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The evolution of Policy Targets Agreements

This paper summarises the changes made to the Policy Targets Agreements (PTAs) since the Reserve Bank of New Zealand Act 1989 came into force in early 1990. The main points made in the paper are summarised here.

  • The PTA is a key element in the New Zealand monetary policy framework. It is the means by which the Minister of Finance/Treasurer and the Governor of the Reserve Bank agree on the specification and measurement of price stability. The PTA forms an important element in the monetary policy transparency and accountability processes.
  • Changes to the PTA can only be made with the mutual agreement of the Minister of Finance/Treasurer and Governor. Both must satisfy themselves that any changes made to the PTA are consistent with the price stability objective, as laid out in the Act. However, the Act makes provision for the Government to override the price stability objective and to require the Reserve Bank to conduct monetary policy for other purposes.
  • Although price stability could be achieved through a number of alternative mechanisms, all the PTAs to date have been based on explicit inflation targeting.
  • There have been six PTAs since the Act came into force. The current PTA was signed in December 1999.
  • Although there have been a number of changes to the PTAs in the last decade, most have been relatively minor in nature. The core features have remained essentially the same, particularly the concept of the inflation target and the "caveats" enabling the Bank to allow inflation to move temporarily outside the inflation target band in certain circumstances.
  • The most important changes made to the PTA have been:
    • the change from requiring a re-negotiation of the PTA where price shocks appear to threaten the price stability objective, to a "caveat" approach requiring the Bank to identify price shocks and to state its intended approach to bring inflation back within the target band, made in December 1990;
    • the lengthening of the period for achieving inflation within the (original) 0 to 2 per cent target band, made in December 1990;
    • the widening of the inflation target band to 0 to 3 per cent, effected in December 1996; and
    • making explicit the requirement for the Bank to seek to avoid unnecessary instability in output, interest rates and the exchange rate in the pursuit of price stability, which was introduced in December 1999.

Introduction

1. This paper should be read in the context of the Reserve Bank's submission to the Review of the Operation of Monetary Policy and is one of a number of background papers supporting that submission. It summarises the main changes made to the Policy Targets Agreements (PTAs) since the Reserve Bank of New Zealand Act 1989 (1989 Act) was enacted.

2. Attached to the paper is an appendix summarising in greater detail the main changes made to successive PTAs.

Background

3. Section 9 of the 1989 Act requires the Minister of Finance/Treasurer, in agreement with the Governor of the Reserve Bank, to fix policy targets for the Bank to carry out its primary function of conducting monetary policy to achieve and maintain stability in the general level of prices. The PTA must be agreed between the Minister of Finance/Treasurer and Governor before the appointment or reappointment of the Governor and applies for the term of the Governor. The Act requires the PTA to be tabled in Parliament, and is therefore a public document. It can be changed or replaced at any time by mutual agreement between the Minister of Finance/Treasurer and Governor. Under the Act, the Governor is required to ensure that the actions taken by the Bank in implementing monetary policy are consistent with the policy targets specified in the PTA.

4. The Act empowers the Government to direct the Reserve Bank to conduct monetary policy for a purpose other than price stability. The direction is effected by Order in Council and may apply for a period not exceeding 12 months, although it can be renewed by the promulgation of a further Order in Council. The direction must be tabled in Parliament and publicly disclosed. In giving a direction to the Bank, the Minister is required to set a new PTA for the duration of the Order in Council.

5. The PTA forms an integral part of the New Zealand monetary policy framework. While the 1989 Act sets out the overall objective of monetary policy as being the achievement and maintenance of price stability, the PTA is the mechanism by which this objective is made operational. It should be noted that the Act is silent on the matter of how price stability is to be operationalised. In principle, any number of alternative mechanisms could be specified in the PTA to deliver the price stability outcome, including, for example, nominal GDP targeting, monetary targeting, using the exchange rate as a nominal anchor or having a price level target. From the outset, however, it was decided that the most appropriate mechanism for delivering price stability in New Zealand would be inflation targeting, and this approach has been adopted in every PTA since the Act came into force in early 1990.

6. In effect, the PTA represents a contract between the Minister of Finance/Treasurer and the Governor of the Reserve Bank, and forms a central element of the Bank's mandate and accountability. The Act and PTA framework were created in the context of the public sector reforms made in the mid 1980s, which stressed the importance of specifying clear policy objectives, assigning responsibility and the necessary authority for meeting the objectives, and providing clear lines of accountability. In this context, the monetary policy framework has four key elements.

7. Changes to the PTA can be initiated by either party. Over the years since 1990, most of the changes to the PTA have been initiated by successive Governments. The changes have occurred either as a result of a change in Government or the reappointment of the Governor. In each case, before agreeing to the proposed changes, both the Treasurer and the Governor must be satisfied that the changes are consistent with the price stability objective (unless the PTA is entered into in the context of the override provision being activated).

8. It is desirable that PTAs are seen as enduring documents and are not subject to frequent changes. For this reason, we have expressed regret that changes made to PTAs have been as frequent as they have been. However, it is also desirable that the Government of the day shares in the ownership of the monetary policy framework and the price stability objective. In that regard, we have taken the view that there is some merit in a new PTA being entered into upon the formation of a new Government.

9. The first PTA was signed on 2 March 1990, shortly after the 1989 Act came into force. Since then, the PTA has been changed five times, with the current PTA coming into effect on 16 December 1999. The core features of the PTA have not changed significantly over the last decade. In particular, the inflation targeting concept, the "caveats" to the maintenance of inflation within the target band, and the accountability structures have all remained essentially unchanged. Most of the changes have been relatively minor in nature, although there have been a small number of more significant changes. And there has been some broadening in the tone and reduction in the degree of specificity of the PTA. This reflects a move away from what was probably an excessively precise approach to accountability for staying in the inflation target in the mid 1990s to a situation today where a somewhat less rigid approach is taken to the Bank's accountability for keeping inflation within the target band.

10. The most important changes have been:

Evolution of PTAs - 1990 to 2000

11. As noted above, the first PTA was signed in March 1990 between the then Minister of Finance, the Hon David Caygill, and Dr Brash. It specified the inflation target as 0 to 2 per cent, to be achieved by the year to 31 December 1992. The target was to be measured using the All Groups CPI. However, in recognition that this index included the purchase price of dwellings and credit finance costs, and was therefore an inappropriate measure of inflation for monetary policy purposes, the PTA required the Bank to calculate an alternative measure of inflation. In the initial stages of inflation targeting under the 1989 Act, the alternative measure of inflation, as calculated by the Reserve Bank, was the CPI adjusted for housing costs and finance credit costs (the Housing-Adjusted Price Index, or HAPI).

12. In recognition that one-off price shocks could result in the inflation rate moving outside the target band, and that monetary policy should not seek to offset the immediate price effect of these shocks, the PTA specified a number of "caveats" to the achievement of the 0 to 2 per cent goal. It provided for the PTA to be re-negotiated where achievement of the inflation target was threatened by any of the following events:

13. The enactment of the 1989 Act and introduction of the first PTA did not result in any immediate changes to the focus and implementation of monetary policy in the early 1990s, given that, by mid 1988, the Bank was already directing monetary policy at reducing inflation to the 0 to 2 per cent target. More generally, since 1984, the Bank had been directing monetary policy solely at reducing the inflation rate. The enactment of the 1989 Act and promulgation of the first PTA therefore represented a continuation of the approach to monetary policy that had been evolving in the latter half of the 1980s. However, the Act and PTA sharpened the clarity of monetary policy objectives and provided a stronger basis for promoting public understanding of monetary policy and lowering inflationary expectations. By entrenching price stability as a statutory goal, and encapsulating an inflation target in the PTA, the new framework also reduced the scope for the government or the Bank to surreptitiously back away from the disinflationary process and medium-term goal of price stability.

14. In December 1990, after the election of a new Government, a new PTA was entered into between the Minister of Finance, the Hon Ruth Richardson, and Dr Brash. It simplified the PTA, removing elements of the former PTA that had merely duplicated provisions in the Act, and introduced two main changes from the original PTA.

15. First, it extended by one year the time for achieving the inflation target band, to 31 December 1993, in line with the new Government's election pledge and the Bank's desire to ease the transition costs associated with the disinflationary process (particularly in relation to facilitating adjustment in the real exchange rate). The change was made at a time when the inflation rate was still significantly above the target band and before it had become apparent that inflationary pressures were subsiding more quickly than had earlier been thought likely.

16. Second, it removed the need for the PTA to be re-negotiated in the event of a price shock. This change was initiated by the Bank as a way of simplifying the PTA and reducing the need for potentially frequent future changes to the PTA that might have arisen under the original formulation. Under the new PTA, in the event of a price shock, the Bank was required to explain in the Monetary Policy Statement the effect of the price shock on the CPI and on the likely achievement of the target inflation band, and to set out the measures being taken to return inflation to the target band. The price shock events referred to in the PTA were much the same as in the original PTA, although a new one was added to the list - changes in government or local authority levies.

17. In accordance with the original requirement to bring inflation down to the target band of 0 to 2 per cent by December 1992, the Bank had announced in its April 1990 Monetary Policy Statement some interim indicative ranges for inflation to ease the transition to price stability. The indicative ranges were 3 to 5 per cent for the year to December 1990 and 1.5 to 3.5 per cent for the year to December 1991. When the time horizon for achieving the 0 to 2 per cent target was extended to December 1993, the Bank announced in February 1991 a somewhat slower track for reducing inflation, with indicative ranges of 2.5 to 4.5 per cent for the year to December 1991 and an indicative range of 1.5 to 3.5 per cent in the year to December 1992. The interim indicative ranges reflected the Bank's desire to achieve a progressive reduction in inflation to the 0 to 2 per cent target band, in the belief that a sharp process of disinflation could impose significant costs on the economy. Publication of the interim indicative ranges also provided additional internal disciplines to assist the Bank in its monetary policy decisions over this period.

18. Given the role of the caveats in the PTA, the Bank began to calculate an inflation measure that came to be known as "underlying inflation", to adjust for the effects of interest rates, housing costs and one-off price shocks. The underlying measure of inflation was released by the Bank each time the quarterly CPI was published by Statistics New Zealand, and the Bank based its monetary policy decisions on the trend in the underlying measure of inflation rather than the so-called headline rate. In the early 1990s, for example, adjustments were made to the CPI to exclude the impact of changes in interest rates and the effect of changes in government charges. In doing this, the Bank demonstrated that it was disregarding the immediate effect on the CPI of these one-off influences, and instead, focusing monetary policy on the medium term trend in inflation - ie on the underlying rate of inflation. However, as became increasingly apparent in later years, the calculation of underlying inflation posed difficulties in determining which items to include or exclude. This sometimes resulted in arbitrary demarcations for determining when items would be included or excluded for the purpose of calculating underlying inflation and tended to result in spurious accuracy. These issues are discussed later in this paper.

19. A new PTA was issued in December 1992, signed by the Hon Ruth Richardson and Dr Brash, when the Minister announced Dr Brash's appointment for a second term. Most of the changes were of a minor, administrative, nature and the basic structure was very similar to the previous PTA. The main change was the replacement of the former requirement to achieve inflation within the target band by December 1993, with an obligation to maintain inflation within the target band. This reflected the fact that the inflation target had been met by December 1991 and maintained throughout 1992.

20. The new PTA was structured to apply for the remainder of the Governor's first term of office (which was due to expire on 31 August 1993) and for his next term of office.

21. A new PTA was issued in December 1996, replacing the one dated December 1992. The new PTA was initiated as a result of the formation of the National/New Zealand First Coalition Government in December 1996, and was signed by the Rt Hon Bill (now Sir William) Birch, Minister of Finance, on behalf of the Rt Hon Winston Peters (Treasurer-elect), and Dr Brash. The PTA introduced two main changes.

Both changes were at the initiative of the incoming Government.

22. The widening of the inflation target was acceptable to the Governor because the wider band was seen as still being consistent with the overall price stability objective and because he felt that it would not materially affect the credibility of the monetary policy framework or adversely affect inflation expectations (which, by the mid 1990s, had become more strongly anchored). Although the widening of the band did not result in any significant change to the Bank's approach to monetary policy, it did enable a somewhat greater degree of variability in the inflation rate and therefore assisted in reducing the constraints associated with the narrower inflation band.

23. The new wording in the PTA, explicitly linking monetary policy with economic growth, employment and development, reflected the new Government's desire for a clearer and more visible statement that price stability is the best contribution that monetary policy can make to economic growth and employment, and not simply an end in itself.

24. The new wording linking monetary policy to broader economic objectives presented no difficulty for the Bank, given that the Bank had, from the time that the 1989 Act was enacted, espoused the view that, over the long haul, monetary policy can most effectively contribute to broader economic objectives, such as encouraging economic growth, by focusing on maintaining price stability. Consistent with the arguments run in numerous speeches and publications from the Bank, the new wording in the PTA emphasised this linkage more explicitly than in earlier PTAs and did not imply a broader set of objectives for monetary policy.

25. A new PTA was issued in December 1997, signed by the Treasurer, the Rt Hon Winston Peters, and Dr Brash on Dr Brash's re-appointment for a third term. The PTA was drafted to apply for the remainder of the Governor's term of office (scheduled to expire on 31 August 1998) and for his next term of office (commencing on 1 September 1998 and due to expire on 31 August 2003).

26. Although the fundamental features of the preceding PTA were not materially altered, the new PTA introduced quite a substantial number of generally minor changes. In some respects, the new PTA was drafted in broader language and a somewhat softer, less prescriptive tone than its predecessors. The changes included the following.

27. The introduction of CPIX as the official measure of inflation for PTA purposes helped the Bank abandon the calculation of an underlying measure of inflation, given that most of the difference between headline inflation and underlying inflation was usually the result of changes in interest rates. The decision to discontinue publication of an underlying measure of inflation also reflected the difficulties associated with calculating underlying inflation - difficulties that had become more apparent as the decade progressed. In particular, the calculation and publication of an underlying measure of inflation was seen as problematic for a number of reasons.

28. Eventually, the Bank concluded that these difficulties outweighed the benefits of calculating and publishing an underlying measure of inflation. The regular publication by Statistics New Zealand of CPIX provided the opportunity to discontinue the publication of underlying inflation. However, this did not alter the Bank's approach to monetary policy. In particular, the Bank continued to disregard the immediate effect of temporary price shocks, such as those referenced in the PTA, and focused monetary policy on keeping inflation within the 0 to 3 per cent band over the medium term, even although there would be times when measured inflation would fall outside the band. Although Monetary Policy Statements from 1998 onwards did not include references to underlying inflation (other than in reference to earlier periods), the Bank was still obliged to explain inflation outcomes where these fell outside the target band. Accordingly, where appropriate, the Bank's Monetary Policy Statements included estimates of price shock effects on the CPIX measure of inflation.

29. The current PTA was signed in December 1999 between the Hon Michael Cullen, Treasurer, and Dr Brash, upon the formation of the new Labour/Alliance Government. The new PTA replaced the previous one, but retained most of the structure and wording, with two main changes.

30. The modified clause 4(c) was made at the initiative of the incoming Government and reflected its desire to ensure that the maintenance of price stability did not create an excessive degree of variability in economic growth, employment, interest rates or the exchange rate.

31. We have viewed the modification of clause 4(c) as largely confirming the approach that the Bank has taken to monetary policy since the inception of formalised inflation targeting. Over that period, the Bank has been mindful of the short term effects that monetary policy can have on the real economy, exchange rates and interest rates. In that regard, throughout the last 10 years of formalised inflation targeting, the Bank has adopted a number of measures in an attempt to avoid unnecessary instability in output and financial market prices. These issues are discussed in the paper dealing with clause 4(c) - "Inflation targeting in principle and in practice".

Appendix

Principal features of, and changes to, successive Policy Targets Agreements

This appendix sets out the main features and changes made to successive Policy Targets Agreements (PTAs) since the first PTA was signed on 2 March 1990.

There have been six PTAs (including the current one) since the Reserve Bank of New Zealand Act came into force on 1 February 1990. The PTAs were as follows:

The principal features of, and changes to, each PTA are summarised below.

PTA dated 2 March 1990

Key features were as follows.

PTA dated 19 December 1990

This PTA replaced the preceding one and introduced several substantial changes. The main changes were:

The key features of the PTA were that:

PTA dated 16 December 1992

This PTA replaced the preceding one, but was very closely modelled on it, with few significant changes.

PTA dated 10 December 1996

This replaced the preceding PTA, was closely modelled on it, but introduced two significant changes.

No changes were made to the caveats or to other features of the PTA.

PTA dated 15 December 1997

This replaced the preceding PTA with the following main changes.

PTA dated 16 December 1999

This replaced the preceding PTA. The wording and format of the preceding PTA were largely retained, but two main modifications were made.