Where New Zealand Goes, the World Goes

An event in 1989 shook the world and radically changed how critical institutions operated. No, I’m not talking about the fall of communism and the following disintegration of the Soviet bloc, but of an obscure change of public policy in a land far, far away. While the rest of the world intently looked at the Berlin Wall crumbling, the New Zealand government enacted a seemingly inconsequential law that would change the world’s monetary regimes forever. They might be about to do it again.  

Let’s backtrack. In the West, the 1980s was a time of desperate search for workable monetary arrangements. We had come out of double-digit inflation in the 1970s and early 1980s; a rise of what its opponents now label ‘Neoliberalism’ in the shape of Mrs. Thatcher in the U.K. and Ronald Reagan in the U.S. In 1979, Paul Volcker, a practical man more than a monetary wonk, kept hiking the Fed’s interest rates until the inflation monster gave in, and in the process exacerbated (or engineered?) a deep recession.

The 1970s stagflation, where inflation and unemployment rose at the same time – believed impossible by economists and policy-makers in charge of most central banks – had wreaked havoc with a monetary system that had worked tolerably well since the end of World War II. 

Against this monetary and fiscal confusion, central banks and monetary economists sought for a way to stabilize the economy and prevent a return to the disastrous decade they had just lived through. Plenty of options were tried, by this or that central bank, almost always involving some specific monetary aggregates such as growth in M1 (coin and notes in circulation + demand deposits) or M2 (adding savings accounts and money market shares). The results were often disastrous, with targets met only by wildly volatile interest rates, exchange rates, or credit creation in the economy. Much like a balloon squeezed at one end only to bulge out at another, monetary targeting was a hopeless attempt.

For decades until the late 1980s, the Kiwi economy had performed noticeably worse than other Western nations: higher unemployment, slower growth, and higher inflation – often much higher and much more variable, ranging from 5% to almost 20% since the 1960s.

Out of this mess, officials at the Reserve Bank of New Zealand (RBNZ) stumbled upon what would be the reigning monetary regime for the next three decades: inflation targeting. Contrary to some of the mythology around independent central banks targeting inflation, the New Zealand Ministry of Finance didn’t wisely foresee how effective this new regime would be. Instead, they decentralized government policy-making across many departments such that their respective leaders were given an objective to achieve in whatever way possible (“Policy Target Agreements”). 

The Reserve Bank Act of 1989 charged the RBNZ with “achieving and maintaining stability in the general level of prices over the medium term,” but left the ‘how’ to its governor. In the literature on central bank independence, this became known as “goal dependent but instrument independent.”

For reasons that were not clear at the time, inflation targeting worked to bring down New Zealand’s stubbornly high inflation and anchor it at a low rate for decades to come. Spurred by their sudden and unexpected success, almost all other central banks moved to the regime of inflation targeting that we’re used to today. 

Don Brash, the RBNZ governor between 1988 and 2002 once noted that moving to inflation targeting would not automatically create credibility for the central bank’s policy: “Our experience suggests that credibility has to be earned […] by our actions and our account of policy, and not legislated.” While facing no lack of opposition to its new policies, the bank under his governorship held its ground, made open projections of where they saw the economy heading, set their short-term interest rates accordingly, and, remarkably enough, convinced actors in the economy and financial markets to trust them. 

The results have been celebrated ever since, with worldwide imitation the highest form of flattery. 

Next Stop: Asset Markets

During the pandemic, housing markets in many places popped, but few rivaled New Zealand’s 20% one-year increase in house prices. Auckland and Wellington, its two major cities, now rank as some of the least affordable places on the planet. 

What has happened so far is that the government asked that RBNZ consider house prices when it formulates monetary policy. In the earliest announcements in November, the government even wanted to include house prices in the RBNZ’s official mandate. We don’t know exactly how much the RBNZ will give in to its government’s demands, as it is due to report back on measures later this year. Instead, official announcements describe the use of some of its macroprudential tools to lean against the mortgage lending market (loan-to-value regulations and bank capital requirements). At the same time, the Finance Ministry has announced measures that aim to reduce investor demand for properties, by removing tax deductions against mortgage interests and extending capital gains taxes for investment properties. 

It’s hard not to observe that these policies work at cross-purposes with the overlooked villain: extremely low policy interest rates. Even more ironic is that the loan-to-value restrictions that the RBNZ are now tightening were removed altogether in April last year to help with the initial shock of the pandemic. It seems market chickens are coming home to roost. 

In a way, it’s also back to the early 2000s for monetary policy debates, when economists argued over whether it was feasible or appropriate for central bankers to “lean against the wind,” i.e. try to identify and prick asset bubbles before they burst, by hiking interest rates. The conclusion back then – later completely overturned by the aftermaths of the Great Recession and the European debt crisis – was that “cleaning up” after a crash was cheaper than holding policy rates higher than was warranted by the economy alone. 

The stronger argument for taking asset prices into account is savings. Price changes in stocks, bonds, and houses are not included in inflation metrics because they aren’t consumption goods. But insofar as they are vehicles for carrying value through time – a service households do have a demand for – it makes perfect sense to include them in the consumer basket we use to gauge overall price inflation. Since you can’t effectively move value forward by simply holding money as its purchasing power would erode, you’re left with picking a spot on the risk-reward investment spectrum (say, from safe but low-earning interest rate accounts to houses, equities, or even bitcoin). 

If these vehicles suddenly are more expensive than they were – a different way of saying that their future expected return is lower – an individual’s intertemporal choice between now and the future has gotten steeper. A given amount of future value costs you more today than it used to. If so, housing and stocks, and bitcoin are just additional consumption goods, the prices of which are relevant for assessing inflation. Including them in the consumer price index that inflation-targeting central banks look at makes sense. And this isn’t rocket science: any introductory microeconomics course will tell you as much, and economists like Armen Alchian wrote about it 50 years ago. In this sense, what the New Zealand government is asking the RBNZ to consider is both trivial and explosively revolutionary. 

In the 1990s New Zealand pioneered inflation targeting, an approach that every major country followed for the next three decades. In a few years we might look back at this fleeting Kiwi attempt at incorporating asset markets into monetary policy with the same admiring eyes that we now see their move to inflation targeting. Where New Zealand goes, the world tends to follow.

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