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Despite its enormous responsibility for the state of the economy, the Federal Reserve’s performance is difficult to assess. One problem is that by statute the Fed is to pursue three separate goals: moderate long-term interest rates, maximum employment, and stable prices. These three objectives tend to come into conflict. At present, for example, the Federal funds rate is approaching 0.1 percent, unemployment is at its highest level in decades, and the price level is in decline. Out of concern for unemployment, however, the Fed is unwilling to raise interest rates At the same time, it is creating a serious threat of future inflation.
A second problem is that the Fed’s three goals are not strictly defined in any numerical sense. Numerical goals are not part of the public record, nor did Fed officials respond to AIER requests for rigorous definitions of the central bank’s goals. As a consequence, the only apparent channel for accountability appears to be political upheaval, in the form of a new nominee for Fed chairman.
In comparison, the mandate of the Reserve Bank of New Zealand (RBNZ) provides a clearer and more successful alternative. Since 1990, the RBNZ and its governor have been subject to an explicit and publicly announced core criterion. The RBNZ is to maintain price stability by holding inflation within an agreed target range for a medium term of 18 to 36 months. Initially, the target range for inflation was 0 to 2 percent. Since 2002 the range has been 1 to 3 percent.
New Zealand’s emphasis on price stability does not preclude a desire from parliament for increased employment. Rather, the policy asserts that the central bank ought not be burdened or distracted by responsibilities beyond its primary purview.
To achieve the stipulated objective, Governor Alan Bollard, the RBNZ’s counterpart to Fed Chairman Ben Bernanke, must commit to a Policy Targets Agreement. The defined targets can only be adjusted by the minister of finance and the governor in a bilateral and transparent manner. Thus, all parties, including the public, are clear on the central bank’s goal. Consequently, political jockeying is limited to the initial agreement—leaving little room for manipulation around the election cycle.
The governor has operational independence. If he meets the inflation target, he can keep his job. If he does not meet the target, he must satisfactorily explain his failure. Otherwise, his initial five-year appointment will be terminated, and a new governor will be appointed swiftly.
Despite initial pessimism, the results of New Zealand’s Reserve Bank Act of 1989 have been positive, as the chart below shows.
Source: Reserve Bank of New Zealand and Statistics New Zealand (Click to Enlarge.)
The chart traces the annual rate of inflation in New Zealand from 1970 through mid-2009. As can be seen, the annual rate of inflation, on average, declined markedly from 11.5 percent in the 1970s and 11.7 percent in the 1980s to 2.4 percent after the new system was put in place in the 1990s. To put that change in perspective, New Zealand went from having twice the rate of inflation of the United States in the 1980s to having consistently lower inflation beginning in the 1990s.
During the 20 years since the law was enacted, in addition to tightened inflation, New Zealand has also experienced almost uninterrupted growth in employment and economic activity—although both declined slightly in 2008.
The Fed is in a precarious position, facing both current deflation and the prospect of severe inflation, along with rising unemployment. However, the Fed’s lack of objective criteria and its politicized and obscure process of accountability mean it is predestined to an ineffectual and murky mix of neither success nor failure.
Other countries, notably Canada and Australia, have already sought to emulate New Zealand’s system. It has demonstrated the effectiveness of a clearly defined prescription, coupled with a politically restrained, results-oriented approach to central bank leadership.
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The downmove in New Zealand inflation rates also seems to comove with falling interest rates in Japan starting from 6% in 1990, the spike down occuring in (*squints) corresponds with the BoJs largest rate cut in its 5-8 year rate cutting cycle in the 90s (technically 5-yr [0.5% effective]).
The left side of the chart is higher relative to the right side of the chart..
Think of the 1970s folks..
Regarding the chart, I did look at including the US data. However, given the high levels of NZ inflation prior to 1990, a display of the difference in performance during the 1990s and 2000s (with higher and more variable inflation in the US) would have required a new diagram with a different y-axis.
The note questioning whether we ought to be concerned by an interest rate of 0.1% confirms that whether an interest rate is moderate, without numerical guidelines, is in the eye of the beholder. The same obscurity holds to the other two stated Fed objectives.
New Zealand was the first country to adopt fully-fledged inflation targeting, so the European nations, and then the ECB, were emulating New Zealand, not the other way around. (One could, of course, design a different target/prescription for the Fed, apart from inflation.)
Regarding lobbying, that is not AIER's role, but of course we hope our work influences the public discourse.
Fergus Hodgson,
According to the New York Fed ( http://www.newyorkfed.org/charts/ff/ ), the daily effective funds rate is approaching 0.2%, and has been rising from 0.13% since early July. The effective Fed funds rate and other short term money market interest rates have shown a stable-to-slightly-upward bias.
Even if the effective fed funds rate was approaching 0.1%, why would it be alarming? Why would one consider an increase in capital bearish, particularly if the Desk at the New York Fed announces over FedWire a larger than usual repo -- i.e., particularly if large amounts of capital enter the private markets from the New York Fed?
And I'd also like to add: Why the RBNZ? Why not the ECB as well? Sure the ECB may not be so pressured with regards to meeting explicit inflation targets, but the ECB, like the RBNZ, has only one mandate: Price Stability.
i.e., both the RBNZ and the ECB are mandated to raise interest rates to "fight [price] inflation", i.e., they are mandated to raise interest rates to fight growth, because they, like most establishment economists, believe that price inflation comes from "excess consumer demand" or "too much growth" and therefore one need only to raise the cost of capital and cause an aggregate reduction in output (recession) in order to lower the price level.
Central banks without a growth mandate in my view have a greater potential to continuously raise interest rates to "fight inflation", i.e., slow growth -- I think the RBNZ should learn some lessons from the Federal Reserve if anything. Not that they should, as they ought to simply define gold in weights and measures and get out of the central banking business altogether.
Certainly, NZ's "Fed" policy seems a factor, but other items also seem relevant. For example, NZ has a remarkable level of direct foreign (especially Chinese) investment, and the level of private debt seems fairly high, looking at figures from The Economist. Seems there are great benefits in eagerly providing something that someone else wants, in having a relatively competent political base, and in maintaining a reasonably disciplined population. Hope we can do the same. Thanks again for the article.