By Alex Tarrant
With incoming Reserve Bank Governor Graeme Wheeler set to sign a new Policy Targets Agreement with Finance Minister Bill English on Thursday, economists are speculating what 'minor changes' might be made from the current agreement.
The Policy Targets Agreement (PTA) is mandated for by the Reserve Bank of New Zealand Act 1989, which legislates the central bank's primary function is to deliver "stability in the general level of prices."
The PTA is effectively a contract between the Governor of the Bank and the Government, setting out the change in the level of prices the Reserve Bank should target over the medium term - which means it only refers to the Bank's price stability goal.
Other roles and powers given to the Reserve Bank, such as foreign exchange intervention, issuance of currency, and financial supervision, are dealt with in the Act itself.
The Reserve Bank Act even allows the government to override the PTA and direct the Bank to use monetary policy for a completely different objective than price stability - for a 12 month period (for which a new PTA outlining the different targets must be signed), and only if the order is made public. Read more on the PTA here. Read the current PTA with Bollard, signed in 2008, here.
What's out, and what's in?
ASB economists said that given Finance Minister Bill English had indicated there would be few changes to the new PTA, the stance of the incoming Governor Wheeler would likely be the more relevant factor in any changes to the RBNZ’s monetary policy outlook resulting from a change in Governor.
Meanwhile, Westpac senior economist Mike Gordon put out a specific note on the possible changes to the PTA. He said its narrow focus meant three factors being talked about in relation to possible changes to monetary policy fell outside its scope.
The first was that the PTA could not remove price stability as the Bank's primary goal, or put other goals such as employment or the exchange rate on an equal footing.
"The Governor can be (and is) directed to consider such aspects, but only as mitigating factors in the pursuit of price stability," Gordon said.
The second was the Governor as sole decision-maker on monetary policy.
"The RBNZ is relatively unusual in this aspect – most central banks decide by vote among a committee or board. It also has a fairly unique enforcement mechanism: the Governor can be removed from office for failing to meet his price stability target," Gordon said.
"The Governor can (and again, does) form an advisory group on monetary policy, but he is not bound by any vote or recommendation, and by the same token can’t pass the buck for failing to meet his target," he said.
These two features were embedded in the Reserve Bank Act, so any change would have to go through Parliament, not just an agreement between the Governor and the Finance Minister.
"That’s not to say that it can’t be done, it’s just that legislative change can be a laborious process – moving to committee decision-making would be particularly complex, as it would require new mechanisms for holding the committee accountable," Gordon said.
"That said, if there were an appetite for change, the way to do it would be to appoint a Governor who was amenable to such changes, and could shepherd them through during the first few years of their term. And appointing an outsider – as Mr Wheeler is – would help to smooth the process," he said.
"The third factor is one of omission. There have long been calls for the RBNZ to develop tools other than interest rates to control inflation, given the collateral damage that can arise, such as an overvalued exchange rate," Gordon said.
"And in fact the RBNZ has spent several years investigating the use of ‘macro-prudential’ tools such as varying bank capital and funding requirements – these are largely aimed at reducing risks to the financial system, but in some circumstances they might bolster monetary policy too. Make no mistake, these new policy tools are coming, and we will have more to say about them in the near future."
"The point here, though, is that the RBNZ doesn’t need to be ‘given’ these tools. In fact, the PTA has never specified the tools that the RBNZ can or should use – its focus is on the ends of monetary policy, not the means," Gordon said.
"The Act is not terribly prescriptive about policy tools either, but it does state that the RBNZ will use its powers for the purpose of "promoting the maintenance of a sound and efficient financial system". An overly intrusive new policytool could face a legal challenge on those grounds," he said.
So what might change in the new PTA from the current one with Bollard?
Westpac gave a number of possibilities, listed from least to most plausible:
Inflation targeting: The PTA defines ‘price stability’ in terms of the rate of increase in the Consumer Price Index. But there have always been alternative definitions, such as targeting a level of prices rather than a rate of change, or targeting nominal GDP (which includes both prices and volumes). We’d put this in the “too radical” basket: there is currently a lively debate around such alternatives, but more as a signalling mechanism for central banks that have already hit the zero lower bound for interest rates. There’s little agreement as to how they would perform under normal conditions.
The target range: As we’ve noted, the RBNZ’s inflation target has been watered down several times over the years. Any further softening can’t be ruled out, though there’s little reason to think that this would bring any long-term benefits. The current range is broadly in line with other central bank’s targets, and past research has concluded that at low rates of average inflation (less than 3%) no one rate is better than another.
That said, raising the target range to 2-3% to align it with Australia would have interesting near-term implications. The RBNZ’s most recent forecasts have inflation averaging just below 2% over the next three years. Faced with an Australian-style target, would Mr Wheeler feel obligated to cut the OCR immediately? In our view, the mere fact that it would put the new Governor in such a position makes it unlikely.
Variations from target: The PTA has always given the RBNZ guidance on how to absorb shocks and one-off factors such as commodity price spikes, tax changes and natural disasters. It’s possible that this list could be extended, but we think the value-added would be fairly low. The current PTA’s focus on inflation over the medium term means that these days the RBNZ is better described as an future inflation forecast targeter; shocks that have already occurred treated as bygones, except to the extent that they could affect the public’s expectations of inflation over longer periods.
Secondary objectives: Aside from looking through one-off shocks, the PTA also instructs the RBNZ to avoid “unnecessary instability” in cyclical factors, namely output, interest rates and the exchange rate. Again, it’s possible to add to this list. The obvious candidates would be asset prices and/or credit growth, given the experience of last decade – around the world, asset prices soared and financial imbalances piled up, while only mild goods and services inflation meant that central banks had little mandate to respond.
We think that some acknowledgement of the role of asset prices is possible in the new PTA. However, including it under the ‘avoiding instability’ clause would be unhelpfully vague, and would vastly underplay the amount of work that the RBNZ has put into developing macro-prudential tools. It would be better to give asset prices their own separate consideration – for example, noting that the formation and bursting of ‘bubbles’ can hinder price stability over the longer term, even if it doesn’t affect CPI inflation over the medium-term forecast horizon.
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