ECONOMICS: A Respectable Inflationary Debate

Business gave Labour leader Phil Goff roasting last month after he told Federated Farmers that Labour now believed it was time to review the country’s monetary policy. His party was, he said, looking beyond the narrow inflation-linked policy target and planned to take growth, productivity, and particularly the exchange rate, into account.
It wasn’t quite like the Pope declaring an intent to take comfort from Protestantism but, since the Reserve Bank Act’s passage 20 years earlier, there has been bipartisan consensus between National and Labour over policy targets and the primacy of price stability.
Goff was effectively announcing an end to the consensus because, he said, “Labour wants to see step change” in the nation’s export performance. “We want policy that will keep our exchange rate as stable and competitive as possible. We want to reduce interest rates for businesses and homeowners, and put more money in the pockets of New Zealanders.”
Goff was sparse on detail, but suggested price stability and low inflation would remain important objectives for the Reserve Bank. The difference would come in the way management of monetary policy interacted with other objectives and would be an important part of Labour’s economic policy at the next election.
Prime Minister John Key countered that if Goff was suggesting move away from free floating exchange rate, he was “buying into very interesting fight”. New Zealand, he pointed out, was major importer of capital, had high levels of foreign debt and did not have the currency reserves to defend fixed exchange rate.
Business New Zealand chief executive Phil O’Reilly waded in, saying that destruction of the consensus would raise questions internationally about New Zealand’s financial stability. The high rate of the dollar was caused more by an unproductive economy, he said, and removing the Reserve Bank’s inflation focus would result in policy trade-offs, giving the central bank the power to act as an alternative government.
The Employers and Manufacturers Association chief executive Alasdair Thompson was even more dismissive, accusing Goff of talking “gobbledegook” without providing any prescription for achieving conflicting outcomes.
The International Monetary Fund has been powerful champion of the inflation management orthodoxy. It was surprising, therefore, that paper prepared recently by top IMF economists joined economic consultancy BERL in asking if the costs of targeting lower inflation are being outweighed by the potential benefits. The Guardian’s Richard Adams saw the significance of the paper, noting that after years of lecturing governments on the need for low inflation and minimal intervention, “the International Monetary Fund’s top economist has admitted that orthodox policies were powerless to prevent the crisis that swept the global economy”.
Adams added: “In stunning turnaround, Olivier Blanchard, the IMF’s chief economist, now suggests that higher inflation, help for the poor and greater government involvement might do better job helping protect countries from financial turmoil.” As the crisis receded, they wanted “a reassessment of what we know about how to conduct macroeconomic policy”.
The reassessment should look at the possibility of raising the target for consumer price inflation to around four percent. By keeping inflation and interest rates low during good times, policymakers had little room to loosen monetary policy in bad times.
Moreover, the paper suggested that avoiding reliance on monetary policy as the sole economic management tool and expansions of the use of regulation and taxation “need to be explored further”.
The New Zealand Government was sticking to its guns, however, and asking what harm might flow from more inflation and worrying that countries teetering on the brink of insolvency might try to inflate their way out of debt. The Economist raised the more fundamental objection that raising the inflation target would undermine the successful stabilisation of public expectations about inflation over the past 20 years. How could central bankers convince investors that change of target was intended to make policy more flexible, rather than to inflate away the state’s debts? “With their credibility undermined, the next crisis would be much harder to fight,” it editorialised.
That, of course, was the stuff for debate. IMF economists had, however, all of sudden made the debate respectable. Those who carp about monetary policy could no longer be dismissed as ignorant, potty or both.

Bob Edlin is leading economic commentator and NZ Management’s regular economics columnist.

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