How Effective is Monetary Policy for Fighting Inflation? A Memoir

Do I detect increasing uncertainty as to the effectiveness of monetary policy to deal with inflation? It may be helpful for an understanding what is going, to recount the conventional wisdom before ‘monetarism’; that term was coined in 1968 so I was there before it and recall some of the debate leading up to it. (To keep this to a reasonable length I have simplified both some of my subtleties and those of others. In particular it does not cover types of inflation triggers – in the early days they were classifieds as ‘cost-push’ and ‘demand-pull’.)

Before Monetarism

When I was an undergraduate, the theory of money was more British based. (Almost as an aside, that means I watched the switch over to an American framework, which may explain why I am more alert than some to the aspects of monetarism which arise out of the particularities of US institutional arrangements.) The Radcliffe Committee, which had reported only a few years earlier, was influential.

It, and other such considerations, led one to be pessimistic about defining monetary stock in a rigorous way for analytical and policy purposes. The ‘M’ in the conventional Econ101 was useful for teaching purposes but which of a host of measures – M0, M1, M2, M3, DCE …. – it refers to was unclear. One interpretation of Goodhart’s law is that any monetary stock measure doesn’t work.

The Demand for Money Equation (DFME)

At the heart of the debate at the time was whether there was a demand for money equation (or to what extent it was stable). I recall an argument in the early 1960s in which Friedman claimed that the demand for money was independent of interest rates and someone else (alas I have forgotten his name) showed it was not.

Econometricians were able to get reasonable DFMEs – after all there were plenty of independent variables to choose from. But they proved not to be very reliable forecasters. Try another independent variable and indeed dependent variables such as the multitude of price indices and income measures, while fiddling around with the time response structure adds to opportunities to torture the data until it confessed; another trick is choice of estimation period.

(An interesting issue is why we have not paid more attention to what price in the economy the RBNZ should be targeting. There are a number of possibilities: the GDP deflator, the Producers Price Index, wages, various asset prices, the exchange rate … as well as the Consumer Price Index – of which there are number of possible measures. The targeting of the CPI is a carryover from the earlier system when it was important in wage setting, but it may also be important when exhortation is being used to affect expectations.)

The estimated equations were also not very precise. High R-squares may still leave a lot of noise – too much for precision management.

Even so, the pure Econ101 demand for money equation got established in the economists’ standard macro-paradigm. I suppose it was because no one can think of an alternative which is as clean mathematically. Radcliffe certainly was not.

The Neutrality of Money

One further assumption was slipped in before the DFME could be used for policy management – that the stock of money has no impact on the level of (real) production in the medium (policy-horizon) period. I was never convinced of this neutrality of money unless we are talking about the very long run. It is a standard controversy as to how quickly an economy adjusts to a shock: monetarists tend to assume quickly; Keynesians, more slowly.

The issue of speed of adjustment is both critical for policy purposes and contested. Before 1984 monetary policy was assumed to take a decade to work through. (In the 1950s, Carl Christ proposed something like: since monetary policy works slowly and fiscal policy quickly, while the Federal Reserve works quickly and Congress slowly, the Fed should be in charge of fiscal policy and Congress in charge of monetary policy. It is not incidental that the way Congress limits fiscal management greatly influences how American economists think about macro-policy; we follow them despite our macro-interventions being more flexible; it would be fair to say, though, that it may have become less flexible since the neoliberal framework took over.)

Then, almost overnight, the conventional wisdom switched to the view that monetary policy impacted more quickly – say, two years. I know of no evidence to justify this change in fashion although I accept that the market liberalisation of the 1980s may have shortened the response time – but I doubt it would have cut it 80 percent.

Going back to the DFME, it follows from the limited version that the stock of money determines the price level in the short-to-medium run. And so monetary policy was assigned the task of targeting inflation. Again, I don’t think there was much empirical evidence for this assignment. But the law is the law, and so the RBNZ has conscientiously pursued this objective. I leave others to judge whether it has been effective.

Interest Rate Management

In fact the RBNZ could not pursue inflation control through controlling the stock of money – there was too much disintermediation going on at the time the new regime was introduced. (I have been told the RBNZ economists had come to this conclusion before 1984.) Instead it used interest rates (especially the OCR), resulting in the RBNZ pursuing a kind of Keynesian policy in the monetarist framework of the RBNZ Act.

My objection to this approach is that interest rates target only certain parts of the economy – inventories, investment, mortgagees – rather than the economy as a whole, so the burden of adjustment was deeper on these sectors than if it had been shared across the whole economy. I argued that fiscal policy should share the burden. This was not a popular view in the 1990s. I argued it both publicly and privately with the RBNZ. (I inferred from their response that they were nervous about saying anything publicly because it might compromise their independence; I found cryptic support in footnotes.) Today, even the Governor of the RBNZ has articulated my sentiment.

So I am not saying that the RBNZ cannot influence the price level through interest rates. Rather I am saying that it is a clumsy, inefficient and painful way of doing so without an accompanying fiscal policy supporting it.

The Exchange Rate

I did not mention the exchange rate in the previous para. That too. I got into a (public) argument with the RBNZ in the 1990s about the role of the exchange rate, with them trying to fob me off with an index which purported to be a measure of the real exchange rate but had the nominal exchange rate in both the numerator and the denominator. Having said that, I have been surprised that the nominal exchange rate has not moved more than it has (which would impact greatly on inflation). One might argue, as I did in the 1990s, that monetary policy covertly targeted a stable exchange rate because if it had fallen, inflation would have been boosted. It is a bit more complicated than that because a current account deficit reflects a deficit in domestic savings relative to domestic investment. The relationship between net savings, interest rates and the exchange rates needs more attention.

Most external transactions have forward cover which goes up to about six months out, so I am told, so one would not expect high short-term volatility. I expected more long-term movement, particularly in a downward direction. I think what has happened is that the monetary regimes I was brought up on had considerable restrictions on capital flows. Following the Smithsonian agreement there was considerable liberalisation so it is easier to borrow offshore. That may be a short/medium run phenomenon; in the longer run the exchange rate may still crash, although the comparative indicators suggest that there are other economies likely to go sooner and that we are most likely to go down during a global financial crisis. Perhaps 2008 was a near miss.

The Great Inflation of the 1970s

A major issue is what was going on during the Great Inflation of the 1970s and how we broke out of it. The conventional wisdom views monetary policy being too loose under Muldoon with the tightening after Rogernomics bringing down the rate of inflation.

My view is more complicated. It gives much greater weight to inflation as distributional conflict; recently Oliver Blanchard articulated a similar perspective.

In the early 1970s, there was high inflation internationally. When it cooled in the mid-1970s New Zealand continued with its high inflation – in the end our prices about doubled compared to our trading partners’. I expect international inflation to transmit into New Zealand under a fixed or near-fixed exchange rate. That explains the early 1970s.

After that I see the high inflation as a consequence of a distributional contest. (The story is detailed in my 1996 In Stormy Seas.) The 1966 wool price collapse had reduced New Zealand real incomes. Who was to take the hit? The tension was there in the early 1970s, obscured by the international inflation and volatile terms of trade. With those both settling down from the mid-1970s, the conflict became more evident. It was compounded by the formal and informal linkages which pervaded the pre-Rogernomics economy. (It was kind of ‘pass the parcel in a Belfast pub’; each actor could temporarily maintain their income by passing their loss on to others who, through the linkages, did the same.)

Certainly, monetary policy was permissive. The tighter stance necessary to kill inflation would have collapsed the economy. In the late 1980s and early 1990s the linkages were broken with labour and beneficiaries taking the income cut required by the wool price collapse. (Holders of wealth invested in fixed-rate interest assets, especially pensioners, suffered more in the 1970s, when interest rates were controlled to well below the rate of inflation.) Thus we were able to follow the disinflation the world economy was undergoing in the late 1980s and early 1990s.

I don’t discount monetary policy, especially the exhortation. If everybody was convinced of the effectiveness of monetary policy on the price level, then expectations managed by exhortation would have some effect. But witchcraft can also have some effect if enough people believe in it.

Since the 1990s, inflation has on the whole been benign up to the last few years. But it was benign between the mid-1950s and mid-1960s, even before monetarism was articulated.

What Next?

I take the view – that British tradition coming to the fore – that the primary role of a central bank is to maintain order in the monetary system. (I accept that initially the Bank of England financed the king’s wars and whores.) Major interventions for this purpose are required only occasionally, although there are prudent measures to be taken in between (and the RBNZ takes them).

One of the ways that order is maintained is by shaping interest rates. Currently the short-term ones are set through the RBNZ operating on the OCR as it targets inflation.

One way of interpreting the 1989 Reserve Bank Act is that the RBNZ should manage short-term interest rates to control inflation independently of fiscal policy. The above analysis indicates I am sceptical that it can do so with the precision and ease expected of it. But one acknowledges that if enough people believe the claim, irrespective of whether it is empirically valid, it will modify their behaviour – especially their expectations – which would have some impact on rising prices. It seems likely that as current doubts evolve, this channel will weaken.

If the RBNZ cannot target prices with any precision then how is it to set its interest rates? I have not been able to observe the Monetary Policy Committee nor are its minutes and discussions public. Here are the issues which may influence their operational decisions (as well as the rate of inflation).

1. If the primary responsibility of a central bank is order in the money markets then they have to set interest rates with this in mind. During a crisis, such as the GFC, this becomes a major consideration. Arguably then, the interest rate settings were to maintain monetary order, even if they promoted inflation. (As an aside, what happened to the Silicon Valley Bank is instructive. My impression is that it would not happen here because of the close supervision of the RBNZ over our commercial banks.)

2. In more normal times interest rates cannot diverge too far from international rates, since that could lead to domestic monetary turmoil as financial entities change their portfolios.

3. I suspect that lurking behind the policy thinking has been the stability of the exchange rate which, of course, affects the level of prices. (In the first part of the postwar era, in an era of fixed exchange rates, the Bank of England used to change the bank rate to deal with runs on the pound.)

4. The RBNZ takes into consideration the capacity utilisation of the economy. It could be justified by a kind of Phillips Curve in which underutilised capacity (in the original Phillips curve it is  measured by unemployment) affects prices changes (in the original Phillips curve the price of labour – wages). The first economists to use prices changes on the vertical axis, were Paul Samuelson and Robert Solow; their version was once known as the Samuelson-Solow curve.) However, managing capacity utilisation could also be interpreted as the countercyclical macro-management of Keynesian economics, except that in the past it was done by fiscal policy and odd interventions (such as hire-purchase regulation) rather than monetary policy. Muldoon referred to it as his ‘fancy footwork’; it is now the Governor of the RBNZ who dances.

My suspicion is that in practice all of these dimensions plus inflation are taken into consideration in the setting of monetary policy. The balance between them probably changes at various times.

If this is correct, the performance of the RBNZ needs to be judged not just by how well it attains the inflation targets set by the Minister of Finance.

For those who are horrified that the RBNZ is not following the remit of the 1989 Reserve Bank Act that it should focus on price stability (there is a clause in the act, though, which also charges the RBNZ with maintaining order in the monetary markets), I remind them that the earlier (1964) RBNZ Act required the Reserve Bank to maintain price stability and full employment. It failed miserably in the 1970s and early 1980s. No governor was sacked or incarcerated for this failure. At the time it was accepted that the RBNZ was being directed by law to do something it could not achieve. I am casting similar doubt on the 1989 act.

Final Thought

In the 1950s and the early 1960s macroeconomic management had as an credible outcome as it had in recent times. But it certainly did not use the overt paradigm on which the 1989 framework was based – it did not exist then.