A dual mandate for an already blunt tool

The Reserve Bank of New Zealand (RBNZ) holds a dual mandate with two economic objectives of:

• Achieving and maintaining stability in the general level of prices over the medium term
• Supporting maximum sustainable employment (MSE). 

Under its remit, the RBNZ must also pay consideration to supporting more sustainable house prices. 

The RBNZ recently released its Review and Assessment of the Formulation and Implementation of Monetary Policy (RAFIMP) through the period of 2017 to 2022 – a period of unprecedent and unique social and economic challenges.

The conclusion of the RAFIMP was that the RBNZ acted in an appropriate manner, given the circumstances, adopting a “least regrets” approach to the implementation of monetary policy, which was consistent with achieving its objectives. This approach, a dramatic easing in monetary policy early-on, avoided worst-case economic scenarios. In addition, the use of additional monetary policy (AMP) tools further contributed to monetary policy stimulus.

However, the review acknowledges, in hindsight, that monetary policy should have been tightened earlier in 2021 to help offset the strong inflationary pressure brought on by a combination of supply shocks.

Annual inflation, measured by the Consumers Price Index (CPI), currently sits at 7.2 percent, as of September 2022. At the same time, employment is above its maximum sustainable level, and the unemployment rate is on an upwards trend. Announced on November 23, these conditions were the motivation behind the 75-basis point hike in the OCR, up to 4.25 percent – the highest it has been since the global financial crisis in 2008. 

It doesn’t smash out economic challenges with precision, but it is powerful, and certainly has a heavy impact on households and businesses. And it is for this reason that the setting and implementation of monetary policy must not only rely on economic theory. Rather, as stated in the purpose of the RBNZ, the well-being of New Zealanders must be promoted. 

Take the Taylor Rule for example, which uses inflation and the output gap (level of excess demand in an economy) to set the short-term interest rate (the OCR). This rule is presented by Massey University in their recently released live gross domestic product (GDP) tracker. When applied, it suggests an optimal, and somewhat radical, OCR of above eight percent. An OCR of this level would have an unwieldly impact on households and businesses, squeezing incomes. 

In understanding the formulation and implementation of monetary policy, you must go back to what its primary purpose is. 

The primary purpose of monetary policy is to control and maintain sustainable levels of inflation. However, it is not unusual for central banks to manage employment levels through monetary policy as well, just as the RBNZ does – to some scrutiny. 

The RBNZ’s dual mandate came into legislation during the RAFIMP period in 2018, at a time when inflation was between the target range and unemployment was relatively low. At this point, there was no pressure, or conflicting motives, on the dual mandate. Later in the review period, the monetary policy committees (MPC) remit was amended to ensure consideration towards house price sustainability in 2021, following a period of world-leading house price inflation. 

Dual mandates are historically criticised for adding complexity to an already blunt tool. And they beg the question whether the best outcomes, in terms of sustainable price levels for New Zealanders, are being achieved. Or whether the added complexity is only distracting monetary policy from serving its primary purpose.

It is important to consider the many factors which contribute to employment, some of which are historically and systematically ingrained in an economy, such as labour force skills and immigration settings. Monetary policy itself cannot influence these factors. In fact, there are much more efficient tools and policies available for managing employment levels. 

Acknowledging that we cannot only rely on economic theory alone, and monetary policy must be set with the well-being of New Zealanders at front of mind, is the dual mandate achieving this? Or does the need to target MSE as well only take away from monetary policy achieving sustainable price levels for the well-being of New Zealanders?