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Monetary policy and the free-market economy

Dr Don Brash

Address to the Auckland Manufacturers' Association


Over recent weeks there have been a number of media reports of people calling for the abolition of the Reserve Bank, or the repeal of the Reserve Bank Act, with the claim that the Bank is an anachronism in New Zealand's free-market economy, that its operations result in New Zealanders having to pay interest rates which are among the highest in the world in real terms, and that these interest rates are pushing up the exchange rate to the huge detriment of exporters and those competing with imports. There are variations around this theme, depending on who is mounting the case, but I think I accurately reflect the general case.

Let me say first that I believe in the benefits conferred by the free market as strongly as anybody in this country: nobody, anywhere, has yet devised a way of organising economic activity which comes close to the free market as a way of efficiently producing the goods and services which people want.

So what are the critics saying and why do I disagree with them? It is not always quite clear what the critics are saying, and they don't all speak with one voice of course.

Is the problem in the wording of the present Reserve Bank Act?

It appears that some object to the particular wording of the present Reserve Bank Act. But the present Act has only two features which seem to generate debate.

First, the Act makes it clear that the Bank must use monetary policy to achieve and maintain `stability in the general level of prices'. In other words, it requires that, since the Bank is legally responsible for issuing New Zealand dollars, it should ensure that the value of those dollars remains broadly stable over time. It seems hard to object to that in principle: if the Bank issues pieces of paper which it expects people to regard as having value, it should surely be required in the interests of simple honesty to ensure that the value remains broadly stable. To argue otherwise would be to accept that the length of a metre, or the weight of a kilogram, should vary over time, depending on the whim of the government. As plenty of countries have found, the economy would be severely damaged by loss of confidence in the size of the basic unit for measuring value.

But, critics argue, why don't you keep prices stable and in addition do what you can to help the economy grow at its full potential, encourage more employment, and improve the competitiveness of New Zealand's exporters? Surely these other objectives are at least as important as whether inflation is 1 percent or 2 percent or even 4 percent? True, but one of the things which both we and other central banks have learned over the last 30 years is that while monetary policy clearly does have an effect on the inflation rate, and does have an effect also on the short-term growth rate of the economy, it can not be used to engineer a sustainably faster rate of economic growth, or a sustainably higher level of employment, or a sustainable improvement in the competitiveness of exporters. For this reason Parliament determined that we should not confuse the issue (and more importantly the public) by pretending that we can in fact deliver those other objectives. It is surely significant that a number of other central banks have recently had their objectives narrowed to an exclusive focus on price stability, while there are strong legislative moves in that direction in some other countries, including the United States.

The second distinctive feature of the present Reserve Bank Act is that it requires the Government of the day to define precisely what it means by the term `stability in the general level of prices' in a written, public, agreement with the Governor of the Bank. Contrary to popular myth, the Act itself does not require the Bank to keep underlying inflation between 0 and 2 percent at all times: that requirement is imposed in the Policy Targets Agreement between Government and Governor, and can be varied at any time. It does not require legislative change to modify the 0 to 2 percent target, but the law does require that any change must be made public. In other words, if Government decides that it wants to erode the value of the dollars issued by the Bank, to `debauch the currency' in Lenin's famous phrase, it has a legal obligation to tell the public that that is its new instruction to the Bank.

I find it very hard to see how anybody could object to either of those fundamental principles, whether they believe in a free market or not. One can, of course, argue whether 0 to 2 percent is the best representation of price stability. One could suggest that -1 to 3 percent would be better, as the Labour Party now advocates. One could suggest that 0 to 2 percent is appropriate, but that that should be achieved on average over a period of years, not during each and every 12 monthly period. All those issues can be sensibly debated. There is no perfect answer to the precise definition of price stability. What can not be sensibly challenged in my view is that the Bank should use every effort to ensure that the paper it issues, and expects people to regard as having value, should retain its value over time, and that Government's intentions in this regard should be absolutely clear to the public.

Incidentally, operating monetary policy to ensure that New Zealand dollars preserve their value over time certainly does not mean that monetary policy should try to prevent all price movements. On the contrary, an economy works best where the prices of individual goods and services are free to move up and down, informing both consumers and producers in the process. But if the signals embodied in relative price changes are to convey useful information, it is important that they are not drowned out by upward movements in all prices: in that (inflationary) situation, the information conveyed by price changes is significantly reduced, and the market severely impaired as a result.

Is the problem having a Reserve Bank at all?

But it appears as if some critics object not merely to the wording of the present Reserve Bank Act, but to the very existence of the Reserve Bank. Why, it is asked, should we have the Reserve Bank intervening in the financial system, pushing the exchange rate up or down, influencing the level of interest rates, and generally interfering with the free play of market forces? Is Don Brash's tinkering really any more desirable than Rob Muldoon's tinkering? We found we did not need the latter, so why do we need the former? Allow me several comments.

First, before debating whether we need any central bank, critics should at very least acknowledge that the manner in which the New Zealand central bank intervenes in the financial market is probably the least interventionist of any central bank in the world. We set no interest rate. We require no minimum deposit with the central bank. We have not bought or sold New Zealand dollars to affect the exchange rate for almost 11 years. We make no stipulations about which sectors should be preferred or avoided by banks in their allocation of credit. We make no attempt to restrict the rate at which individual banks expand their activities. We set no numerical limit on how many banks may be established. We set no limit on how much a bank may lend to an individual borrower. On the other hand, we are totally open about what we are targeting, and how we propose to achieve that target. We publish our inflation forecasts. We disclose many of the key assumptions which underlie those forecasts. Our approach to monetary policy implementation is as different from that of Sir Robert as the inflation outcomes have been.

I am also a little uncertain about whether the suggestion that we have no central bank should be taken at all seriously: to the best of my knowledge every nation state in the world has either a central bank or a currency board, and no New Zealand political party of any description currently favours having no central bank. But how might we operate if we did choose to have no central bank? In principle, it seems likely that there would be three possibilities.

First, we could move to a currency board framework, similar to that adopted by Estonia and Argentina. Both of these countries have government-owned currency boards which issue local currency to the extent that they have United States dollars to back that currency. There are pros and cons of this arrangement. Among the benefits is that the exchange rate between the local currency and the U.S. dollar remains fixed (though of course this means that the local currency relationship with all other currencies is entirely driven by movements in the U.S. dollar). But such a system would not do away with the need for a central bank - it would simply do away with the need for a New Zealand central bank. We would effectively ask the Federal Reserve Board in Washington to make monetary policy for New Zealand.

Secondly, instead of having a New Zealand central bank, we could allow ordinary commercial banks to issue their own bank notes without restriction (so-called free banking). The commercial banks, it has been argued by advocates of such a system, would have a strong incentive not to over-issue notes lest the public started to doubt the ability of the issuing bank to meet its obligations. That seems plausible, but I strongly suspect that the public would quite quickly want to know how to compare, say, Trust Bank notes with Bank of New Zealand notes. Would prices in shops be quoted in ANZ Bank notes? I suspect that the most likely outcome of such a system in the current environment is that banks would start quoting an exchange rate between the notes which they issued and some independent measure of value, almost certainly a foreign currency, such as the Australian dollar or the U.S. dollar. In a relatively short time, I suspect that we would have moved to denominate New Zealand contracts in one or other of those foreign currencies. Again, the solution does not avoid the use of a central bank. It simply hands responsibility for monetary policy in New Zealand to a foreign central bank.

Thirdly, instead of having a New Zealand central bank, we could simply pass a law requiring that bank notes (whether issued by a government agency or by commercial banks) be backed by a specified quantity of some commodity or basket of commodities. Through history, the most commonly used commodity to back paper currency has been gold, and of course countries which required a gold backing for their paper currency were referred to as being on a gold standard. There are, internationally, quite a number of advocates of returning to a gold standard, though there appear to be no advocates of this in New Zealand.

There are both advantages and disadvantages of being on a gold standard: it did give the United Kingdom some three centuries of long-term average price stability, but only at the cost of some very pronounced swings in average prices, with periods of strong price increases punctuated by periods in which prices fell sharply. The price level would inevitably be affected by significant changes in the supply and demand for gold. Moreover, since governments have discovered that, even with a gold standard, they can still `devalue' by the simple expedient of changing the price of gold in their own currency, it is not at all certain that a commodity standard would deliver the long-term price stability which the gold standard delivered to the United Kingdom. If modern societies find themselves unable to devise legislative frameworks which do, over time, protect the value of the basic unit of exchange (paper money), then perhaps there is no alternative to moving to a commodity-backed currency. But I at least am a long way from accepting that that is the best solution available.

I think it is important that those who advocate `scrapping the Reserve Bank Act' make it absolutely clear what it is they object to about the Act, and what they propose as an alternative. After all, if they don't like dealing in New Zealand dollars, they have for some years now been totally free both to write contracts in any other currency of their choosing and to move their assets into any other currency. Indeed, some New Zealanders have exercised their right to open deposit accounts at New Zealand banks in currencies other than the New Zealand dollar. Any New Zealander can borrow in Swiss francs or Hong Kong dollars if they don't like the interest rate on New Zealand dollars. Any New Zealander can legally own gold. It is hard to see how the financial market can be very much freer than that.

Whatever the theory, why are interest and exchange rates so high?

But perhaps after all the critics are not really concerned with the theory of whether the Reserve Bank Act in its present wording is ideal, or whether the Reserve Bank itself should be scrapped. Perhaps I should listen not so much to the words being spoken as to the pain which prompts them - the pain caused by interest rates at what appear, on the face of it, to be high inflation-adjusted levels, and an exchange rate which has risen, on a trade-weighted basis, by some 22 percent over the last three years.

On interest rates, I must say that, while I obviously have a great deal of sympathy for those people who are struggling to make ends meet in the face of interest rates at current levels, it is impossible for me to believe that interest rates are in any fundamental sense `too high'. Total bank lending to the New Zealand private sector has been growing at a rate of about 11 percent, year on year, for very many months now, and shows no sign of slowing. Total bank lending to the household sector has been slowing somewhat over the last year or so - but from a rate of growth of around 20 percent to a still-very-high 14 percent in the year to last November. It is very hard for the Reserve Bank to take seriously complaints about high interest rates in the face of such strong growth in private sector borrowing. (and on the other side of the ledger, not a great amount of evidence to suggest that the household sector is strongly increasing its saving).

I strongly suspect that the paradox between such rapid increases in borrowing and apparently high inflation-adjusted interest rates is that we all calculate the inflation-adjusted interest rate incorrectly. Typically, we all calculate inflation-adjusted interest rates by taking nominal interest rates and subtracting the previous year's inflation, or next year's expected inflation, both using the Consumer Price Index to assess inflation. But of course most of us in the household sector do not borrow to buy the basket of goods and services whose prices make up the CPI: we borrow to buy an asset, most often a house, or a piece of land. What is relevant to our behaviour therefore is not the relationship between the nominal interest rate and our perception of future CPI inflation, but the relationship between the nominal interest rate and our perception of future property-market inflation. With the median house price having risen in the two years to December 1995 by (a total of) 11 percent in Wellington, 14 percent in Canterbury/Westland, 16 percent in Otago and Waikato/Bay of Plenty, 18 percent in Southland, 22 percent in Taranaki, and 36 percent in Auckland, is it any wonder that many people regard borrowing at mortgage rates of around 10 percent per annum as an extremely attractive proposition? The inflation-adjusted interest rate which people buying property see when they make their calculation is very much lower than that which economists and politicians see when they make a calculation based on the CPI, and may well be negative. With expectations of property-price inflation at present levels, any significant fall in interest rates would be bound to reignite upwards pressure on property prices, and further stimulate growth in bank lending.

Eventually, of course, expectations about property price inflation will return to a more realistic level. We quickly forget how heavily many property prices fell in the late eighties, and ignore the incongruity of expecting property prices to rise more quickly than money incomes indefinitely. When expectations of property price inflation do return to reality, then current interest rates will seem a lot higher.

What about the exchange rate? I accept that the 22 percent increase in the trade-weighted index since January 1993, an average annual rate of appreciation of some 7 percent, has been uncomfortably high for many exporters, particularly for those who have in addition faced major falls in international market prices. Probably none has been more adversely affected that beef producers, who have faced a major fall in international prices and a rise in the exchange rate of greatest relevance to them, the New Zealand dollar/US dollar rate, of some 33 percent over the last three years. But three comments.

First, while the New Zealand dollar has indeed risen very substantially over the period since January 1993, the increase over a slightly longer period has been much less. Since January 1990, for example, the increase in the exchange rate, on a trade-weighted basis, has been only 5 percent, or an average annual rate of appreciation of some 0.9 percent. Since the New Zealand dollar was floated in early March 1985, almost exactly 11 years ago, the increase has been only 4 percent, or an average of less than 0.4 percent per annum. The appreciation over the last three years has, in significant part, simply been the reversal of the depreciation which occurred in 1991.

Secondly, while it is certainly true that the only way for exporters to protect themselves against a trend appreciation in the exchange rate is to improve productivity and enhance the quality and market appeal of their products, and that sustained appreciation at an annual rate of 7 percent inevitably puts exporters under very considerable strain, I am constantly amazed at how many exporters gamble on the future of the exchange rate. I read of a provincial exporter last year who complained through the media that they had done their 1994/95 budgets at a New Zealand/Australian exchange rate of A$0.81, at a time when the spot rate was A$0.80, and had then found themselves in considerable financial difficulty when the rate moved to A$0.95 in mid-1995. In other words, they had chosen to gamble that the exchange rate would remain around A$0.80 to A$0.81, or better still would fall below that level, rather than take out a forward exchange rate contract at a rate below A$0.80. In this particular case, they had staked the survival of their business on the future exchange rate, even though they had had the opportunity of locking in the forward rate at a more attractive rate than the one at which budgets had been prepared. Of course, it may be that the company had run out of credit at its bank, and that as a consequence it could not write a forward exchange contract to cover its risk. Or it may be that it was unaware of the existence of such protection against exchange rate volatility. Either way, it was taking a considerable risk, and one which may well have proved fatal to its survival.

Even when the trade-weighted measure of the New Zealand dollar is relatively stable, it is still possible for the exchange rate between our currency and another individual currency to move very violently, as the New Zealand/Australian rate did in the middle of last year and the New Zealand/Japanese rate did over the last few months. Unless an exporter has some natural hedge against currency risk therefore, taking out forward exchange cover almost always makes good sense.

The Reserve Bank can tighten or can ease, but can not control the mix of monetary conditions

But my final point is that the Reserve Bank can not control the mix of monetary conditions. We can tighten monetary conditions, but we can not determine whether that tightening will take the form of an increase in interest rates, an increase in the exchange rate, or some combination of both.

In the weeks since our December Monetary Policy Statement was issued, for example, monetary conditions have tightened. Given the forecast for underlying inflation contained in that Statement (with underlying inflation falling no lower than 1.3 percent over the two and a half years covered by the projection), that tightening has not been unwelcome. It increases the likelihood that, by early next year, underlying inflation will be well below the top of the 0 to 2 percent target range set us by successive Governments.

But most of the tightening which has occurred over the last two months has taken the form of an appreciable rise in the exchange rate, especially against the Japanese yen, with only a very minimal increase in interest rates (indeed, depending on the particular dates on which interest rates are compared, no increase in interest rates). Given the continuing strong growth in bank lending and the source of much of the inflation pressure at the present time, it could well have been desirable for the tightening to take the form principally of a strong rise in interest rates, with the exchange rate appreciating to a more modest extent. But, as indicated, we do not control and can not control the mix of conditions: that is ultimately decided by perceptions about New Zealand's economic prospects in the minds of countless thousands of individual investors, both here and abroad.

It is therefore idle to suggest, as some have done, that the Bank needs to exercise better judgement to ensure the dollar is not pushed up any higher. If inflation is projected to be too high, monetary conditions need to firm, and we are committed to doing whatever is required to deliver the outcomes we have been directed to achieve. Much as we might sometimes wish otherwise, we can not determine the manner in which that firming takes place.