When central banks ignore the Tinbergen rule – the case of RBNZ

The news from the global currency markets this morning:

New Zealand’s dollar was set for its biggest three-day drop since 2011 after the Reserve Bank said its sales of the currency in August were the most in seven years. The greenback headed for its best month since 2012

The kiwi dropped against all 31 major counterparts as Prime Minister John Key was reported as signaling that the currency needs to be weaker. Australia’s dollar declined below 87 U.S. cents for the first time since January. The Hong Kong dollar weakened along with equities in the Asian city amid the largest police crackdown on protesters since it returned to Chinese rule. The euro fell to its lowest in 22 months versus the greenback before the European Central Bank meets Oct. 2.

Everything is wrong about this. I normally think that the Reserve Bank of New Zealand (RBNZ) is doing a fairly good job, but over the past couple of years it has become increasingly erratic in its behaviour and seems to be having a problem focusing on its stated objective of keeping inflation close to its inflation target.

Hence, the RBNZ has in recent years had a pre-occopation with the development in the New Zealand property market and household debt etc. and now it is the level of the kiwi dollar, which is on the mind of the RBNZ. And maybe worse the Prime Minister is now also thinking that he should get involved in monetary policy decision making – at least indirectly.

You gotta ask yourself what monetary policy goal the RBNZ have? After all you cannot have the cake and it eat too. That is the Tinbergen rule – you can only have one policy objective for each policy instrument.

The intervention in the currency market seems particularly odd when we remember that the RBNZ is not unlike a lot of other central banks stuck at the Zero Lower Bound – RBNZ’s policy rate the Overnight Cash Rate is 3.5%. Said, in another way if the RBNZ thinks that the strengthening of the kiwi dollar in anyway was threatening its key policy objective (1-3% inflation) then it can just got the key policy rate.

Furthermore, the New Zealand economy does not exactly look like it needs monetary easing – real GDP growth is outpacing potential growth, inflation is within the inflation target range and inflation expectations seem to be quite close to the 2% mid-point of the inflation target range. And any Market Monetarist would of course also notice that nominal GDP growth has been extreme buoyant over the past year (admittedly it is slowing now).


The strong growth in nominal GDP during 2013 to a large extent reflected a sharp rise in New Zealand’s export prices particular higher dairy prices. That trend has changed significantly in 2014 and that has actually put considerable depreciation pressure on the kiwi dollar recently, but apparently there is enough pressure on the kiwi dollar if you listen to Prime Minister John Key and the RBNZ.

Just ask yourself the question what if the kiwi dollar remains “too strong” for the liking of the RBNZ and the Prime Minister and the RBNZ decides to intervene more what would then happen? What is currency intervention? It is money creation. The RBNZ would print kiwi dollar – expanding the money base.

That eventually will spur NGDP growth and with the economy operating at more or less full capacity utilisation this will spur inflation and increase inflation expectations above the RBNZ’s inflation target. So the question is how much higher inflation will the RBNZ be willing to accept to weaken the kiwi dollar? Will it be willing to jeopardize its inflation target?

This demonstrates that the RBNZ only permanently can weaken the kiwi dollar if it is compatible with the RBNZ’s inflation target. Unless of course the New Zealand government is willing to introduce capital and currency controls. That luckily that does not seem to be on the agenda.

If the RBNZ is targeting inflation then the RBNZ will have to accept the level for the kiwi dollar, which is determined by market forces. If it on the other hand wants to target the exchange rate then it fundamentally will have to give up its inflation target.

I don’t think that the RBNZ is going to mess up things dramatically, but the RBNZ’s pre-occopation with the level of the kiwi dollar is yet another example that central bankers around the world still fundamentally have a hard time accepting the logic of the Tinbergen rule. But there is no way around it – you can only have one monetary policy target – the inflation rate, the price level, the NGDP level or the exchange rate. You can’t do it all.

PS I have often argued that central banks in small open economies use the exchange rate as an way implement monetary policy if it is stuck at the Zero Lower Bound and if monetary easing is needed. However, that is not the case for the RBNZ.

PPS Maybe I am wrong and it might just be the case that the RBNZ knows better than the market – just see here (I don’t really think I am wrong…)

PPPS The RBNZ does not exactly have a good experience playing around with quasi-exchange rate targeting. See here.

There is no ’fiscal cliff’ in Japan – a simple AS-AD analysis

It is now very clear that what Milton Friedman advocated the Bank of Japan should do back in the mid-1990s – to expand the money base to get Japan out of deflation – is in fact working. Nominal spending growth is accelerating and with it deflation has come to an end and real GDP growth is fairly robust.

However, some have been arguing the success of Abenomics will be short-lived and that the planned increases in the Japanese sales tax might send Japan back into recession. In other words Japan is facing a fiscal cliff.

In this post I will argue that like in the case of the 2013-US fiscal cliff the fears of the negative impact of fiscal consolidation is overblown and that the risk of recession in Japan is very small if the Bank of Japan keeps doing its job and try to get inflation expectations back to 2%. It is yet another illustration of the Sumner Critique.

All we need is the AS-AD framework

I think it is pretty easy to illustrate the impact of a sales tax increase in a world with a central bank with a credible inflation target within a simple AS-AD framework.

We start out with a Cowen-Tabarrok style AS-AD framework. We use growth rates rather levels and aggregate demand curve is given by the equation of exchange (mv=py).

The graph below is our starting point.


We have assumed that inflation in the starting point already is at 2%. This obviously is not correct, but it does not fundamentally change the analysis of the “fiscal shock”.

Japan’s sales tax will be raised to 8 percent from 5 percent in April and to 10 percent in October 2015, but here we just assume it is one fiscal shock. Again that is not important for the conclusions.

A negative fiscal shock in a Cowen-Tabarrok style AS-AD framework is basically a negative shock to money velocity (v), which will push the AD curve to the left as nominal spending drops.

However, as it is clear from the graph this will initially push inflation below the Bank of Japan’s 2% inflation target. We are here ignoring headline inflation will increase, but we are here focusing on core inflation as is the BoJ. Core inflation will drop as illustrated in the graph below.

inflation target BoJ ASAD

If the Bank of Japan is serious about its inflation target it will respond to any demand-driven drop in inflation by counteracting that with an one-to-one increase in the money base to bring back inflation to 2%.

The consequence of BoJ’s 2% inflation is hence that there will be full monetary offset of the negative fiscal shock and as a consequence inflation should broadly speaking remain unchanged at 2% and real GDP growth will be unaffected. Hence, under a credible inflation target the fiscal multiplier is zero. As in the case of the US there will be no fiscal cliff. There will be fiscal consolidation but not a negative impact on growth.

This of course does not mean that the fiscal shock will not have any impact on the Japanese economy or markets. It very likely will. It is for example clear that if the markets expect the BoJ to step up asset purchases (increase money base growth) in response to fiscal tightening then that would likely weaken the yen further. Something Japanese exporters likely will be happy about. As a consequence the sales tax hikes will likely change the composition of growth in Japan.

Finally, it should be noted that everybody in Japan is fully aware of the miserable state of public finances and as a result it is hardly a surprise to Japanese households that the government sooner or later would have to do something to improve public finances. In fact the sales tax hike was announced long ago. Therefore, we should expect some Ricardian equivalence effects to come into play here – an increase net government saving is likely to reduce net private savings. So even with no monetary offset there is likely to be some Ricardian offset. That in my view, however, is significantly less important than the monetary policy offset.

How aggressive will the BoJ have to be to offset the fiscal shock?

A crucial question of course will be how much additional monetary easing is needed to offset the fiscal shock. Here the credibility of the BoJ’s inflation comes into play.

If the BoJ’s inflation target was 100% credible we could actually argue that the BoJ would not have to increase the money base at all. The Chuck Norris effect would take care of everything.

Hence, if everybody knows that the BoJ always will ensure that inflation (and inflation expectations) is at 2% then when a fiscal shock is announced the markets will realize that that means that the BoJ will ease monetary policy. Easier monetary policy will push up stock prices and weaken the yen. That will in itself stimulate aggregate demand. In fact stock prices will continue to rise and the yen will continue to weaken until the markets are “satisfied” that inflation expectations remain at 2%.

In fact this might exactly be what is happening. The yen has generally continued to weaken and the Japanese stock markets have been holding up quite well even through the latest round of turmoil – Fed tapering fears, Syria, Emerging Markets worries etc.

But obviously, the BoJ’s inflation target is not entirely credible and inflation expectations are still well-below 2% so my guess would be that the BoJ might have to step up quantitative easing, but it is certainly not given. In fact the Japanese recovery is showing no signs of slowing down and inflation – both headline and core – continues to inch up.

A golden opportunity for the BoJ to increase credibility

Hence, I am not really worried about the planned sales tax hikes. I don’t like taxes, but I don’t think a sales tax hike will kill the Japanese recovery. In fact I believe that the sales tax hikes are a golden opportunity for the Bank of Japan to once and for all to demonstrate that it is serious about its 2% inflation.

The easiest way to do that is basically to copy a quite interesting note from the Reserve Bank of New Zealand on “Fiscal and Monetary Coordination”. This is from the note:

“…the Reserve Bank, therefore, is required to respond to developments in the economy – including changes in fiscal policy – that have material implications for the achievement of the price stability target;”

And further it says:

“These… features mean that monetary and fiscal policy co-ordination occurs through the Reserve Bank taking fiscal policy into account as an element of the environment in which monetary policy operates. This approach is to be contrasted with approaches to co-ordination that involve joint determination of monetary policy by the monetary and fiscal policy agencies.”

And finally:

“While demand – and thus inflation – pressures may originate from a range of different sources, the task of monetary policy is to respond so as to maintain an overall level of demand consistent with keeping inflation in one to two years’ time within the target range. For example, if the government increases its net spending, all other things being equal, monetary policy needs to be tighter for a time, so as to slow growth of private demand and “make room” for the additional government spending.”

If the BoJ copied this note/statement then it basically would be an open-ended commitment to offset any fiscal shock to aggregate demand – and hence to inflation – whether positive or negative.

By telling the market this the Bank of Japan would do a lot to reduce the worries among some market participants that the BoJ might not be serious about ensuring that its 2% inflation target will be fulfilled even if fiscal policy is tightened.

So far BoJ governor Kuroda has done a good job in managing expectations and so far all indications are that his policies are working – deflation seems to have been defeated and growth is picking up.

If Kuroda keeps his commitment to the 2% inflation target and stick to his rule-based monetary policy and strengthens his communication policies further by stressing the relationship between monetary policy and fiscal policy – RBNZ style – then there is a good chance that the planed sales tax hikes will not be a fiscal cliff.

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