Amol Agrawal
In December 1989, the Reserve Bank of New Zealand (RBNZ) adopted inflation targeting. After the breakdown of Bretton Woods and the stagflation episode, central banks had shifted their attention primarily towards managing inflation. Central banks adopted Milton Friedman’s monetary targeting approach where money supply was targeted for managing inflation and inflationary expectations. However, the monetary targeting framework did not achieve the desired results as central banks found it difficult to control the supply of money.
In a remote corner of the world, RBNZ decided to tweak its policies and instead adopted inflation targeting (IT). Under IT, the central bank would target a level of inflation and use interest rates to achieve the desired inflation level. In a speech at the IMF in 2000, David J. Archer, then Assistant Governor of RBNZ, explained how the shift to IT was driven by “least bad of the alternatives available, rather than as the scaling of the intellectual high ground.” He also explained how the key idea was rooted in public sector reform where the government sets the goals and gives professional managers the freedom to pursue those goals. Though a few would have imagined that this practice would soon capture the imagination of monetary economists and central bankers all over the world.
This framework soon became the new gold standard of central banking. After NZ, a spate of countries such as Sweden, Canada, Australia adopted IT. Bank of England, which so far had set the standards for central bankers also adopted inflation targeting in 1998. India too adopted inflation targeting in 2015 after debating the idea for many years. As of 2018, 40 countries had implemented the framework. Usually, most of these countries have either fully floating or managed floating exchange rates.
The advent of inflation targeting led to some other developments in the area of central banking. First, in terms of the central bank’s autonomy, it was understood that governments will set the inflation target and central banks will have operational autonomy to achieve the goal. Second, one saw large-scale changes in the way central banks communicate with markets.
Interestingly, inflation did decline in countries which adopted inflation targeting. However, some researchers questioned this success, citing that the US economy also managed low inflation in that era without adopting inflation targeting. Some researchers cited globalisation and low oil prices as key reasons for the decline in inflation and some even suggested good luck.
The major shock for inflation targeting came via the 2008 crisis. The crisis questioned the central bankers’ one-dimensional focus on price stability while ignoring financial instability which led to the crisis. The central banks were also criticized for ignoring growth and employment in their objectives. There were calls to either drop the IT framework or replace it with a broader framework which includes both growth and financial stability.
Central bankers responded to the above criticism by saying that IT framework was never really one-dimensional. Most central banks adopted “flexible inflation targeting” which gives due importance to growth while keeping inflation under target. Only when inflation is under check, a broad-based and equitable growth is possible. Further, they added as guardians of the payment system, it is not the case that they skipped financial stability completely. Given this back and forth, one has not seen any inflation targeting central bank drop the framework. In fact, the likes of India adopted IT after the crisis and some others like Jamaica are looking to adopt it soon.
Having said that, RBNZ has not been sitting on its success. Just like it gave a solution to the world with its IT framework, it is trying to do the same to the two new challenges of unemployment and financial stability.
First, the New Zealand government has broadened the goals of the central bank and added employment to the inflation targeting mandate in 2018. This is not really novel, as Federal Reserve had a dual mandate of both price stability and unemployment. However, RBNZ's move to a dual mandate would be noticed by other IT central banks. RBNZ Governor Adrian Orr in his statement (2018) said: “The Reserve Bank’s flexible inflation targeting regime has long included employment and output variability in its deliberations on interest rate decisions. What this PTA does is make it an explicit expectation that the Bank accounts for that consideration transparently. Maximum sustainable employment is determined by a wide range of economic factors beyond monetary policy.”
Accordingly, the central bank, while continuing with its mandate of keeping CPI inflation between 1 and 3 percent, will also look at two more objectives: efficiency and soundness of the financial system; avoid unnecessary instability in output, employment, interest rates, and the exchange rate. Thus, unlike a specified inflation target, there is no such target for the other two variables.
The central bank has also shifted the responsibility of setting monetary policy from the Governor to the Monetary Policy Committee. This has been a practice in many central banks and something which surprisingly was not there in NZ. However, its initial selection of MPC members shows a lot of promise with three experts in different fields like agriculture economics, fiscal policy and trade union movement.
Second, to promote financial stability, the central bank has proposed to double the capital level held by banks currently. It has recently put up a detailed proposal on how it plans to achieve these capital levels. This too has surprised economists given the state of the desired recapitalisation.
Third, for increasing central bank transparency, RBNZ has developed one of its kind financial dashboard which is highly user-friendly. The dashboard available at the website allows the users to plug and play around the financial variables of all NZ-based banks. The initiative won the award for “Initiative of the year” by CentralBanking.com. Key people behind the design of the dashboard said that the “sheer volume of disclosure had become very large… and it was difficult to compare one bank with another, and thus banks didn’t come under widespread scrutiny”. Thus, “We wanted to invent something that was accessible.”
To sum up, it is interesting that after pioneering monetary policy in the last 30 years, RBNZ is now planning to do the same in unemployment and financial stability as well. Other central banks have a lot to learn.
(Amol Agrawal is faculty at Ahmedabad University. The views expressed here are his own)
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