Democratic choice for Central Banking, the New Zealand -model

New Zealand has been the last decade's famous example for a successful change in the central banking legislation. In this chapter I will briefly analyse what kind of a central bank legislation this is and how it has affected the operation of the economy. Because the information channels and appointment procedures do not differ considerably from those of e.g. planned ECB, we will concentrate here on the formal agreement for the goal setting. 		 
   

Reserve Bank Act, 1989

 
    The New Zealand model has been considered as an example of a rather independent but democratic central banking institution. This new framework was established in the Reserve Bank Act in 1989. Until the beginning of the 90€s New Zealand experienced high inflation and the country had other economic problems. For these reasons officials decided to try to create a successful in the economy through central bank legislation and other economic policy changes.

   Esa Kaitila: Althought the banking system could be quite similar in comparaison to european monetary systems, the influences of cultural aspects have been ignored wholy. After all the cultures and thinking (for example the sense and meaning of time) can vary dramatically.

 

    The Reserve Bank Act formalises price stability as the primary objective of the monetary policy and establishes a degree of autonomy and accountability with which the bank can pursue this objective. The act requires that operational policy targets that reflect the objective of maintaining price stability in the general level of prices(Mayes and Riches, 1996) will be adopted through negotiation between the Minister of Finance and the Governor of the Reserve Bank. The outcome of these negotiations is published as a Policy Targets Agreement (PTA). The Governor of the Federal Bank will be responsible for the outcome of the monetary policy in relation to the quantified inflation targets in the PTA , and may be dismissed by the Minister of Finance if its performance in "ensuring that the Bank achieves the policy targets€€.has been inadequate"( Mayes and Brendon , 1996). A new agreement will be reached whenever a new governor is appointed and may be revised or replaced by the mutual negotiations of the two parties.

   Esa Kaitila: what is the difference between price stability and inflation used in here? In the first chapter the price stability has been mentioned to be "the primary objective of the monetary policy" and in the second chapter the inflation has classified as "the ultimate target of the monetary policy".

 

    The Policy target agreements recognises that not all price movements come under the direct influence of monetary policy and exempts certain types of price chocks from inclusion in the formal price stability agreement. Altogether four types of chocks influencing the calculation of the inflation rate are excluded; the direct impact of significant changes of interest components of the Consumer Price Index (CPI); the direct impact of significant changes in government charges, indirect taxes, and subsidies; the direct impact of significant price level effects arising from natural disasters; and the direct impact of significant changes in import and export prices. In determining whether the target inflation rate is met the Reserve Bank makes adjustments to the CPI to incorporate these exemptions. This adjusted underlying inflation is the ultimate target of the monetary policy.

 
   

Performance of the Federal Bank in achieving Inflation

 
    No matter how clearly the objectives for monetary policy have been stated, a central bank still faces the problem of conducting the monetary policy measures in a way that is adequate to achieve its goals. It should be kept in mind that the framework in which the monetary policy takes its place is rather difficult. Not only the present state of the economy, but especially its future states are subject to many uncertainties. Implementation of monetary policy is based on prognoses and those cannot ever be accurate enough. In addition monetary policy measures influence the economy with a lag time of up to 2 years and it is unsure how the influences transmit because the monetary transmission mechanism is subject to changes all the time.

 
    In this context New Zealand has been successful in bringing down the inflation rate since the Federal Bank act in 1989. Prior to that time there was a long period of tight monetary conditions as the Bank tried to bring down inflation from the high levels of the 1980€s. The achieved fall in inflation was not only because of central bank measures, but largely because of changes in fiscal policy, liberalisation and changes in labour laws. In the first PTA signed in March 1990 the target rate was set at 0-2 %. This was revised in December 1990 after a change of the government the deadline was extended to December 1993. During this time the Federal Bank was already at the beginning of the period able to ease monetary policy as it became obvious that the target would be undershot. It has been argued that confidence in the Federal Bank€s commitment for price stability was so strong that the inflation expectations of the public decreased considerably. As figure 1 in New Zealand Reserve Bank Bulletin Vol. 59 No. 1, 1996 s. 9 shows, the Federal Reserve has been rather successful in maintaining price stability. During the period under inspection the Federal Bank has had to use very different policies because of ongoing structural changes and their influence on the economic situation. For example, the strong growth of demand and a brief downward pressure on exchange rates led the bank to tighten monetary policy in January 1993. Short term interest rates rose sharply to close to 9 % but fell during 1993 to under 5 %.

 
    The first breach of the target limit has been experienced in 1995. On this occasion the Federal Reserve did not notice until the quarter in which the overshoot occurred, that the underlying inflation would exceed the target band. The Minister of Finance immediately called for an official report on the performance of the federal reserve. In this report the Board of the Reserve argued that it could not reasonably have been expected to anticipate events better. In 1994 it had attacked inflationary pressures but the actual inflation development came as a surprise.

 
    This episode shows that the counterparts take the PTA seriously. It can be seen on the one hand that the Federal Reserve is eager to adjust its policies in cases where there is misperformance and gained confidence through this. On the other hand it can be seen that there is a clear functional interaction between the civil servants of the federal reserve and the political authorities.