What is “formulating monetary policy”?

Under clause 8 of the current Reserve Bank of New Zealand Act, the primary function of the Bank is “to formulate and implement monetary policy”.   All powers rest with the Governor personally.

I did a lot of work over the years on issues around monetary policy, both bigger picture stuff around goals and governance, and on the detailed implementation arrangements (the design of the OCR system itself, and various supporting liquidity management arrangements).  I sat on whatever internal advisory committees we had for the best part of 25 years.  I wrote this piece, for example, and this one.  So I know whereof I speak.  But I don’t recall anyone ever making much of the distinction between formulation and implementation, or getting a legal opinion on which of “formulate” or “implement” mattered in what particular context.  Why would we have?  All the powers rested with Governor, and there was no particularly need to clearly delineate formulation activities from implementation activities, either in the present, or in thinking about contigency planning.

In practice, and on a day to day basis, under the current system the two activities are fairly clearly divided: monetary policy formulation is, in effect, things up to including the OCR decision, while implementation involves the detailed management of market conditions to deliver something akin to the chosen level of the OCR.

But the broad parameters of an OCR system itself –  indeed, even the decision to have an OCR (we’ve only had one for 19 years) –  doesn’t fall neatly on either side of a line between “formulation” and “implementation”.  And then there is foreign exchange intervention for monetary policy purposes. Perhaps things have changed, but when I was there decisions that the preconditions for intervention were right (the “traffic light system”) were made by the Governor in the OCR Advisory Group context, while (rare) decisions to actually intervene were made by the Governor directly liaising with the Financial Markets operational department.

It doesn’t matter much at present, because all powers vest with the Governor, and how or whether he takes advice on individual bits of his monetary policy responsibilities is entirely up to him.

But in the Reserve Bank bill introduced last week splits those two functions apart.

Under the amended clause 8, it is intended that

The Bank, acting through the MPC, has the function of formulating a monetary policy….

and, in section 8(3)

The function of formulating monetary policy includes deciding the approach by which the operational objectives set out in a remit are intended to be achieved.

And in a new clause 9, we read

The Bank has the function of implementing monetary policy in accordance with this Act.

And later in bill, in the new clause 63B we read

The MPC must perform the function of formulating monetary policy in accordance with this Act

Neither “formulation” nor “implementation” is further defined in the Act at present, and I can’t see any attempt to add more specific definitions in the new bill, other than a circular definition which says that

formulating, in relation to monetary policy, has the meaning set out in section 8(3)

Which, to say the very least, isn’t very specific.

I have two concerns about this, which boil down to much the same point I was making in a post last week: this bill would results in a committee which is likely to be nothing more than figleaf, and which leaves all substantive power in the hands of the Governor (and his chosen management team).  That is likely to be even more so in the next serious recession, when the limits of conventional monetary policy (how far the OCR can be cut) are likely to be reached.  If that is the Minister’s intention, he should be honest enough to say so. If he is serious about building a stronger, more open institutions, not totally controlled by management, he needs to look again.

I suspect the intention of the wording of the bill is that OCR decisions (and only those decisions) should be made in, and by, the MPC.   That would be consistent with the explanatory note to the bill, which twice refers (loosely) to the goal being to institute an MPC “to make decisions on monetary policy”.

But the OCR itself is (rightly) not referred to in the Act.  And clause 8(3) only talks, very loosely, about “>deciding the approach by which the operational objectives set out in a remit are intended to be achieved”.   Couldn’t a Governor argue that not even the specific OCR decision is covered by that mandate?   The MPC might decide that it thought an inflation target should be achieved over, say, a two-year forecast horizon, but it isn’t clear why the Governor couldn’t insist that even specific OCR decisions were a matter for him alone, provided they weren’t inconsistent with the MPC’s “approach”.   That interpretation might be buttressed by the proposed wording around Monetary Policy Statements.  MPSs need the approval of the MPC, but the specific material an MPS has to cover is  (emphasis added)

specify the approach by which the MPC intends to achieve the operational objectives [and] state the MPC’s reasons for adopting that approach

I’m not suggesting such a departure is at all likely under the current Governor, but legislation should be written in a way that is robust, including to power-grabbers (either the Governor, or the MPC).   Specifically, it would be quite inappropriate for the Governor to be able to assert that OCR setting was purely his responsibility, and that MPC was only there to provide advice, even a decision, on the broad “approach” to achieving the remit goals.  It would make a mockery of the rhetoric around reform.
Similarly, I don’t think it should be acceptable for the Governor alone to decide to, say, scrap the OCR system itself (which would appear to be possible under the current legislative drafting) or to modify the system substantially in ways that led to much greater (or much reduced) volatility in key financial prices.  I’m not even convinced that choices around the policies the Bank adopts on what sort of collateral to take in its market operations, implementing monetary policy, should be matters for the Governor alone.  Such decisions have the potential to materially affect monetary conditions, and the achievement of the remit goals set for the MPC by the Minister of Finance.   At a bare minimum, the Governor should be required to consult with the MPC on such matters, and have regard to any comments or representations on such matters they wish to make.  Similarly, I don’t believe it should be acceptable for foreign exchange intervention decisions (the traffic lights) done for monetary policy purposes (or, indeed, the policy on such matters) to be made outside of the context of the MPC.

These issues might seem of second-order importance in normal times.  They have the potential to become hugely important in crisis periods, or in circumstances in which the limits of the OCR have been reached (recall that the Bank itself reckons the practical limit is only 250 basis point from here).  In those circumstances, if the MPC has power only over the OCR –  and perhaps not even secure statutory power there –  it will be all-but neutered; irrelevant to the real choices that the Bank management (and perhaps the government) is making.

Thus, for example, decisions to:

  • intervene heavily to drive down the exchange rate,
  • decisions to undertake substantial QE,
  • decisions to intervene to control yields on interest rate swaps

(all options touched on in the Bank’s recent article)

as well, potentially, as decisions around any limits on the volume of notes and coins, or on the conversion rates between settlement balances and notes and coins, would have potentially very large consequences for monetary conditions, and for the ability to meet the remit target

but I suspect the Governor would argue that they are all matters for him to decide, not choices for the MPC.

If the Governor successfully made such an argument, it would be unfortunate on at least two counts:

  • substantively, since the whole argument (made in the Explanatory Note, and in the Minister’s speech) is the benefits of diverse perspectives.  Such perspectives would be likely to be more valuable usual in an unconventional environment, which management had not previously experienced,
  • transparency.  The bill envisages requiring that some (pretty neutered) MPC minutes will have to be routinely published.  But if the important stuff of monetary policy is still being decided by the Governor –  not just him block-voting management in the committee – even what limited gains we might hope for around transparency and accountability will be foregone.

Of course, one way of looking at all this is to observe that if I’m right and the new legislation just cements in effective control by the Governor (through his management majority of the committee, and his likely clout with the board regarding the handful of externals) perhaps it doesn’t really matter very much.    Good people are likely to be reluctant to accept appointment, and that would simply be reinforced during a period when the OCR itself was neutered.

But, presumably the Minister doesn’t accept that interpretation (after all, he talks about the benefits of committees, diverse perspectives etc).  Nor, presumably, does the Opposition –  who talk up the risks to the independence of the Bank.  The legislation should be better-worded:

  • it should be explicit that the MPC has responsibility for decisions on the OCR or any official interest rate,
  • it should be explicit that the MPC has policy responsibility for matters to do with foreign exchange intervention done in support of monetary policy, and for policy parameters around domestic liquidity management,
  • it should be explicit that policy matters to do with, for example, QE should be matters for the MPC
  • operational decisions on matters within these mandates would be matter for the Governor, but accountable to the MPC,
  • and, at very least, the MPC should be free to make written representations on any other aspects of Bank responsibility which, in their view, are likely to affect their ability to deliver the remit objectives.

Consistent with that, of course, the MPC should have a clear majority of outsiders, and a clear majority of the members (preferably all) should be directly appointed by the Minister of Finance, without the involvement of the Bank’s (ill-qualified, illegitimate, and unaccountable) Board.

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