Brian Fallow delves into the multifaceted debate around the proposed overhaul of the Reserve Bank's monetary policy framework

Picture: RBNZ.

By Brian Fallow*

Most of the submissions to the select committee considering legislation overhauling the monetary policy framework do not support the change to the Reserve Bank’s mandate as drafted.

And while the switch from single decision maker to a monetary policy committee is widely supported, there are concerns about the proposed replacement of policy targets agreements with ministerial remits.

Some submitters contend that the move to a dual mandate with an employment objective sitting alongside price stability is a problem in search of a solution. If it ain’t broke, don’t fix it.

 Business New Zealand, Federated Farmers, the New Zealand Initiative and Export New Zealand are in that camp.

Others accept that the current legislation needs to be amended to formally endorse and underpin the way the practice of monetary policy has evolved, to flexible inflation targeting, over the nearly 30 years since the Reserve Bank Act was enacted.

But they argue that the draft legislation is defective in failing to provide any guidance as to which objective – price stability or maximum sustainable employment --  should have precedence in the event they conflict, and needs to be reworded.

Two former long-serving Reserve Bank economists, Michael Reddell and Bruce White, are of that view, as is ASB Bank. The Treasury, in a regulatory impact statement, also marginally favours a clear priority for price stability in the medium to long term.

Westpac and the Council of Trade Unions support the proposed mandate as drafted.

The CTU, expressing a view long held on the left, says: “The single focus of monetary policy on consumer prices and the use of interest rates as the predominant tool to control inflation has in the past had damaging effects on economic development by pushing up interest rates beyond levels that make new projects feasible and raising the exchange rate by attracting foreign funds aiming to profit from the higher rates.”

It points to the period 10 to 12 years ago when the official cash rate was much higher and there were widespread redundancies in the manufacturing sector.

But that was a period when inflation was running around 3%, the top of the Reserve Bank’s target band, and unemployment was at or below 4%, likely to be lower than the estimate of Nairu (the non-accelerating-inflation rate of unemployment at which wage inflation becomes problematic).

So it is not obvious that, had the dual mandate been in place then, monetary policy decisions would have been much different.

This illustrates that the way inflation-targeting central banks – very much the norm – approach their task is to try to minimise the output gap, in other words achieve a balance between demand in the economy and its capacity to meet that demand.

To put it crudely: If demand falls short of what would fully utilise the economy’s resources -- and the unemployment rate is a key indicator of that – it is a signal to cut interest rates or keep them low. But if the indicators suggest the economy is heading towards a level of demand that outstrips the capacity to supply, that excess demand is not going to deliver any more jobs or output. It will only create an environment where firms can raise their prices with competitive impunity, and policy should tighten to pre-empt that.

“If this short-term relationship between inflation and unemployment held perfectly, then a single price stability objective for a central bank would achieve the same outcome as a dual objective targeting both inflation and employment,” the Treasury says.

The trouble is, it doesn’t always. In the event of a supply shock, like a steep rise in global oil prices that raises costs and harms economic growth, stimulatory monetary policy would stabilise output but exacerbate the inflationary impact. Contractionary policy would keep inflation low but exacerbate the decline in output.

If the Central Bank is confident the price impact will be temporary it will “look through it”. But if it looks like becoming persistent and wide-ranging, then a trade-off will have to be made between price stability and returning the economy to full employment, the Treasury says.

“Stagflation” is not just a theoretical possibility, as those who lived through the years of feeble growth and rampant inflation which preceded the passage of the Reserve Bank Act will recall.

Which has priority if the two objectives of price stability & supporting maximum sustainable employment clash?

So the question is whether it is good enough for the Bill now before Parliament to give the Reserve Bank the twin objectives of price stability and supporting maximum sustainable employment, with no guidance as to which has primacy if they should conflict.

The business lobby groups worry about the potential costs to borrowers of uncertainty on this point, if the markets perceive a slackening of commitment to price stability.

“The clearer the commitment to price stability, the lower should be the premium in interest rates for inflation risk,’’ the NZ Initiative says. The case that monetary policy implementation under the existing act has failed to take due account of employment and output issues has not been made, it says, and it sees the decision to blur its primary function as entirely political.

Michael Reddell, whose submission is informed by a high-ranking insider’s experience of how the Reserve Bank approaches its task, suggests the statutory goal of monetary policy should be worded something like this: “Monetary policy should aim to keep the rate of unemployment as low as possible, consistent with maintaining stability in the general level of prices over the medium term.”

So not dual objective but a single objective subject to a binding constraint.

The whole point of what monetary policy can do, Reddell argues, is to avoid (or keep to a minimum consistent with price stability) periods of significant excess capacity. “Maximum sustainable employment” is not a measure of excess capacity; unemployment is much closer to one.

The Bill’s proposed wording treats employment as per se good, but a high performing, high productivity economy might well be one in which people want less work, not more, he says.

By contrast lower unemployment – people wanting a job and looking for one but unable to find one – is unambiguously undesirable.

Reddell’s formulation also makes clear “that the Bank cannot go pursuing its own views on what the unemployment rate can or should be if medium-term price stability is jeopardised.”

Maximising employment versus minimising unemployment

Westpac, on the other hand, argues that the focus on maximising employment, rather than minimising unemployment, would help avoid the negative consequences arising when unemployment may be masked by discouraged workers leaving the work force during a downturn, as has occurred in the United States.

A headcount measure of unemployment is a crude gauge of how much slack there is in the labour market. Some unemployment is frictional (people between jobs in the normal course of events), some is cyclical (so monetary policy might be able to mitigate it) and some is structural (driven by factors like a mismatch between the workforce’s skills and those firms need).

The Reserve Bank has been clear that it looks at a suite of labour market indicators including underemployment (part-timers able and willing to work more hours) and potential jobseekers (who say they want a job and could start one but are not actively looking and therefore not counted as unemployed).

The draft bill essentially delegates the task of giving content to the statutory language “maximum sustainable employment” and “price stability” – and a framework for weighting them – to a new instrument, a ministerial remit.

The remit would replace policy targets agreements negotiated between the Governor and the Minister of Finance. The current PTA translates the Act’s objective of “stability in the general level of prices” into a target of 1% to 3% annual growth in the consumers price index over the (deliberately elastic) “medium term”, and attaches a number of caveats around that.

Business NZ submits that without rigorous definitions of the different types of unemployment and more particularly what is meant by “maximum sustainable employment” the monetary policy committee’s task will inevitably be a moveable feast.

And while the legislation lays down procedure for seeking advice before a minister imposes a remit, the Bill’s provision that “The remit may specify or provide for the operational objectives in any way that the Minister thinks fit…” gives the minster a much stronger role in determining operational objectives, Business NZ says.

“What will happen if both inflation and unemployment are rising and the Minister decides, for political reasons, the Reserve Bank should emphasise employment maximisation over price stability or if stagflation becomes a reality?” it asks.

“We could see the Reserve Bank pressed to undertake overly loose monetary policy thereby driving up inflation. A kneejerk reaction could then follow aggressively combatting high inflation if the Minister decides price stability should now be the higher priority. Rather than creating stable and well-understood monetary policy positions, the Minister of Finance’s new power could (a) undermine the independence of the Reserve Bank and (b), arguably more importantly, result in the boom-bust cycles which, ironically, led to the 1989 Act’s introduction.”

The importance of getting the institutional arrangements right 

ASB advocates retaining the policy targets agreement framework which it sees as creating a practical working compromise between political objectives and the feasibility of monetary policy.

“A remit from the Minister of Finance increases the risk that the Bank’s policy objectives become influenced by the political climate of the time, the risk that the Bank’s operational independence is undermined and uncertainty about the continuity over time of the implementation of monetary policy,” ASB says.

But Westpac argues that the proposed arrangements for providing advice to the Minister on a remit entrench and increase the influence of the Governor and the risk of institutional group think. It proposes instead an advisory committee including representatives from the Reserve Bank, the Treasury, academia and other interested groups.

Given how much of the way monetary policy will work in practice will be determined by these remits, getting the institutional arrangements right is important.

The same is true of the composition of the Monetary Policy Committee (MPC) which is to replace the Governor as sole decision maker.

The Treasury reports that the consensus among the stakeholders it consulted was either supportive or comfortable with the idea.

“Disagreements were largely about whether there should be a majority of internals or externals (with most favouring a majority of internals) as well as whether the Committee should be required to publicly release high-level minutes and the results of any vote.”

The Bill would just about entrench a majority of temple priests on the MPC, which would have between five and seven members comprising the Governor, Deputy Governor, one or two other officers of the Bank and two or three external members. Even if there were a committee of six with three internal and external members the Governor as chairman would be likely to have the casting vote.

And either the Treasury Secretary or someone representing him would attend as an observer, with rights to speak but not vote.

What type of monetary policy committee is envisaged?

Bruce White, who worked at the Bank for 30 years in both monetary policy and prudential roles, says the Bill is not particularly clear about what kind of monetary policy committee is envisaged.

Is it the Bank of England model of a committee of equals, all of whose member, internal and external, are expected and able to bring fully independent input and analysis to the policy assessment and decision making process?

Or is it more like the Reserve Bank of Australia in which analysis and assessments are driven by the internal member, with externals providing a check on, or commonsense test of, their analysis?

If the former, Federated Farmers has a point when it says the pool of truly suitable external candidates is likely to be small in a country like New Zealand.

“We would be particularly concerned about the possibility of non-experts with vested or sectional interests which would compromise the RBNZ’s operational independence and the quality of its decisions.”

Indicative that the RBA model is envisaged, Bruce White says, is that it appears external members will have no public roles and that the recently published advertisements seeking applications indicated it would entail a commitment of about 50 days a year.

The New Zealand Initiative says external members’ expertise in monetary policy will matter. “Crank thinking that cheap Reserve Bank credit is a panacea for most ills has made its mark on New Zealand’s political history. Lay people may be more prone to hoping that more largesse today will not mean more stringency tomorrow,’ it says.

“Publication of lay dissenting views that strike professional money managers and others as irresponsible would raise doubts about New Zealand’s financial management.”


*Brian Fallow is a former long serving economics editor at The NZ Herald. 

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13 Comments

Brian is an intelligent fellow and a good journo. I always wondered whether he 'got' the finite underwrite versus growth forever split. Or the forward-bet overshoot.

So I looked for any indication. In a lot of sentences, only this: "In the event of a supply shock, like a steep rise in global oil prices that raises costs and harms economic growth",

Since 2007/8, and oncoming since perhaps 1970, economic growth has been an invalid measure. Assuming that Brian is meaning GDP growth, the blindsiding and the avoidance have increasingly meant it's a nonsense. (Whether it was prolonged by a certain clique to further it's own advancement, is for a different thread).

As Catton pointed out: "Posterity doesn't vote, and doesn't exert much influence in the market-place. So the living go on stealing from their descendants". Sooner (rather than later with exponential growth) there's not enough left to steal.

To 'overhaul' monetary policy to the point where both it and society can be maintained long-term, probably requires the removal of 'growth', certainly of 'economic' growth (we can grow knowledge of course). The problem here is that all factions making submissions, are steeped in the temporary mind-set that was the 'growth' period.

We probably have to re-assess 'employment' too - given the small part labour plays nowadays, it's probably about as relevant a measure as sales of blue overalls. We cannot keep extracting, churning and excreting resources at ever-increasing rates, nor continue coercing folk to join in and consume. Indeed, those who live lightly, are the ones society should reward; we're lauding the wrong thing. "Maximum sustainable employment" is an interesting phrase - it's probably orders of magnitude less than current levels.

We are moving into a time of major change, with a language and a set of understandings not up to the job. Treasury are struggling (same mind-set problem, same prejudiced teaching) with their 'Four Capitals' thing - these are all part of an upheaval. This piece points to where we are headed:

https://www.monbiot.com/2018/10/01/deathly-silence/

and this excerpt is worth re-posting;
"I recognise that challenging our least contested ideologies – growth and consumerism – is a tough call. But in New Zealand, it is beginning to happen. Jacinda Ardern, the Labour Prime Minister, says “it will no longer be good enough to say a policy is successful because it increases GDP if … it also degrades the physical environment.” How this translates into policy, and whether her party will resolve its own contradictions, remains to be determined".

Hoe we fit 'monetary policy' to 'no degradation, no draw-down, no increase in pollution' is the first question, How we deal with the overshoot in forward bets is the second.

I think the key to debating monetary policy is understanding it, first.
It is a notoriously difficult thing to understand for the generalist - I can almost guarantee that you, yourself (like many who debate its failings), have very little understanding of the Taylor Rule.

https://pubs.aeaweb.org/doi/pdfplus/10.1257/aer.20151299
https://www.frbsf.org/economic-research/files/wp12-01bk.pdf

This is where this whole full employment target has come from. The imaginations of those with little idea of the basis for inflation targeting.

PDK

Is the proposed RBNZ mandate too narrow? I understand what they are trying to achieve and I agree with your views that GDP is a inferior measure (GDP would be perfect in a state of perfect equality). But we have a central bank that in a downturn reduced the OCR and loads the country with debt, which the profit on that debt goes overseas. In the current good times there is no rate hikes to save money and reduce household debt. This is a spiral that will affect growth as an ever increasing pile of money goes into interest payments to overseas banks.

I would like to see a robust discussion about all future factors of the economy with a mandate in place which focuses on real NZ wealth and robustness and not the next 3 months. We need to lay a platform for the next 20-40 years to pull NZ back.
-Inflation
-Employment
-Wage growth
-GDP Per Capita
-Equality
-Debt burden
-Exports / Imports (trade balance, including offshore payments from NZ subsidiaries)

Radical thoughts in the current global political climate

TM - I'm with some of that, but not with some of the accepted phrases.

Pulling NZ back isn't how I see it - making it sustainable long-term, is.

Inflation (or rampant deflation, or permanent stagtflation) doesn't worry me - just means less demand on the physical planet, perhaps.
Employment? We'll all be very busy, is my guess. Not dollar rich, but seriously occupied. With labour being less than1% of total work-done, there's a big void to fill.
Wage growth? If that means access to more planetary parts, sorry, I'm not an advocate. We've been living beyond our physical means and it can't continue.
Sustainable resource-availability per capita might be better than GDP.
Equality - we have to realise that only huge energy availability allowed us to indulge in social niceties - we have to be careful to maintain what we've achieved socially in the down-phase.
Debt? Yep - probably the best move is total forgiveness, or the Steve Keen idea. We can't meaningfully repay debt or honour the current collection of expectations.
I don't rate exports or imports - I just rate draw-down. In a no-draw-down scenario, it doesn't matter what you 'trade'.

Sarkozy called for a new Bretton Woods, a decade ago. There is no 'fix' for growth economics on a finite planet, and we've just squandered the decade can-kicking. May you live in zero-interesting times.....

I think there are problems with trying to keep a ship afloat by addressing the issuance of casino chips on the upper decks. Causal and casual - such a big difference.

Central Banks and Treasuries are probably not the places to address our 'economies' any more - doing so is what has gotten us into the existential bind. My suggestion is that we sort our physical interrelationship with the world out first. Not in terms of 'how much can we make from it?' or 'how much will it cost?' but 'What is long-term sustainable?.

That suggests a total re-vamp of the RMA, including dropping 'economic' as an activity-excuse. Then - and only then - let's see what kind of 'monetary policies' fit the resulting framework.

As for 'Rules' and 'Laws', we have to differentiate between ones which are permanent and those which are just 'current observations'. Moore's Law, for instance, was just a temporary observation.

I follow your comments with interest. While I agree that the paradigm of "perpetual economic growth" is no longer a tenable one, I do not understand what you mean by dropping economic out of decision making equation. If economy is to put resources to their best use most effectively and efficiently, then surely we need economy more than ever. We may need a different set of economic measures, but we do need economic measure none the less.

Who said 'economy is to put resources to their best use'?

My yardstick would be: Will our grand-children thank or curse us?

You could argue that doubling the area of Auckland floorspace, using resources effectively and efficiently, is do-able. I do - but I don't happen to think it's sustainable, though. And certainly it's not if they're finite resources in a maintenance-requiring form. Hence the physical measures first - every member of every generation has the same resource chances, say. I have no objection to arguing that some legacy infrastructure offsets some draw-down - that's where the RMA should be going.

But 'economic? No, it's probably done it's dash. The planet's on it's knees and there's no way the currently-held collection of debts can be meaningfully dissipated without either crashing ourselves as a species, or crashing the system.

If, however, you mean that 'This river shall be kept at a level where it can support x number of xy and z species, and with contaminant counts that never go below a, b, and c' is an economic measure, then I'm with you. I just see it as a physical parameter. Cheers

...

Thanks for reiterating my point above.

You point being that I can't comment because I'm no expert and I didn't know about some irrefutable 'Rule' first coined in 1992?

Whatever.

What you could use your obviously superior knowledge to explain (and it's a serious question) is whether the working masses will be happy dissipating their 'earnings' into ever-higher 'prices' for houses, or into virtual stuff?

Because those are rapidly becoming their only options.

No I say it because:
1 - First you have to understand the monetary and economic system.
You suggest we go from a system where we inherently price everything to a system dictated by some narrowly developed 'rules' or ideals to strictly guide our behavior. You claim to be a scholar of history, but can't see how that is an absolutely absurd solution to the problem, given self interested behavior..
I don't disagree with your points, generally. What I disagree with is you trying to pass off an elementary understanding of economics as a reason as to why the system is irreparably broken.

2 - You need to provide a logical alternative to the status quo. As per above, removing a market system to instead advocate a centrally planned system of allocation is not a solution. I don't need to give examples of why.

Is the system perfect? No.
Is it something we can be proud of? No.
Has economic theory ruined the system? Not necessarily - Political will has.

One thing I do know is that embracing economic logic is the way to make it better. An arbitrary abhorrence of economics will not fix anything.

Good comment. One day we should share a fermented beverage

Self-interested behaviour is indeed the basic problem - and is why all Empires have ultimately failed (we're just running the experiment at global level this time).

But self-interest views things through the filter of economics - particularly the assumption that held proxy will be cash-in-able tomorrow. Face it, almost nobody would work every day if they didn't believe that. And economics has no way of anticipating permanent post-growth shortfalls. It simply wasn't constructed in a no-growth era. Can you run down smoothly using below-zero interest-rates of ever-bigger number? You'd know more than me.

What surprised me years ago, was a Greens election poster, featuring a little girl and the planet. I thought it was irrefutable. 90+% of the population voted against her. From that moment on (I've neve been a Green by the way) I figured we were in long-term trouble, beginning in the near-term. I still reckon that if a Leader put the issue clearly and cleanly in front of Kiwis (not so sure about much of the rest of the world) they might just grasp the nettle.

My challenge to you economics types is to explain how our growth-requiring 'economic' system can be morphed into one requiring less - and ultimately no - resource draw-down. Can the numbers people associate with the ability to 'buy more' be dissociated from 'stuff'? And can the system be made to be anticipatory? Because clearly it isn't, currently.

nymad,

from your comments,I assume that you are an economist. If so,then i will further assume that you were trained in classical economics,where people like Samuelson tried desperately hard to make the subject more 'scientific' through the widespread application of mathematics.
Thus Arrow and Debreu were able to come up with their theorem on market clearing. The assumptions made in this theorem could be classed as heroic,or to a layman,just plain ridiculous. It bears absolutely no relationship to any commercial world,but is celebrated as a great theory.
So too was the Efficient market Theory,until finally,psychologists-Khaneman and Tversky and others,demonstrated that individuals are not rational. Now,Behavioural Economics is finally mainstream and many of the pretensions to economics as a hard science have been rejected. It is and always was,a Social Science.

What exactly you are trying to argue, I have no idea.
Apart from desperately trying to sound educated, I can't see any point in this comment.