Peter Redward is Principal of Redward Associates, an independent economic research company based in Auckland.
It’s time to review the Reserve Bank Act.
The primary legislation governing the structure and the actions of the Reserve Bank of New Zealand is the Reserve Bank Act (1989). When the Act was passed, it was considered ‘state of art’ for its sole focus on price stability as the objective of monetary policy and for its governance structure with sole responsibility for achieving the goal placed with the Governor.
I believe that providing the Reserve Bank with operational independence, setting a single price stability objective, along with the appointment of a conservative Governor with a clear commitment to achieving and maintaining price stability, made perfect sense in 1989.
At the time, New Zealand had a history of nearly 20 years of high and volatile inflation. Inflation benefitted those with the ability to demand higher wages or prices while leaving those without bargaining power, mostly the less advantaged, to suffer. Inflation made business planning nigh-on impossible leading to misallocation of investment, while it encouraged workplace conflict as unions acted to protect their members’ living standards.
Policymakers tried a variety of policies including an ‘incomes-policy’ and the 1982-84 ‘wage-price freeze’ but it was ultimately tight money between 1985-1991 that drove down inflation and anchored inflation expectations. It’s hard to think of anyone who would wish New Zealand to return to the monetary chaos that existed in the 1970’s and 1980’s.
However, the problems that confront us today are different to 1989.
While the Act specifies “stability in the general level of prices” as the sole objective of monetary policy, it’s the Policy Targets Agreement (PTA) signed between the Governor and the Minister of Finance that gives life to the Act. While the Minister and Governor may sign the PTA in good faith, it’s up to the Governor to interpret the PTA on a day-to-day basis and his preferences will determine outcomes. Recently, this contract has specified that the Governor will aim to “keep future CPI inflation outcomes between one percent and three percent on average over the medium term, with a focus on keeping future average inflation near the two percent target midpoint” – but over the term of Governor Wheeler, headline CPI inflation has averaged just 0.8 percent. Even the Reserve Bank’s preferred measure of ‘core’ inflation, the sector factor model, which strips out distortions created by factors such as volatility in international crude oil prices, has averaged just 1.4 percent p.a.
Whether Governor Wheeler consciously aimed for a hawkish interpretation of the Act, or not, we may never know. But hawkish he’s been, leading to tighter monetary conditions than were necessary, boosting the New Zealand dollar and confining thousands of New Zealanders to needless unemployment. While one could argue that tighter policy has contained the property market, our analysis suggests that minor movements in interest rates have limited impact and the Reserve Bank has largely acknowledged this, shifting focus to a direct tightening of access to credit.
Successive Ministers of Finance have attempted to cool the heels of our hawkish Central Bank, adding various barnacles to the PTA, but it’s unclear whether this has had any impact. Rather than continue adding vacuous clauses to the PTA, which may well be ignored, maybe it’s time to adopt a dual mandate in the Act. One possibility is the dual mandate of the U.S. Federal Reserve. The Federal Reserve has a two percent inflation target but it also targets ‘maximum employment’. Economists have differing interpretations of ‘maximum employment’ so it acts as a constraint, and that’s the point.
While no one knows exactly where ‘maximum employment’ in New Zealand is, I believe most economists would agree that it’s likely to be consistent with an unemployment rate somewhere around 4.5 percent (give or take 0.25 percent). If the Reserve Bank had a dual mandate, its elevated level would have acted to constrain the bank’s aborted tightening of policy in 2009 and 2014.
A change in the Reserve Bank Act alone may not be sufficient to constrain a hawkish Governor and we must ask, in a democracy should the power to control the cost of money and the value of the New Zealand dollar rest with just one person?
In addition to moving to a dual mandate, the Reserve Bank needs an overhaul of its governance. This is tacitly acknowledged by the current Governor, who has made much of the fact that the Reserve Bank operates a Monetary Policy Committee, with the Governor implying that decisions are made collectively. The Reserve Bank has in fact maintained an internal MPC since the early 1990’s. But while the legal power to set monetary policy rests in the hands of the Governor alone and there’s very little transparency or accountability, what’s the point?
What’s needed is a formal Monetary Board complete with published minutes and, released after a grace period, transcripts of the meeting and the voting record of members. In a recent speech, U.S. Federal Reserve Vice Chair, Stanley Fischer, argued that this arrangement is superior to the sole responsibility model in achieving outcomes and accountability. Changes to the role and responsibility of the Governor will necessitate changes to the structure of the Reserve Bank Board. Best practice would suggest that a Monetary Board should be created to set monetary policy with the Reserve Bank Board selecting candidates for the committee while maintaining oversight of the bank. To ensure that external board members are not simply captured by the bank it may be necessary to provide a secretariat similar to the Fonterra Shareholder’s Council, operated at arms-length from bank management.
While the Reserve Bank Act has served New Zealand well, it’s time for a review. New Zealand deserves the best and what we’ve got no longer passes muster.