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.