What is Central Banking Really About?

The retirement of the Governor of the Reserve Bank of New Zealand leads to a reflection on what has been really going on.

During Graeme Wheeler’s five-year term as the Governor of the Reserve Bank (RBNZ), consumer prices rose 1.05 per cent annually. He had a Policy Target Agreement with the Minister of Finance ‘to keep future CPI inflation outcomes between 1 per cent and 3 per cent on average over the medium term, with a focus on keeping future average inflation near the 2 per cent target midpoint.’ I leave others to squabble over whether Wheeler succeeded. I want to offer a very different view of the effectiveness of the RBNZ.

In particular, can the RBNZ target on the rate of inflation? The 1989 RBNZ Act assumed that it could. Monetarists believe it could but their theory is founded on assumptions which are not very credible. One is that the economy is closed to the world without exports, imports or capital flows and that it can be characterised by a single commodity (so you cannot get a divergence between housing and other consumer prices).

The theory was so inadequate that the RBNZ quickly abandoned the monetarist account of how the macroeconomy works for the richer saltwater approach, sometimes called ‘Keynesian’. (‘Freshwater’ is the nickname for those US schools of economics (such as at Chicago) which take a ‘monetarist’ stand. They are a long way from the seacoast, which may explain why they are not too good on open-economy macroeconomics. American Keynesians tend to be at universities close to the coast.)

Let me tell you a secret. In the postwar era New Zealand consumer inflation has been remarkably close to that of the OECD despite a variety of statutory and management regimes and Reserve Bank Governors. The one exception was from the mid-1970s to the end of the 1980s. The international inflationary boom of the 1970s had finished but New Zealand’s kept on longer; finally it came to an end and has since been tracking the OECD’s just as it did before 1978.

We can argue why. The simplistic monetarist explanation is the impact of the 1989 RBNZ Act, but any comprehensive review would recognise that the post-1978 inflation was complicated, including the effect of government policy measures (such as GST). Rigid linkages in wage and price setting were making it very difficult to adjust to external economic impacts. In any case, as already mentioned, the RBNZ has not followed monetarist policies even if given a monetarist target.

So what was the RBNZ actually doing? Let me begin with the old-fashioned view that the role of a central bank is to maintain order in the monetary system or  'financial stability' . It was a goal that the best central banks attained after the 2008 Gold Financial Crisis (GFC); the RBNZ among them. They did this despite measures, such as ‘quantitative easing’, which were an anathema to the freshwater economists. (Had they been right, the world would now be experiencing very high inflation. Saltwater economists acknowledge that it is possible that in the long run there will be inflation unless the monetary injection is unwound.)

Since the GFC the RBNZ has been increasing the stability of the financial system. Banks have had tighter requirements and today (but not before 2009) the RBNZ has been in charge of the robustness of the non-bank financial institutions.

Particularly obvious to the public has been its concern with high debt on housing which increases the system’s vulnerability to a fall in house prices or a rise in interest rates. (There is a similar problem with farm debt.) Instructively, the RBNZ did not have the means to deal with the danger by itself – brute force aside – and had to wait on policies responses from a dithering central government. (So much for the belief in the all-powerful RBNZ.) The speculative boom seems to have topped off and the RBNZ is relaxing some of its restrictions (such as the loan-to-value ratio ones). Perhaps it has some confidence that measures promised by the incoming government will reduce the likelihood of a further speculative housing boom.

Even so, the RBNZ measures will not stop an individual financial institution which is imprudent or unlucky from failing. Depositors still need to be cautious. Hopefully, such failures will occur less often; if there is another systemic crisis like the GFC (one which involves the whole system) there may be less damage (but who can be sure?).

Even more obvious to the public is the RBNZ’s six-weekly setting of the OCR (overnight cash rate), which sets the base for our interest rate structure. It is quite a media event (that is, good instant coverage but forgotten shortly after) but what is really going on?

If you believe the conventional wisdom (not always a wise thing to do) you think the RBNZ is targeting inflation. Obviously that is one matter it takes into account but a close reading of its Monetary Policy Statements indicates it is concerned about other aspects of the economy. In any case, if we inflate at roughly the same rate as the rest of the rich world, does it matter?

To go back to first principles, the function of a central bank is to maintain order in monetary markets. Price stability is an important component of that but another najor source of disorder would be if our interest rates were to get out of line with the rest of the world. There could be huge and disrupting external financial flows resulting in speculative booms and busts.

The implication is that the RBNZ has to set the OCR, and the consequential interest rate structure, mindful of what is happening in the rest of the world. There is some room for judgement (including short-term fudging) but, ultimately, if world interest rates rise, we follow whatever the state of domestic inflation. Since international rates are increasing, expect ours to also. Do not be surprised if at some stage in the medium future you pay more for your house mortgage.

And yes, expect to pay more than you might in many other rich countries. Our interest rates have a margin for exchange rate risk and for our relatively high overseas debt. Just how much, is the sort of area where the aforementioned RBNZ judgement comes into play.

Their decisions have been criticised by those with monetarists predilections and by those who would like different interest rates levels (particularly those with mortgages – indebted journalists rarely consult retirees grumbling about low returns on their savings).

Leaving self-interest and ideology aside, Graeme Wheeler and his team go out with a good record, leaving to the successor team (and the incoming government) a sound financial system. Which is what a central bank should be proud of.