Wheeler on the defensive on his way out

Graeme Wheeler held his neutral stance in his last monetary policy decision this week, but the focus was on his defence of his record as an inflation targeter. Bernard Hickey reports.

Reserve Bank governor Graeme Wheeler initially tried at his last media appearance to bat away questions about whether he achieved his agreed aim of keeping inflation around two percent within a one to three percent band, saying he planned to outline his defence of his term's achievements in a speech before it ends on September 27.

Consumer Price inflation averaged 0.9 percent over his five year term and rose over that 2.0 percent midpoint for just one of the 18 quarters he was in charge. Some economists and politicians have challenged Wheeler's performance in the role, given he took a hawkish line early in his term and had to more than reverse a series of rate hikes when the inflation he forecast did not arrive.

That more hawkish line than his predecessor, Alan Bollard, has seen core inflation fall from around 2.9 percent before Wheeler took over to around 1.5 percent now, while unemployment has not fallen as far as it did under Bollard and has remained stubbornly above Treasury's measure of full employment. In theory, the Reserve Bank should be able to use its Official Cash Rate and its forecasting ability to run the economy as fast as it can without generating inflation much faster than 2.0 percent.

A long run of inflation lower than that mid-point and unemployment above its full employment level (the NAIRU or Non Accelerating Inflation Rate of Unemployment) suggests the bank has run monetary policy too tight because it estimated the economy's 'red line' at a lower level than it actually was, and had been running it too slow to hit that real full capacity. Treasury estimated last year the NAIRU was around 4.25 percent. Unemployment is currently 4.8 percent and the Reserve Bank has forecast a drop to a low of 4.5 percent. Unemployment ran under four percent for most of the mid-2000s when Bollard was Governor and inflation was at or above the top end of the inflation band, suggesting he ran the economy too hot.

To be fair to the bank under both Bollard and Wheeler, forecasting this unobservable red line of productive capacity and the NAIRU is particularly tricky when many of the economic engine's variables are bouncing around and can't be controlled, while the engine itself may be changing its 'design' under the hood while it is running (ie undergoing structural changes).

Eventually, Wheeler's was forced into a defence of that inflation targeting record after a series of questions in the news conference and, surprisingly, challenges from National Party MPs in a select committee over why he had not run the economy faster.

Wheeler argued that the economy had been running quickly and above trend for most of the five years he had been running monetary policy.

"You have seen output growth and employment growth above trend, and it's hard I think to make the argument that that's an indication of monetary policy being run too tightly because monetary policy does affect output and employment growth," Wheeler told the news conference.

"There are other factors involved in that of course, in terms of population increase and construction backlogs in terms of that great story, but you are always going to be facing trade-offs around aggregate demand growth in the economy, price pressures, and you are going to be forecasting a lot of things that you find extremely difficult to forecast about commodity prices," he said.

"For example we had a 70% decline in oil prices. We had a 75% decline in whole milk powder prices. The ability to forecast those is highly difficult to say the least."

Wheeler's other defence was that he had to keep an eye on asset prices and house prices in particular. The implication being that if he had run a looser monetary policy to run the economy hotter then house price inflation and the attendant financial stability risks would have been even worse.

"You are also looking at asset prices when you're looking at interest-rate decisions. You are also saying to yourself 'where is the housing market?' What's that going to do to house price inflation? So you are always making these sorts of trade-offs when you are thinking about monetary policy settings."

Wheeler was directly asked again whether his 100 basis points of OCR hikes in mid 2014 to 3.5 percent were a mistake, given he had to unwind them through 2015 and 2016 to the current 1.75 percent.

"I think if you go back for some time you will find that inflation was at the high-end of the band. It was about 2.9 percent. It had been averaging that, and that is one of the reasons why we put the emphasis on the two percent midpoint," he said.

"But we also knew that monetary policy is enormously difficult to calibrate. There are judgments about lags and transmission mechanisms so that is why we always refer to over the medium term and on average and those sorts of concepts."

Wheeler pointed to the surprise fall in oil prices over that period in his defence.

"I think if you go back to that episode we we did raise rates, you had a situation where the terms of trade were at a 40 year high, oil prices had been very strong in the lead up to that and they were remaining at around US$110 a barrel, where they had been for the last four years or so. Milk powder prices were very high, the market was expecting a tightening and they were pricing that in, the terms of trade were at a 40 year high, the IMF like ourselves was forecasting a positive output gap, and I think it was a reasonable judgment on the information that we had available," he said.

Markets and other commentators were expecting a tighter monetary policy as well, he said.

"We tightened it four times. What we didn't anticipate -- I think it's fair to say that it would be very hard for central banks to forecast commodity prices -- we didn't expect that the oil price would be on a downward track that would end up at US$28 a barrel in terms of Brent crude, that whole milk prices would go from US$5,200 a metric ton two US$1590 a metric ton at the bottom," he said.

So I think the test is: do you make appropriate decisions based on information you have available at the time and then, if that information changes on you, do you then make appropriate decisions to modify your views. We tightened four times. We then remove the tightening bias and we then cut seven times. So if you ask 'were those tests met?', I am comfortable that the bank meets those tests."

Wheeler pointed to the solid economic growth of the last five years and the falls in house price inflation in the last year in his defence.

"But by and large has the economy performed well in the last in the last five years in terms of output. House price inflation come down from 15 percent to just over two percent at this point, and core inflation running at around 1.5 percent," he said.

"And given that you're going to have volatility in headline inflation because of tradables inflation then I think that's a pretty good outcome and a central bank can take some credit in those outcomes. It is not the whole story far from it, but I think the Reserve Bank has been pretty successful in many respects."

Later in the select committee Wheeler was challenged by National MP for Wairarapa Alastair Scott why he wasn't more aggressive with rate cuts to "get the show well and truly on the road."

Wheeler replied: :"The show is well on the road."

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