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Dr. Don Brash

How many times do we have to re-learn what monetary policy can and can’t do?

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One of the most depressing things that has happened in New Zealand in recent times was the narrowness with which Winston Peters’ bill to amend the Reserve Bank Act was defeated a few days ago – 61 votes to 60.  Mr Peters’ bill was supported not only by New Zealand First, but also by Labour, the Greens and the Maori and Mana parties.

It was depressing because, after more than two decades of low inflation in New Zealand, with the New Zealand approach to inflation targeting being copied by almost all developed country central banks, virtually half the New Zealand Parliament suffers from the illusion that monetary policy can increase real economic growth and improve the competitiveness of the export sector.

I find it particularly sad that the Labour Party supports this illusion.  The Reserve Bank of New Zealand Act 1989 was, of course, the product of the reforming Labour Government of 1984 to 1990 – and it was passed without a single dissenting vote in Parliament (to be fair, Rob Muldoon was in hospital at the time it was passed).

In 1999, the Labour Party, by then in Opposition, promised a comprehensive review of the Act if they won the election that year.  After they formed a government late that year, they commissioned that comprehensive review by Lars Svensson, a highly respected monetary policy academic (and now Deputy Governor of the Swedish central bank).  And the result?   Following careful assessment of the Act and the way the Reserve Bank was implementing it, Professor Svensson concluded that it was world’s best practice.

Critics of the Act make the point that the New Zealand dollar is over-valued and that the Reserve Bank should be encouraged to reduce its value.  Most objective observers agree that the New Zealand dollar is indeed over-valued, and that as a result the New Zealand export sector, and industries competing with imports, are facing serious difficulties, with major job losses.    I agree too.

That is not the issue.  The issue is what monetary policy can do to rectify that situation.

Let’s suppose that the Reserve Bank was intent on reducing the exchange rate and eased monetary policy – either by further reducing interest rates or by “printing money” – to that end.  If it did this while still insisting that it continued to be intent on avoiding inflation (which is what Mr Peters’ bill would have required), it’s doubtful that the exchange rate would fall much at all, because financial markets would recognise that the Bank would need to increase interest rates in the near future to meet its inflation objective.

But suppose the Bank eased monetary policy and indicated that it would not be too worried about a “temporary” or “small” increase in inflation, the exchange rate might well fall somewhat – and inflation would certainly increase, a result both of the direct effects of the exchange rate depreciation (more expensive imports and “exportables”) and of the easier monetary policy.  In the very short term, exporters would be better off as a result of the lower exchange rate.  But as inflation increased in New Zealand relative to inflation in our major export markets, exporters would soon be again complaining that the exchange rate was “too high”.

What is relevant to exporters is not the “nominal” exchange rate but the inflation-adjusted, or real, exchange rate.  In Mr Peters’ speech to Parliament introducing his bill he spoke of the terrifying prospect – which he implied was anticipated by many observers – of the New Zealand dollar reaching parity with the US dollar.  But he neglected to note that for some decades during the post-war period the New Zealand dollar bought US$1.12, and indeed at one point in the early seventies bought US$1.48.  The reason that those rates would undoubtedly be calamitous today is that inflation in New Zealand has been higher, and productivity growth lower, than in our major export markets.

Sadly, while the Reserve Bank’s monetary policy can undoubtedly influence the nominal exchange rate it can have no enduring effect on the real exchange rate.

Nor can monetary policy have an enduring effect on employment, though again the explanatory note which accompanied Mr Peters’ bill implied that it could. Yes, an unexpected burst of inflation can reduce unemployment – it does that by temporarily depressing real wages.  But as soon as workers realise that their wages are rising more slowly than prices, they take steps to rectify that situation, and unemployment returns to its previous level.  In urging the New Zealand Reserve Bank to emulate the supposedly more flexible monetary policy of other central banks, the supporters of Mr Peters’ bill appear to have overlooked the fact that unemployment is higher in virtually every other developed economy than it is in New Zealand.

The reality is that monetary policy has an enduring effect only on prices.  Its best contribution to real economic growth and employment creation is to keep the price system operating free from the distortions caused by generalised inflation.

Yes, it would be desirable if New Zealand’s real exchange rate were lower.  The best and quickest way to achieve that would be for the Government to further tighten fiscal policy (by cutting government spending or increasing taxes).  This would dampen economic activity and enable the Reserve Bank to ease monetary policy without fear of inflation taking off.  There would be winners and losers from such a policy – but of course there are winners and losers from any change in economic policy, including any depreciation in the exchange rate.  (The harsh reality is that a depreciation of the exchange rate only works if it effectively reduces New Zealand real wages, though neither Mr Peters nor the others who supported his bill were keen to acknowledge that.)

It would be reassuring to think that perhaps Mr Peters’ bill had no serious intent at all – that it was just a device to suggest to gullible exporters that those supporting the bill were really really concerned about their well-being; that Mr Parker has no more intention of changing the Reserve Bank Act than Dr Cullen did in 1999; and that Mr Peters has no more intention of doing so than he did in 1996.

“No more intention of doing so than Mr Peters did in 1996”?  It’s worth recalling that, while Mr Peters campaigned about the evils of an over-valued exchange rate endlessly during the 1996 election campaign, he made absolutely no attempt to change the Reserve Bank Act after he became Deputy Prime Minister and Treasurer – the minister responsible for the Reserve Bank Act – at the end of that year.  Hopefully, he is no more serious about changing it now than he was then.