27 Jul 2016

Calls for overhaul of RBNZ inflation target

9:45 am on 27 July 2016

The emergence of persistently low inflation has prompted calls for an overhaul of the Reserve Bank's inflation target.

Bar graph and arrow illustrating downward trend.

Photo: 123RF

The central bank is mandated to return inflation to the mid-point of its 1-3 percent target band on average over the medium term under the Policy Targets Agreement (PTA) with the Minister of Finance.

But unlike his predecessors, who wrestled with high inflation, Reserve Bank Governor Graeme Wheeler has presided over an economy that has struggled to generate enough to hit the 2 percent mid-point.

Annual inflation has been below 2 percent since 2011 and below the bottom end of the target band since the 2014 December quarter.

While he is not alone among central bankers in failing to generate price growth, a currency trader, Derek Rankin, said New Zealand's PTA was out of date in a world of low inflation.

"Maybe the 1-3 target, or a 0-3 target, or a 0-2 target as it was originally, maybe they're all too high," said Mr Rankin.

"Maybe we should be targeting much lower levels of inflation given the world we're in today."

His thinking is shared by other analysts. Some economists argue the Reserve Bank needs more leeway to combat low inflation, arguing that cutting already record low interest rates does little for a growing economy except inflame an already overheated housing market.

09062016 Photo: RNZ/Rebekah Parsons-King. Governor of the Reserve Bank of New Zealand, Graeme Wheeler delievers lastest OCR annoucement.

Reserve Bank Governor Graeme Wheeler has been at the helm of the central bank during a period of low inflation. Photo: RNZ/Rebekah Parsons-King

Former Reserve Bank chairman Arthur Grimes, now senior fellow of Motu Research, favours tweaking the PTA by returning it to a 0-3 percent target band and doing away with the mid point.

"It means that the Reserve Bank doesn't have to act quite as markedly as it would when inflation is going outside the range, and staying outside the range, for a little while."

In this case, it would take the pressure off the central bank to cut rates from 2.25 percent as expected next month, and risk further fanning the housing market bonfire.

Shamubeel Eaqub

Shamubeel Eaqub said housing debt was the real threat Photo: Supplied

But independent economist Shamubeel Eaqub wants to go further.

He said the inflation bogeyman was dead, and the debilitating effect of mounting housing debt was the real threat.

He said the Reserve Bank needed to widen its focus to clamp down much harder on trading bank as the source of credit.

He is advocating banks holding more capital against their mortgage book to better reflect the risk of potential collapse of an overheated housing market.

"At the moment they lend too much money, and too much money goes into housing."

"And the Reserve Bank has a responsibility to manage that because we know that one of the biggest risks that faces New Zealand today is the housing market and the debt that does with it," Mr Eaqub said.

Policy Targets Agreement under review

The Reserve Bank governor's five year term is up in September next year, and The Treasury is currently reviewing the PTA.

The Labour Party wants a more thorough review of the Reserve Bank's role in the economy through the Reserve Bank Act, which was introduced in 1989.

But finance spokesperson Grant Robertson said, at the very least, a change in the inflation target settings was needed.

"It does need to be reviewed. And if the government is not prepared to look at the fundamental settings of the Act, then it least it then has to have a sensible target range.

"It also needs to look at the issue of CPI [Consumer Price Index] versus core inflation because it's quite clear that the bank is now more focused on core inflation in its statement. Both of those things should happen."

Finance Minister Bill English is open-minded about the outcome of Treasury's review but reiterated it was the Reserve Bank governor's responsibility to get inflation back to the 2 percent mid-point over the medium term.

When that may be, and at what cost, remains to be seen.