Discussing inflation targeting and our exchange rate concerns

In a recent speech (ht Rates Blog) Goff committed to destroying monetary policy independence and damaging the New Zealand economy if he gets into power.  That is all well and good.  However, I think part of the reason this issue has occurred is because of a lack of understand around the necessity of monetary policy independence and inflation targeting, and how all these other factors (like the exchange rate) are determined.  Lets discuss them a little bit here:

When inflation was scaring all of us in NZ we did a series of posts under the “inflation debate” tag.  For more detail on the issues that is a good place to have a little look.

Now fundamentally, an economy is all about REAL goods and services flushing around, things people value and create.  Money only matters insofar as it provides some sort of benchmark that allows us to compare the RELATIVE VALUE of different goods and services.

In the LONG RUN (the period over which all prices can move freely) the relative price of goods and services are indicative of the relative value placed on these goods and services in society and money is said to be neutral.  In this case, monetary policy is something that just doesn’t matter.

Where monetary policy does matter is in the SHORT RUN (when some prices in the economy cannot, or are costly to, change).  In the short run an economic shock may lead to relative prices changing even when there has been no real change in their underlying value, and monetary policy can help to improve matters in this case.

In order to ensure that any “nominal shocks” do not occur, monetary policy has been given POLITICAL INDEPENDENCE (so that politicians cannot try to move things around to win elections) and an INFLATION TARGET.  The purpose of the inflation target is that it allows people to know how much prices will generally change, which informs their expectations when they set prices and make transactions, and which therefore leads to the relative price of goods staying where they should be.

The key thing here is maintaining expectations of inflation at a level that the Bank is targeting.  It does this by setting the opportunity cost to banks for borrowing from or lending money to the Reserve Bank – this is called the official cash rate.  By doing this, the Reserve Bank (in conjunction with some prudential policy) can change the interest rate, which in turn changes peoples incentives about whether to borrow or save now.

If we have experienced a nominal shock which leads to general upward pressure on prices, the RBNZ can increase the cash rate and exert downward pressure on prices.  By doing this, the Bank shows that it aims to keep the general growth in prices at a certain level, and people form expectations of price growth on this basis.

This is the purpose of monetary policy, this is all it is supposed to do.  By making the general change in prices transparent they make it easier for everyone in society to make informed decisions.  From there the allocation of resources depends on the incentives of private agents, which are determined by real factors and any biases stemming from institutional or fiscal organisations.

But what about the exchange rate, and the tradeable sector

In the long run the exchange rate does not matter – it is just some relative value of two currencies, which is based on the relative price of goods (and the cost of transportation) between the nations.  In the long run the price of tradeable and non-tradeable goods will change such that the value of the currency is inconsequential.  Again any concern stems from the short-run.

However, as long as we are focused on ensuring that inflation expectations are “anchored” there really is no point looking at monetary policy.  Why?  The exchange rate is a relative price, not a general price level – monetary policy deals with the general price level, not individual prices.

When we put it in these terms, we realise that IF the NZ dollar is persistently over-valued (or if we just think that the swings are too big relative to the change in the world price of goods) there must be an actual structural reason for that.  The question should be “why is our dollar behaving like this” and “is there a net welfare improvement available from changing policies/institutions that have put us in this position”.

Well what is happening?

As we said here the factors we could point out are:

  1. Other countries are trying to suppress the value of their currency (as suggested here, here, here, and here),
  2. Households and businesses are taking on too much debt,
  3. Government policy is creating a wedge between the private and social benefits of individual actions.

Each of these specific factors may create a real dislocation, and have real welfare consequences for New Zealand.  If it turns out that we do believe any of these factors are at fault, then we could come up with policies to deal with them.  Arbitrarily attacking the monetary policy framework, which has created certainty around changes in the general price level (note that no-one can remove the uncertainty from changes in relative prices – so the Bank cannot be blamed for that) is just silly.

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  1. […] is point number one on our list of issues causing an imbalance (list at the bottom of this post).  I am loath to blame China for the whole imbalance – after all they are artificially […]

  2. […] This post was mentioned on Twitter by Matt Nolan, Politiconomic. Politiconomic said: $$ TVHE » Discussing inflation targeting and our exchange rate concerns: In the short run an economic shock m.. http://bit.ly/1Qdq3U […]

  3. […] for their special monetary policy.  Let me discuss what these mean in turn. [Note we already have two posts on this issue […]

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