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Comments in response to a speech delivered to SEANZA Governors' Forum

The Rt Hon Sir Edward George, Murray Sherwin

Governor Jayawardena, Sir Edward, fellow central bankers.

It is a great pleasure to be here in Colombo to participate in this SEANZA Governors' Forum and to assist our hosts in the celebration of the 50th anniversary of their fine central bank. I promise to be diligent in my contribution to the celebrations!

This is the 5th SEANZA conference that I have had the pleasure of participating in – either as Programme Director, Programme Sponsor in the case of the last course in New Zealand, and now as a delegate at this Governors' symposium. I know only too well the magnitude of the task that our SEANZA hosts take on in volunteering to run these courses. I've heard only very positive comments about the way the Central Bank of Sri Lanka has gone about organising and running this year's programme. Thank you, Governor Jayawardena, for the generous hospitality extended by you and your colleagues.

Let me also extend greetings from Governor Brash, and his apologies and great regrets that he is unable to be here with you. Unfortunately, he had commitments in the US this week. However, I suspect that at this moment he may be rushing back to Wellington to the defence of our rather beleaguered kiwi dollar.

It is a pleasure and a privilege to have this opportunity to offer comments in response to Sir Edward's address. His subject, central bank independence, has received a good deal of airplay over the past decade or so. Central banks are rather prone to waves of fashion that sweep around the globe periodically. It is probably fair to say that the dominant fashions of the 1990's were central bank independence and inflation targeting. The two, of course, tend to go hand in hand. I happen to think that they are pretty good fashions – and as such, I trust that they prove to be more durable than bell-bottomed trousers and platform shoes. Time will tell.

Sir Edward traces the path taken by the Bank of England to independence – at least instrument independence. In doing so, he raises the key issues and options we face as central bankers in thinking about the institutional structures that we can employ to best perform our roles.

My comments will touch on similar issues from the New Zealand perspective, and offer a few observations on the various points raised by Sir Edward. Key points will involve:

  • reconciling central bank independence with democratic political traditions
  • goal versus instrument independence
  • the importance, and limits, of transparency
  • the single decision maker versus committee structures
  • accountability, and
  • funding arrangements for an independent central bank.

Undoubtedly, a primary issue to be faced whenever discussion turns to the merits of central bank independence is the argument that such independence is inconsistent with the traditions of democratic parliamentary structures. We normally expect the authority of the state to be exercised by our elected representatives rather than by central bank bureaucrats.

The case for central bank independence is well understood and well covered in the literature on time inconsistency. In essence, the public, and particularly their elected representatives, are likely to face incentives which bias them in favour of tolerating the risk of increasing inflation. That bias emerges as a consequence of the long and variable lags associated with monetary policy decisions. The benefits of long run price stability lie in the future. The costs that may be associated with attaining or preserving price stability are borne up front. And faced with the immediate imperatives of political life, our democratic representatives face pressures to defer the immediate investment in future price stability in favour of the immediate benefits of lower interest rates and/or faster growth.

In that regard, I'm often asked to explain the apparently aberrant behaviour of our New Zealand politicians in the mid-1980's when the current RBNZ Act was conceived – as just one part of a very comprehensive reform programme. In one sense, the father of our independence was Sir Robert Muldoon – PM and Minister of Finance through the late 1970's and early 1980s. Illegitimate, unwitting and unwilling, perhaps. But father none the less.

Sir Robert governed with the aid of a few well-worn maxims. I digress to mention them because, to me, they encapsulate the time inconsistency process.

A key Muldoon maxim was that "the public would not recognise a fiscal deficit if they tripped over it on the footpath". Well, when the fiscal deficit reached 8% of GDP in the early 1980's, we tripped over it. I don't believe the public had any difficulty in recognising what we had stumbled over.

Another Muldoon maxim, when confronting unpalatable policy advice, was to declare that " there is no point in me taking such an unpopular decision if it simply leads to "that other crowd" (i.e., the Labour opposition) getting into power at the next election and reversing the decision". That, I think, was the epitome of the time inconsistency problem – a democratic leader deferring the hard short-term decisions. Sir Robert was reinforced in his approach to policy management by an unfailing faith that, whatever the negative consequences of today's decision, they could be fixed tomorrow.

The RBNZ Act was a direct consequence of those attitudes. When Sir Robert eventually lost power - as the problems stored up for tomorrow's resolution finally overwhelmed him – the incoming government was determined to find institutional structures to shift the incentives back in favour of long term macro-economic balance. An independent central bank with the single goal of price stability was a key to those new structures.

These institutional reforms owed more to the Harvard Business School than to the Chicago Monetarists we are sometimes accused of following. The Reserve Bank was just one of a number of state agencies being reformed, and the guiding principles in those reforms came from the text books on corporate governance. These principles included:

  • establishing clear objectives
  • providing for clear divisions of responsibility between the key decision makers
  • providing for clear delegations of decision making power which were aligned with those responsibilities
  • specifying accountabilities – those given the authority to make decisions were to be held firmly accountable for the quality of those decisions
  • ensuring transparency, so that all could see what decisions had been taken, by whom, and for what reason.

From those organisational principles arose the preference for an independent central bank.

But how to marry central bank independence with the democratic tradition?

Firstly, we have an Act of Parliament that spells out the medium-term objectives of the central bank in language so uncontentious that no reasonable democrat could take issue. The RBNZ is obliged to pursue "stability in the general level of prices". Who could object to that?

But what is meant by "stability in the general level of prices"? Well, that is not defined in the Act, but the Minister and the Governor are obliged to agree a definition and to publish that definition in a Policy Targets Agreement (PTA) covering the five year term of the Governor. In effect, this is the Governor's employment contract. No goal independence here.

We find this PTA structure to be an important mechanism – conferring a degree of democratic legitimacy on the target, and importantly, openly committing the Minister and his government to the agreed target.

Just as importantly, the Government can override this PTA where it feels that there is good reason – perhaps in some situation of crisis or unusual shocks. That is provided for. But there are some rules to be complied with. The override must be published and must be tabled in the Parliament for debate. Any such over-ride can persist for no more than one year without again being subjected to Parliamentary scrutiny.

In the end, the Government of the day can do whatever it wishes, subject to securing the necessary parliamentary votes. What the RBNZ Act attempts to do is to provide an institutional structure that shifts the odds in favour of long-run price stability and against the easy short-term options of more inflation risk – but all firmly within the democratic tradition.

In common with the Bank of England, we do not have goal independence. There is, however, very clear instrument independence, and that we protect jealously. The Minister is not consulted or even informed of monetary policy decisions until immediately before their public release.

Like Sir Edward, we don't regard the lack of goal independence as a second best arrangement. On the contrary, and for the reasons already mentioned, we regard our structure of a jointly agreed Policy Targets Agreement as an important element strengthening the legitimacy, and therefore the public and political acceptability, of the regime. But, I agree with Sir Edward's comment that the range of definitions of "price stability" available to governments as they think about the appropriate goals for monetary policy is now fairly narrow. In our current environment, for instance, I think it would be difficult for a New Zealand Government to propose an inflation target that ranged beyond, say, 4 per cent. The interesting questions, however, are to what extent the constraints that governments face in that regard are independent of the current global environment of price stability, and how durable those constraints may prove to be in a future, and perhaps more inflation-prone, world.

Any discussion of central bank independence must quickly swing to the issue of transparency. Sir Edward covers this well in his discussion of the operation of the Bank of England's Monetary Policy Committee. He directly links the new transparency of monetary policy which came with the publication of minutes from the "Ken and Eddie" show to the evolution of greater independence for the Bank of England. And appropriately so. It seems to me that, as a general rule, transparency is the great friend of independent central banks. (But as one of my colleagues often reminds us in policy debates, "some may be good, but more isn't always better" – that is also true of transparency as I will discuss shortly.)

In our case, I suspect the transparency provisions of the RBNZ Act are as important as any other feature of the legislation. The objective of monetary policy is published, with a very public pre-commitment to that objective by both the government and the Governor. Any changes, or over-rides to that contract must be published and submitted to parliamentary scrutiny. This transparency and public pre-commitment provide a powerful disincentive to tampering with the target.

The Bank is obliged to publish regular commentaries on monetary policy, both outlining past decisions and providing perspectives on likely future directions. In our case this is done via quarterly Monetary Policy Statements – our version of the Bank of England's Inflation Reports. These Statements include quantitative projections for key macroeconomic variables over the subsequent 3 years. These reports are released with an open press conference in which the Governor is questioned directly by the media and wire services. Market economists also have an opportunity to directly question Bank senior monetary policy personnel in parallel sessions. The release of these Statements has become a very import important focal point for local financial markets.

Any breaches of the inflation target range are reviewed by a committee of the independent directors of the Bank's board, with their review and any ministerial response, also being published. (This is not a statutory requirement, but has evolved in the spirit of the Act.)

The Bank's Monetary Policy Statements are formally reviewed by a Select Committee of the Parliament, during which the Governor, and his senior team, may be questioned by the committee in public hearings.

I raised earlier the issue of where the efficient limits to transparency might lie. This is something that we have given thought to recently, although without yet coming to firm conclusions. The question arises for us in the context of a long established policy of publishing detailed forecasts, both of the main macroeconomic data series, and of the track of monetary conditions that may be needed to ensure that inflation outcomes over the next two to three years are consistent with our 0 to 3 percent inflation target.

At issue is how best to convey a sense of the likely evolution of policy in an uncertain world. Transparency is fine where there is real information content to be revealed. It may be less helpful, even harmful, where the information revealed is subject to significant change in the short term. In general, we have been tending to reduce the detail of our published forecasts in favour of a greater focus on identifying more aggregated and medium term trends in our projections.

Sir Edward discussed the role of the Bank of England's Monetary Policy Committee in terms of both transparency and accountability. As chair of our own MPC, I found this to be particularly interesting. In our case, the MPC is purely an advisory body. All authority and decision making power, under our Act, is vested in the Governor.

You may be aware that the operation of monetary policy in New Zealand will shortly be reviewed, with Professor Lars Svensson of Sweden appointed by the Government to carry out that review. One of the issues Professor Svensson has been asked to look at is that of decision making and governance structures.

In preparing a submission for that review, the Non executive Directors of our board, who are charged with monitoring the performance of the Governor, have looked at whether they should recommend the adoption of a committee-based decision making structure in place of the current single decision maker model. Their deliberations have focused primarily on the risks inherent in the single decision maker approach versus the clarity of accountability under that model relative to the committee alternative. It seems likely that our directors will recommend the retention of the current single decision-maker structure, but with changes which reduce the risks, strengthen the input of external advice, and enhance the board's scrutiny of the Governor's decisions. I would be happy to elaborate on this thinking in our subsequent discussion should Governors be interested.

Finally, let me touch on one other subject, not specifically discussed by Sir Edward, but which I think is important to the structure of central bank independence – that of funding. The reform of the RBNZ charter came in the context of significant reforms to the management of New Zealand's public sector agencies generally. It was very clear at an early stage of the design of the 1989 Act that our traditional right to spend the seignorage as we saw fit, handing over to the Government only what we deemed to be surplus, was never going to be allowed to continue. So how to have an independent central bank, while still imposing some reasonable degree of financial constraint? Resolving this dilemma satisfactorily is important - it seems to me that central banks too often show the signs of inadequate restraint in their spending which ultimately invites government intervention. On the other hand, it is hard to speak of independence if funding is directly controlled by the Government. In our case, this dilemma has been resolved, satisfactorily in my view, through a five year funding agreement in which the Bank and the Minister agree on the quantum of funds that the Bank will be able to spend on its own operations. Any spending over that cap is drawn from reserves, and under-spending of the agreed limit may be added to reserves. Our Non executive Directors also play an important review role in this area, just as they do in scrutinising the Governor's monetary policy decisions.

Sir Edward concludes that it is unrealistic and inappropriate for central banks to think that independence should mean exemption from democratic control. I strongly agree with him. I also endorse his concluding comments that, whatever structures we operate under, political and public confidence is a privilege that central banks must earn through personal and professional integrity, objectivity and competence.

That is the hard part in this uncertain and rapidly changing world.

Thank you.