As the prices of some traded goods have gone up and house prices are relatively very high, the New Zealand economy is experiencing “inflationary pressures.” This has opened the door to a debate on the sources of inflation (see for instance here)—with the current and the ex-Governor of the Reserve Bank of NZ (RBNZ) holding surprising views.
The New Zealand Reserve Bank Act of 1989 is one of the best pieces of legislation ever designed (by a government, that is). It has a single focus on price stability. Originally, the government and the RBNZ signed policy agreements to specify the inflation target (something that the US Federal Reserve doesn’t have). In 1990, the inflation target was 0-2%; it is now 1-3%.
In recent years, broader economic goals have been added to the mission of the RBNZ including avoiding “unnecessary instability in output, interest rates and the exchange rate” (Alan Bollard, Governor). There is now more fuzziness in the medium term about when inflation needs to be within the band. In other words, the RBNZ is in charge of doing more than strictly focusing on price stability. This raises some issues.
First, central banks have tried to do many other things (than focusing on price stability) in the past and they failed. Second, having different objectives enables the central bank to find excuses when the goal of price stability has not been met. And that’s exactly what has happened in the last three years in NZ: inflation has overshot the 3% band (up to 3.4% in 2006). Inflationary pressures have been mounting and it’s getting “harder” for the RBNZ to mitigate them. (To continue reading, click on the link below.)
It is surprising to read that both the current governor, Alan Bollard, and the ex-governor, Don Brash, believe that inflationary pressures are, to some extent, outside the control of the RBNZ. It is probably fair to say that Bollard has had a very soft attitude towards the price stability objective since he started his tenure (an early indicator was the change in the inflation band to 1-3%). Don Brash has recently published an article on petrol tax as a means to control inflationary pressures (see here). The idea is that the tax would reduce the general level of spending in the economy without the central bank having to change its monetary policy. For Brash, taxation is a means to control inflation.
Considering that Don Brash is one of the heroes of late Milton Friedman (see here) and that he presided over the establishment of one of the best monetary policies in the world, his view is really surprising to say the least! For his part, Bollard is not a monetary policy specialist, is Keynesian in his economics, and has more a “mandarin” attitude in his job than that of an inflation fighter.
Now, let’s get the record straight: inflation is always and everywhere a monetary phenomenon (Milton Friedman), i.e. the RBNZ is fully responsible for whatever level of inflation existing in the economy over a given period. This means that as long as the money base doesn’t grow (relatively) faster than output, there cannot be any inflation—and the money base is under the control of the RBNZ. Now, central banks (because they don’t have the means to do so) may have a hard time assessing the demand for money in the short-term (and measuring true price inflation is also another problem). However, there is no doubt that inflation is entirely due to their actions at the end of the day. Consistent with its price stability objective, the inflation range for the RBNZ should be between -1% and +1% and not between +1 and +3%, as is the case now. The reason why the former is not an option is because (a) deflation is regarded as a political evil, (b) the belief that a bit of inflation is unavoidable and good for the economy, and (c) inflation is a form of tax (let’s be frank about it).
Since a picture is sometimes worth a thousand words, see the graph above from Bryce Wilkinson at Capital Economics Limited New Zealand, which depicts the evolution of the NZ consumer price index over the period 1860-2007 (courtesy of Bryce Wilkinson). There is no need to do complex econometrics to see on the graph that inflation is a monetary phenomenon (the “optical least squares” method is enough). In 1934, after the sterling and the gold standard were abandoned, the RBNZ was created. By some interesting coincidence, the creation of the RBNZ corresponds to the starting point of a very long trend in price inflation. Between 1934 and 1995, there was a 36-fold increases in prices, and between 1934 and 2007, it’s a 50-fold increase! Moreover, inflation started to level off after the adoption of the Reserve Bank Act in 1989, which focused monetary policy on price stability. The graph confirms what Federal Reserve Bank economists found in a study: “money growth and inflation are higher” under fiat standards than under gold and silver standards (see Lawrence White’s Cato Briefing Paper). Unlike what Alan Greenspan contends, central banks have not been able to mimic the gold standard system and cannot do so anyway for the reasons that Mises, White, and Selgin have explained.
While no one knows what Bollard will do in the future, I suspect his tenure at the head of the RBNZ will be marked by a substantially higher level of inflation than in the years 1990-2002 (i.e. Don Brash’s tenure minus the first two years during which inflation had to be reduced). Clearly the Reserve Bank Act 1989 was not a guarantee against inflation because it could be tweaked enough (by subsequent governments) to reintroduce the possibility of a progressively fuzzier monetary policy. All this also shows the limits of institutional designs, the limits of the notion of independence from the executive, and the truly disastrous effects of central banking.