Monetary window-dressing

Published in Insights, The New Zealand Initiative’s newsletter, 27 October 2017

Judging by its coalition agreements, the new Government’s unofficial motto is not to do everything differently but to do a lot of things better.

But not every change is for the better. Sometimes, even well-intentioned changes are just window-dressing. The review of the Reserve Bank’s policy targets is the best example.

Under its mandate, the Reserve Bank has one primary role: to keep prices stable. This so-called ‘inflation targeting’ was introduced in 1989. It made New Zealand one of the first countries to commit to this goal.

Now the Labour-NZ First agreement lists “Review and reform of the Reserve Bank Act” as the first action in its economic policy section. What it means is clear from Labour and NZ First politicians’ past statements. The Government wants to give the Reserve Bank more targets, especially fighting unemployment.

Committing the Reserve Bank to both price stability and fighting unemployment would not be unusual. The US Federal Reserve operates under such a mandate.

Yet the real problem is that dual mandates do not work, not even in theory. They are the result of a misunderstanding as anyone who studied economics over the past half a century would know.

In the late 1950s, New Zealand-born economist Alban W. Phillips made a discovery. He showed that historically inflation and unemployment had gone in opposite directions. When inflation was high, unemployment was low (and vice versa).

Some economists concluded from Phillips’ curve that a central bank could choose a little more inflation to help create jobs. As it turned out in the 1970s, that belief was wrong. Back then, many countries experienced ‘stagflation’: high unemployment and high inflation in tandem.

Through the work of many top economists, we have learnt why the Phillips Curve does not offer reliable, long-run policy choices.

Imagine a central bank cutting interest rates to increase employment. Once people expect inflation to go up, they will demand higher wages. And so the employment effect of low interest rates disappears. What remains is both high inflation and high unemployment.

The best way for a central bank to achieve both low inflation and low unemployment is to make it pursue price stability alone.

The next RBNZ governor will no doubt be aware of that. In which case, she could safely ignore any dual mandate passed down from the new Government. And keep focussing on targeting inflation.