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A new deal on monetary policy

March 28, 2018

John Carran

Written by John Carran

Senior Economist at Kiwi Wealth
John's responsibilities include monitoring economies and markets to identify both investment opportunities and risks across asset classes, regions, sectors and industries.


Employment and price stability are now both kings

Notable changes to the objectives for monetary policy and how it is operated were announced by the Minister of Finance, Grant Robertson, on Monday.

The new Policy Targets Agreement (PTA) signed between the Minister and the incoming Reserve Bank Governor, Adrian Orr, now has an additional objective of supporting maximum sustainable employment within the economy. The previous objective of keeping future Consumer Price Index (CPI) inflation outcomes between 1-3 percent on average over the medium term has been retained alongside the new objective.

It’s also worth noting that the legislation governing the Reserve Bank will be changed to mandate a committee structure for making monetary policy decisions, rather than the Governor having sole accountability for decisions. This is in-line with central bank practice in countries such as the US, UK, and the Eurozone, among others.

The world has changed

As Mr Robertson highlighted in announcing the new PTA, the world has changed since the Reserve Bank Act was put in place almost 30 years ago. New Zealanders now expect low inflation, and this is largely factored into their spending and saving decisions. Maintaining price stability is still important, but there is not quite the same need for a laser-like focus on it. There may be times when influencing employment may deserve a little more attention from the Reserve Bank.

Many other central banks around the world have dual inflation and employment objectives and this hasn’t appeared to unduly affect their abilities to achieve low inflation. To be fair, our Reserve Bank has for some time considered the short-term effect of its monetary policy decisions on employment. Therefore, adding employment as an explicit object in the PTA is not such a radical change for the Bank to adjust to.

Monetary policy unlikely to change much, but new risks to manage

I don’t expect that the change to the PTA will affect the day-to-day operation of monetary policy in normal circumstances. Nevertheless, there are risks associated with the change that will need to be carefully managed by the Reserve Bank and the Minister of Finance to maintain the benefits of New Zealand’s hard won battle against high inflation.

There could well be times in the future where the employment and inflation objectives appear to conflict with each other. In such situations, the Minister of Finance will need to be careful to respect the Reserve Bank’s independent judgement in determining which objective has the highest priority. If the Governor risks being censured for his priorities people may question whether he is being pressured to prioritise according to political rather than sound economic reasons.

On the flipside, the Bank will need to be very clear in publicly communicating the reasons for its monetary policy decisions and the relative weight it is giving to its two objectives. This is necessary both to give people and businesses clarity about what to expect, and to allow the Minister of Finance to hold the Governor accountable for his performance in achieving the objectives. Clear communication may be more challenging with a committee now being responsible for monetary policy decisions, particularly if there is a divergence of opinions within the committee. However, as central banks overseas have shown, this challenge is not insurmountable.

Stable prices still important for saving and investment

High inflation distorts people’s saving and investment decisions and ultimately makes people worse off. For example, higher inflation favours people taking on debt, disadvantages fixed income investments, and erodes the purchasing power of peoples hard-earned incomes and savings. A Government and Reserve Bank that act transparently in the spirit of their agreement will ensure that both Reserve Bank objectives are met without introducing unnecessary ambiguity.

This article reflects the personal views of the author at the date shown above. The information provided, or any opinions expressed in this article, are of a general nature only. 

Tags: Economy

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