By Bernard Hickey
Reserve Bank Assistant Governor John McDermott gave a perfectly reasonable and otherwise unremarkable speech in Hong Kong this week in which he concluded New Zealand's inflation targeting regime had been very effective at achieving its inflation target.
This is true, but is not very meaningful anymore.
In fact, it's downright misleading.
That's because inflation targeting, which was a monetary policy framework pioneered in New Zealand and adopted around the world, is now a widely discredited regime for running economies.
Central banks that targeted inflation did achieve their inflation targets over the last 20 years, but they ignored the asset price bubbles and build-ups of household debt and bank leverage that eventually burst with such devastating force on the global economy in 2008.
New Zealand was little different. House prices doubled between 2002 and 2007 and households added around NZ$100 billion of foreign debt. This was virtually ignored by the Reserve Bank of New Zealand, which stuck to its knitting of keeping consumer price inflation between 1% and 3% per year over the medium term.
As Dr McDermott said in his speech, the Reserve Bank has broadly achieved that aim since inflation targeting was introduced in March 1990. He then went on to make some broader claims, which should be challenged.
He said inflation targeting reduced volatility in prices. "That is helpful for resource allocation, affecting longer term performance, and for macroeconomic stability over the medium term," he said.
Really?
Try telling that to young New Zealanders who can't afford to buy their own home without crushingly high debts because of an explosion in prices. Or those poorer families who are now paying much higher rents because of the massive inflation in asset prices. Or those exporters driven out of business because the New Zealand dollar is over-valued by 15%, as measured by the IMF. Or those 50,000 plus New Zealanders who emigrated to Australia last year because they can't make ends meet here and see much more opportunity overseas. Or those creditors looking at New Zealand's current account deficit trending back over 8% of GDP, despite nearly 6 years of slow to low economic growth. Or those looking at New Zealand's per capita GDP still being lower in 2012 than it was in 2003.
The Reserve Bank has drunk its own Kool Aid about the perfectness of inflation targeting and remains stuck fighting the battles of the 1970s and 1980s.
It's perhaps unfair to criticise a financial bureaucrat for toeing his government's line, but Dr McDermott's speech came across as self congratulatory and smug. It was a giant pat on the Reserve Bank's back by a Reserve Banker. His conclusion was that the inflation targeting regime worked fine and just needed a few tweaks here and there.
Yet in many overseas countries central bankers and think tankers are seriously questioning such inflation targeting regimes and proposing alternatives.
Last month Harvard Economics Professor Jeffrey Frankel wrote an obituary for inflation targeting and pointed to a live debate in America and Europe about moving to targeting nominal GDP or his own suggestion for a target for Producer Prices that excludes import prices.
These different approaches are less vulnerable to the sort of asset bubble and supply side shocks that distort inflation targeting regimes.
A good example is the current supply side shocks now driving up house prices and rents in Christchurch and central Auckland, which could unnecessarily trigger interest rate hikes, or the terms of trade shock New Zealand has received that is arguably keeping our rates higher than they should be.
The sooner we shift our monetary policy goal posts the better.
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This piece was first published in The Herald on Sunday.
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