In 1989, the Fourth (New Zealand) Labour Government passed legislation which revolutionized the country’s central bank, and in some respects central banking around the globe.
Prior to that time, central banks were of two kinds – either totally independent of political influence (at least in theory), like the Federal Reserve Board, the Bundesbank and the Swiss National Bank, or mere implementers of whatever monetary policy finance ministers decreed, like most other central banks. The Reserve Bank of New Zealand was of the latter variety.
The 1989 legislation was unique at the time – within a statutory requirement for monetary policy to focus on “achieving and maintaining stability in the general level of prices”, with no reference to economic growth, employment, or the balance of payments, it provided for quite explicit and public political involvement in the definition of the target. The Reserve Bank of New Zealand thus became the first central bank to have an announced inflation target, and the first to combine political involvement in the goal setting with complete operational independence to deliver that goal.
Inflation targeting has of course become almost universal, while explicit political involvement in the goal setting has been copied in Australia, Canada, Sweden and the United Kingdom.
The singular focus on inflation reflected the latest academic thinking of the time – that monetary policy does affect inflation, but has limited effect on economic growth or employment except in the short-term. And in a situation where there needs to be one policy instrument for each policy objective, it makes sense to focus monetary policy on keeping prices stable while using other policy instruments to minimize unemployment and maximize economic growth.
That troubled both the Fifth Labour Government (1999 – 2008) and now troubles the Sixth (formed just weeks ago).
The Fifth Labour Government commissioned Lars Svensson to undertake a comprehensive review of the monetary framework in 2000. He described it as world’s best practice, though recommended that monetary policy decisions should be made by a committee of central bank insiders, not by the Governor personally. The Governor had been given sole decision-making authority by the 1989 legislation as a way of being able to hold somebody to account if the agreed inflation rate was not achieved. Nothing was changed as a result of the Svensson review.
The Sixth Labour Government proposes to change the 1989 legislation in two ways.
First, they want to ensure that all monetary policy decisions are made by a committee rather than by the Governor personally, as happens in almost all other central banks. That may well make sense, even though in practice no Governor since the 1989 legislation was passed has made monetary policy decisions without consulting extensively with colleagues – and certainly not this one! Having said that, the Government apparently wants to include outsiders on the decision-making committee, and finding well-qualified people without a conflict of interest will not be easy in a small country like New Zealand. There is some risk that the new Government will appoint political supporters without too much regard for ability.
Second, the Government proposes to widen the mandate of the central bank so that monetary policy is focused on both inflation and unemployment. They note that many, perhaps most, other central banks are obliged to consider issues other than inflation when determining monetary policy. That is certainly true, though that probably reflects the fact that for many years economists believed that monetary policy could have an enduring effect on unemployment.
While it is certainly appropriate for the Government to tell the central bank that it should deliver price stability within a time frame which minimizes the short-term effect on unemployment, it is unfortunate if it creates the impression that tinkering with the short-term interest rate can have an enduring effect on unemployment.
Copyright © 2020 Don Brash.