While New Zealand has been focused on Covid, travel bubbles, and the America’s Cup, we are witnessing the beginning of the end of independent and sound monetary policy-making in New Zealand.
Central bank independence is a cornerstone of successful monetary policymaking. It addresses the so-called “time-inconsistency problem”. The idea is that monetary policy can temporarily boost economic activity, but because people anticipate this temptation, the policy will only create inflation. The solution is to delegate policymaking to an independent central bank.
Because of independence, the bank is credible in the sense that it is not influenced by electorally motivated politicians.The benefits of independence have been shown in theoretical and empirical research as well as in policy practice. For example, the success of the Deutsche Bundesbank (the German central bank) after the second World War rests to a large extend on being politically independent.
This is an unprecedented event. We are used to see such attempts in countries like Turkey or by President Trump. Witnessing this in New Zealand leaves me speechless.
The independence of the Reserve Bank is currently under attack. This began in November 2020, with a letter written by the Finance Minister to the Governor. In this letter, the Minister – at least to this reader – instructs the Reserve Bank to include house prices into its decision-making process and to pursue policies to intervene in the housing market.
This is motivated by trying to reduce inequality and poverty and to achieve a more productive and inclusive economy. None of these are goals achievable by monetary policy as they are structural, long-run issues.
This is an unprecedented event. We are used to see such attempts in countries like Turkey or by President Trump. Witnessing this in New Zealand leaves me speechless.
The next nail in the coffin occurred on February 22, 2021. Titled Reserve Bank of NZ Order 2021, Treasury has implemented changes to the Remit (the policy target agreement between Bank and Treasury).
The relevant addition reads: “The Government’s policy is to support more sustainable house prices, including by dampening investor demand for existing housing stock, which would improve affordability for first-home buyers.”
It appears that the Labour government is using monetary policy as a last resort to try to achieve its goals. Additionally, it offers the opportunity to shift responsibility and ultimately blame to the Reserve Bank.
Interest rates would have to increase sizably to increase mortgages rates by enough to disincentive people from buying houses (if this works at all). Such an increase in the Covid-recession is not possible. Further, such an increase would lead to an increase in the mortgage payments of those who have already bought a house under one-year fixed mortgage rates and who are heavily leveraged.
This could create adverse effects on financial stability, if people must default on mortgages they cannot repay. Sound familiar? This is how the subprime housing crisis in the US started.
The other option is to use loan-to-value ratios. LVRs have been designed as a policy tool to improve financial stability under the Basel III regulatory framework. However, the idea behind LVRs is to curb excessive credit creation not to influence house prices.
Since Nobel Laureate Jan Tinbergen’s work in 1952 it is well known that you need at least as many policy tools compared to the number of policy targets you have. While Labour is increasing the number of targets (wellbeing, employment, house prices), the number of suitable policy tools is not increasing. Therefore, failure is guaranteed.
Further, the problems in the housing market are not related to monetary policy. They are structural, but the Labour government has already shown that they are not willing or able to address these (see KiwiBuild).
Research by the Deutsche Bundesbank has shown that LVRs reduce consumption and investment in response to shocks. Hence, the irony when the Minister writes “investments in the economy are increasingly being made in the existing housing stock, rather than in the other more productive assets,” in his letter to the Governor. Introducing LVRs will achieve the opposite of what is desired here.
It’s another example that the Treasury should take economic research seriously.
Kiwis should be proud on the achievements of the Reserve Bank over the last 30 years. New Zealand experienced high inflation rates during the 1970s and 1980s. But, since the introduction of the Reserve Bank of New Zealand Act 1989, which established operational independence for the Bank and specified that price stability is the single policy target, New Zealand has seen stable and low inflation rates.
In addition, the Reserve Bank enjoys a high international reputation for innovative research and sound policymaking.
Overall, the recent events pose a clear and present danger to the independence of the Bank and, therefore, macroeconomic stability in New Zealand.
What New Zealand needs is a strong, independent Reserve Bank instructed to achieve and maintain price stability and financial stability. In line with good international practice and research insights, it will adopt new policy tools (such as quantitative easing or macroprudential policies such as LVRs) over time to achieve its goals.
Any interference from the Government into monetary policymaking must stop and the remit has to be changed back to only including price and financial market stability.
