A possible new Policy Targets Agreement

“we have unemployment stuck stubbornly at 5% when it should be below 4%”

Those were the words of the Prime Minister in her speech to the CTU on Wednesday.  The latest published unemployment rate was a bit below 5 per cent.   But the average for the last four quarters is 4.95 per cent, and that for the last seven quarters is 5.0 per cent.

And “it should be below 4%”?   That’s a great aspiration –  ideally the unemployment rate should be much lower than 4 per cent, because even 2.5 per cent means that over a 40 year working life the average person spends a whole year unemployed – ie without any work, but ready to start work, and actively looking for work.     But I presume the reference to “below 4%” is more than that, and is something about what is attainable (sustainably) on, broadly speaking, the current labour market regulations, demographics, and welfare provisions.   Most observers think that the rate of unemployment consistent with stable inflation near the target is around 4 per cent.    Some, plausibly –  but we won’t know unless/until we get there – think it is lower than that.   Certainly there has been no sign of any acceleration in wage inflation with the unemployment rate near 5 per cent.

Most material deviations of the unemployment rate from the true (but not directly observable) long-run sustainable rate are, to a first approximation, due to monetary policy choices.    That was true in years leading up to 2008, when the unemployment rate was lower than the long-run sustainable rate –  monetary policy was too loose, and inflation was rising to outside the target band.  It has been true for the last eight or nine years when, at least with hindsight, monetary policy has mostly been a bit too tight. People who are unemployed, unnecessarily, have paid the price.    It isn’t the done thing to mention this in polite society –  few of whose members are affected directly by unemployment –  but it is true nonetheless.

And so I welcome the fact that we have a government that says it is serious about expecting the Reserve Bank to run monetary policy in a way that promotes full employment –  keeping unemployment as low as is consistent with a sustainable low and stable inflation rate.     I like the fact that the Prime Minister talks about lowering unemployment in her first speech.  (Whether she will do so as readily later in her term is another question).    And I’ve come to agree that adding some reference to unemployment to the mandate given to the Reserve Bank is desirable.     It has always been implicit.  We have active discretionary monetary policy to minimise the output and employment losses when severe adverse shocks hit.  Otherwise, we’d have stuck with the Gold Standard, which was really good for delivering long-run average price stability but –  by design –  less good at short-term stabilisation.

The New Zealand Initiative –  from the right –  disagrees.   In their newsletter this week Oliver Hartwich writes

Yet the real problem is that dual mandates do not work, not even in theory. They are the result of a misunderstanding as anyone who studied economics over the past half a century would know.

The best way for a central bank to achieve both low inflation and low unemployment is to make it pursue price stability alone.

The next RBNZ governor will no doubt be aware of that. In which case, she could safely ignore any dual mandate passed down from the new Government. And keep focussing on targeting inflation.

But that is simply not so.    It is certainly true that over the medium to longer-term monetary policy can only affect nominal variables (inflation, nominal GDP or whatever) and has no impact on real ones such as unemployment.  Most everyone agrees on that.  But it is equally true that monetary policy actions have a short to medium term impact on real variables, not just on prices.  Indeed, in the short-term the real effects are often larger than the price ones.   It isn’t something one can exploit to get unemployment permanently lower –  the long-run Phillips curve is more or less vertical – but it does mean that all discretionary choices about monetary policy are simultaneously choices about both inflation and output/unemployment.  The Reserve Bank knows that.  In fact, every advanced country central bank –  in countries with fairly stable inflation expectations –  knows that.

There is also some disagreement from the left.  In his column in yesterday’s Herald, Brian Fallow was sceptical about Labour’s proposed changes (the details of which we have not yet seen)

…in a later speech outlining his approach, Robertson said: “Had a mandate to maintain full employment been in operation in New Zealand it is likely that it would have constrained the bank’s [subsequently] aborted tightening of the official cash rate in 2010 and 2014. This would in turn likely have seen a faster return to target inflation and faster economic growth.”

Well, maybe. But counterfactual assertions about what would have happened if what did happen had not happened stand on epistemologically boggy ground.

Back here in the actual world, data from the OECD last week shows that New Zealand’s employment rate – the proportion of people aged between 15 and 64 who are employed – is at 76.2 per cent, the fourth highest level among the OECD’s 35 members.

Fallow goes on at some length about employment rates.   But employment rates simply aren’t the relevant variable for monetary policy (although they might tell us about all sorts of other areas of labour market, tax, retirement income etc policies): unemployment rates (and other measures of excess capacity) are.   People who want a job, are available now to start work, who are actively searching for a job, but just can’t find one.

(Having said that, as I’ve written previously I’m not sure that simply a different mandate would have changed the policy mistake of 2014.    With most reasonable possible formulations of an unemployment objective, a hawkish Governor misreading the data (as Wheeler was) would have been likely to have made the same mistake: the right person (“people” when they move to a committee model) matter at least as much as any tweaks to the formal mandate.)

I noticed in the Dominion-Post this morning what appeared to be a suggestion that amendments to the statutory goal for monetary policy might find their way onto the government’s 100 day plan, perhaps in part to ensure that the new mandate was in place before the new Governor is due to take office in March.

No doubt such a limited statutory change could be done quite quickly.  To simply make that narrow change would involve quite a short piece of legislation.  But getting the words right matters – and it isn’t something Parliament should be changing frequently.

Then again, all parties to the new government have also favoured changes to the governance model of the Reserve Bank, and that isn’t something that should be rushed.  The focus to date has been on monetary policy decisionmaking, but the case for reform is probably stronger for the Bank’s financial regulatory functions (where there is nothing akin to the PTA, and too much depends on what is little more than personal gubernatorial whim).   Getting the right governance model for these two quite different functions, and for all the remaining functions of the Bank, and all the consequential changes, takes time to do properly, and would benefit from a full Select Committee process.

As it happens, much of what the government appears to want to achieve can be done through the Policy Targets Agreement anyway.   There is no (lawful) Policy Targets Agreement at present, but a new one needs to be agreed with the incoming Governor before he or she is appointed.   Since the proposed emphasis on unemployment is implicit in the existing framework anyway – it is what a Governor doing his or her job should be keeping a keen eye on in determining the appropriate stance of policy –  simply writing it down more explicitly in the PTA does not raise any particular issues of inconsistency with the existing legislation.

Some might question that, but I’ve had a go at producing a concrete draft of a PTA that captures what seems likely to be the sorts of issues that motivated the Labour Party to promote legislative change.     The resulting text (below) isn’t my ideal framing of the PTA.  Instead, I worked with the text of the most recent document and made as few changes as possible while (a) capturing the spirit of the proposed changes, and (b) avoiding any inconsistency with the existing legislation.  I’ve highlighted the three paragraphs where I’ve proposed changes:

  • 1(b), a now-customary part of the document, where the government of the day lays out briefly its economic objectives, and how it sees monetary policy fitting in,
  • 3(b) where I’ve added words to make clear what has been well-understood since day 1 of inflation targeting, that in managing deviations of inflation from target a key consideration is to minimise short-term output and employment costs, and
  • a new 4(c) which would require the Bank to publish NAIRU estimates, explain why any (actual or forecast) deviations of the actual rate from those estimates was occurring, and to explain what steps it was taking (with monetary policy) to minimise the extent (magnitude and time) of those deviations.

There might well be improvements to this suggested wording.  But these, relatively simple, changes could quickly give effect to what seems to be the thrust of Labour’s proposals.   I’d welcome any comments or alternative suggestions.

Of course, if the government is serious about making a difference –  rather than just signalling one – words alone won’t suffice, whether in the PTA or the Act.  They need to take steps also to find, and put in office, the right people.  The combination –  people and mandate –  gives us a more serious chance of getting unemployment down to around the long-run sustainable rate, and keeping it near there as much as possible, than continuation of the status quo.

These are changes of the sort that the leading academic who reviewed the Reserve Bank’s handling of monetary policy for the previous Labour goverment  (Lars Svensson) would seem likely to endorse.  Svensson served subsequently for several years on the Monetary Policy Board of the central bank of Sweden, where his firm advocacy of an unemployment focus helped get Swedish monetary policy back on track, delivering lower unemployment and inflation nearer the target.  He might be worth consulting again.

Policy Targets Agreement

This agreement between the Minister of Finance and the Governor of the Reserve Bank of New Zealand (the Bank) is made under section 9 of the Reserve Bank of New Zealand Act 1989 (the Act). The Minister and the Governor agree as follows:

1. 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 Government’s economic objective is to promote a growing economy in which full employment is achieved and maintained.   The management of monetary policy, subject to the medium-term constraint of a low and stable inflation rate, plays an important part in supporting this objective.

2. Policy target

a) In pursuing the objective of a stable general level of prices, the Bank shall monitor prices, including asset prices, as measured by a range of price indices. The price stability target will be defined in terms of the All Groups Consumers Price Index (CPI), as published by Statistics New Zealand.

b) For the purpose of this agreement, the policy target shall be to keep future CPI inflation outcomes between 1 per cent and 3 per cent on average over the medium term, with a focus on keeping future average inflation near the 2 per cent target midpoint.

3. Inflation variations around target

a) For a variety of reasons, the actual annual rate of CPI inflation will vary around the medium-term trend of inflation, which is the focus of the policy target. Amongst these reasons, there is a range of events whose impact would normally be temporary. Such events include, for example, shifts in the aggregate price level as a result of exceptional movements in the prices of commodities traded in world markets, changes in indirect taxes, significant government policy changes that directly affect prices, or a natural disaster affecting a major part of the economy.

b) When disturbances of the kind described in clause 3(a) arise, and consistent with a goal of minimising the short-term output and employment costs, the Bank will respond consistent with meeting its medium-term target.

4. Communication, implementation and accountability

a) On occasions when the annual rate of inflation is outside the medium-term target range, or when such occasions are projected, the Bank shall explain in Policy Statements made under section 15 of the Act why such outcomes have occurred, or are projected to occur, and what measures it has taken, or proposes to take, to ensure that inflation outcomes remain consistent with the medium-term target.

b) In pursuing its price stability objective, the Bank shall implement monetary policy in a sustainable, consistent and transparent manner, have regard to the efficiency and soundness of the financial system, and seek to avoid unnecessary instability in output, interest rates and the exchange rate.

c) The Bank shall publish its estimates of the sustainable long-run rate of unemployment in each Policy Statement made under section 15 of the Act.   When the unemployment rate (as measured in the HLFS) deviates, or is forecast to deviate, from this estimate the Bank shall explain why these outcomes are occurring, or are expected to occur, and what steps it is taking to minimise the extent to which the unemployment rate deviates from its estimate of the long-run sustainable rate.

c) The Bank shall be fully accountable for its judgements and actions in implementing monetary policy.

Grant Robertson
Minister of FInance

 

…….
Governor Designate
Reserve Bank of New Zealand

Dated at Wellington this ..th day of …. 201….