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RBNZ's Bollard says inflation targeting serves NZ

RBNZ's Bollard says inflation targeting serves NZ well

RBNZ Governor Alan Bollard today delivered a speech entitled "Flexibility and the Limits to Inflation Targeting." The main message from the speech is that Dr. Bollard believes monetary policy needs to be flexible in order to deal with unavoidable price shocks, while ensuring that inflation returns to target over the medium term. There was no Q&A session following the speech, but it seems Dr. Bollard is making clear that the RBNZ can continue cutting the official interest rate (OCR) even though inflation will stay above target for some time.

Dr. Bollard highlighted that inflation targeting is serving the Kiwi economy well and has placed the economy in a position to manage ongoing shocks. He noted, however, that monetary policy can only do so much to buffer such shocks, especially when they are persistent. The example offered was the quadrupling of oil prices in US$ terms over the past four years. This is one of the main reasons why CPI inflation in New Zealand is currently well above the RBNZ's 1-3% target range. The NZ dollar, at elevated levels in trade weighted terms, has partly helped cushion the impact of the oil price rise.

But, in cases where price shocks are unavoidable, the Governor said that monetary policy still needed to remain "firm enough to ensure that generalized second-round inflation effects do not take hold." Dr. Bollard believes that the current inflation target is helping to anchor inflation expectations, while allowing room to accommodate short-term inflation shocks while ensuring that price stability is maintained.

At the same time, though, economic growth is slowing. The "contractionary effects of the housing downturn, high oil prices and the global credit crunch will substantially outweigh the stimulus from high export prices and projected expansionary policy." Dr. Bollard believes that the resulting weakness in the economy will help inflation return to target over the medium term, justifying the RBNZ's recent adoption of an easing monetary policy bias.

Dr. Bollard last week cut the OCR 25bp from a record high 8.25%, and signaled that more rate cuts are likely. He acknowledged today that there is ample scope for a projected easing in interest rates given that real interest rates in New Zealand are among the highest in the developed world. Our forecast calls for the RBNZ to cut interest rates by another 75bp this year, and by a further 125bp in 2009.


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