Monetary policy and the inflation target
Over the entire post-liberalisation period, New Zealand's real interest rates (short and long term) have averaged well above those in other OECD countries, including Australia. New Zealand interest rates affect the cost of capital (debt and equity) to New Zealand firms, and are likely to affect economic performance adversely. Various critics have suggested that something in the New Zealand monetary policy regime, or the specification of our inflation target, is to blame. We have not seen any evidence to support such a claim.
The Official Cash Rate (OCR) very directly and substantially influences short-term interest rates and also materially affects longer-term New Zealand interest rates[25]. The OCR is set and adjusted by the Reserve Bank with the aim of achieving and maintaining the inflation target agreed with the government. But it is the savings and investment preferences of New Zealand firms and households that ultimately determine where the Reserve Bank needs to set the OCR to keep inflation in line with the medium-term target.
There seem to be three possible strands to the criticism:
- It is sometimes suggested that the inflation target is out of line with international norms or with what is desirable for New Zealand. In fact, the current inflation target (1 to 3 percent annual inflation on average over the medium term) is quite conventional by international standards: a little higher than the target in the euro area, a little lower than that in Australia, and very similar to the targets in the United Kingdom and Canada.
- Even if the target itself is conventional, it is possible that the Reserve Bank might have been running policy too tightly in pursuit of the target. However, over very long periods (including when the Chairman of this Taskforce was Governor), the inflation rate has consistently averaged above the midpoint of the successive target ranges. If anything, some might think that the record suggests monetary policy has been a little too loose on average. It certainly provides no reason to think that monetary policy has been too tight, in a way that could account for the surprisingly high level of real interest rates that has prevailed in New Zealand.
- It has also been argued at times that the Reserve Bank is either excessively reactive or too slow to react. If that were so, it might, at the margin, have undermined our economic performance. The Reserve Bank has published research which suggests that it conducts monetary policy (adjusts interest rates in response to new information) in a way that is very similar to its peers in a number of other similar countries, including Australia[26]. We are not aware that anyone has contested the results of that research. The Reserve Bank of New Zealand no doubt misjudges the data from time to time. So do its peers abroad. On occasion, it acts too soon or too late. So do its peers abroad.
Any explanation of why New Zealand real interest rates have consistently been high by international standards should focus on those factors that influence the supply of and demand for credit, not on the agent (the Reserve Bank) that adjusts the lever (the OCR) to keep the two in balance. It needs to be better appreciated that the average level of real interest rates in this economy, on average over long periods of time, is not set by the Reserve Bank.
The Taskforce strongly endorses the current statutory framework for monetary policy and its focus on price stability. In the last decade alone, the framework has been independently reviewed by both a leading international expert (Professor Lars Svensson) commissioned by the previous Government and, more recently, by Parliament's Finance and Expenditure Committee. Both those reviews concluded that the New Zealand monetary policy framework was consistent with best international practice.
We discuss exchange rate issues, and the merits (or otherwise) of possible alternative exchange rate regimes, later in this report. To anticipate, we see no reason to think that a materially different specification of the inflation target, or any feasible supplementary tools, would be likely to make any material or systematic difference to the size of the fluctuations in the real exchange rate. This is not some statement of blind dogmatism: it reflects the experience of countries as diverse as Japan, the United States, Australia, Canada, Sweden, Norway and Korea[27]. Each of these countries does things a little differently, and they have all had very substantial variability in their real and nominal exchange rates.
Since the Reserve Bank of New Zealand Act was passed in 1989 there have been several changes made by successive governments to the way the inflation target has been specified. The midpoint of the target range has been increased twice, and the accountability procedures have been articulated in more flexible terms. In each case, the advocates for change appear to have argued that such change was important to help improve New Zealand's economic performance and to respond to big swings in the exchange rate. In each case, they were wrong. Each change has probably provided a little short-run relief and no long term gains, simply leaving New Zealand with the cost of a higher inflation rate. Because even firms now expect inflation will average around 2.5 percent over the medium term, we now have some additional distortions and economic costs that we would not have if the inflation rate was lower.
There is no evidence that changes in the inflation target have made any difference in improving economic performance. That is no surprise. Monetary policy made its contribution to improving our prospects back in the late 1980s and early 1990s when corrosive high inflation was excised from the system. New Zealand's approach to monetary policy management and inflation targeting has been widely imitated and admired abroad. Foreign observers are often surprised by the extent to which the monetary policy regime in New Zealand has repeatedly been an issue in political campaigns, in a way not seen in any other comparable country. They now do things our way in Australia, Canada, and the United Kingdom. We should take some quiet pride in that, and get on with focusing on the real issues relevant to our economic underperformance. Attacking symptoms is time and effort not spent on addressing the real problems.
Notes
- [25]Longer-term interest move quite closely day-to-day with those in the United States and Australia. However, over time, the absolute level of, say, two-to-five year interest rates in New Zealand is mainly influenced by expectations of where New Zealand's Official Cash Rate will be set in future.
- [26]See, for example, the paper “How similar is monetary policy in New Zealand, Australia, and the United States?” provided as part of the Reserve Bank's submission to the 2007 inquiry into monetary policy undertaken by Parliament's Finance and Expenditure Committee . The paper is available at http://www.rbnz.govt.nz/monpol/about/3074316.html
- [27]Of these countries, both Japan and Korea have at times undertaken extremely heavy exchange rate intervention.
