Labour and National agree on free trade. But they don’t agree on emissions trading. Now Labour has called an end to a 20-year agreement on inflation targeting. What does that mean?
Nothing immediately — and nothing for at least two years, more likely five and possibly eight while Labour enjoys opposition.
But Labour’s wish to change the Reserve Bank’s remit may signal a significant change in economic policy settings when it does again lead a government.
Trouble is, leader Phil Goff, having got out the fireworks on Thursday, lit only a squib. Labour has much work to do to turn his end-of-consensus announcement to Federated Farmers into deep policy.
Inflation targeting requires the Reserve Bank to set its key interest rate, the official cash rate (OCR), against the sole or dominant objective of keeping inflation within a target band. New Zealand was the first country to do this.
The target band was zero to 2 per cent in 1989, then, at Winston Peters’ urging in 1996, zero to 3 per cent and then, under Michael Cullen from 1999, 1 per cent to 3 per cent.
The measure is the consumers price index. But the Bank “looks through” major shifts in the likes of oil prices or government policies to “core” inflation. It adjusts only for ongoing inflationary effects of those changes, not the first-round effects. The Bank also scans several versions of “trimmed” inflation figures.
The Bank doesn’t mechanically apply a mathematical formula. It focuses on the medium term. It makes a judgment call on employment and growth, which are factors in future inflation — much as does the Australian Reserve Bank, which Goff touts as a model. (Peters and Cullen each added token phrasing about economic growth to the Bank’s instructions.)
Contrary to popular belief, the Bank has let inflation run much more often in the upper half of its target bands than the lower half. Governors Don Brash and Alan Bollard have leaned more toward the growth side of the equation than toward the inflation side. Both let inflation to run over the top of the target band. Neither has dared to go through the bottom.
The result was that, in common with other “western” economies, credit blew out: households and businesses binged on debt. Given that excessive credit is inflationary, central banks probably let prices rise faster than they should have. Computerisation and Asia’s cheap manufacturing suggests that, too.
Foreigners supplied the credit here. By borrowing from foreigners, we bid up the exchange rate to a level which seriously damaged exports. In the domestic economy growth and employment boomed, undeterred by the Bank’s high OCR. It was a grasshopper economy, an endless summer.
Now, post-crash, cash is short. That is keeping trading banks’ funding costs — and lending rates — far above the now very low OCR. The exchange rate has been defying gravity. If it is too high right now, that is not due to inflation-targeting. (Australia’s exchange rate has been slightly more volatile than ours, Australia-touters might note.)
Bill English has reportedly been scanning other countries’ efforts to hold down their exchange rates. Recent examples: Brazil taxes foreign investment in financial assets at 2 per cent; Taiwan restricts access to term deposits. India and Thailand are talking of intervening.
Bollard has been flagging that he would like to adjust liquidity and/or capital ratios countercyclically and thereby influence the banks’ capacity to leverage their lending. During the debt binge that might have moderated the house bubble.
Labour says that reflects its thinking when it talks of “complementary measures” and notes similar proposals in other countries.
But Labour’s strategists also know we do not live by the Bank alone. For example, government spending influences inflation. The higher spending is, the higher interest rates must be.
That poses a conundrum for Labour. Many of its statements this year imply higher spending. But it also doesn’t want high inflation. There is still respect for Cullen’s justification of his vote for the Reserve Bank Act in 1989: he said “inflation is a tax on the poor”, who have little scope to offset its effects.
But there is much more to a coherent economic policy than inflation, interest rates, the exchange rate and government spending. This is why Goff hid the fireworks after lighting his squib on Thursday.
Labour has also to rethink tax, productivity growth and innovation. Like English, it worries about the serious imbalance between exports and the domestic economy, low savings and seriously high foreign debt. Unlike English, Labour is much concerned with “economic sovereignty”.
Labour’s (and English’s) opportunity is to incorporate some of the post-1989 economic analyses and theories. The real challenge for political parties and governments through the next 15 years is not to re-fight 20-year-old battles but to refashion policy weaponry to fit a different world.
For that, much more than squibs is needed.