What the Reserve Bank Believes

Listener 12 February 1994 This is the second 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

Do the monetary policies of the Reserve Bank (RBNZ) cause unemployment? The RBNZ economists have little doubt that there is some sort of connection. I am not referring to the RBNZ’s public statements, which I find confusing and even contradictory, but to what their economists write. Monetary Policy and the New Zealand Financial System, published in 1992 (after the 1990 Reserve Bank Act), has two separate diagrams in chapters written by different economists which show linkages. A simplified summary accompanies this column.

From Monetary Policy To Inflation

At the top are the.Wholesale Interest Rates on which the monetary policy operates. Suppose they rise. Then the RBNZ thinks that the Exchange Rate and Retail Interest Rates will rise. They are shown moving in the same direction by being reverse black. As a result External Demand (for exports) and Domestic Demand (for local goods and services) get depressed. Since the movement is in the opposite direction to interest rates, they are shown in black on white. The depressed demand in turns depresses Real Economic Activity, which depresses Profit Margins and raises Unemployment. The RBNZ economists think that higher unemployment depresses Wages, while the higher exchange rate also depresses Export and Import Prices. Each of the last three then depresses Inflation.

You may not believe the diagram. What is important is that many Reserve Bankers do. It is their beliefs which determine how monetary policy is operated. A main concern is which of the sets of linkages (the channels) is the most powerful.

The year began with Peter Harris of the Council for Trade Unions arguing that the strongest channel was the one on the right, through real economic activity to unemployment and wages. Essentially this explanation is based on the `Phillips Curve’ which says you can keep down wages (and hence inflation) by keeping up unemployment. Perhaps Harris was aware that as some labour markets tighten in the economic upswing, some wage settlements are higher this year than last. He thinks that if the RBNZ judges the wage path to be a threat to its inflation objectives it will attempt to restrain wages by raising unemployment.

The RBNZ has offered several replies, the most interesting of which is that if workers break the unemployment-wage link, and do not take advantage of falling unemployment to lift their wages, then the RBNZ wont have to use unemployment to hold down inflation. This amounts to an incomes policy solution, based on threats from a centralised bully rather than the cooperative approach which is usually advocated.

The Reserve Bank’s seems to think the channel on the left is the more powerful. (The profit margin channel is probably the weakest of the three.) It goes down through the exchange rate, to export and import prices and directly to inflation. Even were that true, a side effect is the depression on external demand, real economic activity, and ultimately unemployment. If that is the main channel of influence, the RBNZ could say that it was not targeting unemployment. Nevertheless unemployment is an unfortunate side effect. Moreover the external sector is the driver for sustainable economic growth, so another disastrous side effect of the RBNZ’s-anti-inflation policy is to inhibit economic growth. (Some Australian economists call these sorts of policies “restrictionist”.)

The RBNZ economists add some further loops to the diagram, such as one involving inflationary expectations. But what is undeniable, is they think monetary policy either impacts on inflation through the real economy (i.e. output, employment, and growth), or that a side effect of the impact is on the real economy.

This has led to the argument that this should be explicitly recognised in the Reserve Bank Act (RBA). As I explained in an earlier column the RBA was passed by parliament without any background economic analysis. It appears that the government and its advisers were so drunk with the ideology of monetarism, they saw no need to argue the economics of their case. Perhaps parliament would not have been quite so keen to have passed the RBA in its current form, if they had had the RBNZ diagram with its explicit recognition that monetary policy influenced the real economy.

One proposed reform is the RBA should be amended so that the RBNZ’s objectives include job creation as well as price stability. There is some truth in the orthodoxy that bankers are not capable of chewing gum and walking a straight line simultaneously. The RBNZ should not be given multiple objectives.

My preference is to have in the RBA the requirement that the RBNZ should pursue price stability without compromising employment, output, or the balance of payments in the long run. Such an amendment would be acceptable to ideological monetarists because they do not think good monetary policy has any influence on the real economy. Thus the amendment need not throw the financial sector into hyper-hysteria. Yet the more pragmatic economists within the RBNZ would recognise that they could not run monetary policy in its present manner. This could force a revision of the approach to monetary policy by the RBNZ. Ultimately it could lead to less restrictionist economic management, favourable to less unemployment and more growth.