Once more on monetary policy, the Reserve Bank and ‘control’.
Listener 21 May, 1994 This is the fourth of a sequence of four columns written in the early 1990s about monetary policy, which continue to be relevant 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
In his April 16 reply to my Who Controls the Exchange Rate?, the Governor of the Reserve Bank tried to distinguish between “control” and “influence” of the exchange rate. Since I want to avoid arguments about words rather than things, I shall withdraw the use of the term “control”. (I was using it in the way systems engineers do.) So let me rephrase and simplify my argument.
The Reserve Bank tells us that its aim is to control inflation. Think about the economy as a yacht which is intended to go in a particular direction. There are many things which influence the direction of a yacht: the wind, the tide, the shape of the boat, the setting of the sails, and the helmsman. In our example the helmsman (the Reserve Bank), operates on the yacht by “influencing” the steering wheel, which “influences” the rudder, which “influences” the direction of the yacht, thereby enabling the yacht’s destination to be controlled.
Readers will recall from my column of 12 February, the Reserve Bank says that its primary influence (on the wheel) is on wholesale interest rates. It also says that these rates impact on the exchange rate – the rudder of the yacht in the analogy. The column went on to show how by “influencing” the rudder the Reserve Bank thinks it controls the direction of the ship.
So how can the Governor write that “we view it [trying to control the exchange rate] as inconsistent (except possibly by a fluke) with controlling inflation”? What I think he is trying to say is this. The Reserve Bank cannot control the exchange rate at one level, and the inflation rate at another except by coincidence. Once the course of the yacht is set, the Reserve Bank is committed to a particular setting of the rudder.
Now if I have got this right, the concern is evident. Exchange rate policy is now a part of anti-inflation policy. The macro-economic policy role of the exchange rate is to influence (or perhaps control) the level of inflation.
But the exchange rate has another major influence. It determines the profitably of exporting and import substituting (of the tradeable sector). If it is being “influenced” for the purposes of price stability, the profitability of those activities is being set for that purpose. So the level of activity of the tradeable sector is being set by the Reserve Bank. As the Governor wrote, it would be entirely coincidental if the target range of the exchange rate chosen for anti-inflation purposes was also the level which made the best contribution to economic growth and employment.
Indeed the suspicion is that the anti-inflation level for the exchange rate is too high as far as the real economy is concerned. In effect the rudder setting may drive the yacht onto a sandbank, so the economy would stagnate, as occurred in the second half of the 1980s. Perhaps a different inflation target – one closer to the world inflation rate – would enable the exchange rate to be set at a level which increased sustainable output and jobs.
The Reserve Bank is given the statutory task to maintain price stability. So it has no interest in considering whether its pursuit of this objective also damages the real economy. (There are those who think that zero inflation is the only thing that matters anyway.) If you read the Governor’s statement carefully you will see that his argument is informed by this sole obsession.
My position has never been that the Reserve Bank should be charged with being concerned with economic growth and employment. It does not have the competence to pursue such objectives. But I wish there was a government agency which showed the slightest interest in the real economy, which thought poverty and unemployment was a curse. It would have the simple task of advising that if the yacht is set on the course for a particular inflation target, the exchange rate rudder must be set on a particular course, which may run the real economy aground.
NOTE The Governor’s article included a graph. He commented on the flatness of the middle, red line (the real exchange rate) saying “in my view it is no coincidence”. It is no fluke, but in part a statistical artefact. The red line is constructed by dividing the green line (the nominal exchange rate) by the blue line (New Zealand consumer prices relative to foreign prices). Consumer prices in the blue line are influenced by the nominal change rate in the green line. It seems likley that 40 to 60 percent of the consumer price index is directly influenced by the nominal exchange rate. Thus flatness of the red line is in part a result of dividing a number by itself. It is what statisticians call “spurious correlation”.