Might the RBNZ overkill on inflation?

Dr Bryce Wilkinson
Insights Newsletter
10 February, 2023

The UK Financial Times opined in late December that the biggest casualty of 2022 was the reputation of big central banks.

Central banks failed to forecast the rise in inflation caused by easy money. When the rise was apparent in 2021, the US Federal Reserve Board and the European Central Bank declared it was temporary. That was also wrong.

Interest rates were too low for too long because of these forecasting errors. Inflation took off.

Central banks have now lifted their interest rates, but are they lifting them too much or not enough? The former represents overkill, the second underkill.

Overkill means a sharper downturn than necessary, underkill means higher interest rates and inflation for longer than necessary.

These forecasting errors have undermined confidence in central banks.

Our Reserve Bank of New Zealand faces this problem. Last November it published a useful review of its monetary policy decisions from 2017. It conceded what could not be denied -- that it failed to predict the rise in inflation in New Zealand.

Even as late as August 2021 it forecast consumer price inflation would be 4.1 percent in 2021 and back to being within its 1-3 percent range target in 2002.

In the event, New Zealand’s CPI rose 5.9 percent in 2021 and 7.2 percent in 2022.

Such major forecasting errors have consequences. The review reported that a majority of those it surveyed in 2022 “had little or no confidence in the Reserve Bank’s ability to bring inflation within the target band by 2024”. Uncertainty affects interest rates.

The review provides little confidence that the RBNZ has learnt much from these bad forecasting errors. At one point it explains that its forecasting framework presumes that inflation will return to its target range “over time”. At another point it says that monetary policy has “on average” been set “such that forecast inflation returned to the target midpoint”.[1]

This unacknowledged circularity is unnerving. The forecasts assume that what is desired from existing policies will be achieved, and policy decisions “on average” assume that the forecasts are right.

If this is an accurate description of the RBNZ’s approach, an optimistic bias is built into its decision-making structure. There is a risk of underkill.

Overkill is a risk too, but underkill has been the pattern.



[1] Remit review, page 87.

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