Reframing the monetary policy debate: Some notes

By Matt Nolan 19/09/2012

Update:  Given all the links in this post, I’m adding it to the rarely used “inflation debate” tab.  An area where I rant incoherently about monetary policy in a way that is aiming to help this debate – rather than just be critical.

From what I can tell, the current debate about monetary policy taking place in the public makes little sense.  While I am sure we all mean well with our opinion pieces, the issues, the problems, the causes, and the tools aren’t really being discussed in a way that someone with an open mind can sit down and look at.  Sadly, I lack the time – and probably the ability – to give this a fair go.  As a result, instead I will just list down some things we need to keep in mind here.

David Parker has recently said two things which he used to justify the RBNZ scrapping inflation targeting, and moving to targeting a bunch of stuff:

  1. The RBNZ needs to help exporters – as other countries are helping exporters
  2. The RBNZ is to blame for our “persistently high exchange rate”

I discussed a similar post of his earlier.  But right now, I want to state that neither of these things is really true – I can 100% understand how someone could come to believe this given what we see going on around us.  However, they aren’t facts – they are fallacies.

Note:  He does mention “protecting financial stability to help exporters” – this statement doesn’t make sense.  The RBNZ does focus on financial stabilty in a seperate role, and with seperate tools – a role that is related to, but seperate from monetary policy (just like fiscal policy).  In none of this is, or should, the RBNZ look at a certain sector in NZ and say “we’re giving you stuff” – that is just wrong.

Sidenote:  If you say “but helping exporters with monetary transfers helps all of us” I will laugh – if NZ goes down that path, I look forward to having my views vindicated in 20 years time ;)

Country exchange rate fiddling?

It turns out that other countries are not helping exporters (apart from some developing nations).  The US and Europe are all involved in Quantitative Easing – which is a form of monetary policy.  We discussed this issue here and here.  QE is not “beggar thy neighbour”, it is an easing of monetary policy because domestic demand conditions in the country are too tight!  If we call this currency intervention, then we should call cutting the official cash rate, or increasing government spending, currency intervention as well!  

Note:  To make it clear, the view is that a high exchange rate slows down a recovery here – however insofar as this happens, our own central bank keep interest rates lower as a result.  As long as QE is consistent with their monetary policy mandate, the countries are not involved in trade protectionism, they are trying to make up for a shortfall in demand.  If anything this is more likely to boost demand here, and boost incomes through commodity prices – implying that arguing against it is arguing against what is in our intereset.

Central banks are not breaking the rules, this isn’t a prisoner’s dilemma – competitive devaluations HELP when demand is suppressed … just look at the Great Depression, and the choice of countries to go off the gold standard!

Persistent overvaluation?

When it comes to the “persistently high exchange rate” we can well point out that there is an issue, – not the nominal exchange rate, but the persistently high real exchange rate.  While a lift in our terms of trade should increase the real exchange rate, the constant current account deficits suggest there is in fact something going on.

However, a persistently high real exchange rate isn’t the fault of monetary policy and the RBNZ.  A persistently high real exchange rate tells us something structural is going on in our economy – it could be a sign of a government sector that is “too large”, poor domestic competition, a excessively low savings rate relative to investment opportunities in a country, or some mix of similar issues.  As a result, this has to do with competition policy, tax policy, government transfers, and the allocation of government services – but nothing to do with the Reserve Bank keeping price growth at 2%pa.  Remember, it isn’t just an issue of too much credit being offered – but too much being borrowed by people domestically who wish to investment and consume.

Remember the exchange rate is a price – it is a “signal” of real imbalances rather than the cause.  Remember, it hasn’t been the “consumption” of cars, TV’s, and baseballs that has been excessive – it has been our “investment” in housing stock prior to the crisis.  Remember that working for families was a large transfer to the middle classes – which helped to smooth income inequality, but also would have pushed up house prices and could have lifted the real exchange rate by increasing demand for non-tradables … in fact the more effective the programme has been, the larger this impact would have been.  I’m not saying that we should reverse these policies – I’m just saying that we should ADMIT they have a broader cost in terms of efficiency, one the government conveniently ignores when it markets them!

Blaming the central bank for this issue involves ignoring the actual causes of the imbalance – for a politician it involves standing up and saying “I want someone else to deal with the problem I’m partially responsible with creating”.  In that sense this is poor.

As a result, when we enter this debate let’s ask “what is the cause of NZ’s high real exchange rate” and “does the RER indicate a “market failure” or “government” failure somewhere within the NZ economy”.  These are the fruitful questions – not arbitrary attacks on the Reserve Bank.

Update:  Good article by Brian Fallow.  I don’t agree with everything in it 100% (flexible inflation targeting is occurring in a lot more places than Aus and NZ – and QE is not “beggar thy neighbour” policy), but it is an excellent discussion of the state of play – and the fact that other policy makers need to take responsibility!