The Reserve Bank has done a fantastic job over the last 27 years, doing what it is supposed to do with clarity and vigour. Long gone are the heady days of 18-19 percent inflation and 20 percent interest rates that we experienced while singing along with Crowded House’s “Don’t Dream its Over,” replaced with years of stable general levels of prices (low inflation). The economic narrative around the Reserve Bank’s inflation focus speaks to ongoing price stability supporting a whole range of broader economic objectives.
It seems, however, that this long-term success has led to “expectation creep” from politicians and the public. Rather than the Reserve Bank simply maintaining stable prices over time, many now seem to expect that the Bank’s monetary policy should be the silver bullet that guarantees a growing economy.
The theory behind this is fairly simple. If the economy starts to splutter, the Reserve Bank can lower the costs of borrowing and enable the private market (via the spending of this cheaper credit) to lift economic output and inflation. If the economy starts to overheat, the Bank raises the cost of borrowing and slows things down.
Unfortunately, as the Reserve Bank Governor Graeme Wheeler has highlighted, the problem we now face is not enough inflation, even in the face of repeated lowering of the cost of borrowing. Retail banks are increasingly not passing the gains— in the form of lower costs of borrowing—on to everyday people. Domestic house prices are at an all-time high compared to incomes, and near zero interest rates the world over “signals that, by and large, central banks have pretty well run out of options.”
What people seem to forget is that New Zealand is a small open economy heavily dependent on trade. As Brian Easton noted years ago, the New Zealand economy is like a boat sailing on the world economic ocean. Our Reserve Bank and politicians can essentially alter the ballast and shape of our boat, but have no control over the conditions of the ocean we’re sailing. If the world is in for an economic storm—which is likely, if for no other reason than aging populations and low birth rates—we are going to feel its effects.
Even though New Zealand is currently weathering the economic doldrums through immigration inflows and tourism, it is a fragile calm. Economic history shows us a pattern of good times followed by hard times and that the ocean conditions can change quickly.
Our expectations of what the Reserve Bank can do in the current economic climate have to come back to reality. We also need to be wary of taking for granted the gains that price stability and clear inflation targeting bring. Politicians should stay clear about what the Reserve Bank is there to do. Offering up new and conflicting goals is a sure fire way to end up back in 1987 with both rising inflation and unemployment, singing Bon Jovi, “Living On A Prayer.”