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Thursday, October 27, 2005

Will the Fed Follow the Reserve Bank of New Zealand and Overshoot?

The Reserve Bank of New Zealand is raising interest rates because CPI inflation is outside the target range. But with core inflation very likely lower than that, perhaps within the target range, and with falling GDP growth further easing inflationary pressures, New Economist questions the central banks decision to continue raising rates to 7.0%:

New Economist: RBNZ overshooting once again: New Zealand was the first central bank to introduce inflation targeting, so you would think they'd have got the hang of it by now. But no - even with Don Brash safely relegated to the Opposition benches, the Reserve Bank of New Zealand still manages to get it wrong. Today they raised the Official Cash Rate by another 25 basis points to 7.0%, the highest in the OECD (aside from Mexico). In today's statement Governor Bollard explained the rate hike thus:

...medium term inflation risks remain strong. Persistently buoyant housing activity and related consumption, higher oil prices and the risk of flow-through into inflation expectations, and a more expansionary fiscal policy are all of concern. While there has been a noticeable slowing in economic activity, and a particular weakening in the export sector, we have seen ongoing momentum in domestic demand and persistently tight capacity constraints. Hence, we remain concerned that inflation pressures are not abating sufficiently to achieve our medium term target, prompting us to raise the OCR today.

Bollard noted "the continuing strength of household spending, supported by a relentless housing market and rapid growth in mortgage lending", along with "a worsening current account deficit, now 8 per cent of GDP." For those hoping for some respite, he warned of "the prospect of further tightening" and added:

Certainly, we see no prospect of an easing in the foreseeable future if inflation is to be kept within the 1 per cent to 3 per cent target range on average over the medium term.

True, annual inflation is 3.4%, breaching the central bank's target band of 1%-3%. But the pick-up in inflation in large part reflects higher oil prices. The pace of economic growth has already slowed significantly, down from over 4% to around 2.5%, with June quarter private consumption growth the slowest in three years. Softer domestic demand will help ease medium-term inflation pressures. The RBNZ look like they are once again going to overshoot by raising rates more aggressively than they need to - just as inflation is peaking and the economy heads into sub-trend growth. Stephen Kirchner at Institutional Economics agrees...

There are those who worry that the Fed is on the measured path to the same mistake.

    Posted by on Thursday, October 27, 2005 at 12:50 AM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (18)

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