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FRBSF WEEKLY LETTEA Number 95-09, March 3, 1995 Rules vs. Discretion in Ne\v Zealand Monetary Policy Since the passage of the Reserve Bank of New Zealand Act of 1989, the singular mandate of the Reserve Bank of New Zealand (RBNZ) has been the maintenance of price stability. Price stability is defined as maintaining increases in the consumer price index (CPI) within the range agreed upon with the finance ministry in the Policy Target Agreement (PTA). Such a rigid target for the rate of growth in the CPI provides a strong degree of accountability by making it easy to assess whether the central bank has achieved its objective. Indeed, the RBNZ's relative success in maintaining low inflation after an initial adjustment period has been well-documented (see Walsh 1994 and Hutchison 1995). Figure 1 New Zealand Inflation 1993-1997 4.50 change in cpr I' 4.00 '\1 3.50 3.00 change in CPI ... net of interest 2.50 2.00 TIEE@}E§§8§?i:§w~~m.~mm 1.50 1.00 The Reserve Bank Act also recognizes that increases in the CPI may not always provide a good measure of monetary policy. For example, if price shocks occur that are outside the influence of monetary policy, some measure of "underlying inflation" may be a better guide to compliance, although, at the same time, it may not be verifiable by outsiders. In that case, a tradeoff arises between the accuracy of policy targets and the accountability of the monetary authority. As long as the verifiable rule was satisfied, this tradeoff was not confronted. However, for the first time since the initial adjustment period, New Zealand's CPI has moved outside its mandated 0-2 percent range (see Figure 1). in 1994 the growth rate of New Zealand's CPI was outside its target range at 2.8 percent, and the forecast for 1995 is 3.3 percent. In this Weekly, we examine the RBNZ's response to this movement outside the target range and its implications for New Zealand's monetary regime. We first examine the Bank's methodology PACIFIC BASin nOTES 0.50 0.00 -t=FFFRP""\lli4"'4""'i"=f'=r"""f''''''i'''''''?~ <c LD M ..,. CD CD c'" Actual c'" CD CD c'" c'" U U U Projected U for determining compliance with the PTA, and compare its measure of inflation to some alternatives. In the end, it appears that a genuine tradeoff between accuracy and verifiability does exist. We argue that the current monetary regime, recognizing this tradeoff,is effectively a "two-tiered" policy: As long as the growth rate of the CPllies within its target range, that is, as long as the central bank strictly follows the policy "rule;' then it enjoys full independence; however, the central bank also has the discretion to deviate upwards from the target when it sees fit, which brings with it the burden of explaining itself to the finance ministry to reconcile its policy with the PTA. In the conclusion, we comment briefly on the merits of this two-tiered monetary regime. Pacific Basin Notes appears on an occasional basis. It is prepared under the auspices of the Center for Pacific Basin Monetary and Economic Studies (CPBMES) within the FRBSF's Economic Research Department. FRBSF "Underlying" vs. "headline" inflation The PTA recognizes that a number of possible price shocks are outside the direct influence of monetary policy and that in certain circumstances it will be appropriate for the Reserve Bank to allow the rate of growth in the CPI to exceed its 0-2 percent range. It also recognizes a distinction between the components of inflation that reflect ongoing increases in price levels and those that reflect one-time shocks. These may include one-time price level shocks, such as changes in the government Goods and Services Tax, or commodity price shocks, such as an increase in world oil prices. In response, it requires . that in the event of such a shock, the Reserve Bank will be fully accountable for its handling of the price effects, and, in particular, for any movement outside the 0-2 percent band. The Reserve Bank isexpected to give full details of its estimate of the direct price impact of the shock and its impact on the achievement of the target range. The central bank complies with this mandate by estimating what it terms "underlying inflation:' This series is estimated by taking the official CPI, which it terms "headline inflation," and making a number of adjustments (Roger 1994a). First, the underlying inflation series explicitly excludes interest rate charges. These pose a particularly perverse problem in using New Zealand's CPI as a measure of monetary policy. Since the RBNZ conducts monetary policy through the manipulation of interest rates, tight monetary policy raises interest rates. This increases the CPI and erroneously indicates "easy" monetary policy. Consequently, the PTA singles out increases in interest rate charges as an "excusable" cause of deviating from the 0-2 percent range. Second, specific adjustments are used to remove the one-time effects of a variety of shocks, such as changes in indirect taxes, government-controlled prices, and important commodity prices. This second adjustment requires thafthe RBNZ estimate the magnitude and speed of the impact of these one-time effects on the CPI. The estimate of underlying inflation generated by the RBNZ thus is dependent on the model used in generating these estimates. Because the Reserve Bank's estimate of underlying inflation relies on judgment in its construction, its validity cannot be directly verified. In addition, there is room for disagreement concerning the proper model to be used in estimating the impact of one-time shocks. For some shocks, such as changes in the prices of intermediate inputs, thetiming and magnitude of the passthrough of these price changes to the CPI is uncertain. For both of these reasons, the use of the Reserve Bank's measure of underlying inflation may undermine its credibility (Roger 1994b). The current situation provides a good example of this credibility problem. As we can see in Figure 1, while the growth rate in the CPI is projected to move well above 2 percent over the next two years, the Bank's projection of "underlying inflation" falls conveniently inside the 0-2 percent range, although it comes perilously close to its boundary at an estimated 1.9 percent rate by December of 1995. In its Monetary Policy Statement (RBNZ 1994), the Bank stresses interest rate charges as the source of divergence between "headline" and "underlying" inflation. However, evenexcluding interest rate charges, Figure 1 shows that the Bank appears to be failing to meet its target. The RBNZ explains this remaining differential as the result of the lagged effect of oil price increases and expected increases in the price of government services such as " ... rates, tertiary fees and Housing New Zealand rentals over the next year" (p. 28). Alternative measures of underlying inflation The Monetary Policy Statement concludes that this movement above the 0-2 percent target range is consistent with the PTA. However, it acknowledges the difficulty of verifying the series externally. In an effort to facilitate policy accountability, the Reserve Bank has considered more mechanical measures of underlying inflation. As noted by Roger (1994b), all of these measures share three characteristics: They can be calculated from the CPI, they exclude the direct effects of interest rate movements, and they involve judgmental methods for purging the impact of supply shocks from the series. The alternative inflation measures use different criteria for downweighting or excluding price shocks from their inflation estimates. Some measures involve removing a number of price shocks from the "headline inflation" series, either by excluding price shocks when their cumulative impact on the 12-month change in the CPI exceeds 0.25 percent, or by excluding certain commodities, such as food and energy components. A concern about these measures is that they require "pre-specification" of the types of price shocks which are suitable for exclusion. Alternative measures use a variety of methods to remove outliers in price changes. These include the "trimmed-mean" CPI which excludes the top and bottom outliers, and the "weighted-median" CPI, which is a weighted average of observed inflation rates calculated as the 50th percentile (weighted) price change. Both of these methods downweight (some to zero through exclusion) extreme price movements regardless of their cause. Consequently, some of these adjustment rnay be undesirable. In addition, some price movements that may warrant adjustment may not receive it. The Reserve Bank has determined that the measures of inflation that require "pre-specification" ofexcluded series fail to provide an adequate replacement for their current more "discretionary" measure, since their potential to fail to account for important supply shocks may prevent them from being consistent with the PTA. Among the trimmed mean and median inflation series, the Reserve Bank has noted that the median inflation series has the advantage of being derived from the entire distribution of prices. The central bank recently announced that it will be publishing the weighted median measure of inflation as a " ... supplement to, as we!1 as a check on, our current measure of underlying inflation" (RBNZ 1994). Conclusion In its implementation, New Zealand's monetary regime confronts us with the familiar tradeoff between rules and discretion. While a mechanical and easily verified 0-2 percent target provides a well-defined rule, it may not be desirable because of the inability of a fixed rule to account for all contingencies. On the other hand, allowing the RBNZ to form its own de facto rule by allowing it to construct its own unverifiable sedes in measuring compliance with its target appears to be tantamount to a policy of discretion. The RBNZ's current regime may be understood as a "two-tiered" policy. The regime has a fixed rule-maintenance of the rate of growth of the CPI within the 0-2 percent range-but it also offers an "escape option" with a penalty. As long as the central bank meets its rigid and verifiable target, it has full independence and need not explain itself. However, if the Reserve Bank lets this verifiable measure deviate from this target, it is required to explain this deviation to the finance ministry in a process in which some degree of independence is presumably lost. In a sense, the Reserve Bank has the discretion to deviate from the verifiable target at the cost of some independence. If the RBNZ values this independence, it will violate the verifiable target only when it deems it necessary. This two-tiered regime may be a desirable one for generating credible monetary policy without unduly constraining the monetary authority in the presence of supply shocks. However, to the extent that the central bank can manipulate its estimate of underlying inflation, it retains some amount of discretion. Achieving flexibility therefore implies forgoing a pure monetary rule regime to some extent. Mark Spiegel Senior Economist References Hutchison, Michael. 1995. "Central Bank Credibility and Disinflation in New Zealand:' FRBSF Weekly Letter 95-06 iFebruary 10). Reserve Bank of New Zealand. 1994. "Monetary Policy Statement". (December). Roger, Scott. 1994a. "Alternative Measures of Underlying Inflation:' Reserve Bank of New Zealand Bulletin 57, 2, pp.109-129. _ _~_.1994b. "Alternative Measures of Underlying Inflation: Further Results:' Reserve Bank of New Zealand Bulletin 57,4, pp. 330-340. Walsh, Carl. 1994. "Is New Zealand's Reserve Bank Act of 1989 an Optima! Central Bank Contract?" Center for Pacific Basin Monetary and Economic Studies Working Paper #PB94-01. Forthcoming Journal of Money, Credit and Banking. Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, or of the Board of Governors of the Federal Reserve System. Editorial comments may be addressed to the editor or to the author.••. Free copies of Federal Reserve publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974-2246, Fax (415) 974-3341. Research Department Federal Reserve Bank of San Francisco P.O. Box 7702 San Francisco, CA 94120 Printed on recycled paper Q with soybean inks. W ..t. ~ Index to Recent Issues of FRBSF Weekly Letter DATE NUMBER TITLE AUTHOR 9/9 94-30 94-31 94-32 94-33 94-34 94-35 94-36 94-37 94-38 94-39 94-40 94-41 94-42 94-43 94-44 95-01 95-02 95-03 95-04 95-05 95-06 95-07 95-08 Sherwood-Call Glick HuhlKim HuhlKim Trehan Laderman Kasa Zimmerman Moreno Gabriel Kasa Zimmerman BoothlChua Mattey Spiegel Trehan Parry Levonian FurionglZi mmerman Rudebusch Hutchison MatteylDean LevonianlFuriong 9/16 9/23 9/30 1017 10/14 10/21 10/28 11/4 11 III 1i 118 11/25 12/9 12/23 12/30 1/6 1/13 1/20 1/27 2/3 2/10 2/17 2/24 Regional Income Divergence in the 1980s Exchange Rate Arrangements in the Pacific Basin How Bad is the "Bad Loan Problem" in Japan? Measuring the Cost of "Financial Repression" The Recent Behavior of Interest Rates Risk-Based Capital Requirements and Loan Growth Growth and Government Policy: Lessons from Hong Kong and Singapore Bank Business Lending Bounces Back Explaining Asia's Low Inflation Crises in the Thrift Industry and the Cost of Mortgage Credit international Trade and u.s. Labor Market Trends EU + Austria + Finland + Sweden + ? The Development of Stock Markets in China Effects of California Migration Gradualism and Chinese Financial Reforms The Credibility of Inflation Targets A Look Back at Monetary Policy in 1994 Why Banking Isn't Declining Economy Boosts Western Banking in '94 What Are the Lags in Monetary Policy? Central Bank Credibility and Disinflation in New Zealand Western Update Reduced Deposit Insurance Risk The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.
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