Friday, 17 July 2015

If it ain't broke...

Every general election, we the people get offered proposals to change our monetary policy regime. Some are predictable: "debauch the currency and devalue ourselves into prosperity". Some want to wind back the clock: "more jobs, not less inflation". Some are bizarre: "let's try some of that quantitative easing stuff they're mainlining overseas".

And that's all fine. In a democracy we're entitled - even obliged - to give the central bank its marching orders. But just for once, I'd like to see our politicians give it a miss in 2017 and leave the damn topic alone.

I felt like that anyway, but I've also just read an article in the latest issue of New Zealand Economic Papers, "Monetary policy and interest rates under inflation targeting in Australia and New Zealand". I'd post a link for you, except that NZEP, the scholarly journal of the New Zealand Association of Economists, is unfortunately one of those traditional charge-for-it academic journals (I should have raised this at the recent Association AGM, but never mind). If you're in academia, you've probably got a subscription: if not, I looked in the usual places for you, to see if there was a work-around by way of Working Paper or what have you, but no luck. Moving right along.

The authors are experienced monetary policy guys (Hakan Berument at Bilkent University in Turkey,  Richard Froyen at the University of North Carolina, Chapel Hill, in the US). And the gist of what they found is that our inflation targetting regime has brought about a step change in people's expectations about inflation. They now think it will be stably low, and that belief has consequently also affected the volatility of long term interest rates, which now don't jump about anything as much as they used to. People have greater confidence any shorter-term shocks will be just that, shorter-term, and that the central bank is on the case.

The authors wondered if our inflation targetting would do even better than a well dug in central bank (they chose the Fed) that doesn't explicitly do the inflation targetting thing. The answer was no...
Our results are, however, consistent with inflation-targetting regimes in Australia and New Zealand having resulted in inflationary expectations as well anchored as in the United States - a substantial change from less stable pre-inflation-targetting regimes
How much better are we than we used to be? Pre targetting (April '85 to January '90), the variance of the (monthly) 10 year Government stock yield was 4.1%. Over the targetting period February '90 to October '12, the variance was 3.1% - but that included the gyrations of the GFC. Ex GFC (February '90 to August '08) the variance was 2.6%. Better, but not massively better.

Significantly, the Reserve Bank changed how it implemented policy in April '99 from a system only monetary policy tragics could understand (targetting 'cash settlement balances') to one everybody could understand (the cash rate). That made a huge difference to people being able to form a clearer view of what was going on: the variance in the 10 year yield for the cash rate period went down to a very much smaller 0.6% (including the GFC) and to a minuscule 0.2% (ex GFC).

So we've bagged one of the big benefits claimed for inflation targetting - as they quote the Harvard economist (and chess grandmaster) Kenneth Rogoff saying,
with long-term inflationary expectations more firmly anchored, long-term interest rates might jump around a bit less, and businesses and investors might find it easier to draw up long-term contracts
As one example, the fact that we've got a working market in longer-term fixed rate mortgages is one of the side benefits of the inflation targetting regime.

So my plea to the pollies is this.

Back off. We've got a working system that's done what it said on the label. It takes forever for new monetary systems to get bedded in and for people to get their heads around them: a central bank's credibility takes decades to lock down. We've got there: let's stay there.

1 comment:

  1. Michael Reddell21 July 2015 at 08:16


    Count me not entirely convinced. After all, the shift to the OCR was an implementation issue - would have made sense whether we were inflation targeting or targeting something else altogether - and the 1985-90 period would have been volatile under any regime, since it was immediately post-liberalisation starting at a time when inflation pressures and expectations were very high. Without having read the paper, it sounds as if it demonstrates the benefits of shifting from macro instability to stability. "Stability" came in the form of inflation targeting, but could have been one of a number of other forms (eg wage targeting, NGDP targeting etc). That is not to argue the case for change, just to be wary of overclaiming the gains that are specific to inflation targeting.