No one can doubt the importance of military credibility in deterring hostile aggressors. Since Russia invaded Ukraine, even a pacifist post-World War II Germany and the previously neutral Nordic countries have learned that lesson.
But the battlefield is not the only arena in which credibility matters. A few decades-worth of economic research makes clear that credibility is critical in the fight against inflation. All things being equal, central banks have a far harder task controlling inflation if markets do not perceive them to be tough on inflation. Inflationary expectations become embedded when firms and workers lose faith in a central bank’s commitment to price stability.
Writing in the Journal of Monetary Economics in 2015, Boston University’s Professor Robert King assessed the value of central bank credibility empirically. A bank that has lost its credibility has to impose far greater costs on an economy than one with its credibility intact. A credible central bank’s retaliation against inflation does not also have to convince people that it is serious about fighting inflation. People already know it. That allows its response to be comparatively moderate.
King’s research is well-known to economists in New Zealand. He delivered his findings as the keynote speaker at the New Zealand Economics Association 59th conference in 2018.
Central bank credibility should also be top of mind for Minister of Finance Grant Robertson. Last week’s inflation figures from Statistics New Zealand provided an unpleasant surprise. Inflation has become more deeply entrenched in the New Zealand economy than even the most pessimistic predictions.
The figures made a mockery of Reserve Bank Governor Adrian Orr’s comments a month ago that the bank’s tightening cycle was ‘very mature.’ At best, his words were premature. Worse than that, they contributed to an impression of a Reserve Bank that wants to talk down the risks inflation poses rather than talk up its willingness to “do whatever it takes” to get inflation under control.
While New Zealand is not alone in failing in its fight against inflation, countries like Switzerland demonstrate the battle can be won. Switzerland’s current inflation rate is a little under half ours and is forecast to fall to less than 2% next year. The Swiss National Bank’s constitutionally entrenched reputation for maintaining price stability has led to a virtuous circle of an appreciating exchange rate and modest inflation. If only our central bank enjoyed the same stature.
Recent survey data released by the Reserve Bank reveals just how much of a battering the Bank’s inflation-fighting credentials have taken. On 12 October, the Bank published the results of the first round of public consultation on its monetary policy remit review.
Survey respondents were asked how much confidence they had in the Reserve Bank to get inflation back within the target range of 1-3% by 2024. The respondents fell into two groups of “representative” and “self-selected” survey recipients. Of the respondents expressing a view, close to 60% of the representative and 70% of the self-selected groups said they had only “a little” confidence or were “not at all” confident in the Reserve Bank getting inflation back within the target range. Meanwhile, only a respective 23% and 28% of the two groups were “somewhat” or “extremely confident.”
The results suggest the Reserve Bank’s once fearsome reputation as an inflation fighter has been squandered.
This should come as no surprise. In combination, Orr and Robertson have beleaguered a once single-minded Reserve Bank with a raft of ancillary policy targets and diversions. Where once the Bank had a steely-eyed focus on price stability, its formal remit now includes maximum sustainable employment and house prices. And then there are the Bank’s other contemporary areas of focus, including inequality, climate change and Māori culture and language.
No one should question the importance of these topics. But they are distractions for a central bank. Little wonder that the Bank’s survey respondents are unconvinced the Bank will win the war against inflation. Or at least not anytime soon.
That brings us to the position of the Governor.
Orr’s five-year term will expire at the end of March next year. He was one of Minister of Finance Grant Robertson’s first appointments following the 2017 general election. The previous Finance Minister, Steven Joyce, had left Deputy Governor Grant Spencer in a caretaker role after Orr’s predecessor, Graeme Wheeler, signalled he would step away from the role after a single term in 2017. Orr took up the role in March 2018.
The Reserve Bank’s poor track record in controlling inflation and its battered credibility under Orr suggest Robertson should not reappoint Orr for a second term. Both the Bank and the country require an inflation hawk in the Governor role. Anything less and the country will suffer unnecessarily.
If not already underway, an international search for a suitably qualified successor should begin immediately. With the Reserve Bank’s credibility at such a low ebb, there may be merit in the Finance Minister selecting a foreign candidate to fill the role. Someone with an established reputation for price stability and a willingness to adopt a “take no prisoners” approach to taming inflation.
In the meantime, Robertson should do two things to assist the new Governor with the war on inflation. First, he should immediately narrow the Reserve Bank’s remit to focus solely on price stability. Anything less is economically flawed and will compromise its effectiveness.
Second, he should modify the rules relating to the Reserve Bank’s Monetary Policy Committee. Like Orr himself, the MPC is one of Robertson’s babies. Introduced in 2020, the committee was designed to ensure the Governor is not the sole decision-maker on monetary policy. Instead, the MPC, which the Governor chairs, is responsible to the Minister of Finance for the Reserve Bank’s monetary policy role.
The only problem is that Robertson’s rules for the MPC forbid any economist with current academic monetary policy research expertise from membership of the committee. This restriction is bizarre. It is also unique to such committees around the world. It deprives the committee of access to up-to-date macroeconomics expertise. And it shackles the committee by making its less-than-expert members dependent on the expertise of the Governor.
Why the Minister of Finance concluded this experimental approach was the optimal governance arrangement for the MPC is anyone’s guess. Regardless, the evidence suggests the experiment should end. The incoming Governor must have access to state-of-the-art expertise. Without this, the credibility of the Reserve Bank will be compromised. And, as decades of research demonstrates, credibility is critical in the fight against inflation.