Oliver Hartwich argues the best way for a central bank to achieve both low inflation and low unemployment is to make it pursue price stability alone

Oliver Hartwich argues the best way for a central bank to achieve both low inflation and low unemployment is to make it pursue price stability alone

By Oliver Hartwich*

Judging by its coalition agreements, the new Government’s unofficial motto is not to do everything differently but to do a lot of things better.

But not every change is for the better. Sometimes, even well-intentioned changes are just window-dressing. The review of the Reserve Bank’s policy targets is the best example.

Under its mandate, the Reserve Bank has one primary role: to keep prices stable. This so-called ‘inflation targeting’ was introduced in 1989. It made New Zealand one of the first countries to commit to this goal.

Now the Labour-NZ First agreement lists “Review and reform of the Reserve Bank Act” as the first action in its economic policy section. What it means is clear from Labour and NZ First politicians’ past statements. The Government wants to give the Reserve Bank more targets, especially fighting unemployment.

Committing the Reserve Bank to both price stability and fighting unemployment would not be unusual. The US Federal Reserve operates under such a mandate.

Yet the real problem is that dual mandates do not work, not even in theory. They are the result of a misunderstanding as anyone who studied economics over the past half a century would know.

In the late 1950s, New Zealand-born economist Alban W. Phillips made a discovery. He showed that historically inflation and unemployment had gone in opposite directions. When inflation was high, unemployment was low (and vice versa).

Some economists concluded from Phillips’ curve that a central bank could choose a little more inflation to help create jobs. As it turned out in the 1970s, that belief was wrong. Back then, many countries experienced ‘stagflation’: high unemployment and high inflation in tandem.

Through the work of many top economists, we have learnt why the Phillips Curve does not offer reliable, long-run policy choices.

Imagine a central bank cutting interest rates to increase employment. Once people expect inflation to go up, they will demand higher wages. And so the employment effect of low interest rates disappears. What remains is both high inflation and high unemployment.

The best way for a central bank to achieve both low inflation and low unemployment is to make it pursue price stability alone.

The next RBNZ governor will no doubt be aware of that. In which case, she could safely ignore any dual mandate passed down from the new Government. And keep focussing on targeting inflation.


*Oliver Hartwich is executive director of The New Zealand Initiative.

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(1) the Reserve Bank has one primary role: to keep prices stable - And what a disaster that has been! because the biggest price factor, crucial to any household, is the price it pays for the roof over its head. Taking just the cost of accommodation (interest cost or implied/actual; rent etc) into account instead of capital cost, may may be convenient, but it's been, as I say, a disaster, and...
(2) the Phillips Curve does not offer reliable, long-run policy choices - I suggest Oliver has a chat to Janet about that....

The best way for a central bank to achieve both low inflation and low unemployment is to make it pursue price stability alone.

Where lower official interest rates equate with "stimulus"?

We need to first make sure we define our terms. Deflation means a general decline in consumer prices. This is distinguished from specific declines as might arise from productivity and technological innovation. A general decline is a monetary phenomenon, not an economic one. This chronic condition is so feared by economists that they have chosen to target a 2% per annum inflation rate (3% in China; 4.5% in Brazil) lest "expectations" of deflation ever become grounded or "anchored.".

Thus, the decline of interest rates to zero corresponds with a monetary imbalance in favor of deflation, if at least an abundance of deflationary pressures. This is something that Milton Friedman also talked about, particularly in 1998 with regard to Japan. He called it the interest rate fallacy, meaning that low nominal interest rates signify "tight" money conditions, or what would be consistent with significant deflationary pressure. It is and remains a fallacy because economists like those at every central bank around the world have decided instead that low rates are only "stimulus."

To correct this view, Friedman pointed out the basic, non-trivial distinction between a liquidity effect and an income effect. Low rates can be stimulative in the short run (the liquidity effect), but over the long run their persistence means something far different. A yield curve is supposed to be upward sloping given the core time value of money and investing. That arises from opportunity cost, meaning the more plentiful the opportunities the greater the time value and the steeper the curve (the income effect). Yield and/or money curves (the eurodollar curve and even the history of the OIS curve) that collapse and remain that way unambiguously demonstrate that "stimulus" deserves only the quotation marks. Read more, more, more and more

Yes. Although opportunity cost is a fallacy in its own right.

Price stability = 0% inflation, surely?

Since about 1994 house price inflation has diverged from consumer goods inflation, prior to that they rose together, see Figure 3 here;
https://www.rbnz.govt.nz/-/media/ReserveBank/Files/Publications/Bulletin...

New Zealand's house price inflation is a result of monetary policy error leading to massive and sustained inflow of overseas capital in excess of our needs. This excess capital inflow comes with new immigrants and via the banking system. The excess capital inflow has gone into bidding up the price of existing assets. It has pushed up the exchange rate to the extent necessary to deter more investment in productive capacity. My contention is that we run a capital importing system which causes a goods,services and investment account deficit.

When will we learn to stop scoring own goals?

I would hope the RB is going to be careful about its discussions about LVRS. Things seem a bit upside down to me. Of course I’m know professional but the housing market in high and at a tipping point. People are full of debt and we have low interest rates with LVRS that seem late to the party. FHBers that from about 4years ago have been pushed out of the market to now. So does the RB pull back on LVRs because as the housing market gets worse they need to do something but interest rates are already low and pulling back on LVRS would seem to be helping investors not FHBers. The problem is FHBers have been out of the market for years because prices are far to high. It’s just about like the government and RB need to say one thing, like they’re trying to hold house prices up but at the same time take them down. You would think LVRS for investors need to stay high for a number of years but very low for FHBers now. Meanwhile does the RB send a number of investors to the wall. In a way I feel a bit sorry for the new RB with what they have been left with because I’ve never in my 57 years seen things so twisted. It’s all to confusing for me but I would have thought leaving or easing LVRs is one thing but a good DTI restriction a must . On one hand a country needs investors and most do it to better themselves and can’t normally afford a large deposit so lower LVRS is a must but a reasonable DTI would stop stupidity

If there's not a low level inflation (say 1-3% target band) then there's no incentive for producers of goods and services to operate in the long term and therefore they withdraw jobs, etc, there'd be no incentive for lenders to loan out credit and thus the oil (credit) that keeps the wheels of the economy turning will grind to a halt. Unfortunately capitalism today is based on growth ad infinitum. What's the solution? I don't know. but it wouldn't be quick, that's for sure. Asking the RBNZ to focus on low inflation AND low employment (low employment is a driver of inflation because consumers spend money, and the amount of money in the system grows, or inflates) is like asking israelis and arabs to make peace. It's not going to happen.