Interest rate crunch: Did the Reserve Bank drop the ball?

The Reserve Bank has a clear task: To hold prices stable by keeping inflation in its target band of 1% to 3% over the medium term.

Inflation data so far this year has shown that it has failed. The latest data showed an annual inflation rate of 7.2%, as the economy dealt with the effect of strong consumer demand colliding with restrained supply.

This means the Reserve Bank has to hit the economy even harder with interest rate rises to get it in check, and it expects to push New Zealand into a recession next year. On Wednesday, it said it was expecting an official cash rate peak of 5.5%. Some economists said that could be optimistic.

So does that mean the Reserve Bank dropped the ball? Or were the past two years such an unpredictable situation that it was impossible to see the right way through?

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It could have been done better

Michael Reddell, an independent economic commentator who has previously worked as a special adviser at the Reserve Bank, says the Reserve Bank has responsibility for what is happening in New Zealand.

“Since core inflation – currently about 6% – is an outcome of monetary policy choices, the current high inflation – and looming recession – is entirely the fault of the Reserve Bank.

“It is their job, taken on voluntarily, and they messed up badly.”

Adrian Orr's team has 'messed up badly', one commentator says.


Adrian Orr’s team has ‘messed up badly’, one commentator says.

He said there were some things that drove inflation that were out of the Reserve Bank’s control, such as movements in oil and food prices, and the monetary policy committee was not meant to try to “lean against” them.

“They are second order: the bank’s various core inflation measures are all between 5% and 7% at present. There are other influences like fiscal policy, but the way the system is set up the Reserve Bank is supposed to move to offset any inflationary impact of fiscal policy choices.”

NZ Initiative chief economist Eric Crampton said, while things like fiscal stimulus through Covid, war in Europe, and Covid shocks had driven inflation, the outcome for the local economy was the responsibility of the central bank and its monetary policy.

“Remember as well that New Zealand has a floating exchange rate which provides a buffer between local inflation and international prices. If other countries run very loose monetary policy and New Zealand does not, the New Zealand dollar appreciates and international inflation does less to affect local prices in New Zealand dollars.”

But maybe it did the best with what it had

As we were told many times, Covid-19 was “unprecedented” and the Reserve Bank was operating on the expectation that things were about to get very bad, very fast.

“If the bank’s forecasts in 2020 and 2021 were very wrong, they were in company – hardly anyone who was doing forecasts saw what actually happened until it was too late,” Reddell said.

“There are good grounds still to think the bank was too complacent last year – board papers released under the Official Information Act have them assuring their board last year they could wait a year to see if the inflation was transitory – but even if they had done a couple of 50bps hikes in August and November last year it would have been too late to have made much difference yet, although it would have lowered inflation faster next year.”

Economist Matt Roskruge, associate dean in the Massey University business school, said you could argue that globally central banks had made an error and had too much easy monetary policy for too long. But he said New Zealand was not alone in it.

Inflation is an issue around the world.


Inflation is an issue around the world.

“Other economies are driving this. Our Reserve Bank is part of a group that has probably dropped the ball. I don’t think it’s fair to say that ours in particular has done anything wrong. Collectively they could have done a better job but that’s easy to say in hindsight.”

Jarrod Kerr, chief economist at Kiwibank, said the combination of low interest rates and wage subsidies had helped the country get through Covid.

“Unfortunately they were much more stimulatory than expected, we’ve had a much better outcome than we thought. The emergency settings were left on for a bit too long.”

But he said, of all the problems we could have now, the current situation is better than what people had predicted going into the pandemic – when forecasts were for double-digit unemployment and a much deeper recession than what is now forecast next year..

“The information through Covid was incredibly mixed. Central banks globally, not just the Reserve Bank, decided ‘let’s just put interest rates through the floor’. Interest rates globally were too low for too long and now central banks are trying to mop it up and restrain markets again.”

ANZ chief economist Sharon Zollner said “if everyone had perfect foresight” the current situation would not have happened. “The same mistakes were made everywhere. There was a global groupthink going on.”

What else could have been done?

Governor Adrian Orr himself told a select committee this week that because monetary policy had been too stimulatory for too long, New Zealanders were now paying the price through higher inflation and higher interest rates.

But he said the alternative might not have been pleasant, either.

He said, with the benefit of hindsight, the bank had worked out that it would have needed a 7% official cash rate in February 2020 to have inflation within its target band now.

“That gives you a sense of the lags that are involved. It also suggests that that would not have been sensible and would not have been consistent with our policy targets agreement. And it would have led to other very severe economic outcomes that we fortunately don’t have to observe.”

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