A Big Change in Monetary Policy?

The Government’s new arrangements with the Reserve Bank represent an explicit acknowledgement of a major shift in theoretical underpinnings; whether it makes much change to the Bank’s operations is another matter.

One of the residuals of Rogernomics (neoliberalism) that the Clark-Cullen Government left unfinished was monetary policy. The Ardern-Peters Government seems to have taken on the challenge.

We can see this from the critics of the new arrangements. An exceptionally important one was economist Arthur Grimes who in the late 1980s had been involved in developing the then-new policy framework and was appointed by the Clark-Cullen Government to the board of the RBNZ and later chaired the board. Grimes was a major critic of the recent announcement, which I will explain shortly, defending the old regime.

But first, one element introduced in 1989, where there seems little disagreement, is that the RBNZ retains sole responsibility for the implementation of monetary policy. In the old days, the Minister of Finance was able to ring up the Governor of the Reserve Bank and direct, say, the level of the base interest rate – that happened under Robert Muldoon. It was secret, except the Governor had to tell various persons and, um, it eventually leaked (economists can be gossipy people),

The current arrangements allow a government to direct the RBNZ but it has to be in writing and tabled in a parliament so there is no secrecy. The claim that the Governor of the RBNZ has unlimited power is nonsense. Not only is he or she subject to the law but the democratically elected government can say (and does say) what the general shape of monetary policy is. The RBNZ then implements it to the best of its ability.

The main way the government tells the RBNZ what it wants is through a Policy Target Agreement (PTA) signed between the Minister of Finance and the Governor of the Reserve Bank. For three decades it has specified an inflation range with the expectation that the RBNZ will operate monetary policy to stay within it.

So what is changing? The 1989 Reserve Bank Act was passed when monetarist thinking was fashionable and intolerant of alternative approaches. (‘Monetarism’ is used here in the technical sense which gives great significance to money supply in the way the economy works, that changes in it determine the rate of inflation and that it should be at the centre of macroeconomic policy.) Thus Section 8 of the 1989 RBNZ Act states ‘[t]he primary function of the Bank is to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices.’ Nothing here about a contribution to broader economic objectives, which the previous legislation mentioned and which are often referenced in the frameworks of central banks overseas.

In fact, in Section 1A there is a secondary purpose which is that the Bank should ‘promot[e] the maintenance of a sound and efficient financial system.’ That was introduced as a 2008 amendment by the Clark-Cullen Government although the notion was sort of implicit in the original 1989 Act.

It harks back to an earlier tradition – before Keynesianism actually – that the function of a central bank was to maintain order in the monetary system. (‘Soundness’ and ‘stability’ are other terms for this order.) If the system becomes disorderly, the means of payment breaks down (as almost happened in the early stages of the GFC) and a money-based economy can hardly function.

This was a British tradition. Americans have been less enamoured with it. In the nineteenth century they relied on private funders for bailouts during their financial panics (with less success). They have had a strong ideology arguing that governments should not get involved. Even so they would have been grateful for the actions of the American Fed(eral Reserve Bank) and the US Treasury during the recent GFC.

I have never been sure whether those who designed the Reserve Bank Act in 1989 were ideological or whether they were too narrowly trained. Whatever, the Act seems to have been designed on monetarist lines. Initially there was money stock targeting – as a good monetarist would advocate – but that quickly proved unworkable and the RBNZ switched to operating through interest rate channels (how Keynesian). However, the notion of inflation targeting has been retained for almost thirty years.

This government has weakened the sole focus on inflation. The latest Policy Targets Agreement signed between the Finance Minister and the Reserve Bank Governor still sets out specific targets for maintaining price stability but it also states that monetary policy is to be conducted so that it contributes to supporting maximum levels of sustainable employment within the economy.

Monetarists reacted critically. The rest saw this as an acknowledgement that monetary policy was no longer run solely on monetarist lines. But, we puzzled, would it make any practical difference to the way the RBNZ actually operates?

Gossipy economists will tell you that the RBNZ has long abandoned a strictly monetarist approach. Rather, it uses a pragmatic mixture of the various forms of monetarism and Keynesianism (including traditional Keynesianism, modern monetary theory, neo-Keynesianism, open Keynesianism, post-Keynesianism and so on).

The RBNZ may now feel it can weigh into public discussion on the determinants of sustainable levels of employment – I would welcome that – and it is likely to consider employment issues more explicitly when it makes its decisions – or at least more explicitly mention them in its analysis. But what else? It may well be that the new PTA does not result in outcomes at all different from the previous one.

My view is that the RBNZ has even less discretion about what it can do than the conventional wisdom says. It has two elements:

First, whatever its legislation, the RBNZ will operate to maintain order in New Zealand money markets. Second, those markets are not isolated from the far-larger international ones despite most public discussion pretending that they are. (In particular, monetarist and closed Keynesians use analytic models which have no overseas sector; oh that the world was so simple.)

What that means is that the RBNZ is limited as to what it can do by what is happening offshore. It is not entirely without some discretion in the short run but in the medium run its responses are shaped by overseas developments. If international interest rates are generally rising, then you would expect local ones to follow; if – heaven helps us – the world economy enters a period of high inflation then our inflation rate goes up too, whatever the PTA promises.

 This may not be the conventional wisdom, but today it may be openly expressed without the discussant being accused of a heinous crime. The revised version of the PTA allows us to have a more free-flowing and less ideological debate about how New Zealand’s monetary system works. That is to be welcomed.


For a damning critique by an outstanding economic theorist of macroeconomics as it is practised with inattention to the underlying economic theory  see my account of Joseph Stiglitz’s ‘Where Modern Macroeconomics Went Wrong’.