Jun 3, 2008

To Cut Or Not To Cut?

Brian Fallow asks the question.

Alan Bollard faces a double dilemma.
The first arises from the fact that the economy is in the worst-of-both-worlds phase of the cycle, with growth feeble but inflation running strong. One says cut rates, the other says wait. But on top of that is a deeper issue raised by Bernie Fraser. That's Bernie Fraser the former Reserve Bank of Australia Governor, not the ex-All Black.
What if these relentless rises in oil and food prices are structural and mark an extended period of transition from an era of cheap oil and cheap food to the opposite. If they are, Fraser says it would be wrong for the central bank to respond by pushing up interest rates - a mistake he compares to pre-Keynesian orthodoxy that Governments should respond to recessions by tightening their belts, which only made things worse. Fraser is reminding us that there is an important distinction between the kind of inflation which arises when demand in an economy outstrips its ability to supply, and the kind which arises from external price shocks such as we have seen in oil and food lately.


If what is under way is a structural worldwide shift to higher fuel and food prices it would be futile to try to counter it through tighter monetary policy. But there is a catch. The caveat is that the central bank cannot ignore the effect on inflation expectations and therefore on price- and wage-setting behaviour. Remember the debilitating wage-price spiral of the 1970s?

Our view is that Bollard will not cut Thursday but will be signalling that a cut this year is on the cards. This should have some impact on forward rates and the dollar. Bollard will be watching this effect very closely. He will also be watching the levels of wage settlements and whether firms are tightening their belts in the same way that consumers obviously are. And therein lies another dilemma, one not covered by Fallow - how is Government reacting? Is Government tightening its belt? What will wage settlements in that sector be like this year? Is the 2% salary increase just awarded to all those who have worked 5 years (in the form of an extra week of leave) be a sign of things to come? In Wellington anyway, it is Government that is setting wage trends not the private sector.