Banking on Inflation

Is the Reserve Bank Act Being Undermined by Incompetence? 

Listener: 29 April, 1995. 

Keywords: Macroeconomics & Money; 

Whenever a New Zealand team appears to be doing badly, the chooks call for the slaughter of its members. I refer not to the cricket team, although that well illustrates the phenomenon. Without a few world class players, like Glen Turner, Richard Hadlee, or an injury free Martin Crowe, no rejigging of the team, coaches, managers, and selectors, is going to convert some very ordinary players into world beaters. 

Alas the fallacy is being repeated in economic policy. A near hysterical headline in the business pages of a recent Evening Post announced the Reserve Bank was “losing battle with inflation,” going on to claim this would “cast[…] doubt on Don Brash’s future as Governor of the Bank.” 

The facts are some economists forecast “underlying” rate of inflation to exceed the 2 percent per annum level set down in the Policy Target Agreement (PTA) between the Governor and the Minister of Finance. The actual rate of inflation has already exceeded this level. However the PTA uses another measure, misleadingly called the “underlying rate”, which is also expected to go above the threshold later this year. 

There is a nice legal point here. What is the Minister of Finance to do? Mr Birch says he will ask for a report from the Board of the Reserve Bank. It is less clear what happens thereafter. No doubt the chooks will ask for the Governor’s head, and perhaps the Board’s, and possibly the Minister’s. The bloodthirsty are unlikely to be rewarded. 

The legal basis is the Reserve Bank Act (RBA), with two key elements. It clarifies the relationship between the Bank and the politicians, giving the Bank operational independence over monetary policy. The general policy goals are also set down in the law, while the specific details are in the PTA. The RBA states that the Bank should attain and maintain price stability, without defining the notion. The PTA sets a particular price measure and target range. I doubt that a court would find that necessarily defined “price stability”. Nor is it likely to incarcerate a Governor, or the Bank Board, if it found the law has been broken. 

Enacting something in law does not necessarily make it feasible. In the nineteenth century the legislature of one American state had a proposal to enact pi (a.k.a. “π” = 3.1416…), the ratio of the circumference to diameter of a circle, to be three-and-one-eighth. Fortunately the parliament was not so foolish to pass the bill. (The proponent gave up his plan to sell textbooks based on 25/8.) Pi is a part of the deep structure of the universe, which mere mortals (or even politicians and lawyers) cannot overrule. 

It would be almost as equally foolish to pass a law requiring the Reserve Bank to be ensure that the New Zealand cricket team will always win. But is the current law any less pious? It is easy for someone, who has never studied economics, listening to the fashions to assume that a Reserve Bank can, by controlling the monetary supply or something, affect the level of prices sufficiently to make the RBA meaningful. There is a crude monetarism which assumes this, but even monetarism’s founder, Milton Friedman, recognises the simple story that inflation is only a monetary phenomenon is nonsensical. However the ideologues who have dominated so much policy discussion in recent years are not going to take notice of Friedman when he contradicts them. 

After the RBA was passed in 1990, I asked the Treasury and the Reserve Bank for their papers advising on the principles. Any discussion on the extent a monetary authority could influence the price level was bound to interesting. However there was not a single sentence in the papers devoted to that issue. It is an extraordinary indictment on parliament that it was able to pass a law without any evidence whatsoever that the law could be put into effect. 

At first inflation fell, as it was falling in much of the rich world. This was seen to be evidence that RBA was working. Now the inflationary pressures are in the opposite direction. The chooks ignore that the RBA is based on poor economic analysis, and assume the law is being undermined by incompetence. I wish economics was so easy. 

So you ask me whether monetary policy can influence the price level sufficiently (and quickly enough) to make the RBA meaningful. The answer is yes, but only with high real interest rates, a high real exchange rate, at a price of economic stagnation and rising unemployment. So if we panic, with headless chooks asking for the head of the Governor, we face the real possibility of a monetary stance which will precipitate a severe depression. 

<>Annual inflation seems set to rise above 2 percent however it is measured. It will not herald the end of the world as we know it. If we think rationally about what is happening. and why it is happening, rather than ideologically or hysterically, it may even lead to better economic management.