By Matt Nolan*
Recently, David Parker from the New Zealand Labour party has started debating whether inflation targeting is now dead – and that we should begin looking at alternatives.
While I applaud David, and the Labour party, for doing what a good opposition should do in investigating alternatives, I believe that the justification for inflation targeting in New Zealand is far from dead.
The recent impetus for challenging the monetary policy framework in New Zealand has come from the Global Financial Crisis. This is surprising, given that it was the actions of our central bank – first in cutting interest rates sharply, and then in working with the Treasury to put in place the deposit guarantee scheme – that helped to prevent the 2008/09 recession from being as deep as the New Zealand recession of the early 1990s.
Judging from this article by David Parker, the desire to change monetary policy settings stems from two views of monetary policy in New Zealand which are incorrect: That the Reserve Bank of New Zealand lifts the official cash rate to deal with higher imported good prices, and that an increase in interest rates by the RBNZ leads to a significant lift in credit flows.
Imported goods prices and RBNZ actions
So what is inflation targeting in the New Zealand context?
New Zealand uses a form of "flexible inflation targeting", where the Reserve Bank of New Zealand tries to ensure that prices rise at a gradual rate, while also aiming to prevent unnecessary volatility in the New Zealand economy.
For a central bank, flexible inflation targeting is akin to "targeting the forecast" – as long as the RBNZ uses an objective forecast model to figure out what it will do with interest rates, and they then set interest rates such that their forecast of inflation is "between 1-3% in the medium term", they have achieved their mandate.
In their forecasts they do not go around assuming large "imported price shocks", and so they are NOT responding to a lift in imported good prices by increasing interest rates.
Part of the reason the RBNZ started cutting the official cash rate in July 2008 was due to the fact that petrol prices had risen sharply, thus reducing consumers’ spending power and thereby pushing down consumer demand.
In fact the Reserve Bank would have started cutting rates sooner if they had the data we had now, as the retail sales series has been heavily revised. At the time, the data suggested consumer spending was only just starting to slow, but we now know this process started in mid-2007.
As a result, any perceived "failure" here was not due to the RBNZ getting confused about imported good prices, but instead due to the fact that data is often quite poor – and we often do not know what has happened until a long time after it has taken place.
Why is this point relevant?
Well it appears that Labour is looking at nominal gross domestic product (NGDP) targeting as a replacement for New Zealand’s flexible inflation targeting Reserve Bank.
Like all national income statistics, NGDP figures are revised and changed constantly – generally we don’t have too much of an idea of what actually happened with NGDP until years after the fact.
We could fiddle NGDP targeting to make “flexible NGDP targeting” – so that the RBNZ only needs to target the forecast. But given neither form of targeting will assume big changes in import prices, then in terms of this issue the two targets only differ in one way – one is a target of the “level” of prices, while the other is a target of the “growth” in prices.
Economists had a debate over targeting the price level, and targeting inflation rates, a long time ago. In the end, inflation targeting was chosen – as we believed there was more value in people knowing "prices can be expected to grow at 2%pa", than there was in people knowing "prices will grow at 2%pa plus or minus whatever adjustment the RBNZ announces it needs to make."
Since monetary policy is about setting these expectations, to reduce uncertainty for firms and households regarding value, inflation targeting is just more appropriate.
Even if monetary policy settings have been responding appropriately to price changes, there is a concern about external credit flows into New Zealand. There is a view that, by pushing up asset prices, the flood of "hot money" has made housing unaffordable and led us to spend too much on flat screen TVs.
This is a lovely story, but it is neither relevant to monetary policy nor particularly true.
Monetary policy is about ensuring that the general price level, on average, grows at a predictable level – and by doing this, the central bank leans against changes in “demand” in the economy to help stabilise economic activity. This isn’t to say the economy won’t grow at slower and faster rates as other things change such as the scarcity of oil or population growth, but given that the RBNZ can’t produce oil or control population flows there is nothing the Bank can do about it.
It is true that interest rates rose between 2002-2007, and it is also true that there were significant capital inflows. However, the fact that interest rates were higher was due to the fact that the Bank was responding to demand pressures within the economy – as a result, in order to understand both the lift in interest rates and the lift in capital inflows we need to ask what was going on in the real economy, rather than attributing this change to the Reserve Bank.
We know that households, and to a lesser extent firms, were keen to borrow, and we know that households spent a lot on building large new houses (although it isn’t clear whether enough new houses were even built). We also know that, due to a glut of savings in developing Asia, credit was cheap and credit conditions were easy.
None of these issues are directly relevant for "monetary policy". However, they do come in under the Reserve Bank’s other mandate of financial stability.
The setting of interest rates, and the targeting of inflation are virtually irrelevant for this part of the Bank’s mandate. Instead, the RBNZ has introduced further regulations and microprudential policies to deal with this. Furthermore, the Bank is looking into the usefulness of macroprudential policy as a way of dealing with systemic risk in the banking sector.
If politicians want to help the Bank research its financial stability aims through funding, then go for it. However, there is no reason to change the Reserve Bank Act due to this – there is no need to change the Bank’s inflation targeting policy when looking at actual monetary policy.
Those in govt need to look at themselves
The determination to change what the Reserve Bank does is surprising to me. Our central bank helped to guide New Zealand through one of the largest global shocks imaginable, helped to keep our core banking system together, and by all but the strictest measures they have achieved their monetary policy mandate.
A clear target for monetary policy, a respect for their role in financial stability, and their credibility with the public were the things that helped them achieve this. It makes no sense to turn around and change what the Reserve Bank is doing after such a success.
Instead, those in government should be looking at themselves.
Policies to favour investment in residential property (through tax status and other regulatory focuses) helped to drive the “imbalances” New Zealand faces.
A failure to take into account population aging is making the government fiscal situation look increasingly unsustainable.
Transfers to the middle classes, which we may feel are fair, still come with a cost – bidding up house prices, and reducing capital investment.
If we want to explain the "imbalances" in the country, and what should be done, we need to look at government policy, and the interventionist policies taking place overseas – the monetary policy of the RBNZ is an unrelated scapegoat.