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Inflation targeting puts Kiwis under the gun

Written By: - Date published: 2:34 pm, April 16th, 2008 - 31 comments
Categories: economy, International - Tags: ,

dollar.jpgAs you know, petrol and food prices are up. These are international prices spiralling up due to growing demand and limited or falling supply. When demand exceeds supply prices rise.

Now, when food and petrol goes up, that’s inflation. In fact it’s most of the current inflation: out of 3.4%, 0.9% is from petrol and 0.9% from food. The Reserve Bank has a target for inflation of 1-3% over the medium term. When it sees inflation rising it puts up interest rates to get inflation down in the target range. This ‘inflation targeting‘ is meant to work by encouraging people to save, not borrow, and take money out of people’s pockets through higher mortgage rates (giving that money to the owners of foreign banks). This takes money out of circulation, reducing consumer demand to match supply. Bye, bye inflation. In theory.

Problem is, the demand for food and the demand for petrol is not going to drop we need just as much no matter what the price. Even if demand did drop a little in New Zealand, the price would keep rising because the market is international. So, our incomes are tightened by the rising prices. Then the Reserve Bank makes it worse by lifting interest rates. That has no effect on inflation, so the Reserve Bank lifts rates again and keeps them up.

The only way to bring overall inflation down is to cripple other spending by forcing us to put more and more money into food, petrol, and housing. But doing that means no-one wants to buy anything, strangling the rest of the economy, and all the while inflation stays up because it’s international. It’s a stupid situation: the Reserve Bank’s inflation targeting punishes Kiwis and the New Zealand economy but can’t fix the underlying causes of inflation.

What’s the solution? Fix inflation targeting. New Zealand was the first country in the world to adopt the practice, during the rightwing economic revolution, and we remain the only country in the world that only considers inflation, not things like growth and jobs, when setting interest rates and looks at all inflation, not just the domestic stuff that interest rates can actually affect. We need to join Australia, the UK, Canada, the US etc by looking at the economy overall and discounting international inflation when setting interest rates.

Where can we look to leadership on this issue? Not National and not Labour. The Greens and New Zealand First have led the way in calling for reform of how we manage interest rates. It’s high time Labour joined them.

31 comments on “Inflation targeting puts Kiwis under the gun”

  1. At the moment don’t we have ‘stagflation’ due to: our GDP growth falling for the last 8 years and inflation rising due to rapidly rising global resource demand ?

  2. Um, Maw – we don’t have slow growth and we don’t have high overall inflation. As these are the two indicators of stagflation I think you may need to reconsider your thesis.

  3. Matthew Pilott 3

    mawgxxxxiv, no – that’s only with an actual economic contraction. At present, we might see a ‘technical recession’, as was the term used, a slight cntraction for two consecutive quarters. Apart from that, our economy has enjoyed one of the best growth periods ever – not what you’d call stagnant.

    Imagine a country with GDP growth figures of, say, 9% last year, 10% the year before, 10.5% the year before. The rate at which its economy is growing is decreasing, but nonetheless the economy is expanding. That isn’t stagflation.

  4. insider 4

    The question that comes up then around growth is, would we have had the same growth if we had not had a focus on inflation?

  5. That is a very good question indeed. I think yes. In fact I suspect that if the reins had been let out a bit there may have been greater room for businesses to borrow for capital investment and less high-dollar pressure on exporters.

  6. Steve Pierson 6

    The thing is, the economy is like an engine, and inflation is like the temperature gauge. Yes, it’s something you want to keep an eye on, you don’t want it getting to the red zone, but it shouldn’t be the only consideration when you decide how hard to press on the accelerator.

  7. Matthew Pilott 7

    insider – perhaps we’d have had the same growth – but it wouldn’t be worth as much, in today’s terms. Any counterpoints out there – i.e. that higher inflation curtails growth (talking about, say 4-5% as opposed to 1-3%, not a mugabesque 100,000%)? I couldn’t say off the top of my head.

  8. Steve Pierson 8

    opinion differs on when inflation begins to hurt growth. this paper says 8% http://econpapers.repec.org/paper/clmclmeco/2000-22.htm , the general economic thought has been that its not bad until 20% plus.

    The difference between, say, 2% and 4% is insignificant as far I’m aware. And that makes sense, the numbers are puny, the ‘menu costs’ are small, and the rate of change isn’t too fast to really put sticky prices out of wack with more fluid ones.

    What really matters is stability. As long as the rate of change (and, so, the real rate fo return investors can expect) remains predicitable people will feel confident investing.

    Maybe matt nolan or phil or another econo-type will have somethign to add.

  9. Phil 9

    I’m indescribably flattered to have been mentioned in the same sentence as Matt – someone with a much greater capacity to eloquently explain economics than I do…

  10. Phil 10

    One thing that has not been mentioned thus far is the effect of the exhange rate. By raising interest rates, our dollar becomes more attractive to the internation community and the exchange rate rises, as ours has done.

    The impact this has is to reduce the cost of imported goods – a critical factor missing from all the bitching and moaning about petrol and food; without the current system in place, we would be facing much MUCH MUUUCCCCHHHH hugher prices for these items than we currently do.

  11. Phil 11

    In defence of the RB and inflation targeting generally;

    To say the RBNZ “only considers inflation, not things like growth and jobs” is simply not accurate.

    Inflation, GDP, jobs, the exchange rate, and a myriad of other indicators all impact upon each other in a free market economy, and the RB places a great deal of emphasis on understanding what it’s actions will do to them.

    DISCLAIMER; the views I have expressed on TheStandard.org are exclusively my own. They are not intended to be viewed as official policy or opinion of my employer, the RBNZ.

  12. While the term ‘stagflation’ was perhaps ‘provocative’ RBNZ figures show that growth has trended down from 6% in 2000 to 2% now. Statistics NZ numbers show that CPI inflation has trended up from 1.5% in 1999 to 3.5 % now. Both appear to have headed in the wrong direction under the current government.

  13. lprent 13

    They are not intended to be viewed as official policy or opinion of my employer, the RBNZ.

    I’ve been aware of that (it has shown on the e-mail you used).

    People can take it as policy that we guard the privacy of people on this blog. We’re quite painfully aware of the issue as is shown on our About page.

    BTW: Hopefully this will never become an issue, but I’ll get seriously annoyed if there is any personal abuse related to people’s occupations if they choose to disclose them.

  14. Pascal's bookie 14

    Phil, what do you think about the situation in the US and how the fed is responding to it?

    I realise that’s a short question asking for a long answer, but what interests me specifically is the fact that the fed has slashed rates massively at a time when inflation is knocking quite loudly on the door.

    At the same time, the fed is bailing out financial institutions by buying up (or loaning against) shitty paper at face value.

    It seems to me that these actions are short term fixes aimed at staving off immediate crises in the form of bank failures and Wall St meltdowns. It seems that just as a big player shifts some dodgy debt that they had hiding on the Cayman’s on to the publically viewable books, the market panics, and the Fed either cuts a deal or chops the rate. And the market bounces as if something important has happened.

    I realise that the Fed has to do something and that large scale bank failures should if at all possible be avoided. I worry about the moral hazards being set up, whereby other banks are watching on and noting that if they just let their own piece of the shitpile get septic enough, the Fed will bail them out. I also worry that the bad debts that no one seems to know the size of are just going to be fixed by an unspoken but deliberate policy of inflating the dollar.

    I’ve got no training in economics, which probably shows. But the steep cuts in interest rates combined with the inflation fears don’t gell to someone who is more used to how the RBNZ operates.

  15. Interest rates are not the problem, merely the symptom. Therefore, we should attempt to address the problem, which are to name a few: grossly low-wages, unproductive and negative incentives in residential housing, relaxed attitudes over the recent term of credit facility – rather plastering over the visible symptoms.

    Other symptoms exist, equally or more important especially in the living standard and social sectors, which may not be not visible to folk of a certain flavour, which are also a result of these negative incentives – but they are failing to be addressed in the rush to deliver silver-bullet political solutions which again – address only the symptoms – and even then, only those that fit in the world view.

  16. Phil 16

    Thanks Lynn,
    Recently RB staff were reminded of the protocol’s around working for a gov’t department in an election year. I figured it was better to be safe rather than sorry if someone stumbles upon my comments later… =)

    Pascal,
    You’re right in so much as it’s a very short question with a very long answer!

    Without wanting to bore you to death with banking regulation, the new capital adequecy rules called “Basel-2″ should do an awful lot to clarify what can be transferred ‘off balance sheet’ (ie; sweet F.A.) which will hopefully go a long way to stopping this sort of accounting nonsense from happening again.

    As for getting out of the hole we’re currently in, the most likely scenario will involve slightly higher inflation around the planet as central banks inject more and more cash into financial markets to improve liquidity… which is really what the whole crisis is all about (as opposed to the underlying soundness of the global macro-financial community, which is pretty good).

  17. Dean 17

    Policy Parrot:

    “Other symptoms exist, equally or more important especially in the living standard and social sectors, which may not be not visible to folk of a certain flavour, which are also a result of these negative incentives – but they are failing to be addressed in the rush to deliver silver-bullet political solutions which again – address only the symptoms – and even then, only those that fit in the world view.”

    In your opinion does government spending have any effect on the inflation rate?

  18. Policy Parrot 18

    Dean: All expenditure has an effect on inflation – that’s a no brainer. However, leading on from your question – is the assertion, that if so, shouldn’t the government reduce spending to tackle inflation – in fact perhaps that is the cause of inflation.

    Which is completely fallacious. Government spending whilst not helping inflation is not the primary cause of it – once again – tackling causes rather than symptoms is the solution, for example – people would not have to spend so much on housing if prices were not artificially high. The asset value of residential housing doubled from 2001 to 2006. Extra spending to finance ever greater debt is the cause of this inflation.

  19. AncientGeek 19

    Steve: I lived, or rather tried to live, through the inflation of the late 70’s and 80’s. It would take a *lot* to convince me that it is anything other than massively corrosive. There is nothing quite as depressing as living with high inflation. At least with interest rates there are things you can do to avoid incurring interest liabilities.

    I think that the current guidelines are probably broadly correct. The effects of controlling inflation might hurt in the short-term, but they force the elements of the economy that are resistant to change to adjust faster (eg house prices). In the medium term that means that required changes are not protracted into long-term torture.

    With all that said, there is probably a case for the RB to run with a bit more temporary flexibility in their medium term objectives. We’re getting hit with a couple of external shocks at present. However looking at the RB’s operations I think thats the policy they’re following anyway.

    Where can we look to leadership on this issue? Not National and not Labour. The Greens and New Zealand First have led the way in calling for reform of how we manage interest rates. It’s high time Labour joined them.

    Yeah right. Hopefully they won’t. I’d prefer them to keep their powder dry for when we really need it.

  20. AncientGeek 20

    Talking about change. I’ve noticed sudden revival of people using motorcycles at work. This morning I heard an e-mail reported on Morning Report. Someone was shifting what they ate, to a cheaper and more healthy diet. Less dairy and meat and more fruit and vege’s.

    I’d expect to see a lot more of that happening. The current shocks happen to be in areas that the market signals operate quite well

  21. Dean 21

    Policy Parrot:

    “Dean: All expenditure has an effect on inflation – that’s a no brainer. However, leading on from your question – is the assertion, that if so, shouldn’t the government reduce spending to tackle inflation – in fact perhaps that is the cause of inflation.

    Which is completely fallacious. Government spending whilst not helping inflation is not the primary cause of it – once again – tackling causes rather than symptoms is the solution, for example – people would not have to spend so much on housing if prices were not artificially high. The asset value of residential housing doubled from 2001 to 2006. Extra spending to finance ever greater debt is the cause of this inflation”

    You know, I don’t think I’ve seen such a perfect example of doublethink in such a long time.

    Let’s recap. You’re saying that the government is spending money because of social inequities, and that the inflation government spending causes is somehow more just than the inflation caused by private investment.

    You’re also ignoring why so many people choose to invest in housing instead of saving. I wonder why?

    You’re saying inflation is largely the fault of private investors, even when we’ve seen a massive increase in government spending as a proportion of GDP.

    You do understand how supply and demand work, don’t you?

    Pull the other one Parrot. It’s got “Labour’s tax cuts are not inflationary but Nationals would be” written on it.

  22. Inflation has been caused by the doubling of the residential housing asset base, and the greater spending that is now required to retire debt. This phenomenon represents an increase in value in scale several factors greater than any influence that increased government spending has had.

    To say increased government spending has no affect on inflation would be incorrect. However, I agree with Michael Cullen – how capping or reducing increased government spending – which has been necessary to improve performance delivery of social services (there does need to be improvement in the service side of the public sector but this cannot be achieved by unduly limiting or slashing staff) – would have negligible effect on reducing inflation.

  23. Dean 23

    “However, I agree with Michael Cullen – how capping or reducing increased government spending – which has been necessary to improve performance delivery of social services (there does need to be improvement in the service side of the public sector but this cannot be achieved by unduly limiting or slashing staff) – would have negligible effect on reducing inflation.”

    Cullen also said that any tax cuts that National would deliver would be inflationary, yet his would not be.

    Or perhaps I’m wrong. Could you explain to me why tax cuts delivered by Labour are not inflationary, whereas tax cuts by National would be? I am all ears.

    Somehow, I don’t think you’re listening to the right advice when it comes to understanding the causes of inflation.

  24. r0b 24

    Cullen also said that any tax cuts that National would deliver would be inflationary, yet his would not be.

    Could we have the original source for that quote please Dean?

  25. Dean 25

    “Could we have the original source for that quote please Dean?”

    You have GOT to be joking. Surely. Are you honestly telling me you’ve never heard Cullen say either of these things?

    I’ll give you some links tomorrow.

  26. r0b 26

    I’ll give you some links tomorrow.

    That would be grand.

  27. What we have is an unprecedented economic collapse of the entire financial system as the result of irresponsible injections of fiat money into the system by the Federal reserve of New York in order to save the bankers elite after 20 years of bubble building and deregulation. If you really want to know more about the money system than watch these two films: The Money Masters http://aotearoaawiderperspective.wordpress.com/interesting-videos/documentaries/the-money-masters/
    Money as debt
    http://crazyrichguy.wordpress.com/what-is-money/
    and read 5 articles starting with this one:
    http://aotearoaawiderperspective.wordpress.com/the-financial-tsunami-the-preeminent-role-of-new-york-banks-and-wall-street-investment-banks/the-financial-tsunami-sub-prime-mortgage-debt-is-but-the-tip-of-the-iceberg/
    Then remember that John Key was only one of 4 advisors to the Federal Reserve from 1999 until March 2001 when he was Global Head of the Forex department of Merrill Lynch. A position that is upon invitation only, and which brought him very much to New York and Wall street.
    This was at the time when the federal reserve won the price after years of lobbying: the repeal of the Glass-Steagall_Act in 1999 which allowed the banks to go on an all out robbing spree. http://en.wikipedia.org/wiki/Glass-Steagall_Act.
    And then I suggest you get a Kings seed catalogue and order your seeds, dig up your gardens and start growing you own food because if John Key gets elected that is what you will have to do in order to get food. No let me correct that, you will have to do that any way because the international bankers elite has f*cked up the system all ready, him being elected and them being able to rob this country of it’s resources would merely be a little icing on a cake on their already bloated table.
    By the way, why was John Key meeting with his old bosses in October 2007 for a breakfast in an office of Merrill Lynch in London? Well, if you have watched the films and read the articles you will know. On that level it’s: Once a banker always a banker.

  28. Sounds like you guys have been having a robust discussion of inflation targeting. I just recently wrote about it after seeing Kiwiblog and Kiwiblogblog talk about it:

    http://tvhe.co.nz/2008/04/16/why-does-the-target-rate-matter/

    “opinion differs on when inflation begins to hurt growth. this paper says 8%”

    One important thing to remember here is that this paper measures the cost of inflation now on growth. But I don’t think it takes into account inflation’s impact on inflation expectations, which then negatively impacts on future growth and welfare.

    This is why the Reserve Bank has changed its mandate to medium term inflation – as it is worried about what people expect inflation to be (as if people expect high inflation wage and price demands will be high to compensate, causing the inflation).

    Furthermore, although the RBNZ does not explicitly target output, it uses an output gap model and a fair amount of adaptive expectations stuff for determining where inflation will go. What this means is that, if economic growth starts falling sharply, they expect inflationary pressures to fall and so will be more likely to cut rates. In a sense this model does incorporate some type of “implicit” target rate of growth – what they call the natural growth rate.

  29. Steve Pierson 29

    I know some people have had a problem with us coming down heavy on abusive commentators and trolls, and I’ve personally been quite hesitant about it. But I just want to say this is a great thread full of intelligent comment and that wouldn’t be possible if we had dad4justice intervening about ‘lickspittle labour’ every five minutes and the Michele Cabiling types hurling abuse and homophobia.

    cheers, you fellas and fellaesses

  30. Fred 30

    Steve, good post.

  31. r0b 31

    I’ll give you some links tomorrow.

    How you doing there Dean? Any luck?

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