July 2008 official cash rate cut: The long and winding road

So the Reserve Bank has cut interest rates.

If you normally read this blog you will know that this disappoints me – and I am grateful that both of you understand the pain I’m going through 😉

There has been a lot of commentary on the Reserve Bank’s decision, which I will link to before moving into my own discussion (TUMEKE!) (The Inquirying Mind *) (The Hive) (Not PC) (The Standard) (Kiwiblog *) (No Minister *) (Colin Espiner) (Show me the money) (Jafapete). I am happy to see so many New Zealand blogs willing to discuss the issue – even though my views may be quite different 🙂

Now let me tell you what I’m thinking:

First, you may wonder why I named this post after a relatively melancholy Beatles song – well I’m not sure. I guess it was the meeting of the words long and winding that appealed to me. See the inflation figure we see when we look at the CPI does appear to be quite “winding” – it jumps up to 4% then will slide back down to 2%, while all the while things don’t feel too different to any of us. The long part represent to me what actually matters about inflation – the long-term.

Inflation is the trend rate of growth in prices. Now our measure of price growth can jump around because of relative prices changes (which is happening currently with food and fuel prices rising) however this isn’t really “inflation” – and as a result the Reserve Bank should look past it.

When we discussed what inflation is, we recognised this, and we discovered that inflation expectations were the primary concern when we looked at inflation. Fundamentally, if all price setters believe prices will rise by 5%, irrespective of the real economy, we will get a 5% increase in prices – the expectation of inflation causes inflation.

Now the Reserve Bank says we don’t need to worry about that – inflation expectations are well anchored. However, if rapid price increases are allowed to persist, an expected increase will be factored into peoples prices and wage claims, which in turn will lead to self-fulfilling inflationary pressures.

The wage price spiral that was prevelant in the late-70’s and early 80’s stemmed from two oil shocks, which pushed up the relative price of oil, then pushed up the general cost of production, and then fed into peoples expectations of what inflation would be – it is that final step that the Reserve Bank has to stop happening.

Now inflation has been banging around at the top of the target band for a good number of years – if it wasn’t for the falling relative price of traded goods over the past five years we would have been persistently outside the RBNZ’s target band. In this sense, the Reserve Bank has been very lucky.

However, instead of using this good fortune to make sure that inflation expectations were well anchored, the RBNZ has let them crawl up (source here and here). In a situation like this the Bank really needs to state that it will work to keep growth in the general price level down – so that inflation expectations can stay fixed. However, the Bank DIDN’T EVEN MENTION inflation expectations in the latest statement!!!

Over the past five years the RBNZ has provided a textbook example of dynamic inconsistency:

Government policy makers also suffer from dynamic inconsistency, as they are best off promising that there will be lower inflation tomorrow. But once tomorrow comes lowering inflation may have negative effects, such as increasing unemployment, so they do not make much effort to lower it.

The Bank keeps saying they will act to make inflation lower tomorrow – eventually, people won’t believe them and we will be stuck with permanently higher inflation outcomes and no real economic benefit. As inflation has costs is that what we want?

Fundamentally – the trend growth in prices is rising. A 1-3% target band implies that we should be aiming for an average of 2% in the medium term, but more and more people are interpreting it as implying that 3% inflation is the norm. How long till we accept 4%, even 5% inflation, as part of “the normal function” of the economy.

The worst part is that we won’t realise how much it is costing us – the mis-allocation of resources is an insipid cost, but it is also hard to identify, and puts us in a situation where we are all significantly worse off.