Why Time Consistent Monetary Policy Matters

The other week I explained why Bernard Hickey is wrong about the likelihood of the Greens, NZ First and Labour changing the Reserve Bank’s mandate and reducing central bank independence.

One of the reasons why central bank independence is important is because it affects inflation expectations. When inflation is expected to be higher, the nominal interest rate will increase to account for inflation lowering the real value of money lent to the government.

What this means for the New Zealand government’s finances is that the cost of servicing debt will rise. This means that in exchange for chasing after kooky policy goals like full employment and lowering the exchange rate, there is an increase in the risk premium on New Zealand government debt.

Time consistency of policy is an economic concept that in order for the government and Reserve Bank to be taken seriously, they have to commit to a policy in advance and not suddenly change their tune.

The Reserve Bank currently does this through their regular statements that accompany Official Cash Rate decisions and a plethora of working papers, articles and market updates throughout the year that give a clear indication of what the Reserve Bank thinks on topical monetary policy issues.

If the troublesome troika get their hands on rewriting the Reserve Bank Act after 2014, a substantial rise in the risk premium payable ultimately by taxpayers through lower government spending and higher taxes, is inevitable.

The independence of the Reserve Bank and provisions of the Public Finance Amendment Act mean that the New Zealand government can borrow to finance deficit spending but nowhere near to the extent that many other countries can.

In effect, there is a built in dilution effect that means kooky ideas cannot run their true course. A Greens/Labour/NZ First coalition would not be taken seriously by market participants. When that scenario becomes likely as John Key’s popularity subsides, forward interest rates and exchange rates will reflect that.

Any step towards reducing the Reserve Bank’s independence runs the risk of far higher debt servicing costs for the government. This means less money for things New Zealanders care about like welfare and hospitals, and a widening revenue gap needing to be plugged by higher taxes.

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