Monetary policy: towards the next recession

Tomorrow Graeme Wheeler will announce his second-to-last OCR decision.  Assuming, as everyone seems to expect, that the Governor largely restates the policy stance he adopted six weeks ago, I expect to agree with him.  Within the huge, and inevitable, bounds of uncertainty, the current OCR seems plausibly consistent with core inflation getting back to around 2 per cent, and there is no strong impetus that should be pushing the Reserve Bank to either raise or lower the OCR any time soon.

If anything, one could probably more readily argue for another cut, rather than any increase, just because core inflation has remained so low for so long and it has proved harder to get it back up than most had expected.  The unemployment rate – an indicator that the Labour Party is rightly calling for the Bank to give more weight to – points in the same direction.   In that respect, I disagree with the collective view of the NZIER’s Shadow Board, who have a clear upward bias.  As an aside, it is interesting  to note that the BNZ’s chief economist, Stephen Toplis, shares the upside bias, but is the only one of the panel to put a substantial weight on the possibility that further cuts might prove, as things stand, to be appropriate.   Here is the probability distribution (percentages) of his recommendations.

toplis shadow board

But in this post, I really wanted to focus on some longer-term issues where I think there is rather more serious reason to doubt that the Governor is adequately discharging the responsibilities of his office and reason to worry that, in fact, some of his duties have been neglected.     And these aren’t just issues about economic forecasting, something that no one is very good at, and where anyone who pretends otherwise is a fool.

My concern is the next recession.   No one knows when it will be, but it has been seven or eight years since the last one ended.    People will chip in to point out that there is nothing inevitable about another recession just because a few years have passed since the last one, and no doubt that is true.  Nonetheless, downturns and recessions do happen, and discretionary monetary policy exists mostly to help cope with them.  (And to anyone who wants to argue that Australia hasn’t had a recession for 26 years, the simple response is (a) check out the fluctuations in the unemployment rate, and (b) check out the fluctuations in the RBA’s policy cash rate.)

Perhaps others will want to point out that the Reserve Bank still seems to think that the neutral interest rate is perhaps 200 basis points higher than the current OCR.   Perhaps they are right, and perhaps not.    But even if, in some sense, they are right, it will be no comfort –  and provide no buffer – if the next recession were to occur in the next couple of years (and if you think that unlikely –  as probably I do too –  recall that the track record of forecasting recessions, globally or domestically, is even worse than the usual economists’ dismal record of macro forecasting).

If anything, of course, these issues are even more pressing in most other advanced countries.  The only upside to having, on average over very long periods of time, the highest interest rates in the advanced world is that the practical lower bound on nominal interest rates is a bit further away here.    But it is quite close enough.  In New Zealand recessions, cuts in short-term interest rates of 500 basis points or more haven’t been exceptional.  After the last recession, the OCR has been cut by a total of 650 basis points, and (core) inflation still hasn’t got back to target.   So when you are starting with an OCR of around 1.75 per cent, and the practical lower bound on nominal interest rates is probably around -0.75 per cent, the leeway that is left is much less than one would typically like.      People can put on brave faces and pretend otherwise, or simply try to ignore the issue (the latter seems mostly the New Zealand approach), but burying your head under the pillow doesn’t make the problem go away.

And it is not as if this is some flaky Reddellian issue that no one else in the world cares about.    In Canada, for example, there is formal process for reviewing their inflation target every five years.   At the last review, they left the target unchanged, but only after doing a huge amount of work looking at some of the alternatives.   That work was openly foreshadowed (eg in a speech here ), and a great deal of it was published, and is available here.

Over recent years, two former IMF chief economists –  Ken Rogoff and Olivier Blanchard –  have called for inflation targets to be raised to provide additional scope for discretionary monetary policy in the next downturn. [UPDATE: I had meant to include this link to a recent post from Simon Wren-Lewis, an Oxford professor of macroeconomics, which also touches on the fiscal options.]

In the US context, I linked a couple of weeks ago to a speech by John  Williams, head of the San Francisco Fed, openly exploring whether the Fed should move away from inflation targeting to price-level targeting, again with a view to increasing resilience in the next downturn.    As I observed then

I’m not persuaded by Williams’ case, but what struck me is how open the system is when such a senior figure can openly make such a case.  The markets didn’t melt down. The political system didn’t grind to a halt.  Rather an able senior official made his case, and people individually assessed the argument on its merits.

And then a couple of weeks ago there was an open letter to the Board of Governors of  the Federal Reserve from 22 economists calling for serious consideration to be given to an increase in the inflation target, and specifically that

the Fed should appoint a diverse and representative blue ribbon commission with expertise, integrity, and transparency to evaluate and expeditiously recommend a path forward on these questions.

As they noted, other senior Fed people had openly acknowledged the importance of the issues.

And was the letter  –  mostly from a group of fairly left-leaning economists, but including one former FOMC member, and one former member of the Bank of England’s Monetary Policy Committee –  just ignored?   Time will tell, but Janet Yellen was asked about it at her press conference.  Her response?

Ms Yellen stressed in her news conference last week that there were both costs and benefits to a higher inflation target, but she added that the Fed would be reconsidering the issue in the future. “We very much look forward to seeing research by economists that will help inform our future decisions on this.”

There are pros and cons to making changes, whether simply to raise the inflation target, or to look at options such as levels targets for the price level, nominal GDP, or wages.    Personally, I would prefer that central banks (and finance ministries) focused on options that eased or removed the effective lower bound on nominal interest rates  (issues on which, again, very able people internationally have written).   As I noted in an earlier post on these issues

At the extreme, central bank physical currency could be withdrawn and completely replaced with electronic central bank liabilities, on which (say) negative interest rates could be paid.  But that would take legislation and considerable organisation, and would be an unnecessary over-reaction, while there is still a considerable revealed demand to transact (in the mainstream economy) in cash.  Better options might be to, say, cap the total issuance of Reserve Bank physical currency and allow an auction mechanism to set a variable exchange rate between physical and electronic Reserve Bank liabilities.  Banks themselves could be allowed to issue currency again –  on whatever terms they chose.  Or the Reserve Bank could simply put in place an administered premium price on access to new physical currency (eg a 2 per cent lump sum fee would be likely to introduce considerable additional conventional monetary policy leeway).  Each of these possibilities has potential pitfalls and possible legal issues.

But now is the time to be doing the research and analysis.  Now is the time to be working through the technical obstacles and logistical constraints.  And now is the time to be (a) canvassing the issues in public, and drawing on the perspectives of outside experts as well as public servants, (b) to be making the informed decisions as to whether (reluctantly) inflation targets need to be raised, and (c) to be able to lay out in public a confident articulation of how the authorities envisage that they would handle the next significant recession, given the evident limitations at present.

Why does it matter now?     There are at least two reasons.  The first is that if a higher inflation target is part of the answer, now is the time to do it.  It can’t meaningfully or usefully be done in the middle of the next recession, because by then there will very serious doubts that the authorities can get inflation up to even the current target rate.  And the second reason is because when the next recession is upon us (whenever it is) commentators will very quickly realise the limitations of conventional monetary policy.  We’ve been used to a world in which central banks could act decisively to lean against recessions – not prevent them, but limit the damage that is done, and prompt a rebound.   If people realise that is no longer possible to anything like the usual extent, they will –  entirely rational –  adjust their expectations in light of that knowledge.   Expectations quickly become reality in that sort of climate, deepening (perhaps quite materially) the recession.     It would be almost inexcusable to simply let that happen –  with all the real adverse consequences on individuals and families from unemployment –  when there has been years to prepare against the possibility.

The third consideration is a bureaucratic one.  There will be a new Policy Targets Agreement negotiated before the new Governor takes office next March.  In the normal cycle of our law, that is the time to make any significant changes in the regime.    And now is time to be doing the work on these issues, and canvassing them in public.  There aren’t automatically obvious right answers to these questions, and answering them –  what are the best guidelines to govern macroeconomic management – isn’t just a matter where those inside the bureaucracy are blessed with a monopoly on wisdom.      (It is an  unusual and undesirable feature of our law that the Policy Targets Agreement is formulated before the Governor takes office –  when he or she may have little specific expertise, and little access to staff (or outside) advice –  but that is just one of the many aspects of the Reserve Bank Act that is overdue for reform.)

There are at least two countervailing arguments that I want to address briefly.     The first is one that I take some comfort from myself.    Foreign trade is more important to the New Zealand economy than it is, say, to the United States.    Should our OCR ever have to be cut to the effective lower limit (even if it was then no lower than those of most other advanced countries) it seems highly likely that our exchange rate would fall very substantially.    We’ve seen that in the past when the gap between our interest rates and those abroad has closed (most obviously in 2000).  That would make some material difference in buffering our economy.  Against that, however, it is important to recall that in each past New Zealand recession the exchange rate has also fallen a long way.  We seem to have needed both large interest rate cuts and large falls in the exchange rate.

The second countervailing argument is the potential role of fiscal policy.    But although New Zealand’s government debt position isn’t bad:

  • it is not as good as it was going into the last recession,
  • since then we’ve been reminded repeatedly of the potential fiscal pressures from natural disasters,
  • there is no coordination framework between fiscal and monetary policy and the Reserve Bank (rightly) has no control over the use of fiscal policy,
  • it isn’t clear that in any of the countries that actively used fiscal policy in the last severe recession it was done on a scale that was enough to make a decisive difference,
  • while politicians in other countries were often willing to actively use fiscal policy to boost demand for a year (or perhaps two), the imperatives –  political, economic or market –  for tightening up again seemed to take hold pretty quickly,
  • fiscal policy is simply less well-suited to the cyclical stabilisation role than monetary policy.

But if fiscal policy is to be a big part of New Zealand’s answer to the limitations on monetary policy in the next recession, again the issues need to be openly canvassed and debated now.

These are issues that should be worrying the Reserve Bank, the Treasury, and the Minister of Finance.  But there is not a hint of such concern in any of their publications or public statements.  This isn’t one of those issues –  is a bank on the brink of failure eg –  where secrecy is required.  If anything, it is one that would benefit (perhaps greatly) from open discussion, and a sharing of perspectives, research insights, and other analysis.

Each year the Reserve Bank (for example) is required to publish a Statement of Intent.  In many ways it is a bureaucratic hoop-jumping exercise, but it does require the Governor to set out the Bank’s priorites and areas of focus for the coming three years.  I’ve written here previously about how these issues –  really important medium-term considerations –  have had no mention in past Statements of Intent.   There will be a new SOI out in the next week or so –  they have to publish before 1 July.    Of course, at this stage with only three months left in office, what the Governor thinks of as the priorities for the next three years may not matter much in practice.  But it will be interesting to see if he has given these “next recession” issues any space in this year’s document.   I hope so, but fear not.

It is a shame that he hasn’t used the opportunity of his last year in office, when he could have acted as an honest broker and champion of opening up issues for his successors, to have openly put these issues on the agenda –  in public and for the Bank’s own research.  To do so would have been fully consistent with his responsibilities under the Act.  It would, almost certainly, have been a more appropriate use of his energies than corralling his senior managers into efforts to censor a market economist who disagrees with him in tones the Governor finds uncomfortable.  Leadership is about looking beyond the trivial, restraining your own irritations, and focusing attention on important issues that may be just beyond the horizon (and the immediate concerns of officials and market economists) right now, but are no less important for that.

One would hope that when the Board is interviewing candidates for the next Governor (recall that applications close in a couple of weeks) these are among the sorts of substantive issues they are conscious of.  But you have to wonder how they would do so.  The Board has no role in the formulation of the Policy Targets Agreement, and among its members there is very little expertise in the sorts of issues that need to be grappled with.  As a group that has collectively defended the status quo, it isn’t obvious that it would be in the personal interests of any applicants to seriously challenge in front of the Board whether things are quite right.  That would be a shame.  (And again, it is reason for reforming the Reserve Bank Act –  both to shift the setting of the policy target away from the appointment of a Governor, and to shift responsibility for appointing a Governor more squarely to the Minister of Finance.)

As a marker of just how untransparent the New Zealand system is, the Reserve Bank proved highly obstructive a couple of years ago when I sought papers relating to the 2012 Policy Targets Agreement.   To the credit of Treasury, while I’ve been typing this post I’ve just received a 90 page release of papers relating to the negotiation of the 2012 PTA.  People shouldn’t be having to dig this stuff out years after the event.    Setting the rules, and institutions, for New Zealand macroeconomic management should be one of those areas where government agencies are open and pro-active, before and after decisions are made.



Some puzzles about the Monetary Policy Statement

After the last OCR review I noted that if I was going to go on agreeing with the Governor, there might not be much point in writing about the OCR decisions.  I agree with him again today.

Writing earlier in the week about what the Bank should do I concluded

So where does it all leave me?  Mostly content that an OCR around 1.75 per cent now is broadly consistent with core inflation not falling further, and perhaps continuing to settle back where it should be –  around 2 per cent.   Of course, there is a huge range of imponderables, domestic and foreign, so no one should be very confident of anything much beyond that.

And I was pleased to see how much emphasis the Governor placed today on the inevitable uncertainties around the (any) forecasts and projections.   Trying to project where the OCR might appropriately be a year or two from now is mostly a mug’s game.  Getting the current decision roughly right is towards the limit of what the Bank can actually usefully do.  I think they have today, although only time will tell.

I also liked the continuing emphasis on how low core inflation is globally.  This is my chart making that point, taking the median of the core inflation rates of the places in the OECD with their own monetary policy (so that the euro-area counts as one observation, and individual euro-area countries don’t count at all).

OECD core inflation

But there were some puzzles and some unsatisfactory aspects in both the statement itself and in the press conference the Governor and his chief economist just hosted.

First, it is quite remarkable that there is no mention at all in the document of the forthcoming hiatus.  After 25 September, we’ll only have an acting Governor for six months (itself a questionably lawful appointment), and we won’t have a permanent Governor until next March.   The Policy Targets Agreement expires with the Governor, and there won’t be a formal Policy Targets Agreement in place during the interregnum.   The Reserve Bank Act requires that the Monetary Policy Statement address how the Bank will conduct monetary policy over the following five years.  Given that we also have an election approaching in which most of the opposition parties are promising some changes to monetary policy, there is more than usual uncertainty about the path ahead –  the people and the law/PTA to which they will be working.    It isn’t the Bank’s place to take partisan stances, but it would be only reasonable –  in a genuinely transparent organisation, complying with the law –  to touch on these issues, if only briefly.     At a trivial level, the PTA has been reproduced in the MPS for decades, reflecting the central role PTAs have in New Zealand short-term macroeconomic management.  What will be done in the November and February MPSs?   

Rather more importantly, although I agree with the Governor’s current stance, I’m not sure I’d be taking the same view as him about the outlook for monetary policy if I shared his economic forecasts.

Here is my puzzle.   This is the Reserve Bank’s chart of their estimate of the output gap.

output gap may 2017

They now reckon it has been pretty flat around zero for the last two to three years.  I’d be surprised if there has been quite so little excess capacity –  and in fairness, they do explicitly highlight the quite wide range of estimates they have  –  but it is their current central view.   But then look what happens starting now.  They expect quite a material positive output gap to emerge.     And they think that will translate into quite a lift in wage inflation.

wage inflation may 17

Now, it is quite true that they need to see a lift in wage inflation if core inflation, across the economy, is to settle near 2 per cent, the target the Governor has committed to.    But if I really believed that things in the wage-setting markets were likely to turn around that much that quickly, I’m not sure I’d be running with such an “aggressively neutral” (ANZ’s words) stance right now.  Perhaps it doesn’t really matter to the Governor –  the sole decisionmaker –  because he won’t be there?

I’m a bit puzzled as to why they expect such a material increase in capacity, and wage, pressures.   They expect to see real GDP growth accelerate a bit.  Over the 18 months to the middle of next year, they expect quarterly growth to average 0.9 per cent.  By contrast, in the last couple of years, on their preferred production measure, real GDP has grown by only 0.6 per cent a quarter on average.

It isn’t that clear why they expect such an acceleration (which we’ve seen forecast before).  Perhaps it is partly the lagged effect of last year’s fall in the OCR?  But then, as they note, bank lending standards appear to have tightening, and funding margins risen, which will offset some of the effects of the OCR cut.   Dairy prices have certainly increased, which will provide some support to spending.  The exchange rate has come down a bit recently (more so this morning) but the level the Bank assumes –  a TWI above 75 for the next year or so – isn’t much below the average for the last couple of years.

And then there is immigration.    Here are the Bank’s projections.

immigration may 17

They expect the net immigration numbers to start falling over very sharply, starting now.    As the Governor noted, they (and other people) always get their immigration forecasts wrong.   But any significant reduction in immigration –  and this is a halving in the next couple of years –  is a material reduction in both demand and supply for the whole economy.   It is more than a little surprising that the Bank believes we will see both an acceleration in total real GDP growth and a sharp slowdown in net immigration.

The Bank appears to still believe the story that, at least this time round, high net immigration has eased overall capacity pressures.  If they are sticking to that story –  and they appeared to in the press conference –  then perhaps that is why they think we should be expecting a sharp pick-up in wage inflation starting now.    It doesn’t ring true to me –  and it has never been how New Zealand immigration cycles have worked in the past –  but if that is part of their story, something they genuinely believe, then –  as I already noted – I’m a bit surprised by the “aggressively neutral” policy stance.  On my own reading of course, any material slowdown in net immigration (unless it is accompanied by a big Australian economic rebound) will weaken near-term demand more than supply, as it has typically done in the past.

Two other points that came up in the press conference seemed worth commenting on.

Bernard Hickey asked the Governor what the Bank’s definition of full employment was.  The Governor was quite open, if a little tentative, in suggesting something around 4.5 per cent.  That is lower than the actual unemployment rate has been since the first quarter of 2009 –  eight years ago.     But, as Hickey noted, it is still above the Treasury’s published estimate of near 4 per cent.     The actual unemployment rate now still stands at 4.9 per cent.

The Bank’s chief economist and Assistant Governor, John McDermott, then picked up the question.   The gist of his response was that it was a silly question.   At some length he tried to explain how the Bank relies on the output gap for its assessment of overall capacity pressures in the economy.  He went to argue that labour market variables were so slow to respond that if one waited to evidence from them before moving it would almost certainly be “too late”.    Doubling down, he argued that in a New Zealand context it was “almost impossible” to estimate any sort of NAIRU, and that any attempt to do so was just ‘guessing”.

In a way, I wasn’t surprised by these arguments.  He used to run the same lines to me when I worked for him.   But familiarity doesn’t make the arguments any more convincing.  For a start, everyone recognises that inflation targeting is supposed to work by focusing on the forecast outlook, perhaps 12-24 months ahead.  Monetary policy works with a lag.  In principle, waiting to see actual outcomes –  on whatever measures –  will typically mean acting too late.

But, on the one hand, this is the very same central bank which set a new world record this cycle, by twice beginning to increase interest rates (in 2010 and 2014) only to have to quickly reverse themselves.  It is quite a while since they were too late to tighten (and McDermott was the Bank’s chief economist in both instances).

And what of the output gap the Bank wants us to put our faith in?  Here was one of the leading international experts  (and a former practitioner) on inflation targeting, Prof Lars Svensson writing on measures of excess capacity (LSRU is the long-term sustainable rate of unemployment, the bit not influenced by monetary policy)

What does economic analysis say about the output gap as a measure of resource utilization? Estimates of potential output actually have severe problems. Estimates of potential output requires estimates or assumptions not only of the potential labor force but also of potential worked hours, potential total factor productivity, and the potential capital stock. Furthermore, potential output is not stationary but grows over time, whereas the LSRU is stationary and changes slowly. Output data is measured less frequently, is subject to substantial revisions, and has larger measurement errors compared to employment and unemployment data. This makes estimates of potential output not only very uncertain and unreliable but more or less impossible to verify and also possible to manipulate for various purposes, for instance, to give better target achievement and rationalizing a particular policy choice. This problem is clearly larger for potential output than for the LSRU.

He summed it up recently even more succinctly

My experience of practical policymaking made me very suspicious of potential output, essentially an unverifiable black box, and consequently of output gaps. Instead, it made me emphasize the (minimum) long-run sustainable unemployment rate and consequently the unemployment gap.

And it is not even as if McDermott’s point about lagging labour market data has much obvious validity relative to measures of the output gap.  I had a look at the peak of the last (pre 2008) boom.

The unemployment rate troughed in the September and December quarters of 2007.

The output gap –  as estimated today – peaked in the September quarter of 2007.

But that caveat (“as estimated today”) matters hugely.  At the time, there was huge uncertainty about, and significant revisions to, estimates of the level of the output gap.   In the December 2007 MPS, for example, there isn’t a chart of the quarterly estimated output gap.  But the estimate for the average output gap for the year to March 2008 was 0.6 per cent.  At the time, they (we) thought the output gap had peaked in 2005.    The Bank’s current estimate is that the output gap in late 2007 was around 2.5 per cent.    Those aren’t small differences.   And they are pretty inevitable.      By contrast, there has never been any doubt that the labour market was at its tightest in late 2007.

No one is going to disagree that it is hard to estimate a NAIRU –  or Svensson’s LSRU – with hugely great confidence.  But much the same –  typically only more so –  can be said of almost any of the concepts the Bank uses in its modelling, forecasting and policy assessments (eg neutral interest rates, potential output, and equilibrium exchange rate).  And, relative to output gap measures, the unemployment rate is a directly observable measure of excess capacity, easily comprehended and prone to few revisions.   And unemployment is something that citizens care directly about.

In McDermott’s shoes, I’d have said something like “we really don’t know, but we are pretty confident it is lower than the current 4.9 per cent unemployment rate.  Treasury’s estimate of around 4 per cent might not be far from the mark, but we won’t really know until we get nearer.  The fact that the unemployment rate is, with quite a high degree of confidence, above the NAIRU is consistent with wage and price inflation having been pretty subdued for a long time, and is consistent with the Bank’s stance, of keeping interest rates below our estimates of neutral for the time being”.    It wouldn’t have been hard to have run that line.

Perhaps people (eg FEC) might like to ask the Bank why it appears to put so much less weight on direct measures of unemployment than, say, their peers in the United States (or most other central banks) appear to.  None takes a mechanical approach, none assumes the NAIRU never changes, none assumes they know it with certainty.  But they seem to think it matters –  and might matter to citizens and politicians to whom they are responsible –  in a way that simply eludes the Reserve Bank.  It is partly why I’ve come to the conclusion that some form of what the Labour Party is promising –  a more explicit statutory focus on unemployment in the documents governing the Reserve Bank and monetary policy –  is the right way ahead for New Zealand.   Concretely, I’ve suggested that the Bank be required by law to publish periodic answers to Bernard Hickey’s question –  what is full employment, what is the (estimate) NAIRU?

Finally, I was interested in the Governor’s evasiveness when asked about possible statutory changes to the provisions in the Reserve Bank Act that currently make the Governor the sole legal decisionmaker.    It is fine to emphasise that in practice monetary policy decisions have always been made in a collective environment –  whether the Official Cash Rate Advisory Group in the past, or the current mix of the Governing Committee and the Monetary Policy Committee.   But we don’t have rules and laws for good times and when things are working well.   And, as it happens the Bank and Governor haven’t covered themselves with glory in the last seven or eight years.

The Governor simply avoided answering the question of whether the law should be changed, even if only to cement in the collegial practice.  Since (a) the Governor is leaving shortly, and (b) the Minister of Finance has commissioned advice on the issue and Labour (and the Greens) are campaigning for change in this area, it is hardly as if letting us know his views would tread on taboo territory.   Perhaps to do so would have been to acknowledge that in no other central bank does one unelected person –  a person selected other unelected people –  have so much power, not just in monetary policy but in financial regulatory matters.  It is something where change is well overdue.

Challenged as to whether legislative reform in this area might not enhance transparency (eg publication of minutes, or even the airing of alternative views), the Governor fell back on his old claim that the Reserve Bank is one of the most transparent central banks in the world.  That simply isn’t so. It scores well, as I’ve put it previously, when it publishes material on stuff which it knows little or nothing about (the outlook for the next few years, where its guess is as good as mine, and none of the guesses are very good).  But it is highly non-transparent when it comes to the stuff they do know about.  Thus, we don’t see any of the background papers that go into the OCR deliberations (although I did once use the OIA to get them to release 10 year old papers), we see no minutes of the deliberations, no record of the balance of the advice the Governor receives.  And competing views (on the inevitably uncertain outlook, and the right policy stance) are not aired at all.    That is a quite different situation from what prevails in many other advanced country central banks (although of course there is a spectrum, but we are at one end of it).

As another telling example of how untransparent thiings are in New Zealand, I was reading the other day a piece by John Williams, the very able head of the San Francisco Fed, and a member of the FOMC.    In the US system he is a pretty senior guy –  not Janet Yellen, but not just a Reserve Bank chief economist ever.   His widely-distributed article was devoted to advocate a material change in how US monetary policy is done –  abandoning inflation targeting in favour of price-level targeting –  to provide greater policy resilience in the next serious downturn.   I’m not persuaded by Williams’ case, but what struck me is how open the system is when such a senior figure can openly make such a case.  The markets didn’t melt down. The political system didn’t grind to a halt.  Rather an able senior official made his case, and people individually assessed the argument on its merits.

The other bit of the paper that struck me was this

Now that we’ve gotten the monkey of the recession off our backs, we have the luxury of being able to look to the future. This presents us with the opportunity to ask ourselves whether the monetary policy framework and strategy that worked well in the past remains well suited for the road ahead.

Such introspection is healthy and constitutes best practice for any organization. In fact, the Bank of Canada has already shown us the way. Every five years, they conduct a thorough review of whether their policy framework remains most appropriate in a changing world. This is an exercise all central banks should undertake, including the Fed.

I’ve made this point myself previously.  The Bank of Canada is very open about these reviews they conduct.   By contrast, in New Zealand, it is still a struggle to get from the Reserve Bank and Treasury papers relating to the lead-up to the 2012 PTA, and all the (limited) deliberations then took place behind closed doors.   We will have a new PTA early next year, and we know –  from other documents Treasury has released –  that Treasury had some sort of review underway and almost completed before the Minister decided to delay the appointment of a permanent Governor. But given that PTA is the guide to the management of the key instrument in New Zealand short to medium term macro policy, it would be both appropriate, and more truly transparent, for much of the background thinking and research to occur openly.  It is too near the election now, but a jointly hosted conference every five years reviewing the experience with the PTA and looking at alternative options (even if none ends up adopted) would be one feature, in our system, of meaningful transparency.  We have very little of that at present.

(And, sadly, we’ve never seen anything from our Reserve Bank on the possible challenges if the practical limits of conventional monetary policy are exhausted in a future severe downturn).

It will be a challenge for the new government to lift the performance of the Reserve Bank in future.  It would be easier to make a strong start in that direction by legislating first to make the appointment of the Governor a matter for the Minister of Finance (and Cabinet)  –  as it is in most other places –  not something largely in the hands of the unelected faceless Reserve Bank Board (which doesn’t even seem to manage well basic record keeping).

Reflecting on the macro data

The Reserve Bank’s Monetary Policy Statement (Graeme Wheeler’s second to last) will be out on Thursday.  I’m not in the market economists’ game of trying to tell you what the Bank will do and say (although no one expects they will do anything concrete with the OCR this time).  I’m more interested in questions around what they should do.  In time, what they should do, they usually will do.  But sometimes not until they’ve tried the alternatives.

I wrote about last month’s CPI data a few weeks ago, concluding that there had been a welcome, and expected, increase in core inflation (it is what typically happens if inflation is below target and the OCR is cut fairly substantially) but that

With the unemployment rate still above estimates of the NAIRU, and most indicators of inflation suggesting that core is probably (a) still below target, and (b) not picking up very rapidly, it certainly isn’t time for hawkish talk about near-term OCR increases.

Not everyone agrees of course.  I noticed the BNZ’s economic commentary yesterday which opened with this confident assertion

There is no excuse for the cash rate to be just 1.75% in New Zealand.

I don’t think I’m unduly caricaturing their record to say that, for at least the last decade, the BNZ economics team has never seen an OCR increase they didn’t like, even –  or perhaps especially –  those which had to be quickly reversed.  But mindful that in the story of the boy who cried wolf, the wolf eventually did come, I thought it was worth having a look at the latest wave of data.  Last week, we got the full quarterly set of labour market data (HLFS, QES, and LCI), and the Reserve Bank’s quarterly expectations survey.  To cut a long story short, it doesn’t alter my view.

Take the expectations survey first.   The headline story was one in which the two year ahead expectations of the inflation rate (of a sample of moderately informed observers –  including me) rose quite materially, and now stand at 2.17 per cent (up from around 1.65 per cent in each quarter last year).

infl and expecs

This measure of expectations isn’t typically very volatile, but it is typically somewhat responsive to changes in headline CPI inflation.  We’ve just had quite a large change in headline inflation, so some increase in the expectations measure shouldn’t be surprising. It certainly shouldn’t be concerning.  After all, ideally, the Reserve Bank wants people to believe, and act as if they believe, that on average over time CPI inflation will average around 2 per cent –  the mid-point of the target range, and the explicit focus of the current (but about to expire) PTA.

In fact, no one really knows whether this survey measure captures how people actually think and behave in real transactions in the goods, labour and financial markets.   It might be as good a proxy as we have, but (a) we don’t know, and (b) it still might not be good at all.  Glancing at the time series, there is a tendency for falls and rise to be at least partly reversed quite quickly.

But if inflation expectations are really in some sort of 2 to 2.2 per cent range, I’d welcome that.  With repeated increase in tobacco excises –  not some underlying economic process –  there is a reasonable case, in terms of the PTA, that headline inflation should average a little higher than the mid-point, and than “true” core inflation.  Only if inflation expectations were to rise further from here might I start to get a little disquieted.

In trying to make sense of the inflation expectations numbers, one thing I haven’t seen mentioned is the Labour Party’s monetary policy release.   There was a quite a bit of focus last month on their pledge to add some sort of employment objective to the Reserve Bank Act, and concerned expressed in some quarters that that could lead to higher inflation over time.   If it was a factor, you’d presumably have to take the probability of Labour leading a new government (call it a coin toss at present?) and multiply that by the probability that the change in regime (and perhaps the sort of people a new government might appoint) would make a material difference over time.  I have no evidence one way or the other, but it wouldn’t surprise me if there was a small effect of this sort.   (My own two year ahead expectation in the survey was 1.5 per cent –  around the current rate of inflation in the Bank’s preferred sectoral factor model).

Not many commentators seem to pay much attention to the rest of the expectations survey, even though its strength is partly the range of macro questions that are asked (although I’ve suggested some modifications to the Bank in their review of the survey).

Take GDP for example. There is no sign of respondents expecting real growth to accelerate.  Two years out they expect annual real GDP growth of 2.6 per cent – down on the previous quarter, but not far from the average response over the last couple of years.    But the survey also asks for quarterly GDP predictions for the next couple of quarters, and year-ahead predictions.   That enables one to derive an implied six monthly growth rate for the second half of the coming year.  Here is the gap between the expected growth rates for the first six months and the second six months, going back to just prior to the 2008/09 recession.

expec GDP growthAs we headed into the recession there was a lot of expectation of a strong rebound.  Even up to around 2012, respondents expected growth to accelerate.   For the last few years they haven’t expected any acceleration, and now the expect it to slow.  To be specific, respondents expect 1.6 per cent total growth in the first half of this year, slowing to 1.2 per cent in the second half of this year.     We don’t know quite why –  perhaps they expect immigration numbers to slow –  but it doesn’t speak of a sense that things are getting away on the Reserve Bank.   Similarly, two years out respondents expected that the unemployment rate would still be 4.9 per cent.

Perhaps these respondents will be proved wrong –  they often are, forecasting is like that –  but at the moment it doesn’t look like an imminent risk of core inflation rising much further, or to levels that might prove problematic for a flexible inflation targeter focused on medium-term inflation outcomes around 2 per cent.

What of the actual labour market data?   We have some problems at present because of the breaks in various HLFS series that occurred when the revised survey questions were put in place last year.  I’m still staggered they could have made these changes without running the two sets of questions in parallel for perhaps a year, to allow robust adjustments to be made for the discontinuities.   HLFS hours worked measures, employment measures, and probably participation rate measures all seem to have been affected to some extent.   We are pretty safe in saying that the number of people employed in New Zealand did not grow by 5.7 per cent last year (as the HLFS suggests).

What of the simplest headline number, the unemployment rate?   There isn’t much doubt that the unemployment rate has been falling over the last few years.  It is what one should expect after a serious recession, and with the stimulus to demand provided by low interest rates and large migration inflows (given that immigration typically adds more to demand in the short-term than it does to supply, thus tending to lower unemployment and use up spare resources in the whole economy).

But what should be somewhat disconcerting is that the unemployment rate has (a) gone largely nowhere in the last year, and (b) is still well above pre-recession levels (unlike the situation in many other advanced countries with their own monetary policies).   In the prevous boom, the unemployment rate got down to around 4.9 per cent as early as the start of 2003.     The picture isn’t much different if one looks at the broader (not seasonally adjusted) SNZ underutilisation measure.

U and under U

There still appears to be some progress in using up spare capacity in the labour market, but not very much at all.

What about the rate of job growth.  Fortunately, we have two measures: the (currently hard-to-read) HLFS household survey measure of numbers of people employed, and the QES (partial) survey of employers asking how many jobs are filled.   Unsurprisingly, the trend in the two series are usually pretty similar, even if there is a fair bit of quarter to quarter volatility.


Since we know there are problems in the HLFS, and the QES doesn’t look to be doing something odd, perhaps we are safest in assuming that the number of jobs has been growing at an annual rate of around 2.5 to 3 per cent.   That isn’t bad at all. But SNZ also estimates that the working age population has been growing at around 2.7 per cent per annum.  No wonder the unemployment rate is only inching down.

One can do a similar picture for the annual growth rates in the two (HLFS and QES) hours worked series.

hours qes and hlfs

It was pretty clear that there was around a 2 per cent lift in HLFS hours worked from last June, just on account of the new survey questions.  It seems safer to assume that total hours worked across the economy might have grown by around 3 per cent in the last year.   That is faster than the growth in the working age population, pointing to some increase in effective utilisation, but not a dramatic one.  For what it is worth, in the latest releases, the two hours measures were both quite weak in the March quarter.

(And remember that nothing in the expectations survey data suggested pressures were likely to intensify from here.)

And what of wages?    There is a variety of measures.  The QES measure is quite volatile –  there are issues of changing composition –  and I don’t put much weight on it.  But for what it is worth, average hourly earnings rose 1.6 per cent in the last year on this measure, around the lowest rate of increase seen for decades.    The Labour Cost Index measures should get more focus (but have some challenges of their own).

lci inflation 2Perhaps there is some sign of a possible pick-up in the analytical unadjusted series (which doesn’t try to correct – inadequately –  for productivity changes) but it is a moderately volatile series, and the most recent rate of increase is still below the peak in the last little apparent pick-up a year or two back.

A common response is “ah, but what about the lags?”.  But as we’ve shown, there is little sign of any material tightening occurring in the overall labour market, no sign of expectations that that is about to change, and so little reason to expect much different wage inflation outcomes over the next couple of years from what we’ve seen in the last couple.  At best, there might be some slight pick-up in wage inflation (especially if the increase in inflation expectations is real), but any pick-up is going to be from rates of increase that have, over the last couple of years, been consistent with disconcertingly low rates of core inflation.

So where does it all leave me?  Mostly content that an OCR around 1.75 per cent now is broadly consistent with core inflation not falling further, and perhaps continuing to settle back where it should be –  around 2 per cent.   Of course, there is a huge range of imponderables, domestic and foreign, so no one should be very confident of anything much beyond that.   But it is worth bearing in mind that the unexpectedly strong net migration over the last few years has been a significant source of stimulus to overall domestic demand (including demand for labour).  In the face of typically too-tight monetary policy, it is part of why the unemployment rate finally started gradually coming down again after 2012.

Whatever happens to the cyclical state of the Australian economy, the National government is already putting in place immigration policy changes that should be expected to lead to some reduction in the net inflow of non-citizens, and two of the main opposition parties are campaigning on promises of much sharper reductions than that.   If such policy changes come to pass then, all else equal, the OCR will need to be set lower than otherwise.  It isn’t something that Graeme Wheeler can or should actively factor into this week’s OCR decision, but it may well be something the acting Governor needs to think hard about (if any decisions he makes are in fact lawful) after the election.

Is there a Singaporean idyll?

Winston Peters was interviewed on the weekend TV current affairs shows.  Any sense of specifics on his party’s immigration policy seemed lacking – perhaps apart from something on work rights for foreign students.  But I rather liked his line that while ministers and officials have been telling us for years that we have a highly-skilled immigration policy, all we hear now is all manner of industries employing mostly quite low-skilled people telling us how difficult any cut back in non-citizen immigration would be.

But what really caught my attention was when, in his TVNZ interview, Peters reiterated his view that what New Zealand really needs, in reforming monetary policy and the Reserve Bank, is a Singapore-style system of exchange rate management.    It was also highlighted in his speech on economic policy last week.  It is clear, specific, unmistakeable….and deeply flawed.   It seems to be a response to an intuition that there is something wrong about the New Zealand exchange rate.    In that, he is in good company.   The IMF and OECD have raised concerns over the years.  And so have successive Reserve Bank Governors.   I share the concern, and I devoted an entire paper to the issue at a conference on exchange rate issues that was hosted by the Reserve Bank and Treasury a few years ago, and which was pitched at the level of the intelligent layperson interested in these issues.   Another paper looked at a variety of alternative possible regimes, including (briefly, from p 45) that of Singapore.

What is the Singaporean system?  In addition to the brief summary in the RBNZ paper I linked to in the previous paragraph, there is a good and quite recent summary of the system in a paper published by the BIS written by the Deputy Managing Director of the Monetary Authority of Singapore MAS).

The key feature of the system is the MAS does not set an official interest rate (something like the OCR).  Rather, they set a target path (with bands) for the trade-weighted value of the Singaporean dollar, and intervene directly in the foreign exchange market to manage fluctuations around that path.   There is a degree of ambiguity about the precise parameters, but the system is pretty well understood by market participants.    Interest rates of Singapore dollar instruments are then set in the market, in response to domestic demand and supply forces, and market expectations of the future path of the Singapore dollar.    It has some loose similarities with the sort of approach to monetary policy operations the Reserve Bank of New Zealand adopted for almost 10 years in the late 1980s and early 1990s, and which we finally abandoned in 1997 (actually while Winston Peters was Treasurer).   It is also not dissimilar to the approach –  the crawling peg –  used in New Zealand from 1979 to 1982 (at a time when international capital flows were much more restricted).

There is no particular reason why a country cannot peg its exchange rate, provided it is willing to subordinate all other instruments of macro policy (and short-term outcomes) to the maintenance of the peg.  It is what Denmark does, pegging to the euro.  Singapore’s isn’t a fixed peg, but the macroeconomics around the choice are much the same.

It is a model that can work just fine when the economies whose currencies one is pegging to are very similar to one’s own.  Denmark probably qualifies. In fact, Denmark could usually be thought of as, in effect, having the euro, but without a seat around the decisionmakers’ table.

It doesn’t work well at all when the interest rates you own economy needs are materially higher than those needed in the economies one is pegging too.    Ireland and Spain, in the years up to 2007, are my favourite example.  Both countries probably needed interest rates more like those New Zealand had.  In fact, what they got was the much lower German interest rates.  That had some advantages for some firms.  But the bigger story was a massive asset and credit boom, materially higher inflation than in the core countries, and eventually a very very nasty and costly bust.  Oh, in the process of the boom the real exchange rates of Spain and Ireland rose substantially anyway.    Because although nominal exchange rate choices –  the things that involve central banks –  can affect the real exchange rate in the short-term, the real exchange rate is normally much more heavily influenced by things that central banks have no control over at all.

One can, in part, understand the allure of Singapore. It is, in many respects, one of the most successful economic development stories of the post-war era.   Productivity levels (real GDP per hour worked) are now similar to those of the United States, and places like France, Germany and the Netherlands, and real GDP per capita is higher still.   You might value democracy and freedom of speech (I certainly do), but if Singapore’s achievement is a flawed one, it is still a quite considerable one.  And if Singapore is todaya big lender to the rest of the world, it wasn’t always so. Like New Zealand (or Australia or the US) net foreign capital inflows played a big part for a long time.  As recently as the early 1980s, Singapore was running annual current account deficits of around 10 per cent of GDP.

And the Singaporean model is not one of an absolutely fixed exchange rate.  It is a managed regime (historically, “managed” in all sorts of ways, including direct controls and strong moral suasion).  It produces a fairly high degree of short-term stability in the basket measure of the Singapore dollar.      But it works, to the extent it does, mostly because the SGD interest rates consistent with domestic medium-term price stability in Singapore are typically a bit lower than those in other advanced countries (in turn a reflection of the large current account surpluses Singapore now runs –  national savings rates far outstripping desired domestic investment).  As the Reserve Bank paper I linked to earlier noted

From 1990 to 2011, the average short term Singapore government borrowing rate was 1.8 percent p.a. below returns on the US Treasury bill.

Those are big differences (materially larger than the difference between the two countries’ average inflation rates).  And they mean that Singapore dollar fixed income assets are not particularly attractive to foreign investment funds.  By contrast, New Zealand’s short-term real and nominal interest rates are almost always materially higher than those in other advanced countries.   Partly as a result, even though Singapore’s economy is now materially larger than New Zealand’s, there is less international trade in the Singapore dollar than in the New Zealand dollar.

Winston Peters has talked about wanting a lower and less volatile exchange rate.  He has given no numbers, but lets do a thought experiment with some illustrative numbers.  The Reserve Bank’s TWI this afternoon is just above 75.  Suppose one thought that was, in some sense, 20 per cent too high, and so wanted to target the TWI in a band centred on 60, allowing fluctuations perhaps 5 per cent either side of the midpoint (so a range of 57 to 63).    What would happen?

The Minister of Finance might instruct the Reserve Bank to stand in the market to cap the exchange rate (TWI) at 63.   If our interest rates didn’t change, the Reserve Bank would be overwhelmed with sellers (of foreign exchange) wanting to buy the cheap New Zealand dollar.  After all, you could now earn New Zealand interest rates –  much higher than those abroad –  with very little downside risk (certainly much less than there is now).  In the jargon, people talk about “cheap entry levels”.   There is no technical obstacle to all this.  The Reserve Bank has a limitless supply of New Zealand dollars, but in exchange would receive a huge pool of foreign exchange reserves (it is quite conceivable that that pool could be several multiples of the size of New Zealand’s GDP, so large are the markets and so small is New Zealand).

Ah, but the Singaporean option doesn’t involve interest rates remaining at current levels.  Rather, they are now set in the market.  And so, presumably, our interest rates would fall, probably very considerably.  In the current environment, they might even go a little negative.   That would deal with the short-term funding cost problem associated with the huge pool of reserves.  But what would happen in New Zealand with (a) a much lower exchange rate, (b) much lower interest rates, and (c) all other characteristics of the economy unchanged?   The answer isn’t that different to what we saw in Spain and Ireland.  Asset prices would soar, credit growth would soar, general goods and services inflation would pick up quite considerably.  Of course, there would be more real business investment and more exports, at least in the short term.  And that would look appealing, but as time went by –  and it wouldn’t take many years –  the real exchange rate would be rising quite quickly and substantially (as domestic inflation exceeded that abroad).  Export firms would be squeezed again.   If anything, the higher domestic inflation would lower domestic real interest rates even more, so the credit and asset boom would continue.  And before too long it would end very badly.

That might sound over-dramatic.  And if the ambition was simply to stabilise the exchange rate around current levels, things probably wouldn’t go too badly for a while.  But Peters has been pretty clear that his aim is a lower exchange rate, not just a less volatile one.

The lesson?  You simply cannot ignore the structural features of the economy that give rise to persistently high real interest rates, and a high real exchange rate.  And those features have nothing whatever to do with the Reserve Bank or monetary policy.    They are about forces, incentives etc that influence the supply of national savings, and the demand for domestic investment (at any given interest rate).   All that ground is covered in my earlier paper linked to above.

Of course, the Singaporeans also increasingly can’t ignore those forces.  Decades ago, global financial markets weren’t that well-integrated, and the Singaporean web of controls was pretty extensive.  For some decades, even as Singaporean productivity growth far-outstripped that of other advanced countries, Singapore’s real exchange rate was not only pretty stable, it was falling.  Here is a chart of the BIS measure of Singapore’s real exchange rate all the way back to 1964.   The current system of exchange rate management didn’t start until about 1980.

Sing RER

It was, in many ways, an extraordinary transfer from Singaporean consumers to Singapore-operating exporters.  The international purchasing power the economic success should have afforded consumers and citizens kept getting pushed into the future.

But even in Singapore, these things don’t last forever.  Look at that last 10 years or so, when the real exchange rate has appreciated by around 35 per cent.   The real value of the SGD is still miles lower than where long-term economic fundamentals suggest they should be –  consistent that, the current surplus is still around 18 per cent of GDP –  but there has been a lot of change in its value over that time.  For many firms even in Singapore that must have been a challenge.  With US interest rates near-zero for much of that time, historically low Singaporean rates will have afforded the authorites fewer degrees of freedom than they had had previously.

(The Singapore authorities impose all sorts of other controls, including their compulsory private savings scheme and increasingly onerous direct controls on private credit.  I’m not going there in this post, partly because it will already be long enough, and partly because what I’ve heard from NZ First is about the exchange rate system in isolation).

Singapore is a (hugely-distorted) economic success story in many respects.  Some mix of the people, the policies and institutions, and the favourable geographical location all helped.   Nonetheless, it some ways it is an odd example for New Zealand First to favour.

For example, Singapore has had an extremely rapid population growth, mostly immigration-fuelled, in recent decades.  Here is a chart of Singapore’s population growth and that of Australia and New Zealand.

sing popn

(On my telling, Singapore has had opportunities, and lots of savings, and thus rapid population growth made sense, enabling more of those opportunities to be captured, even while real interest rates stayed lower than elsewhere –  although not, presumably, as low as they would otherwise have been.)

And Singapore’s economy is pretty volatile.  Sadly, the IMF doesn’t publish output gap estimates for Singapore, but the MAS estimates (in that document I linked to earlier) suggest much more volatility than we see in New Zealand or most other advanced economies.  And here is annual growth in real per capita GDP for New Zealand, Australia and Singapore.

sing real gdp

Hugely more volatile than anything we are accustomed to (and in recent years, interestingly, not even materially higher).

And for all that the MAS likes to emphasise the close connection between the exchange rate and inflation, here are the inflation rates of the three countries.

sing inflation

On average, the differences aren’t that large, but even in the last 15 years or so Singapore’s inflation rate has been more volatile than those of Australia and New Zealand.

It isn’t really clear that Singapore’s system is even serving them that well these days.

But what of exchange rate comparisons?  You might have supposed that Singapore’s exchange rate was a lot less volatile than New Zealand’s.  But here, from the RB website, is the monthly data for the SGD and the NZD, in terms of the USD since 1999.


And, yes, the New Zealand dollar is more volatile in the short-term, but even there over the last seven years or so the differences are pretty small.   And if hedging isn’t always easy, particularly for firms without large physical assets, it is a lot easier to hedge those sorts of short-term fluctuations than it is the longer-term real exchange rate uncertainty.  (And, of course, given Singapore’s faster productivity growth, you might still be troubled that our exchange rate has more or less kept pace with theirs, but that is a real and structural issues, not one that can be fixed by fiddling with the exchange rate system.)

As it happens, Australia is our largest trade and investment partner.   Here is how our exchange rate, relative to the Australian dollar, compares with the Singapore dollar relative to the US dollar.


It is an impressive degree of stability.  Again, in the very short term the New Zealand exchange rate is a bit more volatile, but it isn’t obvious that for longer-term planning purposes New Zealand exporters have had it tougher –  on the volatility front at least –  than those operating from Singapore.

And, as a final chart, this one uses the BIS’s broad real exchange rate indices to illustrate movements in the real exchange rates of Singapore, New Zealand, and (another export-oriented development success story) Korea.


Singapore’s real exchange rate has certainly been the most stable of the three, but if anything Korea’s has been more volatile than New Zealand’s.   It would clutter the gaph to have added it, but Japan’s real exchange rate has also been more volatile than New Zealand’s.

There are real exchange rate issues for New Zealand.  The fact that our real exchange rate hasn’t fallen, even as relative productivity performance has fallen away badly, is a crucial symptom in our overall long-term disappointing economic performance.  It has meant we’ve been less open to the world (lower exports, lower imports) than one would have expected, or hoped.   But the issue isn’t primarily one of volatility –  which is mostly what the Singaporean system now tries to address –  but of longer-term average levels.   This real exchange rate symptom appears to be linked to whatever pressures (NB, not superior economic performance) have given us persistently higher real interest rates than the rest of the world.   New Zealand First, and other parties, would be much better advised to focus their analysis, and proposed policy solutions, on measures that might directly address these real (as distinct from monetary) issues.    As it happens, a much lower trend rate of immigration seems likely to be a strong contender for such a policy –  taking pressure off domestic demand for resources, and freeing up resources to compete internationally.     Singapore simply isn’t the answer.


Svensson and Labour’s monetary policy

In 1999, having been out of office for nine years, the Labour Party campaign platform included promises about monetary policy.  They undertook to change the Policy Targets Agreement –  and they did, adding the words (still) requiring the Bank to “seek to avoid unnecessary instability in output, interest rates and the exchange rate”.

But they also promised an independent inquiry into the operation of monetary policy.    It was then 10 years since the Reserve Bank Act had been passed, and we’d gone through both a wrenching but successful disinflation, and through one full business cycle since something like price stability had been established.    Some of elements of the management of that cycle hadn’t been the Reserve Bank at its finest:  use of the Monetary Conditions Index to guide short-term policy management had given us a (relatively short) period of quite astonishing interest rate volatility, not helped by being slow to appreciate the significance of the Asian financial crisis.

I don’t suppose Michael Cullen was ever a great fan of Don Brash’s.  But Brash had already been reappointed for a third term in 1998 (arguably fortunate that the reappointment was done before the nature of the MCI debacle was fully appreciated).   And Cullen was clearly uneasy about the volatility in New Zealand interest rates, and about the big cycles in the exchange rate.   There were also suggestions that he was a bit uneasy about the rule of a single unelected technocrat at the Reserve Bank of New Zealand, and Labour at times seemed to look longingly across the water at the Reserve Bank of Australia (with a higher target, more flexible rhetoric, and a reputation for being a steady hand).    And, of course, Labour was coming into government with Jim Anderton as Deputy Prime Minister.  Anderton had still not been reconciled to the Reserve Bank Act framework at all.   So it was, all round, opportune to have an inquiry.

But of course whenever one sets up an independent inquiry, the name of the person appointed to conduct the inquiry tells one a lot about what the appointer is looking for.    There were all sorts of names bandied about at the time, including (for example) Bernie Fraser who had until recently been Governor of the Reserve Bank of Australia, and whose centre-left sympathies were not exactly unknown.  But the government settled on Swedish academic Lars Svensson.  Perhaps being Swedish  –  home of centre-left big government – lulled some on the left of New Zealand politics.  But, more importantly, Svensson was also a leading academic author on aspects of the (then still relatively new) theory and practice of inflation targeting.  He’d also spent some time in New Zealand a couple of years earlier, as the Reserve Bank professorial fellow.    In other words, it was never likely to be a terribly radical report.

And it wasn’t.    Which is not to say that it wasn’t a useful exercise, or that Svensson did not make some useful recommendations.  He did.  Some of the less important recommendations –  eg around the make-up of the Bank’s Board, and the publication of a Board Annual Report –  were even adopted.    Some others that should have been adopted –  for example, the introduction of a monthly CPI –  still, unfortunately, haven’t been.  Svensson also proposed legislating for committee decision-making for monetary policy, but his proposal of a committee of insiders (including the role I then held) went nowhere: among other reasons no doubt, Michael Cullen hadn’t come into politics to give statutory power to more Reserve Bank pointy-heads.

I was quite heavily involved in the review, both in contributing to the Reserve Bank’s own substantial submission to the inquiry and –  along with a couple of Treasury economists –  as part of the secretariat to the inquiry itself.  For an inquiry into the Bank, it was a bit of an odd arrangement  –  shortly after the inquiry began I was promoted into one of the half dozen top policy/management roles in the Bank and did the two roles in tandem –  but I guess it is a small country, and there was never much doubt about the overall favourable stance Svensson was likely to take.  He was a big fan of Don Brash, and the conclusions were his not those of the secretariat (in fact, flicking through notes stapled in my copy of the report yesterday I noticed that in some places we –  and the Bank –  urged Svensson to toughen up his comments, lest the report look in places a bit like a whitewash.)

But the main point of this post isn’t about history.  It was initially prompted by an observation in a column in the Sunday Star-Times the other day, in which their resident right-wing columnist was quoting Svensson from 2001.  Damien Grant, in commenting sceptically on Grant Robertson’s proposals,

Robertson might find it useful to know that when Cullen became finance minister he commissioned a review of the Reserve Act by Swedish economist Lars Svensson who concluded:

“It is beyond the capacity of any central bank to increase the average level or the growth rate of real variables such as GDP and employment.”

The understanding that monetary policy can only influence the value of money and nothing else is one of the few untarnished successes of modern economic thought. It is deeply disturbing that Grant Robertson does not seem to appreciate this.

As a commenter observed yesterday, no mainstream economist believes that monetary policy can change the long-term level of employment/unemployment/real GDP or whatever.  In the long-term monetary policy can only affect nominal variables.   Svensson certainly believed that then and believes it now.   I don’t know whether Grant Robertson does, but I expect so.

But equally, not many mainstream economists believe that active monetary policy typically has no effect (short to medium term) on real variables.   There is pretty general acceptance, I think, that the depth and severity of the Great Depression was in substantial part a matter of monetary mismanagement.  That’s a deliberately extreme example, but it both illustrates the point and (historically) provides some of the backdrop to modern more active discretionary monetary policy.  In earlier decades, adjustments in central bank interest rates (where central banks existed at all) were mostly about maintaining the gold (or silver) convertibility of the currency.  Domestic economic conditions didn’t play much of a role.    Really bad experiences like the Depression, along perhaps with the rise of universal suffrage (the more marginal got a say in politics), helped change that focus.

Writing in 2001, reviewing New Zealand policy, Lars Svensson had no doubt about the importance of real variables in the management of monetary policy.   He didn’t question section 8 of the Reserve Bank Act –  the focus on price stability.  But his articulation of flexible inflation targeting –  what the Reserve Bank saw itself practising – involved short-term trade-offs between pursuit of the inflation target, and the variability of the real economy.  At the time, as an academic, he focused explicitly on the trade-off with variability in the output gap (the gap between actual and potential output), and devoted several pages of the report to a discussion of the issue, describing it not just as a very short-term matter, but as a “short and medium term” issue.    (For anyone interested, the full report and associated documents are here.)     What he was talking about wasn’t at all inconsistent with the 1999 addition to the PTA, quoted above, about seeking to “avoid unnecessary instability in output”).    And there was only one tool –  the OCR.

Standing back from his more theoretical perspective, there was good reason why one might want explicit consideration of real variables in the official articulation of what an independent central bank was asked to do.   One doesn’t need active monetary policy if all one is concerned about is long-term stability in the general level of prices –  something passive like the Gold Standard would do it.    But the Reserve Bank Act –  and other comparable legislation abroad –  was about a regime for governing the discretionary active use of monetary policy.   We had –  and have –  such a policy because it was believed that discretionary monetary policy could make a difference, over meaningful horizons, to real economic outcomes (GDP, unemployment or the like) even if not to the trend or potential levels of those variables.

Some years later Lars Svensson himself became a policymaker, as a fulltime member of the executive board of Sweden’s Riksbank.  The Executive Board makes the monetary policy decisions in Sweden.    Many of my old Reserve Bank colleagues don’t agree, but I think Svensson proved to be an ideal person to have on a monetary policy decisionmaking committee.   He had strong expertise in the subject – albeit initially at a rather abstract level –  and a cast of mind which meant that he wasn’t just going to fall into line with the preferences of the Governor and the long-term staff advisers.  He strongly and opened argued against the Riksbank’s strategy, adopted several years back in the wake of the global recession of 2008/09, of trying to use monetary policy to lean against the accumulation of household debt, even at the expense of inflation undershooting the target (and unemployment remaining very high).   It was a costly failed experiment, which the Riksbank eventually abandoned.

His experience as a policymaker led Svensson to recraft how he thinks about the objective of the central bank and explicit role that unemployment should have in that thinking.   He hasn’t, of course, changed by one iota his belief that in the long-term the level of real variables is determined by a whole bunch of regulatory, demographic etc factors, but not by monetary policy.    He reflected on these issues a couple of years ago in a lengthy lecture, Some Lessons from Six Years of Practical Inflation Targeting (of which only the first 10 pages are directly relevant to this post), and in another article How to weigh unemployment relative to inflation in monetary policy?

He notes

Flexible inflation targeting involves both stabilizing inflation around an inflation target and stabilizing the real economy.  A clear objective for monetary policy contributes to monetary policy being systematic and not arbitrary. Furthermore, for central-bank independence to be consistent with a democratic society, it must be possible to evaluate monetary policy and hold the central bank accountable for achieving its objective. This requires that the degree of achieving the objective can be measured. A numerical inflation target allows target achievement with regard to inflation to be measured and the central bank to be held accountable for its performance regarding inflation stabilization. But if monetary policy also has the objective of stabilizing the real economy, that part of the objective must also be measurable, in order for monetary policy to be evaluated and the central bank be held accountable. Given this, how should stabilization of the real economy be measured?


Stabilization of the real economy can be specified as the stabilization of resource utilization around an estimated sustainable rate of resource utilization, accepting the conventional wisdom that the sustainable rate of resource utilization is determined by nonmonetary factors and not monetary policy and therefore has to be estimated. But how should resource utilization be measured? More precisely, besides inflation, what target variable (or variables) should enter the monetary-policy loss function? One can answer this question by interpreting the legislated mandate for monetary policy and by examining what economic analysis suggests about a suitable measure of resource utilization.

In Sweden, the Riksbank’s own act mentions only price stability.  But

 The Riksbank’s mandate for monetary policy follows from the Sveriges Riksbank Act 1988:1385 and the preparatory works of the Act, the Government Bill 1997/98:4 to the Riksdag (Swedish Government 1997) that contained the proposal for this legislation. In Sweden, the preparatory works of laws carry legal weight, since they contain guidance on how the laws should be interpreted. According to the Riksbank Act, the objective of monetary policy is “to maintain price stability.” The Bill further states (p. 1): “As an authority under the Riksdag, the Riksbank should, without prejudice to the objective of price stability, support the objectives of the general economic policy with the aim to achieve sustainable growth and high employment.”

(I didn’t know this when in 2014 we wrote a Reserve Bank Bulletin article on the statutory goals for monetary policy in a range of countries, the Swedish entry in which thus should thus be discounted, or read in the light of these Svensson comments.)

Svensson continues

The idea in the Bill is hardly that there is any conflict or tradeoff between sustainable growth and high employment. Furthermore, for many years Swedish governments have emphasized full employment as the main objective for general economic policy.  Also, in this context, high employment should be interpreted as the highest sustainable rate of employment, if we accept that monetary policy cannot achieve any level of unemployment and that the sustainable rate of employment is determined by nonmonetary factors. According to this line of reasoning, the Riksbank’s mandate for monetary policy is price stability and the highest sustainable rate of employment.

In practice, he argues that the unemployment rate –  and in particular the gap between the actual unemployment rate and the long run sustainable rate of unemployment (LSRU, determined by those non-monetary factors) should be the focus.   15 years ago his focus was on the output gap but

What does economic analysis say about the output gap as a measure of resource utilization? Estimates of potential output actually have severe problems. Estimates of potential output requires estimates or assumptions not only of the potential labor force but also of potential worked hours, potential total factor productivity, and the potential capital stock. Furthermore, potential output is not stationary but grows over time, whereas the LSRU is stationary and changes slowly. Output data is measured less frequently, is subject to substantial revisions, and has larger measurement errors compared to employment and unemployment data. This makes estimates of potential output not only very uncertain and unreliable but more or less impossible to verify and also possible to manipulate for various purposes, for instance, to give better target achievement and rationalizing a particular policy choice. This problem is clearly larger for potential output than for the LSRU.


Compared to potential-output estimates, estimates of the LSRU are much easier to verify, more difficult to manipulate and can be publicly debated. Independent academic labor economists can and do provide estimates of the LSRU and can verify or dispute central-bank estimates. Several government agencies have labor-market expertise and provide verifiable estimates of the LSRU. One could even think of an arrangement where an independent committee rather than the central bank provides an estimate of the LSRU that the central bank should use as its estimate, to minimize the risk of manipulation by the central bank. Furthermore, unemployment is better known and understood by the general public than output and GDP.

He concludes

Most importantly, it has much more drastic effects on welfare. As expressed by [academic labour economist, and former Bank of England Monetary Policy Committee member]   Blanchflower (2009):

Unemployment hurts. Unemployment has undeniably adverse effects on those unfortunate enough to experience it. A range of evidence indicates that unemployment tends to be associated with malnutrition, illness, mental stress, depression, increases in the suicide rate, poor physical health in later life and reductions in life expectancy. However, there is also a wider social aspect. Many studies find a strong relationship between crime rates and unemployment, particularly for property crime. Sustained unemployment while young is especially damaging. By preventing labour market entrants from gaining a foothold in employment, sustained youth unemployment may reduce their productivity. Those that suffer youth unemployment tend to have lower incomes and poorer labour market experiences in later life. Unemployment while young creates permanent scars rather than temporary blemishes. 

When unemployment rises, the happiness of both workers and non-workers falls. Unemployment affects not only the mental wellbeing of those concerned but also that of their families, colleagues, neighbours and others who are in direct or indirect contact with them.

Thus, I think there are strong reasons to use the gap between unemployment and an estimated LSRU as the measure of resource utilization that the central bank should stabilize in addition to stabilizing inflation around the inflation target.

Svensson proposes reduces all this to a “loss function”, to which, in principle at least, central bank monetary policy decisionmakers can be held to account, with formal weights attached to each of the inflation gap (from target) and the unemployment gap (from the LSRU).

Personally, I think he is rather unrealistic in supposing such a formulation is possible, at least as the basis for formalised accountability.    But if it is practically challenging (or even impossible), the sort of analysis he advances here isn’t unorthodox or out of the mainstream.  It is simply one plausible extension of the conventional economics of modern monetary policy, from one of the leading contributors to the academic literature (and someone who has himself been exposed to the real world challenges of policymaking).

I don’t know specifically what Svensson would make of the current debate in New Zealand, or of what the Labour Party (at quite a high level of generality) is proposing.    What we do know is that Labour is proposing nothing nearly as specific or formal as Svensson argues for: there would be no numerical unemployment target or an official external assessment of the NAIRU (or LSRU).  My impression would be that his reaction would be along the lines of “well, of course the unemployment rate –  and short to medium term deviations from the long-run level, determined by non-monetary factors – should be a key consideration for monetary policymakers; in fact it is more or less intrinsic to what flexible inflation targeting is”.   He might suggest there are already elements of that in the PTA, but that making it a little more high profile, with an explicit reference to unemployment, might be helpful.     I might be wrong about, but it could be worth Robertson or his advisers getting in touch with Svensson –  who retains an interest in New Zealand, and gave a paper here only a couple of years ago –  and asking.


Cosmetics (can) matter: Labour’s monetary policy proposals

I’ve already written a bit about Labour proposals on monetary policy (here and here) and, for now at least, I don’t want to write anything more about the proposed changes to the decision-making process or the plan to require the Monetary Policy Committee to publish its minutes.  If there are all sorts of issues around the details of how, I haven’t seen anyone objecting to the notion of moving from a single decisionmaker model to a a legislated committee, or objecting to proposals to enhance the transparency of the Bank’s monetary policy.    The Bank was once a leader in some aspects of monetary policy transparency, but is now much more of a laggard.

Where there has been more sceptical comment is around Labour’s proposal to add full employment to the statutory monetary policy objective.    At present, section 8 of the Reserve Bank Act reads 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.

Responding to this aspect of Labour’s announcement hasn’t been made easier by the lack of any specificity: we don’t know (and they may not either) how Labour plans to phrase this statutory amendment.    There are some possible formulations that could really be quite damaging.  But there are others that would probably make little real difference to monetary policy decisionmaking quarter-to-quarter.  Probably each of us would prefer to know in advance what, specifically, Labour plans.  But this is politics, and I’m guessing that there is a range of interests Labour feels the need to manage.  In that climate, specificity might not serve their pre-election ends.  One could get rather precious on this point, but it is worth remembering that there are plenty of other things that may matter at least as much that we currently know little about.  Under current legislation, who becomes the Governor of the Reserve Bank matters quite a lot to shorter-term economic outcomes, and we have no idea who that will be.   The details of the PTA can matter too, and under the governments of both stripes the process leading up to the signing of new PTAs has been highly secretive (often even after the event).  For the moment, we probably just have to be content with the “direction of travel” Labour has outlined.

In some quarters, Labour’s plans for adding a full employment objective have been described as “cosmetic”, as if to describe them thus is to dismiss them.    That is probably a mistake.  When I went hunting, I found that cosmetics have been around for perhaps 5000 years (rather longer than central banks).   People keep spending scarce resources on them for, apparently, good reasons.     Why?  They can, as it were, accentuate the positive or eliminate the negative –  highlighting features the wearer wants to draw attention to, or covering up the unsightly or unwanted marks of ageing.    They (apparently) accomplish things for the wearer.

What is the relevance of all this to monetary policy?  Well, there has been a long-running discontent with monetary policy in New Zealand, especially (but not exclusively) on the left.  In the 28 years since the Act was passed there has not yet been an election in which some reasonably significant party was not campaigning to change either the Act or the PTA.  We haven’t seen anything like it in other advanced countries.   Personally, I think much of the discontent has been wrongheaded or misplaced –  the real medium-term economic performance problems of New Zealand have little or nothing to do with the Reserve Bank –  and many of the solutions haven’t been much better (in the 1990s, eg, Labour was campaigning to change the target to a range of -1 to 3 per cent and NZ First wanted to target the inflation rates of our trading partners, whatever they were).     But that doesn’t change the fact that there has been discontent –  and more than is really desirable.

I’m quite clear that there is no long-run trade-off adverse trade-off between achieving and maintaining a moderate inflation rate (the sorts of inflation rates we’ve targeted since 1990) and unemployment.  And since something akin to general price stability generally helps the economy function better (clearer signals, fewer tax distortions etc) there is at least the possibility that maintaining stable price might help keep unemployment a little lower than otherwise.  Milton Friedman argued for that possibility.

But I don’t think that is really the issue here.

Because it is not as if there are no other possible connections between monetary policy and unemployment.   Pretty much every analyst and policymaker recognises that there can be short-term trade-offs between inflation and unemployment (or excesss capacity more generally –  but here I’m focusing on unemployment).   Those trade-offs aren’t always stable, even in the short-term, or predictable, but they are there.    Thus, getting inflation down in the 1980s and early 1990s involved a sharp, but temporary, increase in the unemployment rate.  That was all but inescapable.  And when the unemployment rate was extremely low in the years just prior to 2008, that went hand in hand with core inflation rising quite a bit.  Monetary policy decisions will typically have unemployment consequences.    Unelected technocrats are messing, pretty seriously, with the lives of ordinary people.   It is all in a good cause (and I mean that totally seriously with not a hint of irony intended) but the costs, and disruptions, are real –  and typically don’t fall on the policymaker (or his/her advisers).

And it isn’t as if monetary policymakers are typically oblivious to the pain.   There was plenty of gallows humour around the Reserve Bank in the disinflation years, a reflection of that unease.  And yet often the official rhetoric is all about inflation –  as if, in some sense, what look like relatively small fluctuations around a relatively low rate of inflation, matter more than lives disrupted by the scourge of unemployment.

So perhaps that is why cosmetics can matter, and serve useful ends even in areas like monetary policy.     There isn’t that much difference, on average over time, in how the Reserve Bank of New Zealand, the Reserve Bank of Australia, or the Federal Reserve (or various other inflation targeting advanced country central banks) conduct monetary policy.   They each tend to react to incoming data in much the same way (again, on average over time).   In the financial markets, they probably each have much the same degree of “credibility” (people think the respective central banks are serious about their stated inflation targets).   And yet my impression is that the Federal Reserve, for example, talks much more about unemployment than the Reserve Bank of New Zealand does.   The Fed gives the impression that (a) it is aware, and (b) that it cares.  In the last decade or so at least, that has been much less so here.

In New Zealand, the problem has been compounded by a sustained period when the Reserve Bank turned out to have run monetary policy too tightly (including two tightening phases that had to be quickly reversed).  Over that period –  and today –  the unemployment rate (the number of people unemployed  – the phrase I always used to encourage staff to prefer when we replied to correspondence) has been persistently above estimates of the NAIRU (non-accelerating inflation rate of unemployment).

The Reserve Bank is entrusted with a great deal of discretion, in an area riddled with uncertainty and imprecision.  We don’t know exactly what the NAIRU is (nor does the Bank).  We don’t even know what “true” core inflation is, let alone what it will be over the 12-24 months ahead, the sort of period today’s monetary policy decisions affect. That makes signalling and symbols perhaps more important than otherwise.

It is also why lines like

“It is mathematically impossible to target two variables with one instrument.” 

while formally true, aren’t really the point here.   Voters –  or some subsets of them –  simply want to know that those other things matter –  and matter quite a lot –  to the people wielding the power.    And as there is quite a connection between monetary policy choices and fluctuations in the numbers of people unemployed, they aren’t irrational to do so.    After all, they might well note that the old argument –  “well if unemployment is too high, inflation will undershoot the target and the Bank will quickly correct that” doesn’t sound so compelling after years of an undershoot, and years when unemployment has lingered quite high.

There is a whole variety of ways to send the signals:

  • one can tinker with the PTA again (most of the changes of 28 years have had this quality about them –  including for example the current references to unnecessary variability in output, interest and exchange rates),
  • one can choose a Governor who is known to care (although typically technocrats won’t be much known at all),
  • one could require the Bank to publish estimates of the NAIRU and report regularly on how monetary policy was affecting the gap between actual unemployment and the NAIRU,
  • the Bank could regularly write about, or give speeches, highlighting the importance of unemployment (gaps) in its thinking, and expressing discomfort whenever unemployment has to be temporarily high.

Or one could tinker with section 8 of the Act and add a full employment reference.

Perhaps Labour actually has a combination of these sorts of approaches in mind.  Amending the Act is isolation might not do much (even in signalling and symbolism) in isolation, but it might encourage the appointment of a Governor who took seriously the concern (after all the Bank’s Board has to operate under the Act), and it might encourage the Governor, the Bank, and any future Monetary Policy Committee to address these issues more directly in their own communications.

And at a political level, if they are serious about prioritising full employment as one  over-arching goal of economic policy (which seems a worthy goal to me, even if there are good and bad ways of pursuing it), a change to the Reserve Bank Act might also signal –  what the monetary policy analysts already know – that in the medium to longer-term monetary policy and the Reserve Bank are no obstacle to full employment.

As I noted last week, in 1950 the incoming National government amended the Reserve Bank Act to specify an objective for monetary policy as follows

[The Bank] shall do all such things within the limits of its powers as it deems necessary or desirable to promote and safeguard a stable internal price level and the highest degree of production, trade, and employment that can be achieved by monetary action.

Something similar, in today’s language, seems at worst unobjectionable to me.  At best, it might strengthen public confidence in the Bank and encourage the Bank and its incoming Governor and Deputy Governor to convey with more conviction how seriously they take the overall economic environment –  real firms, real people –  within which the Bank exercises its considerable discretionary power.

Reflecting on all this over the weekend, another parallel struck me.  In wartime, the priority is to win the war.  In many ways it is as simple as that.  A single objective.   And yet combat generals, delegated power by political leaders, who become known as reckless with the lives of their men eventually forfeit trust, corroding the loyalty of those who serve them (and those who appoint them).   Wars involve losses of life, often heavy losses. No general can take on the role without being ready to see young men lose their lives, perhaps in very large numbers.  And yet –  at least in a free society –  we don’t want generals who are indifferent to the cost.  We want them to spend lives as if each one were precious.  Soldiers who believe that of their generals probably fight with more conviction and determination.  And societies give leeway and respect to those generals, allowing them to lead the battles that, in time, win the war.   It isn’t a dual objective –  in the end societies do what they need to to survive and prevail –  but it isn’t irrelevant either.


Possible Reserve Bank reforms: some reactions

Some of the media reaction to talk –  from both the government and the Labour Party –  of possible changes to the Reserve Bank Act  has been a bit surprising.  One leading journalist behind a paywall summed up both the review Steven Joyce has requested and Labour’s proposals as “utter balderdash”, apparently just because there are more important issues politicians should be addressing.  No doubt there are –  housing, the languishing tradables sector, non-existent productivity growth and so on –  but competent governments, backed by a large public service, can usually manage more than one thing at a time.    And although there are plenty of details to debate on Reserve Bank governance, they aren’t exactly divisive ideological issues.   A parliamentary under-secretary or Associate Minister handled most of the details of the 1989 Reserve Bank Act, in a government that did a great deal of other (often more important) stuff.

Bernard Hickey’s story on the government’s review and Labour’s proposals is headed Monetary Policy Reforms a Mirage.     That could be so.  If National is re-elected, they might advance no governance reforms.  Or they might just legislate for something very like the sort of internal committee that, in various shapes and forms, has been the forum in which the Governor made OCR decisions ever since the OCR was introduced.  But apparently at his post-Cabinet press conference, the Prime Minister –  who had rejected earlier Treasury advice in this area in 2012 –  opened up the possibility of a committee not just composed of insiders.

Meanwhile, English hinted Treasury might look at whether a rate-setting committee could include non-Reserve Bank personal. That would be a matter for the review, he said.

Beginning a process of discussing reform options tends to put a range of issues and options on the table.

The sort of decision-making and governance reforms being advanced by Labour and the Greens would be most unlikely to be “simply a mirage”.     There are number of concerns that what Labour is proposing does not go far enough, but again they are probably best seen as the starting point for a more detailed review if/when Labour and the Greens take office.  There is a risk that it could all come to not very much.   After all, even over the last 15 years the Reserve Bank has had a couple of Governor-appointed outsiders involved in the advice and decisionmaking process –  the Prime Minister’s brother is one of them at present –  and that hasn’t made much difference at all.  And requirements to publish minutes/votes can be subverted too.      But that it is why the appointment of the new Governor is so important.  If Labour and Greens are serious about reforming the way the Reserve Bank operates,  then if they become government they need to move quickly to find a person (perhaps a top team) they have confidence in, to work with The Treasury and the government to implement legislative reforms, and to lead the internal process changes to make the new, more open, vision a reality.    If they are serious about greater openness, they need to ensure they have a Governor who shares that reforming vision.   Such a Governor could make a considerable difference even if, for example, the new Monetary Policy Committee (MPC) were to have a majority of executive members.

In some ways, much the same goes for the, less substantively important, proposal to add some sort of full employment aspiration/objective to the statutory goal for monetary policy.    I’ve described it as virtue-signalling, but on reflection that might be slightly unfair.  In the narrow context of the Reserve Bank Act, it is probably about right –  if the Bank has had things a bit tight over the last few years, leaving unemployment higher than it needed to be, then often enough over the life of the Act, the unemployment rate has been below the NAIRU.   Changing the words of section 8 of the Act in isolation won’t make much difference. After all, Australia and the United States have wording Labour prefers, and yet the cyclical behaviour of their economies hasn’t, on average over time, been much different from New Zealand’s.

So I’m sure there is a bit of pure product-differentiation about Labour’s proposal in this regard.  That isn’t unusual. Most changes to the Policy Targets Agreements over the years –  from both sides of politics –  have been more about product differentiation than substance, about scratching itches rather than making much difference to how monetary policy is actually run.  For Labour there is probably is some perceived need to differentiate, and a desire to campaign (and govern?) on a whole-of-government commitment to promoting and facilitating full employment.   That is an unquestionably worthy goal.    If monetary policy choices aren’t going to make very much difference to the medium or long-term rate of unemployment, they can (and have) made quite a difference in the shorter term.  So one way of telling Labour’s story is that they want the word to get out to the public that they are committed to (medium-term) full employment, and they want the public to know that the Bank isn’t in any sense an obstacle to that, and to hear the Bank talking of the importance of the issue.  These are real people’s lives.   I noted yesterday

So the problem typically hasn’t been that the Reserve Bank doesn’t care about unemployment –  although they don’t mention it often, and there is little sense in their rhetoric of visceral horror at waste of lives and resources when unemployment is higher than it needs to be.

They probably should be talking about it more, with conviction.  The legitimacy of independent public agencies depends on part of people believing that those entities have the public interest at heart.  And everyone knows –  central banks acknowledge –  that in the shorter-term their choices do have (sometimes painful) implications for the numbers of people unemployed in New Zealand.  At a bloodless technocratic level, I’ve suggested Labour could amend the Act to require the Bank to regularly report on its estimate of the NAIRU, and how monetary policy is affecting the gap between the actual unemployment rate and the NAIRU.  But this isn’t just a bloodless technocratic concern.

So again, getting the right Governor matters –  someone who will talk convincingly and engagingly as if what they are about affects ordinary people, including those at the margins (vulnerable to unemployment and the resulting dislocation to their lives).

So, from the perspective of both strands of the Labour reform proposal, my concrete suggestion to them is that if they lead a new government after the election, they should quickly pass a one (substantive) clause amendment to the Reserve Bank Act.

Section 40 of the Act at present reads

40 Governor

(1) There shall be a Governor of the Bank who shall be appointed by the Minister on the recommendation of the Board.

(2) The Governor shall be the Chief Executive of the Bank.

Simply deleting “on the recommendation of the Board” would make our practice much more consistent with that in most other countries.  It would remove the controlling influence of a Board appointed entirely by the previous government, and it would allow Labour to have in place to lead the rest of their Reserve Bank reforms, someone of their choosing, someone in whom they have confidence.  That is how other advanced democracies do things.  It isn’t about appointing party hacks –  it is how Janet Yellen, Mark Carney, Ben Bernanke, Glenn Stevens and Phil Lowe were all appointed; capable people who commanded the confidence of the government that appointed them.

(Although it isn’t a priority for me, making this change might actually strengthen the effectiveness of the Bank’s Board in holding the Governor to account.  At present, when the Board (in effect) appoints the Governor they have a strong interest in backing their own judgement, and providing cover for the Governor.   If they were responsible for monitoring the performance of a Governor directly appointed by the Minister, they’d have less vested interest in the individual, and perhaps be more ready to represent the interests of the Minister and of the public).

As I was finishing this post, I noticed a highly critical article on by Alex Tarrant.  Although he isn’t quoted, it reads in part as if Tarrant has been interviewing his father, Arthur Grimes, one of the designers of the current Reserve Bank Act monetary policy provisions, and former chair of the Reserve Bank Board.   There is a lengthy discussion of time-inconsistency issues –  a regular theme of Grimes’s.    I’m not going to attempt to respond in any detail now, but would just observe that whatever the explanations for the rise of inflation in the 60s and 70s (and I’m not persuaded by the story Tarrant quotes), what Labour seems to be proposing is something not far removed from the sorts of formal wording, and policy rhetoric, routinely used at the Reserve Bank of Australia and the Federal Reserve.  One can debate whether it makes much sense to use such langugage, or whether the formal statutory provisions in those countries make much difference, but it is hard for any detached observer to suggest credibly that the Reserve Bank of Australia or the Federal Reserve have suffered greater difficulties with credibility, or with the willingness of the public and markets to take their words seriously, than the Reserve Bank of New Zealand has faced with the current section 8 wording.   If anything, the Reserve Bank of New Zealand has had rather more problems –  odd experiments like the MCI, and two quickly-reversed tightening cycles in the last decade –  even if those particular mistakes and problems don’t have their roots in the wording of section 8.  And unlike other inflation targeting countries, there has never been an election since the Act was introduced in which some party or other (and not just the remnants of Social Credit) has not been campaigning for changes to the Reserve Bank Act or the PTA.  You don’t find anything like it in other inflation targeting countries.