In defence of the monetary policy scapegoat

In a recent speech to Federated Farmers, Phil Goff brieflymentioned that the monetary policy consensus between the two main parties wasover.   Such a statement is at best a mistaken way of mentioning policydifferences 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 Labourparty is dealing with by ending the monetary policy consensus.

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

The purpose of keeping inflation low and stable is such thatthe future general price level in the economy is predictable.   By ensuring thatinflation stays at a set rate, people can make decisions and plan spending and investmentwith more certainty – both in terms of government policy regarding the generalprice 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 itdetermines the quantity of money in the economy.   If all prices were perfectlyflexible, 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 callthe long run.

In the shorter term, the price of some things in the economycannot adjust.   Given this, monetary authorities can seem to push up growth andlower unemployment just by surprising the economy with a bunch of freshlyprinted money.  

However, the gain from printing dollars is only temporary.  The employers that have been tricked into hiring and producing on the basis offalse 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 costof having higher and more variable inflation rates as the central bank losescredibility.

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

However, this ignores what monetary policy is and drivesmonetary authorities on a fool’s errand to turn monetary policy lead into realeconomy gold.   The fact is that the one monetary policy instrument that exists(changing interest rates) can only target one goal – and ultimately the onlytarget 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 shouldeach have their own single target.   Giving the Bank multiple instruments tosimultaneously achieve multiple targets would be a recipe for confusion, andwould ultimately damage its ability to achieve any of its targets.

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

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

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

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