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Opinion: In defence of inflation targeting in NZ; Why the RBNZ is a scapegoat for the failure of government

Opinion: In defence of inflation targeting in NZ; Why the RBNZ is a scapegoat for the failure of government

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.

Credit flows

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.


*Matt Nolan is an economist at Infometrics. He also runs economics blog

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Hugh - I agree Labour should apologise to the people. They knew what was happening and they knew housing prices were unaffordable and they addressed the issue with the introduction of the Working for Families subsidy.  
The illusion of wealth is nothing more thana mix of feel good hormones while burying your head in the sand. 

National are no better.

They didn't address the issue at all.  Handing out subsidies does not address the underlying problem and most likely fueled the unaffordability.  The subsidy was pure vote buying and the masses happily accepted the bribe.  Criminal.
Addressing the issue would've required questioning the why of the unaffordability of housing, the increasing costs of living. 

I wouldnt say deliberate but allowed as any restrictions on kiwi's freedom to buy would have cost votes....if not a "good" economy. 
I also dont think under a National Govn it would have been any better, just look at Brash's tax bribe in fact considering Brash's far right agenda its likely he would have stimulated the gambling even further with more tax cuts etc....

While I agree on the scapegoat theme I dont agree that inflation targetting is still relevent.
quite the opposite.
In the past we had pull inflation where ppls money was increasing more than goods, so prices got pulled up....some pushing as well as wages filtered through to costs, sure. However materials and energy were cheap and didnt effect an economy's performance.
After peak oil and indeed many other raw materials peaks these inputs are now significant. Did you notice that every time energy costs get to 6% of US GDP it goes into a recession? Well thats our future, 6% and more so a perma-recession at best...At the same time ppls wages are at a ceiling so ppush inflation will remove $ and curb activity. As un-employment rises wages will decline, ie deflation....
So in a situation like this any attempt at rising interest rates is going to be counter-productive, if not late to boot....Late because as an economy recovers spiraling energy costs will kill recoveries such as they will be.
Hence inflation targetting is dead (mostly)

"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." Little off topic
Core banking system was held together by the Australian regulators, not the RBNZ, the RBNZ took a light handed approach by overseeing a self regulating environment.
You would have thought with all their jet setting and studies of financial history they would have seen that people will try and maximise their returns and light handed oversight is another name for a rouges charter. Little bit more cynacism and a lot more commercial nous would have helped.
If we didn't have the Australian regulators we would be the Greece of the South Pacific. we have seen what has happenned to the seconadry banking system not supervised by the Aussies and ignored by the RBNZ.
This has a ring of the Securities Commission, we didn't have the legislation to anable us to blah blah blah.

Seems to be synchronicity in action.
Compare Bollard's comments in this article with the views written above.

That is one area where I disagree - as the asset purchases pushing up exchange rates are similar in form to standard monetary policy actions IMO.  In which case, the Bank should be responding to that in the same way they always respond to changes in relative interest rates.
I'll defend the Bank from unfair claims, but I don't necessarily agree with everything that comes out of them ;)

Same old same old, steady as she goes boys: one target one lever.
Inflation targeting has a place, at some point in history it might have be of prime importance, but not anymore we live in deflationary times. Nearly every other advanced economy has thrown away the rule book (and Australia is starting to think about it) printing, shorting, prudential focus it’s all on – but not in New Zealand.
It is interesting to see how the orthodox inflation targeters transform any policy intervention as really inflation targeting in disguise.  Thing is breaking the rules and printing or shorting call it what you will has consequences elsewhere.
If you doubt that take a look at:
It is too easy to point over the road and say that fiscal policy is to blame, or on the other side say there is nothing to be done about the currency – if you can’t be effective in the job there are choices.  Fact is nobody here cares about the currency (one target), wonder why they care in the rest of the world.
Inflation targeting will have a place but right now it is not the key issue, for New Zealand the key now is what to do when everyone else has thrown out the rule book.
Time for something different.