Monetary and fiscal policy: How an agreed inflation target affects fiscal policy

27 September 2010

Notes for discussion at the Australian Conference of Economists on 27 September 2010

Mr Chairman, I’m honoured to be taking part on this panel in the company of such distinguished economists.   I particularly want to pay tribute to Dr Jan Libich, who has done such important work in this whole area of the interaction between monetary and fiscal policy.  He and I first had contact when I was Governor of the Reserve Bank of New Zealand and he was doing research on inflation targeting.  We met when I was Leader of the Opposition in the New Zealand Parliament.  And we now share a link to La Trobe University, where I am an Adjunct Professor.

When the Reserve Bank of New Zealand Act was passed in 1989, I doubt if anybody fully understood how it would impact on fiscal policy.  The focus was on monetary policy, and getting inflation under control. 

New Zealand had had relatively high inflation throughout the seventies and early eighties.  A new (Labour) Government had won election in 1984 amidst a serious balance of payments crisis and with strong inflationary pressures barely kept in check by tight controls on prices, wages, dividends, rents and interest rates.  The new Minister of Finance, Roger Douglas, was determined to deal with the underlying imbalances in the economy and, in so doing, reduce inflation to very low levels.

The central bank, like central banks in most countries at the time, was totally beholden to the political process.  The Bank gave the Minister of Finance advice on monetary policy, but the decisions were made by the Minister.  And the result had been not only relatively high inflation but also a pronounced cyclicality of policy – with a cycle which bore a strange resemblance to the three-yearly election cycle.  The government ran large fiscal deficits, and there was no discernible connection between fiscal policy and monetary policy.  If an election were imminent, both fiscal policy and monetary policy seemed primarily geared to securing the re-election of the governing party.

The 1989 Reserve Bank Act changed that.  The Act required monetary policy to “achieve and maintain stability in the general level of prices”.  There was no reference to output, employment, the balance of payments or, of course, fiscal policy.

But the Act did require that what was meant by “stability in the general level of prices” should be agreed between the Minister of Finance on behalf of the Government and the Governor of the Bank, and, importantly, that that agreement should be made public.

In February 1990, I signed an agreement with the Minister of Finance to deliver 12-monthly inflation as measured by the CPI of between 0 and 2 per cent by the end of 1992.   I had been given complete independence by the 1989 Act to run monetary policy without reference to the government, and I was to be held to account for achieving the agreed inflation objective.  I’m not sure that even then either the Minister or I fully appreciated the extent to which our agreement would inevitably affect fiscal policy.

In the middle of 1990, just six months away from a general election, the Minister of Finance brought down his annual budget.  Not surprisingly, politics being what it is, the budget was expansionary, and seen as such by financial markets.  There was concern about this loosening of fiscal policy, and this was reflected in both a rise in long-term interest rates and a fall in the exchange rate. 

In the Bank, we judged that the combination of easier fiscal policy and lower exchange rate would be stimulatory – and stimulatory to the point where our ability to deliver the agreed inflation target by the end of 1992 was in jeopardy.  So we responded by tightening monetary policy (just a few months prior to the general election it should be noted – nothing quite like it had happened in New Zealand history before). 

Immediately, an editorial in New Zealand’s largest daily paper, the New Zealand Herald, noted that the Budget had “rekindled inflationary expectations.  The (Reserve Bank) was bound to lift interest rates…. Electors are frequently bribed to their ultimate cost.  This time the independence of responsible monetary control quickly exposes a fiscal fraud.”[1] 

The main Opposition party campaigned in the election on a commitment to get interest rates reduced, but there was no suggestion that they would do this by removing the instrument independence of the Reserve Bank.  On the contrary, the 1989 Reserve Bank Act had been passed into law less than a year earlier with the full support of the Opposition (or at least, no Member of Parliament voted against it, perhaps because Sir Robert Muldoon, who had been responsible for much of the high inflation of the late seventies and early eighties, was in hospital at the time!).

No, the Opposition claimed that they would get interest rates down not by leaning on the central bank but by “giving monetary policy some mates”, through tighter fiscal policy and deregulation of the labour market.

Following the late 1990 election, which resulted in the Opposition winning the Treasury benches, the new Government did exactly that, embarking on a substantial programme of fiscal consolidation and a considerable liberalization of the labour market.  By 1994, the budget was in surplus for the first time in decades (the result both of one very determined Minister of Finance and of the Fiscal Responsibility Act which she promoted), inflation was within the agreed target range, the economy was growing strongly and 10 year New Zealand government New Zealand dollar bonds were, briefly at least, yielding less than US Treasuries!

A few years later, with several years of fiscal surplus behind it, the Government undertook to reduce income taxes subject to three conditions being met: one was that the target level for gross sovereign debt would not be threatened, one was that the budget would remain in surplus after the tax reductions, and one was that the Reserve Bank would not regard the proposed tax cuts as requiring a significant tightening of monetary policy.  The Minister of Finance formally wrote to me at the time to seek confirmation that the tax reductions would not require a significant tightening and, given the outlook for inflation at the time, I was able to give him that.

Roll forward 10 years to the middle part of the most recent decade.   I was no longer Governor.  I was in Parliament, but unfortunately (for me) the Leader of the Opposition and not the Prime Minister!  The government was running a fiscal surplus but the economy was running at full capacity – arguably at somewhat above full capacity – and government spending was increasing strongly.  The Governor tightened monetary policy repeatedly to the point where, by mid 2007, New Zealand had one of the highest policy interest rates in the developed world (8.25%). 

Was this designed to discipline fiscal policy?  Not directly, but it was a good illustration that the stance of fiscal policy inevitably has consequences for the stance of monetary policy, and indeed the Governor made it clear in a number of public statements that one of the reasons why he had had to tighten policy was the substantial stimulus arising from the strong growth in government spending, growth which inevitably had implications for pressure on resource utilization and inflation.

There is inevitably interaction between monetary and fiscal policy.  The nature of that interaction will depend on a number of factors, but crucially on what kind of pre-commitment the monetary authority makes to keeping inflation under control.  Any kind of explicit inflation target will have a bearing on fiscal policy because both monetary and fiscal policy inevitably have some effect on resource use and therefore on inflation.

Where the inflation target is agreed between government and central bank, as in the New Zealand case – and of course also now in the Australian, Canadian, and UK cases – that link between monetary and fiscal policy becomes much tighter. 

Some central bankers are very dubious about allowing governments any role in determining, or even influencing, the goal of monetary policy.  I disagree.  I think giving governments an explicit role in agreeing the goal of monetary policy is highly desirable.  This is partly because once the government has agreed the inflation target with the central bank – and made that target public – the central bank is almost entirely protected from political attack provided that the inflation rate is, and is likely to remain, within the agreed target.

But the other major advantage in having the government and central bank formally agree on the inflation target is that it really does mean that the government is forced to take the inflation target into account as it determines its fiscal policy – because it knows that any major change in the stance of fiscal policy must inevitably trigger a response from the monetary authority. 

And because most governments are constantly suffering from the temptation to run a more stimulatory fiscal policy, knowing that that may provoke a tighter-than-otherwise monetary policy is a most useful constraint.

I have not the slightest doubt that having legislation which requires government and central bank to formally agree, and disclose to the public, the inflation rate which the central bank must target has a most useful role in creating strong incentives for good fiscal policy.

And I say that despite the concerns of those who argue that an inflation target of any kind, and especially one which is the product of a formal agreement between government and central bank, creates a strait jacket for monetary policy which is a net negative.  I doubt if anybody who has actually been the Governor of an inflation targeting central bank would agree.  An inflation target is only a strait jacket if it is badly designed.  All those with which I’m familiar allow for monetary policy to respond flexibly and predictably to exogenous shocks, be those shocks violent movements in international oil prices, natural calamities or some other price shock having little or nothing to do with fiscal or monetary policy.

[1] New Zealand Herald, 3 August 1990.

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