The Hole in the Reserve Bank

Listener 22 April, 1991. This is the first of a sequence of four columns written in the early 1990s about monetary policy, which continue to be significant today. They are
The Hole in the Reserve Bank
What the Reserve Bank Believes
Who Controls the Exchange Rate?
The Meaning of Influence

Keywords Macroeconomics & Money

When I left New Zealand in the mid-1960s there was a large hole where the Reserve Bank building was to be constructed. When I returned in the early 1970s the hole was still there. Apparently, a mistake had been made in the building’s foundations, which had to be ripped out; no easy task with the walls of a money vault. Reserve Bank foundations are like that, whether they are vault walls or the credibility of the bank’s policies.

The policy foundations appear in the Reserve Bank Act 1989 which says, “The primary function of the bank is to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices.”

But can monetary policy maintain price stability? It is one thing to write an objective in statute: another to achieve it. (We could ask the Reserve Bank to run its monetary policies to achieve and maintain the supremacy of the All Blacks. Is the current law’s objective any more plausible?) Thus far I have been unable to find any statement to the government, or Parliament, at the time the act was formulated that explains how the objective is achievable.

I am aware of the extreme monetarist view that in the medium term inflation is solely a monetary phenomenon. But even the Reserve Bank doesn’t go that far. One of its explanatory booklets says, “In the medium term monetary policy mainly affects the level of inflation.” There is a big difference between “mainly” and “solely”.

But if the bank apparently accepts that in the medium term its policies will affect other economic variables, it does not say which ones or by how much. My view, and I am not alone, is that monetary policy has a long-run effect on the level of output, employment and foreign debt because, in the short run, it affects the acquisition of capital, technology and human skills.

Achieving the bank’s primary goal is feasible, but it may involve hiking up the exchange rate to the point where it will destroy even more of the capacity of the import-substituting and export sectors, and so our ability to produce, employ and grow. That is what has happened over the last five years and, if the present policies are pursued, it will continue to happen over the next five.

But, whatever the theoretical issues, hardly anybody -survey respondents, forecasters, markets -believes that the Reserve Bank will attain its given statutory objective of a nil to two percent rate of consumer inflation by the end of 1993.

Recall that on March 2, 1990, agreement was signed with the then Minister of Finance, David Caygill, to achieve the stability target by the end of 1992. Almost 300 days later the new Minister of Finance, Ruth Richardson, delayed the target date by 365 days to the end of 1993.

It is no good saying that 1t won’t happen again, because the most recent agreement allows for deviations from the target if there are external price shocks, natural disasters, changes in government levies and taxes or for any other reason that seems a good excuse. There will be such shocks in the next three years, so the target is fatuous. Indeed, on the very day she signed the agreement Richardson announced one such shock cuts to welfare state benefits and user pays for the rich. No one knows the impact these moves will have, but some preliminary estimates by the NZIER suggest they could be equivalent to a price hike of around seven percent.

Even the Reserve Bank’s own statements suggest a certain lack of conviction. Its 1990 post-election briefing draws attention to the need for appropriate fiscal and other government policies to co-ordinate with its monetary policy. I agree. I wish it had said so in the 1984 briefing: perhaps we would be in less of a mess if it had. But the bank did not say even this when its bill was being passed. Raising the matter now suggests that, having been given the ball, the bank doesn’t think it can score by itself.

An even odder excuse is its badmouthing of the official consumers price index (CPI). There were no such complaints about the CPl’s integrity before the bill was passed; it was judged one of the best in the world. But when it became the measure of the bank’s performance, the bank said the CPl’s treatment of housing was flawed (without offering any theoretical justification) and its post-election briefing included a criticism of the CPI’s treatment of cars. To the outsider it all looks like asking for the try line to be moved in 20 metres.

Like the faulty vaults, the bank has to rebuild the foundations of its monetary policy. It is no good trying to do it imperceptibly, step by step. Arguing that the bank’s policies are feasible, while its actions undermine them, is not credible. That is why I support a parliamentary review of the Reserve Bank Act. The objective of attaining and maintaining stability of prices must be tempered by a phrase like “without compromising long-term growth and employment” and the country’s foreign balance sheet”.