Panic

The Governor Has Blinked

Stagflation it is. It seems that New Zealand is headed for the worst economic outcome. The Reserve Bank has reduced the official rate by half a percentage point. It has done so, said the Governor, as an "insurance" measure. According to the NZ Herald:

Reserve Bank Governor Alan Bollard has cut the official cash rate half a percentage point to 2.5 per cent in what he termed an "insurance measure" to stave off a severe downturn in the wake of the 6.3 magnitude Christchurch earthquake.

Economic growth, already anaemic, is now expected to weaken still further as a result of the Christchurch earthquake.

But at the same time inflation is soaring. Raw material costs are up. Commodity prices are booming--already impacting food and petrol prices. The cost of living is rising sharply. 

Earlier this week, the Treasury said there were inflationary pressures throughout the global economy, and the Christchurch reconstruction was so large it would inevitably have an impact on inflation. The faster the rebuild, the greater the pressure on prices, it said.

This is what is meant by stagflation: a stagnant economy with rapidly rising prices--at the same time.

Under the stagflation syndrome, rising prices feed into the wage spiral; demands for cost-of-living wage adjustments become the norm. The currency collapses. The Reserve Bank, having got behind the inflation curve, finds itself rapidly pushing up interest rates to catch up and get inflation under control. Recession turns into depression. This is now a very real prospect for New Zealand.

Now, to be fair, this is not the view of the RB. It believes that inflation, rising because of the GST hike last year, will soon abate.

The central bank expects inflation will come back within its target band of between 1 per cent and 3 per cent once the effects of last year's hike in consumption tax flow through, and forecasts 4.4 per cent growth in the consumer price index in the March 2011 year, slowing to a pace of 2.1 per cent in 2012 and 2.4 per cent in 2013.

It seems that it has discounted the risk of inflationary expectations starting to affect people's economic and social behaviour. When people and business believe prices are going to be likely higher in six months time it affects their expectations, actions and behaviour. That's when the inflation spiral sets in.

The Governor Bollard will have to rush to catch up with the risk of rampant inflation. We believe he has made a grave mistake. But that's what happens when a Governor decides to go beyond his mandate in law and considers the Bank has a responsibility to act to maintain economic growth, rather than keep inflation within a mandated band. Sadly, he has been encouraged to think that way by the public pressure coming from the Prime Minister and the Treasurer. So much for the chimera of an independent Reserve Bank.

It would seem that the current Governor and Government now increasingly see themselves as being above the law.

If our prognosis of stagflation, followed by rapidly increasing inflation, is right, then John Key's muddling through trying to keep everyone happy will, in hindsight, be judged to be naive, politically cowardly, and economic folly. Still, he's a nice bloke and that's the main thing.