Cullen attack on Reserve Bank guarantees interest rate rise

By NZPA

Friday 28th June 2002

Finance Minister Michael Cullen's attack on the Reserve Bank this week makes it virtually impossible for acting governor Rod Carr not to raise interest rates at Wednesday's cash rate review.

Having strongly signalled further rate rises at the last Monetary Policy Statement, Dr Carr could not be seen to be backing down and diminishing the independence of the bank if he decided a rate rise was now not in order.

Not that the indicators suggest rates should be held. Despite business confidence turning negative, strong GDP growth and a record balance of payments surplus in the first quarter all suggest a rise is appropriate.

So what was Dr Cullen up to when he attacked the bank for not being flexible enough over its 0-3 percent inflation target?

Two things. First and foremost it was politics, and secondly it was a genuine attempt to debate the operation of monetary policy and whether New Zealand can improve its growth performance.

The selection of former governor Don Brash high on the National Party's list as its de facto finance spokesman has put the Reserve Bank firmly on the election agenda. Dr Cullen and Labour may perceive Dr Brash as a weak link -- a man they can portray as a party-pooper who chokes growth at the first sign and prefers high interest rates.

Both Dr Cullen and Dr Brash lack the common touch, each being seen as eggheads. But Dr Cullen has more experience in the nasty game of politics and has a highly refined sense of cunning.

Dr Brash showed he wasn't above a little bit of politicking himself. He accused Dr Cullen of the worst interference in the bank's affairs since Rob Muldoon was minister of finance. He also charged Dr Cullen with being soft on inflation.

In fact, Dr Cullen does not want to change the 0-3 percent inflation target. Rather than always aiming at the mid-point, he wants the bank to keep inflation within the target over the course of the business cycle, similar to what happens in Australia.

The good news about this discussion is that New Zealand is fiercely debating fractional changes in inflation. That's an indication of how far the debate has shifted since the 1980s.

Dr Cullen is striving to get New Zealand back to the top half of the OECD in terms of living standards and to do that it needs to average 4 percent growth for a decade or longer.

That task becomes very challenging if the Reserve Bank slams the brakes on the economy by hiking interest rates every time the growth rate approaches or exceeds 3 percent.

The bank argues that that is New Zealand's maximum sustainable rate. Anything above would see demand exceed supply, resulting in inflation.

But while low inflation is desirable, Dr Cullen argues that squeezing out the last bit comes at an unacceptable cost to growth.

"We accept that an occasional cold shower is necessary to prevent the economy from overheating, but too much time in a cold shower can lead to near permanent shrinking of vital growth potential."

Labour's soon-to-be-released economic policy will include a further refinement of the Policy Targets Agreement (PTA) between the finance minister and Reserve Bank.

Dr Cullen accuses the bank of ignoring changes to the PTA made when Labour came to power which required the bank, when setting monetary conditions, not to cause undue volatility in exchange or interest rates.

"We need to renegotiate that agreement to ensure that it reflects the original intention," Dr Cullen said.

When Winston Peters became Treasurer in 1996 there was market concern at his direction to the bank in the PTA to take cognisance of growth as well as inflation.

However, the bank simply carried on regardless, repeating its mantra that the best contribution it could make to growth was to keep inflation low. Dr Cullen believes the bank has done the same with his changes.

Ironically, Dr Cullen has wide support in the business community for a more flexible approach to inflation and his attack on the bank may be an attempt to curry favour with business. Dr Brash counters by noting business has never in his experience supported decisions to raise rates.

He said the bank aimed at the mid-point of the 0-3 percent target but rarely achieved it. Unsurprisingly, he totally disagreed the bank had misinterpreted the PTA, citing the example of the bank cutting rates in 2000 despite inflation being at 4.0 percent.

Dr Brash said an independent review on monetary policy by Swedish academic Lars Svensson concluded the RB had the best international practice of flexible inflation targeting.

On one point he totally agrees with Dr Cullen -- that higher growth is "fundamental to our future".

"I left the job precisely because I felt that present policies don't deliver the growth outlook that we need."

Dr Brash advocates lower tax rates, less government and less welfare to stimulate growth.

"This election is primarily about growth and how we get more of it."

Economists, as ever, are in both camps. On one side there is Macquarie Bank, Deutsche Bank, Hong Kong Bank, and Berl which want a more flexible Australian-style approach. On the other are main bank economists, and NZIER and Infometrics who regard anything other a sole objective of price stability as voodoo economics.

Dr Cullen said Macquarie Bank's view most tallies with his own. Macquarie's head of economics Richard Gibbs said that under the current monetary policy structure, the economy is "condemned to a sentence of sub-par growth in which monetary policymakers assume little responsibility for the underemployment of resources".

He said the game had changed because low inflation is embedded.

"A multi-faceted target is consistent with other key central banks around the world," said Mr Gibbs.

Maintaining a sole target of price stability in an environment of reasonably low and stable inflation imposed a dead weight cost on the economy in terms of its potential for growth.

The recent comment by Dr Carr that New Zealand had already rejected the failed experiment of allowing more growth was "a fatalistic and damning indictment of the New Zealand economy.

"I'm not prepared to condemn the New Zealand economy to 2-1/2 percent growth."

Bank of New Zealand head of economics Stephen Toplis says the debate is an exercise in pedantry. An economy's potential growth rate remained simply a combination of labour force expansion and productivity.

He believes nothing will change.

"What will happen is the introduction of a few weasel words that reinforce the fact that zero-to-three is the target and not 1.5 percent."

He doubts it will result in higher inflation or a reduction in the bank's independence.

"Even was the PTA wording to be changed, we doubt very much whether outcomes would shift much."

But one near certainty is that Dr Carr and other uber inflation hawks including Reserve Bank assistant governor David Archer may as well toss their governor applications down the dunny.

With polls showing Dr Cullen a shoe-in to be the next finance minister and inflation doves like Hugh Fletcher appointed to the Reserve Bank board, look for the appointment of a pragmatist with market credibility along the lines of Deutsche Bank chief economist Ulf Schoefisch.

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