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The Reserve Bank in Wonderland

Published in The National Business Review (Auckland), 29 March 2018

Humpty Dumpty would have fun with the Policy Targets Agreement (PTA) between Finance Minister Grant Robertson and the new governor of the Reserve Bank, Adrian Orr:

“When I use a word,” Humpty Dumpty said, in rather a scornful tone, “it means just what I choose it to mean – neither more nor less.” “The question is,” said Alice, “whether you can make words mean so many different things.” “The question is,” said Humpty Dumpty, “which is to be master – that’s all.”

The world of monetary economics is not quite as colourful as the characters in Lewis Carroll’s Alice in Wonderland and Through the Looking Glass. However, the governor may find himself in the role of Humpty Dumpty when interpreting his political directives. That is because the PTA is meaningless without his interpretation – and potentially little more meaningful with it.

There has been much noise over introducing employment into the targets the Reserve Bank should strive for.

Arthur Grimes, regarded as one of the intellectual fathers of the Reserve Bank Act and a former chairman, was most strident in his criticism. He called the decision “disastrous” and “crazy” and warned it could destabilise the economy. A former governor, Don Brash, expressed similar concerns.

From a theoretical viewpoint, it is easy to understand such criticisms. It is a simple matter of fact that for decades no long-term conflict between price stability and employment has been shown to exist. One would struggle to find any respectable economist making the contrary case.

In other words, the best way for the Reserve Bank to support full employment is to focus on price stability.

In this context, let’s note that achieving full employment is not something any central bank could ever achieve on its own. Governments can thwart central banks’ best efforts in numerous ways. Setting a high minimum wage, making the labour market inflexible and allowing industry-wide bargaining will all increase unemployment despite central banks’ best-intentioned actions.

But that is just a theoretical obiter dictum, so back to the new PTA.

Labour has long talked about using the Reserve Bank to combat unemployment. This recently felt out of place, especially as the unemployment rate was falling below 5% and edging closer to what economists would call “natural” or “frictional” unemployment.

But, obviously, it was Labour’s right to propose adding something about employment to the Reserve Bank’s targets. Not because unemployment was high. Not because monetary policy could even do anything about it in the long run. Simply because it felt right to Labour – or at least more holistic than a focus on price stability which was regarded as too narrow.

The employment target is therefore a political symbol. It results from the wish to demonstrate to move on from the 1980s and do something new. It demonstrates Labour’s ambitiousness in economic policy.

The challenge then was to square the circle of such political ambitions with the cold-hearted reality of monetary economics. And this is where the PTA comes into play.

If we read the PTA carefully, it does not in fact issue an employment target. After committing the central bank to price stability, it adds: “The conduct of monetary policy will maintain a stable general level of prices, and contribute to supporting maximum sustainable employment within the economy.”

I am not a linguist but this is obviously not the most straightforward set of instructions. It is a qualification inside a condition within an attenuation:

• The PTA could have said something about monetary policy contributing to full employment (which would have been mistaken). Instead, it only asks it to contribute to support to an employment goal.
• It could have mentioned full employment but it only talks about maximising employment.
• It could have left it at maximising employment but qualifies it further by calling for the maximisation of sustainable employment.

And, just to make it even clearer that the minister of finance understands the importance of controlling inflation, in the hierarchy of goals, price stability (with no such qualifiers) comes first.

What the PTA actually requires the governor to do is to think about employment – after he has done his job of achieving price stability. It does not measure his success by achieving a specific employment outcome.

Price stability remains defined as “CPI inflation between 1-3% over the medium-term.” The maximum sustainable employment rate, by contrast, is a vague goal.

Since the PTA only asks for a contribution to support employment, even a fall in employment could be reconciled with it. The governor could simply point out that even his best contributions could have done nothing to reverse the negative effects of, say, a global economic downturn or bad domestic economic policies.

The phrasing of the PTA’s employment target is sufficiently qualified that it allows the governor to do with it as he feels he must. It also requires reporting on the employment effects of monetary policy and to avoid employment crises but, after the definition of the policy targets, these requirements hardly matter.

With this new PTA, the Reserve Bank has arrived in Wonderland. It looks as if it has a new employment target. But it is (thankfully) subject to interpretation.

More significant changes are on the horizon for the Reserve Bank but for the time being at least there is no need to panic. The new PTA is of a kind that even monetary orthodoxy should be able to live with.

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