Why does no one in authority apparently care about inflation? Why are the Reserve Bank and the government loosening monetary and fiscal policy when we have inflation bursting out of its skin?

The only conclusion can be is that the good doctors Alan Bollard and Michael Cullen are genetically soft on inflation.

The Reserve Bank’s rate cut today and governor Bollard’s virtual promise of even lower rates to come are a clear signal to price and wage setters that he is less worried about inflation than about growth. The Labour-led government’s decision in May to open the taps for tax cuts and spending increases set the inflationary tone.

Both arms of economic policy are now set to destroy all the hard work done in the late 1980s and early 1990s to put the inflationary genie back in the bottle.   Today’s decision is a disaster that in years to come we will seen as the day our inflation guardian looked the other way and let that genie escape again.

Getting it back in will be painful. The last time we had to stuff that sucker back in bottle we had to hike interest rates to almost 20% and unemployment eventually hit 11%. I know. I was there. I remember. Why don’t the good doctors?

I graduated into that recession we had to have in 1990 and 1991. I hoped our policymakers would never had to learn that lesson again. Or more correctly, I hoped they would never forget what happens when you ignore the dangers of inflation. It destroys the savings ethic. It erodes economic confidence. It is a killer. Why let it off the leash again? There are some (bad) reasons why some want it off the leash I ‘ll explain lower down.   

Today’s decision by Dr Bollard to cut interest rates is not just surprising. It is extraordinary.

He has cut the official cash rate at a time when  annual consumer price inflation is set to hit 5% in the September. Who is predicting that? Dr Bollard is. Here’s what he said today in the statement.

Recent oil and food price increases mean that annual CPI inflation should peak around 5 per cent in the September quarter of this year.

That is above the 4.7% he was predicting just six weeks ago. That is a full 2% above the top of the band he is supposed to be targeting.

Yet he goes on to say:

However, we expect that inflation will return inside the target band in the medium term. The weaker economy is expected to reduce pressure on resources, making it more difficult for firms to pass on costs and for higher wage claims to be agreed.

Why does he think inflation will fall from 5% to under 3% when all the signs are the other way around?

Price setters who responded to surveys by the National Bank and the New Zealand Institute of Economic Research expect to increase prices as much now as they did back in 1987 when inflation was over 18%. Regardless of where it is coming from, the inflationary demons are ripping through the economy. Employers and employees are all thinking: “How can I get a wage increase or increase prices?” Inflationary expectations are above the 1-3% band the Reserve Bank is supposed to target.

Many inflation deniers and those wanting rate cuts will say this is all about imported inflation. There’s nothing we can do about oil prices and food prices, they say. We need to ‘”ook through” this one-off inflation spike and concentrate on boosting the economy, they say.

But they are wrong. Our inflation problem is mostly a domestic one. Wages are still rising much faster than they have in years. Domestically driven non-tradeables inflation has been over 3% for 5 years. How long before our policy setters notice? Price setters sure have. Government fees and charges, power prices, local government fees and a variety of local costs have all risen sharply. Much of this inflation is driven by government demand for resources, in particular skilled labour.

The government’s decision to pump in about 2% of GDP’s worth of fiscal stimulus over the next couple of years has added fuel to the fire.

I have written elsewhere that this is all part of a consistent watering down of the Reserve Bank’s inflation fighting credibility, record and focus. It started when the target band was first widened and then lifted.

Dr Bollard and Dr Cullen have also changed the way they operate monetary policy through the policy targets agreement so that the Reserve Bank now focuses on the average inflation forecast (not outcomes) over the medium term. There is now so much wiggle room in the Policy Targets Agreement around that target that you could drive an inflation truck through it.

That is what is happening now.

The good doctors are driving that inflation rate higher in front of a crowd of cheerleaders. Exporters love a lower dollar and lower interest rates.  More importantly, borrowers love inflation because it erodes the value of their debt over time and increases their ability, via higher nominal wages, to pay it off easily.

We now have a lot of borrowers and a lot of debt. There is now $170 billion of household debt, up from $70 billion in 1999. We have collectively gone on a mortgage-debt-funded spending spree that made the economy (and Labour) look good for eight years until it all came home to roost in the form of higher interest rates, a house price crash and a recession.

Meanwhile, the amount of money in household savings in bank deposits and debentures (!) has risen to $90 billion from $43 billion. Of course, savers hate inflation. It erodes the purchasing power of their money over time and their real returns are often lower.

So you can see now that this national battle over inflation is not a fair fight. The borrowers have more at stake. They are politically powerful and every politician loves a rate cut. There are 1.3 million mortgages and probably a million or more voters who therefore will vote for inflation.

There will be few people who fight in favour of monetary and fiscal policy that aims to control inflation. Spending now and voting now (rather than in a decade’s time) is so much more appealing and fleetingly satisfying.

Except it’s the wrong thing to do over the long term. We let the inflation genie out of the bottle at our peril. It will cost jobs and wealth and economic stability.

Split Enz sang in the 1980s (the last time we let inflation out of the bottle) about how ”History Never Repeats”.

If only that were true.

Dr Bollard and Dr Cullen (and they are definitely a team now) are repeating the mistakes of the past.

And we will all pay.

Last 5 posts by Bernard Hickey

• Dear John: Please tell us the truth about the economy - we can handle it - February 23rd, 2009
• Kill the glass white elephant in Dunedin with a rates revolt - February 9th, 2009
• A ‘rolling maul’ budget is better than an ‘up the jumper’ miracle - February 8th, 2009
• Why we should give thanks when Telecom ‘exports’ 250 jobs to Manila - February 4th, 2009
• Freeze public-sector wages and lift the minimum wage - February 2nd, 2009