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PUBLIC ACCESS:
In defence of the monetary policy scapegoat
Fri 4 Dec 2009 by Matt Nolan.

In a recent speech to Federated Farmers, Phil Goff briefly mentioned that the monetary policy consensus between the two main parties was over.   Such a statement is at best a mistaken way of mentioning policy differences and at worst a commitment by the Labour Party to damage the New Zealand economy.

Don’t get me wrong, there are issues in the economy that area concern (eg housing bubbles).   However, these are not the issues that the Labour party is dealing with by ending the monetary policy consensus.

At its heart, the consensus between the two main parties was to do with the target of monetary policy – monetary policy must be implemented by an independent Reserve Bank to ensure that inflation remains within a low and narrow band.

The purpose of keeping inflation low and stable is such that the future general price level in the economy is predictable.   By ensuring that inflation stays at a set rate, people can make decisions and plan spending and investment with more certainty – both in terms of government policy regarding the general price level and on the basis of lower variability in general prices.

Such a goal makes sense because of what monetary policy is.  Monetary policy involves the setting of interest rates, and through this it determines the quantity of money in the economy.   If all prices were perfectly flexible, any change in the quantity of money in the economy would simply turnout to be inflation.   This is what occurs over the time frame economists call the long run.

In the shorter term, the price of some things in the economy cannot adjust.   Given this, monetary authorities can seem to push up growth and lower unemployment just by surprising the economy with a bunch of freshly printed money.

However, the gain from printing dollars is only temporary.  The employers that have been tricked into hiring and producing on the basis of false price signals will, in time, lower their production again.   In the end, the economy ends up back where it was – except that we face the permanent cost of having higher and more variable inflation rates as the central bank loses credibility.

The Labour Party has decided that monetary policy should do more than maintain low and stable inflation.   They feel that monetary policy should also help to drive economic growth, redistribute resources, and control the level of the exchange rate.

However, this ignores what monetary policy is and drives monetary authorities on a fool’s errand to turn monetary policy lead into real economy gold.   The fact is that the one monetary policy instrument that exists (changing interest rates) can only target one goal – and ultimately the only target it can achieve successfully is that of the level of inflation.

Including other instruments to achieve other goals is fine, but these instruments should have a good reason for being controlled and should each have their own single target.   Giving the Bank multiple instruments to simultaneously achieve multiple targets would be a recipe for confusion, and would ultimately damage its ability to achieve any of its targets.

If it is true that the housing market is bubbly, and if it is true that the exchange rate is higher than fundamentals suggest, then we should be asking why – what factors in the real economy are driving people to spend too much on housing, and what factors are pushing our dollar up to this level?

By asking these questions we are likely to find that the cause of any problems in our economy has more to do with issues in specific industries than in monetary policy.   Whether it is the result of structural policy by the government (eg tax policy) or the low exchange rate policies of other nations overseas, the fact is that domestic monetary policy is not at fault.

Warping the Reserve Bank Act to focus on a multitude of different goals will not solve these underlying issues; it will just cloak the symptoms by damaging other sections of the economy.   Although pretending to solve an issue may be beneficial for politicians, it is not the best way to run New Zealand economic policy.

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