The Bollard Doctrine

Hide Behind the Eight-Ball

Faced with mounting evidence of inflation at every hand, the Governor of the Reserve Bank, Alan Bollard today opted boldly to do nothing.  New Zealand official cash interest rates remain at artificial, historic lows.  Dr Bollard cited global uncertainty and the soaring New Zealand dollar to record highs as justification for his sitting-on-hands repose. 

The higher the dollar rises, the lower the prices of imports, keeping inflationary pressure down--which is to say, obscured.  Despite this, food price inflation is reported to be running at nine percent. 

It would appear that the good Governor may have forgotten Goodhart's Law.
  This "law" states that as soon as a regulatory body identifies an economic or statistical piece of data as an indicator around which it will build its policy or regulatory actions, the data loses its power as an indicator.  The reason this happens is that all markets, both capital and labour markets, are forward looking and anticipatory.  Once a regulatory body identifies an indicator that will guide its regulation and actions (e.g. inflation rates) markets anticipate the future direction of the indicator and invest or divest accordingly. 

With inflation rising one would expect that international currency speculators would want to stay well clear of New Zealand, since inflation erodes the real value of our currency over time.  Why suddenly has it become  hot to invest in the Kiwi?

With Goodhart's Law in mind we believe that the international capital markets have decided that New Zealand is going to experience severe inflation going forward.  New Zealand is not alone in this: inflation is now unleashed globally; New Zealand will be no exception.  Meanwhile, the Reserve Bank has kept the official cash rate at ridiculously low levels to "stimulate" the economy.  Counter-intuitively, international investors have decided that this makes the New Zealand dollar and NZ dollar interest bearing assets a no-risk bet for the intermediate future. 

Sooner or later, the Reserve Bank will have to start raising interest rates.  The longer it delays, the more attractive the New Zealand dollar becomes because delay means higher interest rates for longer, as the Reserve Bank will then have to play catch up with exploding inflationary pressures.  Even if the dollar were to fall, this would be compensated by rapidly escalating interest rates because the inflation genies would then be well and truly unbottled.  Buying the NZ dollar is thus a fairly riskless trade for international currency speculators at present.  The longer Bollard delays, the less risky the trade becomes, and the higher the currency will rise. 

Meanwhile, the extravagantly high dollar chokes off our tradeable economy.  Well done, Dr Bollard. 

Goodhart's Law implies that the sooner a regulatory authority acts on information from its chosen "indicators" the quicker capital markets will return to "fair value" or intrinsic value.  The longer the delay, the more speculative and distorted capital markets will become.  Dr Bollard, one fears, is more focused upon achieving economic growth than upon controlling inflation.  In other words, he does not subscribe to the "spirit" of the Reserve Bank Act, and so feels free to downplay, if not ignore its letter.  Hence his delays in acting. 

We may be unjust in this assessment.  But then again, we recall that he was appointed by one Dr Michael Cullen who wanted, at the time, a Governor of the Reserve Bank who would take a more balance approach to monetary policy than Bollard's predecessor--one more accommodating to the concerns of government (that is, the next election). 

If we are right, one of the sad things is that the currency speculators will be the winners.  They are making money off a dithering and foolish Reserve Bank Governor, albeit at great damage to our productive economy.  It's like taking candy off a baby. 

Goodhart's Law has not been revoked.  Someone had better tell Dr Bollard.