RBNZ – first in, first out?

The Reserve Bank of New Zealand has a special place for central bank watchers.  It pioneered the introduction of inflation targeting in the 1990s[1], and was for many the first truly independent central bank of the modern era, with a target of 0-2% inflation and the full freedom of independent policy operation to achieve it.

The RBNZ’s target has evolved over the years.  The agreement with the government was changed to a 1-3% target band for inflation in 1996, and in 1999, it was modified again make it clear that the RBNZ should also seek “to avoid unnecessary instability in output, interest rates and the exchange rate in the pursuit of price stability”[2]:  while not a dual target like that of the US Federal Reserve, this was nevertheless enough to ensure that the Bank should not single-mindedly pursue an inflation target regardless of the consequences on the rest of the economy.   But the independence of the Bank, and its governor, were never compromised.

However, could the RBNZ now also lead the way away from inflation-targeting?  The new Labour/New Zealand First government is planning a review of the Reserve Bank Act, which, according to the Financial Times, could possibly include an expanded role for the Bank, including greater emphasis on the exchange rate and on employment.

There are three potential consequences of a possible move away from the RBNZ’s inflation targeting mandate.  None of them is certain, but each carries its own risks.

The first is that that the Bank may end up with mutually inconsistent domestic goals, for instance one where the stability of the exchange rate runs counter to the development of inflation, or where low inflation conflicts with the greater emphasis on employment.  This risk is increased by the fact that each goal is likely to need a separate tool, meaning a heightened possibility of a conflict of aims.

The second is that central banks in different countries may end up with mutually inconsistent international targets.  Broadly speaking, the post-war era has seen central banks move in more or less the same general direction – attempting to fix exchange rates or reduce and/or stabilise inflation (and recently of course, increase inflation).  But there are examples of times when central banks had mutually inconsistent goals – e.g., 25 years ago in Europe, where the Bundesbank’s near- and medium-term aims differed radically from the needs of most of its European neighbours, leading to currency (and political) crises for France, Italy, Spain, Sweden and most famously the United Kingdom, in the last case culminating in sterling’s departure from the ERM on Black Wednesday, 16thSeptember 1992.

The third potential consequence is that the RBNZ once again becomes the mould-breaker and sets a path away from the central bank orthodoxy of the past 25 years, encouraging other governments to rein in central bank independence and impose all sorts of new duties on their central bankers – not just safeguarding financial stability, but perhaps also targeting lending to worthwhile causes, monetary financing of government deficits, off-budget financing of public sector projects and so on.

It is early days yet and foolish to speculate too much.  But as we observed in our previous series on the future of central banking (“Central Banking – Responsibility without Power”, 2.09.17), the more central banks are given to do, the less likely they are to be able to fulfil expectations and the more likely it will then become that their ostensible failure is a further reason to bring them back under government direction.

It is perhaps no surprise therefore that the kiwi dollar is already weakening.  And that other central banks are watching developments in Wellington closely.


[1]              Strictly speaking, the RBNZ was not the first central bank to target price developments. That honour goes to the Riksbank, which in September 1931 was instructed to stabilise the domestic price level after Sweden had dropped the gold standard. However, this was price-level targeting, slightly different from inflation-targeting.

[2]              See an analysis of the RBNZ’s policy framework at https://www.rbnz.govt.nz/monetary-policy/about-monetary-policy/independent-review-of-the-operation-of-monetary-policy-2/the-evolution-of-policy-targets-agreements