Wednesday 13th April 2011
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The Reserve Bank of New Zealand (RBNZ) is not moved by a report arguing that the "great recession" the world has just experienced exposed flaws with using inflation as a target of monetary policy.
The RBNZ has been held up as a model central bank with a clear inflation target and independence to pursue it, but economist Scott Sumner argues that such regimes are flawed because they rely on consumer price indicators that are affected by factors not requiring a monetary policy response such as sales taxes and exchange rates.
A report he has written, published by the Adam Smith Institute, advocates the use of a nominal gross domestic product (GDP) target for monetary policy.
"Had central banks pursued nominal GDP targeting during 2008, it is quite likely that both the financial crisis and the recession would have been much milder," the report said.
The RBNZ told NZPA that it considered its inflation targeting regime to be successful.
With the exception of Spain, which joined the European Union, all the countries that followed New Zealand in adopting inflation targeting continued to use it today, the RBNZ said.
The RBNZ said that nominal GDP targeting was a complex, technical approach to monetary policy.
GDP was subject to large revisions, making policy very difficult to communicate.
Also, the RBNZ's policy targets agreement (PTA) with the Government requests that output be taken into account, enabling the bank to respond to broader economic developments than just inflationary ones. The PTA is also very specific about monetary policy not needing to respond to sales tax and other government charges.
Sumner said that nominal income targeting offered several important advantages over inflation targeting, and no significant drawbacks.
If oil prices rose sharply under strict inflation targeting, non-oil prices would have to fall to offset the increase in oil prices. If nominal wages were sticky, the fall in non-energy prices might lead to much higher unemployment.
Nominal GDP targeting would allow a temporary period of above 1.5% inflation, along with somewhat lower output, in order to cushion the blow on the non-oil sectors of the economy.
One of the criticisms of inflation targeting is that because central banks focus on consumer prices, they allow asset bubbles to form, which eventually destabilise the economy.
"Nominal GDP targeting cannot completely eliminate this problem, but it would impose more monetary restraint, as compared to inflation targeting, during periods where output growth was above normal."
Monetary policy could not prevent some loss of output from a housing market slump but it could prevent the shock from unnecessarily spreading to otherwise stable sectors of the economy.
The report said that housing by itself could not explain the great recession.
"Most observers have reversed cause and effect, assuming a simple financial crisis recession transmission mechanism, whereas the actual pattern was much more complex, with lots of reverse causality," the report says.
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