New target, same old direction
Reserve Bank’s new goal likely to have little effect on interest rate decisions
If it ain’t broke, fix it anyway seems to be the thinking behind the Government’s determination to add “supporting maximum sustainable employment” to the Reserve Bank’s mandate — on equal terms to its longstanding price stability objective.
It will probably make no difference to the interest rate calls the bank makes, which is just as well, because any difference it did make would probably be for the worse.
But at the press conference after signing the new Policy Targets Agreement (PTA) on Monday, the change left incoming governor Adrian Orr in the uncomfortable position of having to reassure the markets that it would be business as usual at the bank, without quite saying so while Finance Minister Grant Robertson was standing right there.
When would the dual mandate result in different interest rate calls to the previous regime, with its sole inflation target?
“In general times it should not make too large a difference,” Orr said.
Should the dual mandate be seen as a signal to the bank that when in doubt — and there is often doubt — it should err on the easy side?
“Not necessarily,” said Robertson, but Orr was more emphatic. “No. There is no inflation bias” in this change.
What about the risk that as the labour market is typically the last cab off the rank in cyclical upswings and downturns, a focus on it will leave the bank behind the curve in setting monetary policy, resulting in more volatility in output, interest rates and the exchange rate?
The bank was fully aware which of the many indicators it considered were forward-looking, which were coincident and which were lagging, Orr said. In other words, it has always been conscious of that danger.
The bank is hardly oblivious or indifferent to the state of the labour market in making monetary policy decisions.
It is not just in the business of delivering price stability over the medium term, essential as that is.
It is in the stabilisation business. That means moderating the amplitude of the business cycle. It means stimulating demand, and with it employment, through lower interest rates in response to a negative shock like the global financial crisis. It means reining in demand through higher rates when it is in danger of outstripping the economy’s capacity to supply, as that excess demand will not deliver more output, just inflation.
They call it flexible inflation targeting. In practice it means that, so long as inflation expectations remain well anchored, the bank can afford to allow inflation to deviate from target (the 1 to 3 per cent band, unchanged in the new PTA) in order to avoid undue volatility in the real economy, including employment.
And that is the most you can expect from a central bank. In particular, the world learned the hard way in the 1970s that in the long run you can’t buy more jobs by tolerating more inflation.
Even in the mid-2000s boom, when New Zealand’s unemployment rate fell below 4 per cent, inflation was running at 3 per cent, the top of the Reserve Bank’s target band. It ended up pushing the official cash rate to 8.25 per cent and mortgage rates to double-digit levels, contributing at least to the recession which followed.
The Government has a target of reducing unemployment to 4 per cent within its first term in office, Robertson said, but both he and Orr were quick to acknowledge that achieving that would depend on factors outside the central bank’s control.
The semantics of the PTA changes reflect that: “The conduct of monetary policy will maintain a stable general level of prices and contribute to supporting maximum sustainable employment within the economy”. The “contribute” and “support” recognise that at most, monetary policy can influence the cyclical element of unemployment, not the structural and frictional elements.
As Robertson put it in the Cabinet paper explaining the change, “the sustainable level is largely determined by structural factors in the economy such as the level of skills in the economy and the regulatory system, rather than monetary policy. If monetary policy attempted to boost employment beyond this level it would lead to inflationary pressures and therefore have negative effects on the sustainable level of economic activity in the long term.”
So what is the sustainable level? Economists have the concept of NAIRU — the non-accelerating inflation rate of unemployment — a piece of barbarous jargon which essentially means the unemployment rate consistent with stable inflation in the short to medium term.
NAIRU can’t be observed. It has to be estimated and that is an arcane and imprecise exercise, whose results vary over time. Right now, the bank puts it at 4.7 per cent but that sits in a fairly fat uncertainty band ranging from 4 to 5.5 per cent. The Treasury’s estimate is 4.3 per cent.
The bank’s critics point to the fact that while both the unemployment rate and its preferred estimate of NAIRU have trended down since the GFC, unemployment has run higher than NAIRU until very recently (the current unemployment rate is 4.5 per cent).
To those who conclude that this shows policy has been too tight, the short response would be: “House prices not high enough for you then?” After all, monetary policy affects other things as well.
The unemployment rate that statisticians report is a function of the participation rate. To count as unemployed, you have to be actively seeking a job and ready to start one; the statisticians’ tests for that are somewhat crude. And at the moment labour force participation, at 71 per cent of the working age population, is historically high.
There are other, broader measures of labour market slack like the underutilisation rate (currently 12 per cent) which includes part-timers who want to work more hours.
While the new PTA wisely does not set a quantified target for maximum sustainable employment, it will require the bank in its quarterly monetary policy statements to explain what measures it has taken into account, and how, in reaching its monetary policy decisions.
That adds some sort of transparency.
But it would not do much for accountability to compare something like unemployment, which is crudely measured, against a benchmark like NAIRU, which is about as useful as a tape measure printed on elastic.
The world learned the hard way in the 1970s that in the long run you can’t buy more jobs by tolerating more inflation.