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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
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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

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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.
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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.