I was about to post a comment on Eric’s blog – but then the comment got long, and I realised I needed a blog post. So here it is.
Eric Crampton raises some important points regarding the Reserve Bank’s view on the ETS in New Zealand. Essentially, they are ignoring it – a policy decision that a lot of analysts have disagreed with. However, this is one of those cases where I would tend to side with the Reserve Bank, lets work through the discussion to figure out what value judgments I’ve made to get there
Update: Eric discusses further here.
In the initial post Crampton stated:
As I’d understood it, there would be both a level and a rate effect [from the ETS]: implementing the system gives a level shift that RBNZ would rightly look through, but if the thing’s going to be effective, it’ll also have to have a rate effect. Why? Even if they don’t put a declining cap on the trading scheme, economic growth will make the cap increasingly binding and consequently will raise the trading price and consequently will force prices up and consequently will raise inflation expectations in the medium term.
It is true that rising inflation expectations would lead to a response from the Reserve Bank – so I agree here. And, if we say that the price of emission permits rises over time this does imply that measured price growth will be faster. But I felt:
Persistent relative price shocks aren’t inflation either – unless we believe they will feed into inflation expectations. As a result, the Reserve Bank is effectively just saying that they don’t expect inflation expectations to change markedly in the face of the ETS.
Eric responded to my relatively empty point by saying:
Agree that a persistent relative price shock isn’t inflation, but ETS isn’t a carbon tax: if this were a carbon tax plus commensurate tax reductions, all would be fine: definitely then just a relative price effect.
Now I can discuss where my head is at in more detail
In essence, the final version of the ETS is similar a carbon tax – in so far as the optimal tax would have to be set at the market price for emission permits and the income generated from an ETS goes directly into lower income taxes (relative to what they will be given our agreement with Kyoto). The transition to this optimal level is just a series of relative price shocks. Furthermore, if the price of emission permits rises through time the optimal carbon tax would have to do the same – in essence, the fact that the optimal carbon price is rising through time, and so permit prices are rising, is just a series of relative price shocks – and so this shift doesn’t have a clear impact on Bank policy.
The main thing that makes it “not just relative price shocks” is Kyoto. If we have a net liability under the Kyoto protocol this would be equivalent to a negative terms of trade shock (something I would term a negative supply shock) – so the Bank would optimally want to partially accommodate that (given their implicit quadratic loss function). Note: I am really just saying that they wouldn’t respond to an increase in the price level directly – I did not mean to infer that they would be willing to let inflation expectations rise, which is what this sounds like.
The main question has to be how an ETS impacts on inflation expectations (these would be the second round effects). The Bank must believe that the gradual nature of the ETS’s introduction, and the negative direct income effect stemming from any Kyoto liability, will be sufficient factors to prevent them having to do anything – they don’t think inflation expectations will move. If anything, the common belief that we will end up with a liability as a nation (when all the figures are finally together) implies that Bank policy should respond by EVEN LESS than it would in the face of a compensated relative price shock – as it is a negative supply shock. Update My logic was off here, as explained by Seamus in the comments.
Finally, my impression is that in the initial article they were simply stating that they wouldn’t directly act on the jump of the price level – they were not saying that rates would not be different than under a counterfactual situation with no ETS
So my value judgments in agreeing with them are:
- Can’t see inflation expectations moving (this presupposes the Bank will move on inflation expectations – so is virtually tautological )
- In less tautological terms, the path of interest rates may differ from the no ETS counterfactual – but it will not be explicitly because of the initial price level shift from the ETS. Telling people that the optimal path through the medium term may differ because of impossible to quantify second round effects (as the Bank will be reacting to expectations and monetary aggregates, not the ETS directly) may come off as overtly wonkish