Comment: A plea to the Reserve Bank of New Zealand
Friedberg Mercantile Group director general Albert Friedberg pens an open letter to the Reserve Bank.
Friday, September 4th 1998, 12:00AM
The Governor (along with his capable staff) has done more to regain for his institution the prestige due to a monetary authority than, dare I say, any other central banker in the world. The RBNZ is today an absolutely transparent entity, fully accountable to Parliament and the people, enjoying the good fortune of being staffed by highly competent and innovative economists, grounded in the best tradition of classical economics -- yet willing to explore new horizons. Anyone who has read their lucid and informative publications will no doubt agree with this assessment. I confess to delighting in them.
All the more reason to take issue with the way the RBNZ conducts monetary policy. My criticism is threefold:
With what it says. Time and again, one hears the Governor or a member of his staff speak about "easing" or "tightening" monetary conditions, or "engineering" easier or tighter monetary conditions. In fact, the only thing that the RBNZ does is threaten, bluff, and cajole -- each passing threat becoming less and less potent. If the RBNZ was serious about changing monetary conditions, it would, at the very least, change its daily cash target (a second-best choice). This target has remained at $5 million since August 1995! Since then, interest rates have soared and fallen, and similarly, the TWI has risen and fallen, with nary a finger being actually lifted. If the RBNZ wants to "signal" its desideratum or even wants to "guide" the market, it should call a spade a spade and use a more appropriate language.
With what it tries to accomplish. Since, by definition, monetary conditions are created by a monetary authority, the RBNZ cannot simply wish a particular monetary condition. It can "wish" a mix of interest rates and nominal exchange rates -- something that the Bank has explicitly acknowledged that it does not want to do -- but it cannot "wish" a monetary condition other than adding or subtracting commercial bank reserves and currency (reserve money). It is interesting to note that reserve money has fluctuated in recent years between 6% and 0% per annum, and most recently has been stuck in a 2% to 3% range year-on-year. The RBNZ could best signal the market by speaking or projecting a growth rate for this variable, leaving interest rate and exchange rate levels to the market.
With what it thinks. The Reserve Bank appears to believe that it knows best what level of monetary condition is most appropriate to achieve its inflation targets. Yet, time and again, the market has exceeded these projected levels, evoking, as we mentioned earlier, strong official (verbal) protests. In the speaking notes to journalists that accompanied the release of the Monetary Policy Statement of August 20, the Governor admitted that there were "sound reasons for substantially greater deviation from ‘desired’" in the last quarter. This was due to the much weaker than expected economic data that became available just a few weeks after the release of the May Statement. It added, rather significantly, that "as the new data emerged, financial markets generally [my emphasis; is the admission that difficult?] adjusted smoothly in the direction of a lower MCI. In that situation [my emphasis again], there was little case for a Reserve Bank response."
New economic data comes out every minute and every hour of the day. It is the business of thousands and even millions of investors and speculators to continuously assess this information. Moreover, they bet their livelihood on the correctness of these assessments. The free-market Governor of the RBNZ knows better than anyone that this is so. Why then does he think that he can pre-set MCI levels and that he can protest "deviations"? Why does he not trust the market’s judgment?
There is a further flaw in the RBNZ’s thinking. By wishing/guiding/signalling a particular level for this famous Monetary Conditions Index and simultaneously targeting an inflation rate, the RBNZ is coming close to trying the impossible. Let me explain. A fall in the terms of trade or a world depression that affects the quantum of exports would make New Zealand residents poorer. Economic good sense dictates that the Kiwi’s real rate of exchange would have to fall to reflect this relative impoverishment. A lower rate of exchange means that New Zealand residents will be able to buy fewer goods abroad, precisely because they have become poorer. Or, they would have to work harder and export more at a lower price to pay for a given level of imports. A lower rate of exchange will permit the export sector to sell abroad even as international prices for its goods have fallen, simply because its costs, measured in international currency, have fallen.
Fearing inflation, however, the RBNZ would resist depreciation by hoisting interest rates. Deflation of the price level would ensue, accomplishing, via the price level, a fall in the real rate of exchange. And here comes the twist: The RBNZ cannot allow prices to fall either, as it is mandated to maintain prices in a 1% to 3% range. How, then, will the necessary real adjustment occur? Not via a falling exchange rate nor via falling prices. By impeding a real adjustment, the RBNZ condemns the country to a spiralling depression, as the country cannot overcome its recent impoverishment. This, in a nutshell, is the result of simultaneously targeting inflation, interest rates, and exchange rates.
The RBNZ should draw the appropriate conclusions from recent deviations. In the first place, the dramatic fall in the MCI -- again, far greater than originally planned for -- has not resulted in higher inflation. The RBNZ attributes it to "excess capacity and weak international prices for both imports and exports." We would rather argue that weak export prices and international demand have "impoverished" the residents of New Zealand and that, therefore, the fall in the MCI, and more particularly the Kiwi, has been the result of real factors, not monetary excesses.
Currency depreciations do not create permanent inflation unless accommodated by monetary easing. This has been the recent experience of Canada and Australia. Even countries like South Korea and Thailand have seen very modest inflation despite experiencing dramatic currency depreciation. Secondly, the markets have been right on the mark.
I am not advocating a policy of currency depreciation or currency appreciation. I am advocating a clean, transparent, and effective monetary regime -- absolutely becoming to this RBNZ -- that will not tamper with the market’s judgment. The RBNZ can either announce a target for reserve money, in keeping with steady, noninflationary growth (the Friedman rule), or it can, after some experimentation, adopt a neo-Wicksellian approach and target a relatively flat yield curve. The RBNZ would then sit back and allow the market to find interest rates and exchange rates consistent with these monetary conditions.
These two monetary rules fit admirably well with the pure (and very commendable) floating rate regime that has been in effect for well over 15 years. Alternatively, as some of my colleagues would have it, the RBNZ could fix the Kiwi to the US dollar, back the peg with enough foreign currency to cover M1 -- in effect creating a currency board -- lock the doors of the Central Bank, and throw away the key. Finally, and even more daringly, it could bring back the only true free market monetary regime -- free banking.
By his own admission, the Governor is a staunch believer in free markets. He has created the conditions by which these markets can function with the least amount of friction. He could guide them, but he should not be infuriated if he finds that the markets don’t always agree with him. Most of all, he must now learn to trust them.
Albert D. Friedberg is Director-General Partner of Friedberg Mercantile Group, a Canadian Investment Dealer and currency trading firm based in Toronto.
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