FRBSF Economic Letter
96-25; September 9, 1996
Accountability in Practice: Recent Monetary Policy in New Zealand
Two recent news stories offered examples of dramatically contrasting
relationships between a government and the authority charged with monetary
policy. In Russia, President Boris Yeltsin pressured the Central Bank
of Russia into providing $1 billion for new government spending, even
though officials of the central bank protested that Yeltsin's demands
were a threat to the bank's independence.
In New Zealand, the inflation rate, as measured by the Reserve Bank of
New Zealand's estimate of underlying inflation, was 2.1 percent for the
year ending March 1996. When this statistic was released, the Minister
of Finance immediately issued a press statement demanding an explanation
for this breach of the Reserve Bank's 0-2 percent inflation target. Both
the Chairman of the Non-Executive Directors and the Governor of the Reserve
Bank responded with public letters in which they expressed their concern
over the breach and explained that policies were in place to bring inflation
back within the target range.
It is hard to imagine a sharper contrast: In one case, a politically
dependent central bank; in the other, a central bank with an externally
mandated goal to which the elected officials can hold it accountable.
And both stories offer a contrast to the situation in the U.S., where
the Fed has the independence to resist heavy-handed political pressures
but lacks a clear mandate for which it can be held accountable.
The desire for greater central bank independence and for some
means of assessing central bank performance helps to explain why many
countries are establishing explicit inflation objectives for monetary
policy. The popularity of inflation targeting is based on the belief that
explicit targets lend credibility to low-inflation policies and that explicit
targets provide a transparent means of measuring the central bank's performance.
This type of goal dependence--in which the explicit goal of
monetary policy is defined by the legislative process--combined with the
freedom to conduct policy to achieve the stated goal--often characterized
as instrument independence--does provide a natural measure of
the success or failure of policy. But what actually happens if the goal
is not achieved? This question is particularly appropriate when, as is
the case in some countries, the central bank itself has adopted an inflation
targeting objective or where the target inflation rate is based on a measure
produced internally by the central bank.
A review of New Zealand's recent experiences with inflation targeting,
focusing on whether the policy reforms there have succeeded in establishing
a framework with clear goals and a mechanism for accountability, offers
some lessons for other countries moving towards the adoption of targets
Many nations have revised their central banking structures over the past
five years, but New Zealand's Reserve Bank Act of 1989 continues to remain
a focus of interest for several reasons. First, New Zealand was in the
vanguard of the recent wave of central bank reforms, and as such provided
an early example for other nations looking to insulate their central bank
from direct electoral influences. Second, the New Zealand approach is
the most explicit attempt to establish a policy structure that includes
means to ensure accountability. Third, and perhaps most importantly, New
Zealand has enjoyed remarkable success in achieving and maintaining relatively
low rates of inflation, rates that certainly represent a contrast from
its earlier history. From 1973-1985, for example, New Zealand's inflation
rate averaged over 12 percent, compared to roughly 7 percent in the U.S.
And while average inflation in the U.S. averaged only 3.8 percent from
1986 to 1992, it was 6.9 percent in New Zealand. However, between 1992
and 1994, the inflation rate in New Zealand, at 1.35 percent, was less
than half that experienced in the U.S.
The basic outlines of the New Zealand reforms are well known (see, for
example, Walsh 1995). Price stability is defined by the legislative act
as the sole objective of monetary policy, and the actual implementation
of policy is guided by the Policy Targets Agreement (the PTA) between
the Minister of Finance and the Governor of the Reserve Bank. A mechanism
for holding the Reserve Bank Governor accountable was written into the
Act by (1) making the Governor directly responsible for the conduct of
monetary policy, and (2) allowing for the Governor's dismissal if the
goals established in the PTA are not met.
The PTA's have defined the target to be 0-2 percent inflation as measured
by the Consumer Price Index (CPI). Exceptions that would allow the range
to be exceeded include various supply side shocks (increases in indirect
taxes or government charges, livestock diseases, terms of trade shocks,
etc.). In such cases, the Reserve Bank Act allows the government and the
Reserve Bank to negotiate a new PTA.
This structure makes responsibility clear: The Governor, and not a committee
such as the FOMC, is responsible for policy decisions, and success or
failure to fulfill the goals of the PTA are transparent--the inflation
rate as measured by the CPI is frequently available and widely publicized.
How has this structure worked in practice? Spiegel (1995) argued that
the Reserve Bank of New Zealand appeared to be operating under a "two-tiered"
system: As long as CPI inflation remained below 2 percent, the Reserve
Bank enjoyed full independence; whenever inflation rose above 2 percent,
however, some degree of independence was lost because the Reserve Bank
was forced to justify its policies.
During the last two years, however, this is not quite how the system
has worked. As CPI inflation rose above the 0-2 percent range in late
1994, the Reserve Bank focused more and more on its own measure
of inflation, the so called "underlying rate." And the CPI inflation
rate started being referred to in Reserve Bank publications as the "headline"
At the time, there were reasonable grounds for skepticism over these
developments. After all, one of the attractive features of the New Zealand
policy framework was its carefully designed mechanism for accountability.
Letting the Reserve Bank define its own inflation rate, especially one
that looked like it would peak at just under the 2% upper limit allowed
under the PTA, would appear to have threatened the whole notion of accountability.
In fact, however, the Reserve Bank has maintained its credibility. The
two-tiered system Spiegel identified is now based on the Reserve Bank's
own measure of inflation. In response to the recent very small deviation
of the underlying rate above 2 percent, the Bank Directors stated that
they "regret the 0 to 2 percent underlying inflation target range
has been breached..." (Sir Peter Elworthy to Rt. Hon. W.F. Birch,
Minister of Finance, 19 April 1996) and they publicly reaffirmed their
commitment to the 0-2 percent range. The Directors also affirmed their
support for the job being done by the Governor, stating that the breach
should not "call into question the Governor's performance or his
Notice that the statement says that the inflation target range applies
to "underlying inflation"; that is, the Reserve Bank is to be
judged by whether a statistic that it constructs remains within the target
range. Interestingly, underlying inflation for the year ending July rose
further to 2.3 percent, while headline inflation fell to 2.0 percent.
A policy regime with a clear goal, defined in terms of an easily observed
measure, facilitates policy accountability. But the use of actual inflation,
whether measured by the central bank or not, raises a variety of implementation
One problem arises because the CPI may not be the appropriate measure
of inflation. In New Zealand, for example, the inclusion of interest costs
in the CPI means that contractionary monetary policy--policy that boosts
interest rates in the short term--increases inflation as measured by the
CPI. This provides a misleading indicator of policy and is a major reason
the Reserve Bank shifted focus away from the CPI. There are also many
factors in addition to policy actions that affect the inflation rate,
so the central bank's ability to control inflation is imperfect, and the
central bank's performance evaluation should not be based on the effects
of unforeseen events.
But perhaps most importantly, a breach of the target range reveals something
about monetary policy a year or more earlier; it says little about whether
current policy is appropriate. Thus, while using the actual variable in
terms of which the goal of policy has been defined as a measure of performance
has much to commend it, it also has problems: It can be misleading or
it can simply provide an assessment of policy that comes too late.
Lars Svensson (1996) has suggested that inflation forecasts may solve
some of the difficulties that arise in using actual inflation in an inflation
targeting system. Inflation forecasts have all the desirable properties
of a good intermediate target. For example, such forecasts are highly
correlated with the variable of ultimate interest, i.e., the actual rate
of inflation. Furthermore, they are more easily controllable than the
actual rate of inflation. In fact, just as was the case with the Reserve
Bank Act of 1989, perhaps New Zealand is again out in front. According
to a description of policy by Mayes and Riches (1996) in the Reserve Bank's
Bulletin, "The current operational framework employed by
the Reserve Bank is based directly on forecasts of inflation" (p.
If the central bank's forecasting model is made public, inflation forecasts
could provide a transparent measure of how well the central bank is doing.
Of course, central banks might have an incentive not to reveal their true
forecasts, but in this case, market expectations or private forecasts
of inflation could play a role in assessing the job being done by the
During the 1990s, New Zealand has achieved one of the most enviable inflation
records, and several lessons can be drawn from this experience. First,
the establishment of explicit goals contributes to the transparency of
monetary policy. But these advantages are diminished if performance is
based on internally generated statistics. The successful period from 1991
until 1994 in which "headline" inflation was brought down to
and kept within the 0-2 percent range was undoubtedly critical in establishing
the policy credibility needed for markets to accept the Reserve Bank's
"underlying" inflation measure. So despite the formal reforms
in New Zealand, the Reserve Bank still had to earn credibility by actually
delivering low inflation.
Second, a strict inflation targeting regime is probably not feasible
because it ignores the effects of supply side disturbances to the economy.
That is why the Reserve Bank has been successful in shifting the debate
away from "headline" inflation and onto its measure of underlying
inflation. This implicitly allows it to adjust its inflation target in
light of supply side disturbances while still maintaining the transparent
framework provided by inflation targeting.
Third, inflation targeting, in practice, is likely to mean inflation
forecast targeting. So either market-based expectations or the central
bank's own internal forecasts, made public, should be used to assess the
conduct of policy. Perhaps the introduction of inflation-indexed bonds
in the U.S., which would allow a market-based forecast of inflation to
be derived from the interest rates on indexed and nonindexed bonds, will
serve a useful role in providing an assessment of U.S. monetary policy.
Carl E. Walsh
Professor of Economics
University of California, Santa Cruz
Federal Reserve Bank of San Francisco
Mayes, David G., and Brendon Riches. 1996. "The Effectiveness of
Monetary Policy in New Zealand." Reserve Bank of New Zealand Bulletin
56 (1) (March) pp. 5-20.
Spiegel, Mark. 1995. "Rules vs. Discretion in New Zealand Monetary
Policy." FRBSF Weekly Letter 95-09 (March
Svensson, Lars E.O. 1996. "Inflation Forecast Targeting: Implementing
and Monitoring Inflation Targets."Institute for International Economic
Studies, Stockholm (June).
Walsh, Carl E. 1995. "Is New Zealand's Reserve Bank Act of 1989
an Optimal Central Bank Contract?" Journal of Money, Credit and
Banking 27(4) pt. 1 (November) pp. 1179-1191.
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. Mail comments
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