the associated debt-fuelled spending binge, in the process saddling the export sector with painfully high exchange rates.

But a lot has changed since then.

The housing boom has turned to bust. The world is no longer awash with cheap money; on the contrary, a credit crunch has made the imported savings upon which we rely a lot more expensive. Interest rates, the dollar and petrol prices are falling. But even with its recent fall, crude oil costs almost twice what it did when the select committee's terms of reference were agreed. And while inflation then was running at 2 per cent, we are now staring down the barrel of 5 per cent.

The point is that this would be the worst possible time for politicians to undermine the credibility of the monetary policy regime.

The challenge monetary policy faces has switched from dealing with runaway house price inflation and its spillover effects on household debt and consumption to how to keep the lid on inflation expectations in the face of a sustained oil shock. "The currently high level of inflation, if sustained, might lead the public to revise up its expectations for longer-term inflation.

"If that were to occur, and those revised expectations were to become embedded in the domestic wage- and price-setting process, we could see an unwelcome rise in actual inflation over the longer term. A critical responsibility of monetary policy-makers is to prevent that process from taking hold."

These are not the words of Reserve Bank Governor Alan Bollard, though he has made the same point several times in recent months. It was his American counterpart, Federal Reserve chairman Ben Bernanke, testifying to Congress last month.

With inflation across the developed would running at 4.4 per cent, this is not just a local problem.
Under a flexible inflation-targeting regime, such as we have here, the appropriate central bank response to a surge in oil prices is to "look through" it, allow the shift in relative prices to do its work and not tighten policy.

But the caveat - repeated with increasing urgency by central bankers lately - is that that tolerance cannot extent to "second round" effects, where people try to avoid a drop in real wages or profit margins by passing on higher costs to their employers or customers, creating a persistent inflationary spiral.

In embarking on an easing cycle two weeks ago, Bollard is in effect trusting to the severity of the recession and the flexibility of labour and product markets to avert that danger. Much as people might want to pass on higher costs, they might not be able to.

But that is a gamble on his part, because one of the big structural changes which has occurred in the economy has been the shift to a much tighter labour market.

Such is the gap in incomes between New Zealand and Australia, and most other developed countries, that we lose almost as many Kiwis as we gain immigrants. Net migration, while positive, consequently does little to offset the dominant demographic trend of an ageing population.

So unemployment has been low and labour force participation high by historical and international standards. We will get some fresh data this morning on whether that has changed much.

But even if it has and the danger of an old-fashioned wage-price spiral passes, and even if petrol prices continue to fall, the underlying trends look as if they are here to stay. The challenges posed by a common labour market with Australia will remain. So will an oil price outlook driven by relentlessly rising demand in Asia and a rising cost curve on the supply side, even if there is some temporary relief at the heavy cost of a global economic slowdown.

So can the monetary policy framework cope?

"This framework has worked well ... [It] was designed to have the necessary flexibility to cope with the business cycle, shocks that may occur, the inevitable errors in forecasting and lags in the effects of policy decisions. The framework does not assume that inflation can be fine-tuned over short periods."

Again, these are not Bollard's words, but those of his Australian counterpart Glenn Stevens last month. They are, however, very much in line with Bollard's trenchant defence of the current regime in a speech last week.

He pointed out that real per capita incomes had grown more rapidly in the low inflation environment since 1990 than in the high-inflation 1970s and 1980s.

He pointed out that most developed countries had followed New Zealand in adopting an inflation target for monetary policy and that our target band was a middle-of-the road one.

In an implicit response to Winston Peters he said the "superficially attractive" option of requiring monetary policy to pursue multiple objectives such as growth, employment, exports and the balance of payments had been tried before, here and abroad, and found to result in stop-go policies and high inflation.

Inflation expectations have been on a clear upward trend since the start of the decade, rising from less than 2 per cent then to nearly 3 per cent now in the Reserve Bank's own survey. The National Bank's business outlook survey has expectations higher still.

And with the Reserve Bank itself forecasting inflation to hit 5 per cent in the September quarter (which it hopes will be the peak), confidence that we are still in a low-inflation environment will come under further strain.

Yet even at this delicate juncture it appears that the Government is prepared to undermine that confidence by politicising the monetary policy arrangements.

Associate Finance Minister Trevor Mallard said in Parliament early last month - and not at all off the cuff - that the tools available to the Reserve Bank had not been able to address the inflation challenges presented first by the housing market and latterly by high oil and food prices. "In fact in the first case it could be argued they exacerbated the problem."

The Government was open to looking at alternatives, Mallard said. But, when pressed the following day about what they might be, he said: "I'm not proposing any change at all and I want to make it absolutely clear no decisions or current proposals are before the Government."

The financial markets seem to have looked at the political polls and Bill English's defence of the status quo and concluded that the issue is moot.

But the risk remains that Labour will have another go at making this an issue of political branding ahead of the the election, sacrifice 20 years of bipartisan support for the inflation-targeting regime and undermine the Reserve Bank's credibility - just when we need it most.

Hat Tip: The visible hand in economics

I totally agree with all the above...both Cullen and Bollard are guessing that they are right about inflation coming down in the medium term...but if they are wrong, we and all the country pay a terrible price, anyone remember the inflation of the seventies?

They are gambling with our low inflation futures!

But then, they will not be around to worry about it. KT

RBNZ Intervention disappears

The Reserve Bank of New Zealand (RBNZ) said on Friday it sold a net NZ$14 million ($10.8 million) of New Zealand dollars on the spot foreign exchange market during November.

The figure compares with a net NZ$10 million sold in October.

Back in June, the RBNZ sold a net NZ$736 million when it intervened on foreign exchange markets for the first time since the New Zealand dollar was floated 22 years ago to limit the rise in the kiwi. The figures are not a direct and complete indication of the amount spent on intervention and include liabilities of the New Zealand government's Debt Management Office.

Data from the central bank also showed its net short currency position - a figure which the RBNZ has said better reflects its currency dealings - rose to NZ$2.48 billion from NZ$2.4 billion in October.

Given that they began intervening at 0.7620 on 11 June 2007, their average is probably around 0.7700. So they are breaking even at present.

Lets hope they have learned, that it is best to let the markets find their own level.
What that true level is, nobody knows, least of all a central bank.

RBNZ intervention numbers out

Figures released today show the RBNZ sold a net NZD702 mln in June. The first intervention (officially confirmed) was on 11 June when the NZD/USD was at 0.7620, with other unconfirmed interventions happening in June and July at various higher levels.

Given that the NZD/USD is currently at nearly two month lows of 0.7570, I would say, at this point anyway, the RBNZ is ahead of the game!

How the Reserve Bank of New Zealand should manage Monetary Policy

Monetary policy appears to be ineffective and the Reserve Bank is losing credibility. Through 2006 the Governor, Alan Bollard, regularly threatened the markets with a rate rise, but in the end none came.

It should make some sense that with that much talk surely there must have been some action? I argue to the contrary; to make a bigger impact the Reserve Bank needs to say less. A lot less.

For the Reserve Bank to be effective, it needs to employ silence. Alan Bollard has yet to twig that markets love volatility and cannot make money in times of stability. Each time the Reserve Bank speaks, ostensibly in the interests of transparency, the New Zealand markets react. Not to what Mr Bollard says, but the way he says it, and more importantly, what he doesn’t say. They ignore the lines of text in favour of reading the bits in between.

2006 was a good example of this. First the markets were convinced that the Reserve Bank was going to lower interest rates as the economy slowed. Indeed, in March, the Reserve bank said that it did “not expect to raise interest rates again in this cycle”, which itself was a further softening of the language it used in January.

By June the rhetoric had slipped further, to “we do not expect to tighten policy in response to the high headline inflation in the short term. But, equally, we cannot afford to ease policy until we have more certainty that future inflation outcomes will be trending down comfortably below 3 per cent. Given this situation, we see no scope for an easing of the OCR this year.”

Then in September the language started to reverse: ”we are less confident that no further policy tightening will be required in this cycle. In this regard, we will want to be clearer about the economic situation and outlook. However, there is clearly no prospect of an OCR cut for some considerable time.”

By the end of the year the Reserve Bank was outright threatening: “further tightening cannot therefore be ruled out. This will depend on economic outcomes and in particular the emerging trends in housing and domestic demand indicators. Any easing of policy must remain some considerable way off.”

All this had a dramatic impact not only on the market setting of interest rates, but more dramatically on the value of the New Zealand dollar. And yet in the course of the year the Reserve Bank actually did … nothing.

In contrast to the style of management here the Reserve Bank of Australia (“RBA”) has a much simpler plan. If it has nothing to do, it has nothing to say. As a result the Australian currency and interest rate markets tend not to be pitched around by loose words.

The RBA meets 11 times a year to discuss the setting of interest rates, but when it makes no interest rate change it says nothing more than it agreed to make no change. Four times a year it states its case for how and why it is managing monetary policy, but these Statement on Monetary Policy documents are mostly read by insomniacs. The Statements only get read thoroughly when the RBA has something to say.

That meant that through 2005 there were few words written by the RBA and the markets had little to react to. It was only last year when the RBA communicated often, as it was changing rates (relatively) often.

For New Zealand’s monetary policy to be more effective the Reserve Bank need only mimic the RBA’s process:

Discuss interest rate settings each month (not 6 weekly).
If there is no change made, make no comment.
Publish the Monetary Policy Statement 4 times a year at different dates from the regular monthly meeting.

By limiting what is said through the year to only what is relevant the words published will receive the interest they deserve. Volatility will diminish and markets will not create instability as they jump at each Reserve Bank threat.

Who knows, households may then move back to floating rate mortgages, as 90% of Australia is and so when the Reserve Bank does do something it will be noticed…and have the impact it desires.