How the Reserve Bank thinks we should evaluate its monetary policy

The Reserve Bank released a new issue of the Bulletin yesterday headed “Evaluating Monetary Policy”.   Bulletins carry the imprimatur of the Bank itself, and in this case the key messages are conveyed in quotes from Assistant Governor John McDermott in the accompanying press release.  I’m sure Graeme Wheeler himself will have gone through this quite carefully before agreeing to its release, and we can assume that the article speaks for the Governor.

In principle, the article isn’t a bad idea.  It is worth having an accessible summary reference that outlines the key legal provisions that govern the Bank’s accountability for monetary policy, and which articulates some of the real challenges in scrutinising and holding the Bank to account in the approach to conducting monetary policy (“flexible inflation targeting”) that is now pretty widespread.  As I’ve pointed out previously, the Act was written for a simpler (not very realistic) conception of monetary policy.

But it is also the sort of article that needs to be written rather carefully and modestly.  The people (or institution) being held to account are not the ones who get to define how we review and assess them, and hold them to account. That is up to us –  whether “us” is citizens, markets, MPs, media, lobby groups, the Minister of Finance, or whoever.  If it ever comes to a question of dismissing the Governor, the formal legal provisions would have to be considered very carefully, but short of that  –  and I hope we are always short of that –  a wide range of factors will, and should, be taken into account.  Some of them are the rather narrowly technocratic items in the latest Bulletin.  But many aren’t.  And an article of this sort from the Board –  who are actually paid to hold the Governor to account –  might have been more valuable.

In publishing this Bulletin, I suspect the Bank had a couple of motivations.  One probably was genuinely didactic and informative – the public service of reminding readers of some of the issues.  But I suspect the rather more important consideration was defensive. It looks like an attempt to get critics off their back, and perhaps even to fend off doubts that even some Board members might have had (the Board, while compliant overall, has always had its awkward characters)  about just how well the Governor has been doing in ensuring that the Bank achieves the policy targets.  An article like this will have been in the works for several months.

I don’t think the article does either job well.  If anything, it raises more concerns about the depth and authority of the key policymakers and advisers at the Reserve Bank.    My advice to them, had they asked, would have been that there might have been a useful role for two quite separate articles:

  • One on the framework itself, a reminder of how the accountability system is designed, and is evolved.
  • A separate one that reviewed , with the benefit of hindsight, the conduct of monetary policy over the last few years.   Would we have learned anything from the latter?  Perhaps not, but having the Governor make the strongest case he could, including showing us how he has learned from mistakes and the flow of new information, would have been revealing, however good or bad the document actually was.

Except in passing I’m not going to debate here the record of the last few years.  The article touches on it directly in a rather unconvincing box (pages 16 and 17), but in fairness it is difficult to do justice to the arguments on either side in five charts and six short paragraphs.  But, as a hint, if you want to persuade thoughtful people of your case, it is good to actually engage with the arguments or alternative perspectives the critics have offered.  Anyone can beat a straw man, but what is gained by doing so?

My copy of the article is riddled with comments in the margins, and I won’t bore readers by going through them all.

But let’s start with John McDermott’s press release, which pummels a straw man and declaims what should be a platitude.

The straw man?  We are told, portentously, that “it is not sufficient to look at inflation outcomes alone when assessing the conduct of monetary policy”.  Indeed, but whoever said it was?

And the platitude?  This point is repeated so often, between the article and the press release, that they really must want us to take notice: “a central bank should make full use of all relevant information, and learn from new information and forecast errors as these come to light.”   Really?    I’m sure we hadn’t thought of that before.    Of course, but critics will suggest that it is precisely what the Reserve Bank has not been doing in recent years.  They haven’t convinced us –  and don’t really try to do so in the article – that they have taken the best possible approach to learning from their mistakes.  That cause is not helped when the Governor is so reluctant to concede that any mistakes were ever made.

The article has a number of curious features even in its description of the formal accountability process.  For example, the phrase “Minister of Finance” does not appear at all.  And yet the Minister of Finance:

So how did the Bank manage to write a whole article about monetary policy accountability and not mention the Minister of Finance?  Ours is quite a different system than those in most other countries.

I think it is partly because they use a muddled concept of accountability.  The article is headed “evaluating” monetary policy, which  – at least to some ears –  has rather technical connotations to it.  But even allowing for that,  there is an important distinction between people having views on the monetary policy performance, and people with the power to do something about it.  Real accountability implies the presence of remedies –  the Board and the Minister have them, but we don’t.

The article also veers down an odd line of argument that confuses transparency and accountability (and evaluation for that matter).  Take this paragraph:

Well-informed oversight from external stakeholders benefits the Bank in two ways. Firstly, a clear understanding of the Bank’s policy goals, and how it might be assessed against those goals, helps external stakeholders predict how the Bank is likely to react to new information. This improves the efficacy of monetary policy, since agents in the economy can react instantly to new information, rather than having to wait for guidance from the Bank. Secondly, it provides several avenues – in addition to the role played by the Board – for direct feedback to improve the Bank’s decision making. Well-informed feedback can help the Bank identify faster the need for policy adjustments.

But “oversight” isn’t there to benefit the Bank –  it is supposed to protect the public and the country.  There is certainly a reasonable argument that transparency about the goals the Bank is working to and the “reaction functions” it uses can be helpful in engendering public and market responses to data that are consistent with how the Bank will eventually adjust monetary policy (so, could we see that model?), but that is a different matter from policy evaluation or accountability.  One can be predictably wrong –  as the Bank has become over the last couple of years-  as well as predictably right.  And, incidentally, it would be interesting to know whether any feedback from anyone has made any difference to “improve the Bank’s decision making” or “identify faster the need for policy adjustments”

But perhaps the critical caveat is “well-informed”?  Is there any feedback or criticism about monetary policy that the Bank (current Governor) has regarded as well-informed?

The Bank goes on to note that “self-assessment by the Bank is an important part of the accountability framework”.   The willingness to recognise mistakes and learn from them should be one of the characteristics the Board and the Minister should be looking for in evaluating the Governor’s performance.  I’m not sure, though, that I have seen those aspects commented on in the Board’s Annual Reports.

And it is a little surprising that the article does not refer to the one place in the Act where the Bank is required to undertake and publish self-assessment and review.   Section 15 of the Act governs Monetary Policy Statements, which are formally only required every six months. But each such statement must

contain a review and assessment of the implementation by the Bank of monetary policy during the period to which the preceding policy statement relates.

This section of the Act certainly needs updating, but the Bank does not even try to comply with the spirit of what those who drafted the law were about.  After constant nagging, they started publishing a box in each MPS which probably barely meets the formal legal requirements –  it briefly describes monetary policy over the preceding period, but makes no attempt at assessing or evaluating such policy  (as distinct –  and the distinction is important –  from defending it).  I used to argue that perhaps once every two years such a review and evaluation should be undertaken as a major special chapter in a Monetary Policy Statement, perhaps informed by commissioned reports from independent experts.   (The article also omits to mention the legal requirement on the Board to “ determine whether policy statements made pursuant to section 15 are consistent with the Bank’s primary function and the policy targets agreed to with the Minister under section 9 or section 12(7)(b)”)

Changing tack for a moment, there are a couple of interesting and slightly surprising observations in the article that bear on current policy.  I and various market commentators have been critical of the Bank in recent months over the claim it is making that things are okay, because inflation will be back well inside the target range by early next year.  The Bank’s forecasts are quite clear that this happens only because of the direct price effects of a lower exchange rate.  As outsiders have noted, one-off shifts in the price level are not the same as the medium-trend in inflation, and there was little basis to think that temporarily higher headline inflation foreshadowed rising core inflation.

It was, therefore, both reassuring and discomforting to find this quote in the article

Tradables inflation tends to be more affected by short-term disturbances, due to exchange rate movements and volatility in international prices. It is therefore more common for the Bank to look through short-term variability in the prices of tradable items.

Reassuring, since staff clearly haven’t abandoned the framework –  trends in the persistent components of inflation are really what matter to them.  But discomforting because in press release after press release (it was there again last week), speech after speech, the Governor tries to get us to focus on a headline inflation rate that is just temporarily boosted by the lower exchange rate.   That isn’t accountability or clear communications.  It looks a lot like just trying to muddy the waters to distract people from the persistent undershoot in core inflation.

The article also discusses the timeframe over which the Governor aims to get inflation back to target. But it is a puzzling discussion because it concludes with a quote from a speech Alan Bollard gave in late 2002, shortly after he had become Governor.  The target inflation rate had been raised and (arguably) some more flexibility had been added into the PTA. The Governor (and we his advisers) wanted to help outsiders understand how we would apply the new PTA.  He stated that his interpretation of the PTA was that following deviations from the inflation target range, things would be on course if “projected inflation will be comfortably within the target range in the latter half of the three year period.”  In other words, current inflation might be above target, but for the period 18 months to three years ahead, the Bank’s forecasts should show inflation settling “comfortably within” the target range, on credible assumptions.  Alan was a dove, who was keen to “give growth a chance”.   He proved content to have forecasts settling back to around 2.5 per cent in that 18 month to three year window.

The Reserve Bank in this article has now reaffirmed that approach to the PTA.  Which is puzzling, because the 2002 PTA made no reference to the midpoint.  That was something Alan often reminded us of –  getting to the midpoint might be nice if we got there, but there was no pressing need to do anything active about it.   But, as the current Governor has often reminded us, the reference to a focus on the 2 per cent midpoint, added in 2012, was put there for a reason – to help anchor inflation expectations near the midpoint of the target range.  But how can we –  or markets –  take seriously the PTA’s focus on the midpoint if the Bank is going to run the Bollard rule, and suggest that so long as its forecasts show inflation 18 months to three years ahead at, say, 1.5 per cent, that is consistent with the PTA?  Perhaps they mis-stepped in putting this article together, and no one noticed this tension?  If so, a clarification might be in order in the December MPS.  But if it is deliberate, those paid to hold the Bank to account –  the Board and the Minister –  should surely ask the Governor some fairly pointed questions?

Two final observations on the accountability material.  The Bank, as it always does, puts great store by the material that it publishes, and which it chooses to make available to people scrutinising its performance.  Perhaps just because the article was written by macroeconomists (who don’t tend to pay much attention to public policy and governance frameworks more generally) it did not mention at all the Official Information Act, which applies to the Bank as well and exists in part to enable better scrutiny of public agencies. Of course, the track record suggests that the Reserve Bank regards the Official Information Act as a regrettable legal obligation, to which minimalistic compliance may be necessary, but only after as much delay and obstruction as possible.  Self-selected transparency is not a great basis for scrutiny, challenge and review –  although the resistance to greater transparency may provide useful signals about the more general approach of the organisation.

And I was (somewhat geekishly) interested that the article does not seem to contain even once the word “model”.  It is difficult to evaluate monetary policy without a model in mind of how the economy works.  The Bank has prided itself over the decades on the extensive investment it has put into developing formal models of the economy, and undertaking formal structured research.  I’ve never been entirely sure that it was money well-spent (and the main model is still held secret), but John McDermott took a different view (and in the recent round of cost-cutting, the Bank’s research and modelling functions were not cut  back at all).    The authors of the article cite various academic articles from abroad, and most of them use formal models for policy evaluation.  I can quite understand that the Governor might not want the Bank to come across as too geeky and unrealistic, but if the Bank has really lost so much confidence in these more formal approaches to evaluation, even as inputs provided to those holding the Governor to account, that in itself is quite revealing.

Almost finally, I was mildly amused that the authors chose not to reference the previous article on the Bank’s website that dealt with these issues.  It is a few years old now, but the relevant legislation and economic challenges haven’t changed.  I’m sure there was a good reason for not doing so.  Like the current article, it (no doubt had to) understates the  limitations of the Board as a monitoring agent, but it did include a slightly richer list of the sort of things those looking to hold the Governor to account might reasonably be expected to take into account.

Some of the items the Reserve Bank’s Board might be expected to concern themselves with in fulfilling the monetary policy monitoring role include:

  • The processes the Governor uses to gather and interpret economic information.
  • The choices the Governor makes in allocating resources areas of the organisation relevant to monetary policy (including judgements he makes on whether to seek more, or fewer, resources, when the five-yearly funding agreement is negotiated)
  • The means the Governor uses to ensure that he is exposed to alternative perspectives.
  • The quality of the people the Governor appoints to advise him on policy choices.
  • The way in which the Governor applies section 3 and 4 of the PTA (dealing with deviations from the target range, and the avoidance of unnecessary instability).
  • The way in which the Governor thinks about and responds to the uncertainties around monetary policy.
  • The ability of the Governor to articulate the reasons for his policy choices, and his ability to convince others of his case.
  • The processes the Governor uses to assess past policy and learn from experience.
  • The stability through time in the Governor’s policy choices.

It would be interesting to see an article of this sort dealing with the Bank’s financial soundness and efficiency functions and responsibilities.  If effective accountability for monetary policy is hard, except perhaps at the point of any gubernatorial reappointment, it must be well-nigh impossible for the Bank’s other main functions.