Technically Speaking: Central banks around the world under attack for inflation target

Friday 26th May 2000

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Exchange rates charts make the New Zealand dollar look pretty sick. Interest rate rises are not salvaging the currency's value because it is recognised that they will cut growth, yet our monetary policy is trapped on the escalator of rising US interest rates, as is Australia's despite Prime Minister John Howard's recent denial.

Concerns about the potential for growth in the economy now the Reserve Bank has put up its official cash rate to 6.5% have been cited as a reason for currency weakness but the govern-
ment has had its own part to play.

Before the last general election I noted the status and independence of the Reserve Bank could be at risk on left-wing victory and that prediction appears to have been validated. Some have accused Finance Minister Michael Cullen of talking down the dollar but the greater risk is of his government talking down the Reserve Bank. If there is to be a major falling out between the Labour/
Alliance partners, the Reserve Bank could well be the cause of contention. The Reserve Bank Act represents an ideological faultline between the left and the far-left that cannot be stably bridged unless one or the other faction surrenders its position.

The Labour/Alliance government structure with Dr Cullen competing for attention with Deputy Prime Minister Jim Anderton may be shaping up to be worse for the economy and the currency than having Winston Peters as treasurer in the ill-fated National/New Zealand First coalition. At least Mr Peters had a competent minder in Sir William Birch and was recognised as a show pony and therefore discounted.

There seems to be no minder for Dr Cullen and Mr Anderton and both look like show ponies where the economy is concerned. Mr Anderton is no friend of the Reserve Bank Act, as it represents the sort of thing he quit the Labour Party in high dudgeon over. In addition, Dr Cullen and Mr Anderton are likely to be ideologically ill-disposed to accepting advice from the Treasury and the Reserve Bank where it does not fit with their own command economy philosophies.

Although he now claims to be onside with the Reserve Bank, in opposition Dr Cullen made a speciality of baiting the bank. He was a tardy critic of the bank using the Monetary Conditions Index (MCI) as a primary instrument of monetary policy. The MCI played off interest rates against TWI rates in a ratchet system. When the MCI was dropped for the official cash rate, Dr Cullen appeared to take the credit but then turned around and demanded the Reserve Bank manage the currency as well as interest rates. Pre-election he opined that governor Don Brash would be summoned in for regular fireside chats and put right on monetary policy.

On election, the Labour/
Alliance government rewrote the Reserve Bank's brief. As if that was not enough, Dr Cullen issued a notorious public "Please explain" to Dr Brash when the OCR was raised earlier this year. Not to be outdone, Mr Anderton tried to second-guess the bank on its OCR settings thereafter.

Now the Reserve Bank is to be the subject of a government inquiry. Both Dr Cullen and Mr Anderton are challenging the Reserve Bank's legislated independence and undermining its reputation here and abroad. A government cannot wage a propaganda war on its own central bank and expect the currency to hold up.

The Reserve Bank is not alone in finding itself in the middle of soul-searching over whether it should keep inflation as its only target and not aim for a wider range of objectives. The Economist reported (May 13-19) that the same debate is taking place in Europe and the US. The Europeans are worried about the weak euro and the strong pound. As with New Zealand, the politicians in Europe have undercut the euro by being too ready to issue competing press releases about it. In the US, the Federal Reserve is in the gun over whether it should have put up interest rates sooner to prick the stockmarket bubble. The Economist referred to a report entitled "Asset Prices and Central Bank Policy," written by banking heavyweights Stephen Ceccetti, Hans Gensberg, John Lipsky and Sushil Wadhwani, that will be published in June. The report apparently recommends central banks should concern themselves not only with inflation,but also with asset prices for stocks and currencies.

The currency interventionist tide seems to be turning, with the Economist referring favour-ably to the "standard reference" on intervention, Does Foreign Exchange Intervention Work? by Kathryn Dominguez and Jeffrey Frankel (1993).

The magazine goes so far as to say "Governments, especially of small open economies, are right to pay regard to the value of the currency, and right to try to influence it under certain circumstances even if they do not go all the way and fix it [to another currency] once and for all." In manipulating the currency's value a distinction is made between the good way, sterilised intervention, where government debt is sold to soak up currency issued to buy foreign exchange, and the bad way, unsterilised intervention, where the currency issued is not offset by debt. Sterilised intervention is dubbed "an independent instrument of policy because it leaves monetary policy (defined in terms of money supply) unchanged."

It seems as though an orthodoxy is emerging for central bank response to asset prices but any debate around the matter needs to be safely quarantined off from the continuing operations of Reserve Bank's in the meantime for fear of undermining confidence.

Much attention will be paid to what the Americans and the Europeans decide. What we do not need, however, are catcalls from the sidelines by politicians whose self-serving time horizon - running out to the next election - is shorter than the Reserve Bank's anti-inflationary attention span.

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