The Reserve Bank Act requires the Governor of the Bank to use monetary policy to “achieve and maintain stability in the general level of prices”, and requires that, before anybody is appointed as Governor, what this should mean in practice should be agreed between the Minister of Finance and the person whom the Minister wants to appoint as Governor.
And there is currently quite a bit of market and political discussion about what the new PTA between Dr Cullen and Dr Bollard should look like.
It is quite unclear to me why there needs to be any change in the PTA, and certainly unclear why there should be any increase in the target rate of inflation. The PTA which I signed with Dr Cullen in December 1999 – requiring me to keep inflation as measured by the CPI within a range of 0 to 3 per cent, but recognising that there would be circumstances where attempting to do this would be quite inappropriate, and making it clear that in pursuing its price stability objective the Bank should avoid unnecessary instability in output, interest rates and the exchange rate – worked just fine, and needs no alteration.
It was understood from the beginning of the inflation targeting regime in 1988 that there is no perfect definition of “stability in the general level of prices”, and that the CPI probably overstates “true inflation” because of a number of measurement issues. For that reason, the original inflation target required the Bank to keep inflation between 0 and 2 per cent, not at an average of zero.
Perhaps in a very small economy like ours, subject to a wide range of shocks from weather and overseas markets, a target as narrow as 0 to 2 per cent was too narrow and required monetary policy to be excessively activist, and for this reason I was comfortable when asked to sign an agreement which incorporated a somewhat wider range at the end of 1996. And though the new target, 0 to 3 per cent, had a slightly higher mid-point than the earlier target, I was opposed to widening the target range while keeping the mid-point unchanged (perhaps by adopting a target of minus 1 to +3 per cent) because no central bank would be comfortable with negative inflation.
Raising the mid-point of the target still further, as seems to be contemplated, runs the serious risk of raising inflation expectations (and therefore interest rates – financial market commentators are already suggesting that the margin between New Zealand bond rates and those in the United States is likely to increase) and seriously stretching the definition of “stability in the general level of prices”.
But perhaps it would be desirable to stretch the definition of “stability in the general level of prices”? Perhaps we could get more growth by doing so? Alas, I have seen absolutely no evidence which would lead me to believe that adopting a more relaxed attitude to inflation would generate more economic growth on a sustainable basis.
Shortly after the change of Government in late 1999, one of the world’s leading authorities on monetary policy, Lars Svensson, was commissioned by Government to do a report on the way in which the Reserve Bank had implemented monetary policy over the previous decade. He made it very clear that “in the long term, monetary policy cannot increase the average level or the growth rate of real variables such as GDP and employment, or affect the average level of the real exchange rate.”
But, it is sometimes suggested, didn’t the PTA which Dr Cullen signed with me in late 1999 produce excessively reactive or inflexible monetary policy, and shouldn’t the new PTA try to avoid that? On the contrary, Lars Svensson concluded that “the Reserve Bank’s current conduct of monetary policy is entirely consistent with the best international practice of flexible inflation targeting, with a medium-term inflation target that avoids unnecessary variability in output, interest rates and the exchange rate.”
As an example of this flexibility, the CPI increased by 4 per cent in the year to December 2000. Yet the Bank’s next change to the Official Cash Rate, in March 2001, was a reduction in that rate.
Yes, our interest rates are somewhat higher than they are in most other developed countries at the present time, but New Zealand has been in a very different place, economically, than most of those other countries, with strong prices for our major exports (until very recently in the case of dairy exports), a very low exchange rate, good growing weather down on the farm, and strong net inwards migration. It has been entirely appropriate for our interest rates to be a bit higher than those in other developed countries, and there is certainly no evidence that I know of that the economy has needed more stimulus from interest rates than it has had over the last 12 months or so.
To be sure, the Reserve Bank has operated monetary policy to return inflation to around the middle of the target zone agreed with the Minister, but it has done that with the aim of reducing inflation gradually, with the least possible disruption to the real economy or to inflation expectations.
And the evidence for that claim? Most measures of inflation have been closer to 3 per cent than to 2 per cent over the last two years, and the CPI is not projected to go below 2 per cent until the second half of next year in the Bank’s August Monetary Policy Statement. That seems pretty flexible to me.
On 14 August, Standard and Poors MMS issued a press statement which said, in part:
“These data (showing accelerating inflation pressures in the non-tradeables sector of the New Zealand economy) make a nonsense of the view that the RBNZ has been holding back the NZ economy in favour of a rigid defence of the 1.5% mid-point of its inflation target range. The data demonstrate that the RBNZ has allowed inflation to seriously test the upper limits of the range, and even exceed it temporarily, by letting the economy run in excess of potential. An economy that ran any faster over the last few years would most likely have seen a persistent breach of the inflation target range. The NZ economy currently compares very favourably to other (US dollar) bloc economies that are meant to be the beneficiaries of more discretionary monetary policy frameworks.”
In the interests of all New Zealanders, I hope that Dr Cullen and Dr Bollard sign a PTA which is identical to the current one.
Copyright © 2024 Don Brash.