Are the Reserve Bank's inflation and employment targets fit for purpose?

Reserve Bank Governor Adrian Orr. Photo / Mike Scott

The Reserve Bank of New Zealand (RBNZ) is considering whether it needs to be given more guidance on how it balances meeting its inflation and employment objectives.

It is also weighing up whether its inflation target is set at the right level, and whether a numerical value needs to be put on its employment target.

It's asking the public for feedback as a part of a five-yearly review it's required to do by legislation of its monetary policy remit.

While the outcome of the review will affect the way monetary policy is set between 2023 and 2028, the issue of how the inflation and employment targets are weighted is topical.

Debate is under way among central bank observers over whether too much of a focus on the employment target led the bank to overcook its response to Covid-19, and whether the RBNZ should now aggressively hike interest rates to get on top of inflation or be more mindful of not spurring too many job losses.

The National Party is also campaigning on removing the employment target. However, doing so would require legislative change and is out of the scope of the remit review.

The RBNZ's Monetary Policy Committee is tasked with keeping annual consumer inflation between 1 and 3 per cent in the medium term, and ensuring there is "maximum sustainable employment".

It uses tools like the Official Cash Rate (OCR) and quantitative easing or tightening to achieve these goals.

How should the inflation and employment targets be weighted?

The RBNZ, in its consultation document, said the inflation and employment objectives align in the long term.

"Returning inflation to target is consistent with the economy and employment operating at their maximum sustainable levels," it said.

"In the short to medium term, however, there may be situations where monetary policy faces a trade-off between price stability and maximum sustainable employment.

"Inflation can increase due to factors that have nothing to do with the underlying level of demand in the economy, such as when global oil prices increase. Such 'cost push' shocks can have negative impacts on household incomes – reducing output and employment – yet at the same time put upward pressure on inflation."

The RBNZ noted that if it responds to high inflation by hiking interest rates, this could dampen the economy and create job losses. But if it prioritises employment by keeping interest rates low, inflation could rise.

The RBNZ said the upside of there being no guidance around how it should balance these objectives is that it can be flexible.

On the other hand, more guidance could "enhance credibility by providing more certainty to the public on how the Monetary Policy Committee will respond to different economic situations".

The RBNZ said including more guidance could also make the committee more "democratically accountable".

It concluded: "The remit could be extended to reflect the Monetary Policy Committee's current understanding that inflation forecast targeting is generally the best approach to achieving the dual mandate, and/or include more guidance on how to balance the economic objectives when they are in conflict."

Should the RBNZ target higher or lower inflation?

The remit review also asks the public for feedback whether the inflation target is set at the right level.

The RBNZ said, "Overall, low, positive, and stable inflation is believed to be the best option for achieving long-term economic prosperity...

"Although there is uncertainty about what the best target is."

The RBNZ noted that changing the target, which it is currently overshooting a lot with inflation at 6.7 per cent, would be costly.

Change could also undermine confidence in the RBNZ, or prompt people to think it's "shifting the goalposts" to make it easier for it to reach its target.

The RBNZ said having a higher inflation target would give it the ability to cut the OCR more aggressively in response to economic shocks, even though this could lead to higher prices over time or increased inflation volatility.

On the other hand, having a lower inflation target would reduce volatility and prices/wages changing at different rates. But this could increase the risk of severe economic downturns, by limiting the RBNZ's ability to completely slash the OCR.

What about house prices?

The RBNZ also considered how the Monetary Policy Committee should be made to consider climate change, house prices and the distributional effects of its policies.

Its view was that these issues shouldn't be addressed in the remit, as this creates ambiguity and affects the committee's ability to carry out its role efficiently.

Finance Minister Grant Robertson last year amended the remit to require the committee to assess the impacts its policy has on the Government's housing policy.

The RBNZ believed a "letter of expectation" from the Government might be a more appropriate way for the committee to be made to consider wider economic issues.

The public has until July 15 to make submissions on the review.

The RBNZ will use this feedback to inform a second round of consultation later in the year.

It will then also seek views on the Monetary Policy Committee's charter – the document that sets out the Monetary Policy Committee's meeting processes.

The RBNZ's advice will go to the Minister of Finance in 2023 for a decision on if, and how, the remit and charter will change from 2023 to 2028.