So far, the easy part, Donal Curtin

A new approach to central banking: the New Zealand experiment and comparisons with Australia
Sir Frank Holmes
Institute of Policy Studies, $15.00

There is an economists’ joke about economists: it says an economist is someone who looks at something in the real world working perfectly well in practice and sits down to figure out whether it could possibly work in theory. It’s tempting to take the same approach to New Zealand’s monetary policy regime: it has produced in practice (as it was required to) 11 straight quarters of sub‑2% inflation, yet there may be good theoretical reasons why it may not always work as it ought.

Sir Frank Holmes, in his latest monograph for the Institute of Policy Studies, looks at a comprehensive range of theoretical and practical aspects of New Zealand’s approach to central banking ‑ the price stability target, the transparency of monetary policy, the Reserve Bank Act, the operational autonomy of the Bank, a largely “hands off” and market-driven approach to prudential supervision of the financial system. Along the way he compares what New Zealand has been doing with what has been happening in Australia, based on (amongst other sources of evidence) personal interviews with the governors of both countries’ Reserve Banks.

In summing up, Sir Frank gives approval to what New Zealand has been up to:

It can rightly be argued that a commitment by government to reducing unemployment, raising living standards and dealing with pressing social problem is at least as important as a commitment to price stability. But amendment of the Reserve Bank Act and its administration would be more likely to undermine than to assist the capacity of the Government to honour such a commitment. (p57)

He also notes that the empirical evidence, though surprisingly sparse, suggests that:

[s]ince 1973, low inflation countries have tended to enjoy slightly faster growth. The low‑inflation countries have also clearly had the lowest jobless rates. If anything, low inflation seems to have favoured job creation. From the mid‑1980s, high‑inflation countries have tended to have higher real interest rates than low‑inflation countries. This has made the adverse consequence of inflation far more severe than they were in earlier years. (p20)

Sir Frank covers the issues most people will want to seek guidance about: is low inflation a good idea in the first place, what does it cost to achieve or to maintain, what role did monetary policy play in the 1988‑89 and 1990‑91 recessions, is the 0% to 2% inflation target unnecessarily restrictive, how does the RBNZ actually go about doing things in the marketplace to achieve its targets, can it forecast inflationary pressures well enough to cut them off before they turn up as actual inflation, and what can monetary policy realistically expect to achieve?

In his characteristically diplomatic and urbane way, though, Sir Frank somewhat pulls his punches when it comes to comparisons with the RBA. He presents, fairly, the RBA’s various rationales for its view of it role and its operations: he doesn’t go on (as perhaps he ought, and as today’s financial markets certainly do) to argue that much of the RBA’s argument are either old‑fashioned, wrong, or self‑serving.

Take the important issue of a central bank’s credibility. Credibility is a useful thing for central banks and their economies: if people know a central bank is serious about valuing low inflation and follows through to deliver it, then the bank has to squeeze less hard than a bank with low credibility would have to. The RBNZ and the Bank of Canada have credibility, the Federal Reserve Board (Fed) and the Bundesbank have it (in the Buba’s case, more on its record of the past 40 years than on its record in the last year or two); the Bank of Japan is developing some since it deflated the share price and property mania.

And the RBA? On a car smash scale, its credibility lies somewhere between pranged and totalled. How does anyone know? Because the RBA maintains that it does not yet need to tighten monetary policy, and nobody believes it: Australian financial futures markets are predicting that short‑term interest rates will be a full two percentage points higher by Christmas.

Or take the transparency of monetary policy. Everyone knows what the RBNZ thinks: it formally tells us twice a year, in its monetary policy statement; its twice‑a‑year economic forecast gives us more information; the governor or his deputy will weigh in from time with one‑off speeches; and the people in charge of the day‑to‑day open‑market operations add their tuppence if they feel their actions need explaining. In the United States, the Fed chairman fronts up to Congress with his Humphrey‑Hawkings testimony (and indeed used the last appearance in January to foreshadow the February tightening), and we get to see the minutes of the Open Market Committee (which takes monetary policy decisions), albeit in arrears.

And in Australia? Rowan Atkinson’s black cat, in a dark room (that isn’t there) is easier to find than a clear statement at any point in time of the RBA’s priorities or assessments (believe me, I’ve been to Martin Place, and I’ve looked). Mind you, it’s not entirely the RBA’s fault: when you have been given multiple but sometimes inconsistent objectives as your riding instructions, as the RBA has in its charter, sometimes it’s not humanly possible to make a coherent statement of what you’re trying to achieve.

No matter which of the many policy issues Sir Frank has covered, the answer comes out the same way ‑ New Zealand is up there with best modern practice and Australia is in most areas either lagging behind or in disagreement. Prudential supervision? Australia is broadly carrying on with the supervisory tradition that signally failed so many countries in the late 1980s (including New Zealand); New Zealand is striking out in a new and promising direction. Australia is still in the business of trying to influence what banks do; the RBA is currently trying to discourage mortgage lending and encourage business lending and in the Australian Government’s eyes it remains a dangerously radical idea for banks to run pension savings for their customers. In New Zealand the idea that the retirement income account offered by my bank or the similar vehicles offered by other banks could conceivably be contrary to public policy would (rightly) be regarded as absurd.

Perhaps the least plausible of the RBA’s activities is its occasionally heavy foreign exchange market intervention. Sir Frank observes that “while acknowledging that there were risks in these policies, the RBA claims that in the long run they have proved financially profitable as well as stabilising in their effects” (p42). Ever polite, Sir Frank does not pronounce on the validity of those claims. I would argue (and I believe that a large majority of financial market economists would agree with me) that there is not a single modern instance of a central bank successfully standing in the way of where the markets wanted to take an exchange rate. The Bank of England raised godzillions of readies in the morning and was chucked out of the European exchange rate mechanism (ERM) by lunchtime; just this month the Fed decided to support the dollar against the mark and the yen and ended up with the dollar weaker against both; and the recent fate of Malaysia’s central bank is a grisly reminder of just how much money you can lose when you start thinking you can make intervention financially profitable. It’s odds on that if the RBA persists in its policy, sooner or later it will come an almighty cropper.

It’s easy (and sometimes fun) to draw flattering comparisons between New Zealand’s economic reforms and Australia’s lack thereof, but it is not right to argue that everything New Zealand has done in monetary policy was right in theory or effective in practice. Especially in the early days of the present regime, when the RBNZ was introducing the idea of “primary liquidity”, it was not at all clear how much primary liquidity was the right amount for the RBNZ to manage as the day‑to‑day monetary policy instrument. The RBNZ’s computer models by definition couldn’t give an answer, since there wasn’t any track record for the equations to pick up. In short, there was a fair degree of by‑guess-and‑by‑God experimentation and arguably a degree of monetary policy overkill along the way.

There will be some experimentation required over the next year or two, too, when the irresistible force of a strong cyclical expansion meets the immovable object of a 2% inflation target. So far, monetary policy has had it easy ‑ first recession, then a large degree of slack in the economy made it relatively easy to work inflation down. If the RBNZ can still show sub‑2% inflation in, say, 18 months, then (and only then) will we be able to start drawing strong conclusions about the success of the whole process.

The jury, in short, is still out, especially as there are some theoretical niggles that might yet derail our monetary policy ‑ if (as Milton Friedman argued) inflation is always and everywhere a monetary phenomenon, then New Zealand’s current strong rates of money and credit growth bode no good down the track. Maybe you can explain away the strength of business borrowing as cyclical, related to a temporary surge in capital spending, maybe you can explain away the surge in household borrowing as cyclical, as high levels of consumer confidence release strong pent‑up demand to trade up the house and buy the new car and furniture; and maybe you can’t find any good statistical relationship between the money supply and anything else anymore. But if I were the personally accountable governor, I’d be worried.

Second, our monetary policy rests on the assumption that, given the state of the world and the state of the New Zealand economy, there is some combination of New Zealand interest rates and value of the NZ$ that is consistent with maintaining 0%‑2% inflation. But what if there isn’t? Suppose, for example, that the rest of the world doesn’t want to hold New Zealand dollars at the desired interest rate? It crossed my mind at the time of the RBNZ’s apparently successful temporary tightening of policy in January 1993, that, in part, they lucked into it, with the pound sterling conveniently going into another of its tailspins just when the RBNZ needed the TWI to go up. But if push comes to shove, and the world’s financial markets don’t want the combination on offer from the RBNZ, they won’t take it. Perhaps the greatest benefit of credibility is that it reduced the risk that the markets will take that wayward view ‑ but it doesn’t eliminate it.

In summary, this monograph will take the intelligent layperson, the amateur economist and the junior practitioner well into the monetary policy jungle. To get through to the other side (if there is anything on the other side) you’ll need another guide. If Holmes’ book has a fault, it is light on bibliography and if you want to explore (say) the links between central bank independence and a country’s inflation rate, you’ll find the topic raised here, but you’ll have to find articles on the topic for yourself.

Donal Curtin is chief economist of the Bank of New Zealand

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Posted in Economics, Non-fiction and Review
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