When low interest rates might not be best

Alan Bollard delivers his third-to-last monetary policy statement this month. The good news is that last year inflation dropped into the bottom half of his 1-3 per cent target range. So, is he going out on a high?

Central banks are supposed to be dead boring. Over the past three years they have become truly central to much of the global economy, doing things sober central bankers are not supposed to do to remedy what market bankers caused by doing things they were not supposed to do.

Here the Reserve Bank has stuck pretty much to inflation targeting, embedded in the 1989 legislation and in policy targets agreements (PTAs) successive finance ministers signed with Don Brash and then Bollard.

Inflation targeting assumes that keeping inflation low, in a band or close to a number, will promote economic stability.

In fact, inflation targeting did not stop us joining much of the “developed” world in a binge, from which we now have a hangover — in some countries a crushing one.

Through the 1990s the explosive growth of low-cost manufacturing in China drove down consumer goods prices and computerisation drove down the price of many services. Even allowing for some drivers in the other direction — for example, costly new medical interventions — overall prices should logically have been going down, not up.

But Alan Greenspan at the Federal Reserve reckoned all was well as long as prices didn’t go up too much. He, then Ben Bernanke ran that line through the 2000s.

The Reserve Bank and politicians here agreed. In fact, Winston Peters in 1996 and Michael Cullen in 1999 lifted the PTA target, Peters from 0-2 per cent to 0-3 per cent (midpoint 1.5 per cent) and Cullen to 1-3 per cent (midpoint 2 per cent).

Moreover, politicians always prefer inflation in the top half of the target band. That way the official and market interest rates can be slightly lower and home owners, manufacturers and unions get less agitated. Politicians have not minded much when inflation has gone through the top of the band, even if not driven by the likes of the 2010 GST increase. They would mind very much if it went through the bottom of the band because they would be accused of standing by while jobs were destroyed.

The result of letting inflation run at even 2-3 per cent when it should have been sub-zero — deflation — was a money blowout. The result of that was a bubble, the antithesis of good monetary policy.

Here at least, unlike Greenspan and Bernanke, Brash, then Bollard did bother about the bubble. Bollard took the official cash rate up to 8.25 per cent in 2007-08. One result of that was a high exchange rate which destroyed jobs in export and import-substitution industries. High interest rates also deterred investment which could have created jobs and lifted wages.

Now in the United States, Japan, Britain and Europe central bank interest rates are at or near zero. Central banks are also printing money furiously. This, coupled with “fiscal stimulation”, is supposed to generate “recovery”.

But persistent very low interest rates can, perversely, hamper growth. For example, they send a signal that the economy is at best iffy and at worst in peril which is likely to make consumers wary of spending and instead prefer to pay down mortgages and other debt and to make companies wary of investing, even if (as now in the United States and Europe) they have stacks of cash.

And if interest rates stay low, those trying to save for retirement figure they need a higher level of capital to generate their target income — so those people save more and spend less and dampen “recovery”.

This growth-arresting theory about low interest rates is one element in a flourishing worldwide first-principles debate on what central banks should do. Bollard has timed his exit well.