What legislation used to require of monetary policy

This was what section 8 of the Reserve Bank Act, and associated provisions, replaced.  It is easy to forget –  and for many younger readers, never to have been aware –  just how different things were.  Of course, we had a singe decision-maker back then too, although as Minister of Finance and an elected MP, the single decision-maker could be (and often was) tossed out of office.

8. Primary functions of Bank

(1) The primary functions of the Bank

shall be—

(a) To act as the central bank for New Zealand; and

(b) To ensure that the availability and conditions of credit provided

by financial institutions are not inconsistent with the sovereign right of the Crown to control money and credit in the

public interest; and

(c) To advise the Government on matters relating to monetary policy, banking, credit, and overseas exchange; and

(d) Within the limits of its powers, to give effect to the monetary policy of the Government as communicated in writing to the Bank under subsection (2) of this section, and to any resolution of Parliament in relation to that monetary policy.

(2) For the purposes of this Act, the Minister may from time to time

communicate to the Bank the monetary policy of the Government, which shall be directed to the maintenance and promotion of economic and social welfare in New Zealand, having regard to the desirability of promoting the highest level of production and trade and full employment, and of maintaining a stable internal price level.

(3) The Bank shall, as directed by the Minister, regulate and control on behalf of the Government—

(a) Money, banking, banking transactions, any class of transactions of financial institutions, credit, currency, and the borrowing and lending of money:

(b) Rates of interest in respect of such classes of transactions as may from time to time be prescribed:

(c) Overseas exchange, and overseas exchange transactions.

(4) The Bank shall make such loans to the Government and on such conditions as the Minister decides from time to time, in order to ensure the continuing full employment of labour and other resources of any kind.

For those interested in the history, and how the functions/objectives/powers provisions changed (as they repeatedly did –  this was the 1973 formulation) there is an interesting Bulletin article here by Christie Smith and James Graham.  In case anyone thinks my post this morning was a recantation of a commitment to monetary stability (which it certainly wasn’t) I remain proud of the fact that my grandfather’s cousin was the Minister of Finance who introduced the concept of a stable internal price level to the Reserve Bank Act, and removed the formal power for the Minister of Finance to direct the Bank.  Those changes didn’t last long.

Should the statutory objective for monetary policy be changed?

Since 1989, section 8 of the Reserve Bank of New Zealand Act has read as follows:

The primary function of the Bank is to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices.

That provision was widely seen as one of the centrepieces of the new Reserve Bank Act in 1989. It does not directly guide day-to-day monetary policy, but rather it should constrain the Minister and the Governor in negotiating Policy Targets Agreements (PTAs). PTAs must, by law, be consistent with section 8: as the Act puts it, the targets are “for the carrying out by the Bank of its primary function”.

The wording raises a variety of geeky questions.   Should, for example, the Act really describe monetary policy as the Bank’s “primary function”, or just treat monetary policy as one of a variety of functions Parliament assigns to the Bank?   Is it really sensible to talk of stable levels of prices, when neither the Bank (nor ministers, nor Treasury) has ever shown any interest in stabilising the level of prices, as distinct from the rate of change in those prices (“the inflation rate”). More troublingly, perhaps, can a medium-term trend inflation rate of 3 per cent (which we had got up to prior to the 2008/09 recession, and which would double prices every 24 years) really be described as “price stability”?

I’m not going to try to answer those questions today. But they illustrate that there is no particular reason to think that the current specification of section 8 should be treated as sacrosanct. My impression over many years at the Reserve Bank was of a tendency (I may have shared this attitude at times) to treat section 8 as the battle standard of orthodoxy, such that any change would be akin to allowing the barbarians to overrun the fortress.

Going into last year’s election, each of the Opposition parties (Labour, Greens, New Zealand First, Internet-Mana) was campaigning to change section 8 of the Reserve Bank Act.   Of course, typically they were looking for rather more change than just a change of overarching statutory objective, but two parties were quite specific in what they were looking to do with section 8 itself

In Labour’s case, as I noted a couple of weeks ago, they came up with this formulation

“The primary function of the Bank with respect to monetary policy is to enhance New Zealand’s economic welfare through maintaining stability in the general level of prices in a manner which best assists in achieving a positive external balance over the economic cycle, thereby having the most favourable impact on the stability of economic growth and the level of employment.”

And New Zealand First has sought to introduce legislation amending section 8 to read as follows:

The primary function of the Bank is to formulate and implement monetary policy directed to the economic objective of maintaining stability in the general level of prices while maintaining an exchange rate that is conducive to real export growth and job creation.”

In both cases, it would appear that the framework of a Policy Targets Agreement would continue.   Labour was quite explicit about maintaining the inflation target.

In fact, looking around the world’s advanced economies there is a wide variety of ways in which countries have written down what they are looking for from their central bank and monetary policy. In a fairly short issue of the Reserve Bank Bulletin published late last year, Amy Wood and I looked at the wide variety of ways legislation is written in 18 advanced countries (or regions in the case of the euro) that now use inflation targets as the day-to-day centrepiece of monetary policy.

There are big differences across countries. Some of those differences are about the age of the legislation. Old legislation looks quite different from newer legislation. Some is probably about the preferences of legislative drafters in different countries. And one important difference that became apparent is that in some countries they have written a limited statement of what a central bank can directly achieve, while in others they have written more about the longer-term desired outcomes that might flow from good monetary policy. And while acts of Parliament are one part of the mix, they often aren’t the only place in which society’s aspirations for monetary policy are set down.

At one extreme, in Sweden the only formal document – the central bank act – simply states that the goal of the Riksbank’s monetary policy is “price stability”. There are no other formal or binding documents (although there are plenty of Riksbank texts on what current governors interpret the Act as meaning).

The US legislation, by contrast, is a mix of medium-term objectives (things the central bank might more directly affectl) and desired outcomes from good policy. The Federal Reserve Act requires the Fed to “maintain long-run growth in the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production”. Stable money growth was the thing the Fed could directly influence. But the Act goes on to state that this is to be done “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”. Congress didn’t care about money supply growth for its own sake, but for the things that are thought to flow from it.

The Bank of Canada operates under very old legislation. The Bank is required to “regulate credit and currency to control and protect the external value of the national monetary unit” (this dates back to before the era of floating exchange rates), but again it does not do this simply for its own sake. Rather, Parliament goes on to explain that the desired outcome of monetary policy is “to promote the economic and financial welfare of Canada”

I could go on. Even the ECB, established by treaty rather than by national legislation, operates under provisions which state that while the primary objective is “price stability” a variety of good things that should flow from the work of the ECB specifically and the EU more generally (eg “…stable prices, sound public finances and monetary conditions and a sustainable balance of payments”).  When I first stumbled on that last clause, about a sustainable balance of payments, I wondered if the Labour Party people were aware of it.

In many countries, even with quite recent legislation, there is an explicit obligation on the central bank to work together with, or support, other government economic policies, at least so long as doing so does not threaten the primary price stability goal,

What about the New Zealand situation?

Section 8 of the Act is pretty clear and succinct about what monetary policy is for, but nature tends to abhor a vacuum. Trace through the evolution of the Policy Targets Agreements since 1990 and you will more and more stuff written down, that was previously unwritten and somewhat taken for granted. But political pressures and criticisms of the Bank saw more and more details added in.  The 1992 PTA was perhaps the most cut-down approach.

Price Stability Target Consistent with section 8 of the Act and with the provisions of this agreement, the Reserve Bank shall formulate and implement monetary policy with the intention of maintaining a stable general level of prices

But in late 1996, a revised PTA was signed as part of the National-New Zealand First deal. It moved beyond just writing down the direct stuff the Bank could manage, to articulating what the point of pursuing price stability was.   The ‘so that” language that Winston Peters introduced here paralleled the “so as to” in the Federal Reserve Act.

Price Stability Target

Consistent with section 8 of the Act and with the provisions of this agreement, the Reserve Bank shall formulate and implement monetary policy with the intention of maintaining a stable general level of prices, so that monetary policy can make its maximum contribution to sustainable economic growth, employment and development opportunities within the New Zealand economy.

In 1999, in the wake of the MCI debacle, Michael Cullen added this provision.

In pursuing its price stability objective, the Bank shall implement monetary policy in a sustainable, consistent and transparent manner and shall seek to avoid unnecessary instability in output, interest rates and the exchange rate

It isn’t in the Act, but it is no less binding on the Governor (and successive Governors who have signed it). Unfortunately, as I noted last week, it is a somewhat troublesome clause, in that no one has ever been sure quite what the practical import was. At one level it was uncontroversial – avoid “unnecessary instability” – but quite what is “necessary”?

In 2002, Michael Cullen and Alan Bollard reformulated clause 1, restoring a clean focus on price stability in a), which just mirrors section 8 of the Act, while adding a separate sub-clause outlining what the government’s economic policy was looking for, and a sense of how price stability contributes.

Price stability

a) Under Section 8 of the Act the Reserve Bank is required to conduct monetary policy with the goal of maintaining a stable general level of prices

b) The objective of the Government’s economic policy is to promote sustainable and balanced economic development in order to create full employment, higher real incomes and a more equitable distribution of incomes. Price stability plays an important part in supporting the achievement of wider economic and social objectives.

With a change of government in 2008 there was a change in economic policy goal

The Government’s economic objective is to promote a growing, open and competitive economy as the best means of delivering permanently higher incomes and living standards for New Zealanders.  Price stability plays an important part in supporting this objective.

And finally in 2012, the words –  already present in section 10 of the Reserve Bank Act since 1989 – about having regard to the efficiency and soundness of the financial system in conducting monetary policy were added.  Quite what these words mean in practice is also less than clear –  even after 26 years.

No other countries have a binding legal arrangement akin to the Policy Targets Agreement.

There is a wide variety of ways in which countries, with very similar practical monetary policies, write down what they want from their central banks.  So the current wording of section 8 should not be sacrosanct –  the only possible way sound money could be preserved.  Personally, I would have no great objection if the wording introduced to the PTA in 1996 were to be translated in an amended section 8 of the Act.    I’d probably have slightly more problem with the Labour Party’s version from the manifesto last year, but ultimately it is for politicians to lay out higher level objectives for the Reserve Bank, and monetary policy.

But, and in a sense this is the point of the Bulletin article, those sorts of alternative formulations would not, on their own, be likely to make any material difference to the way monetary policy was run.  Practical differences flow from different Governors and different Policy Targets Agreements.  If political parties want actual practical differences in how monetary policy is run, they need to look to what they are negotiating in the PTA, and with whom.  As it stands, although the Reserve Bank has made more than its fair share of policy mistakes, evidence suggests that in normal times it has responded to incoming data in much the same way as central banks in Australia, the US, or Canada do.  And legislatures in each of those countries have written things down in rather different ways, to each other and to New Zealand.

There is no harm in amendments that may have little practical impact.  Symbolism matters, and since few would argue that  price stability should be sought for its own sake, there should be no strong objection to writing down in statute what it is hoped that good monetary policy will help contribute to.  Indeed, I would argue that it is better to write it down in statute than to keep fiddling with the Policy Targets Agreement. PTAs can be signed in the dead of night, perhaps involving two people only, as part of bundles of post-election negotiations.  The first the public know about the new terms is when the parties publish the signed document.  By contrast, even in New Zealand, the legislative process is usually much more open and transparent. Bills typically go to select committees, which invite submissions and review the arguments from outsiders before making recommendations.  And the hurdle of making changes in law is higher than for the PTA –  which has become something each change of government feels obliged to change.

I would favour amending section 8.  We need to face the fact that New Zealand is probably the only advanced country in which monetary policy has been repeatedly an election issue.  There has not been an election since 1987 in which one or other party was not campaigning on changes to the Act or the PTA.  That is no passing discontent.

Changing section 8 isn’t the biggest issue to address is reforming the Reserve Bank, but it shouldn’t be treated as of no importance either.

Since I’m not a die-hard inflation targeter either, I would favour something along these lines

Monetary policy shall be formulated and implemented towards the economic objective of maintaining medium-term stability in the purchasing power of the New Zealand dollar, so as to  maximise the medium-term contribution monetary policy makes to full employment and to the economic and social welfare of the people of New Zealand.

With such a clause, clause 4b –  the troublesome clause about avoiding unnecessary variability – should be able to be junked.  Parliament will have made clear that the whole point of the Bank is to promote good economic outcomes, and the longer-term interests of New Zealanders.  But don’t lose sight of the fact that New Zealand’s real medium-term economic failures have little or nothing to do with the conduct of monetary policy, or the way the Reserve Bank Act is written.

Of course, there still will –  and should  –  be vigorous debates about what intermediate targets the Bank should be required to pursue.  Many will favour the status quo, others might favour NGDP targets, and some might come to favour wage growth targets.  Some might favour a more active role in exchange rate smoothing. But those debates too should be carried on openly.  As I’ve argued before, the Minister of Finance and the Treasury (with or without the cooperation of the Bank) should already be planning an open process for consideration of issues before the next PTA will be due in 2017.  As 2017 is election year, the earlier the better really.

Of course, there is probably another debate to be had, before the Act is next comprehensively reviewed, as to whether there should be a single overarching objective for monetary policy and financial regulatory policy.  I think that would be a step in the wrong direction.  They are two quite different functions, just as monetary policy and fiscal policy are quite different.  But perhaps that is a topic for another day.