A new report by the New Zealand Institute of Economic Research (NZIER) has said that the Reserve Bank needs to reassess its use of inflation targeting.
While inflation targeting has long been a successful way of managing inflation without reducing economic growth, times have changed.
The current economic environment means the Reserve Bank’s battle is not so much demand, but rather supply shocks to the way companies operate, the report said.
Such shocks – which include new technology and improvements in logistics – are global and growing more prevalent.
The result of this has been low inflation globally which, in turn, has left central banks keeping interest rates low to stimulate demand to get inflation back on target.
And New Zealand is no exception to this, the report pointed out.
“Right now, the Reserve Bank is in a bind: leave rates on hold and miss the inflation target or lower interest rates to hit the inflation target, but risk an asset price spiral.”
NZIER believes this means targeting inflation is no longer fit-for-purpose.
Targeting income growth – which is the sum of inflation and economic growth – produces good outcomes as central banks can respond more rapidly to supply shocks, the report said.
“Nominal GDP targeting requires raising interest rates when nominal GDP is above trends and lowering rates when nominal GDP is weak.”
It would allow the Reserve Bank to shift interest rates when a supply shock hits the economy.
But the report said it would also be as effective as inflation targeting in dealing with demand shocks – for example, it would have allowed rapid rate reduction during the GFC.
In the NZIER’s view, if low inflation continues for much longer, it will be hard to describe the situation as temporary.
This means that either rates will need to be lower or the inflation target is undermined, the report concluded.
“In contrast, nominal GDP targeting seems like an increasingly sensible framework for setting monetary policy delivering a better mix of inflation and GDP growth. “
Massey University banking expert David Tripe said targeting income growth is an idea that has some popularity internationally.
However, no central bank has implemented it as yet, he said.
“It would be most applicable in particularly low inflation environments – like Japan or parts of the Eurozone. But inflation in New Zealand is not that low.”
The question is whether the approach would result in any significant difference in outcomes, Tripe said.
“It is not possible to predict, but I suspect it wouldn’t make much difference.”
Somewhere down the track it might be appropriate to have a closer look at the idea, he added.
