Aide-Memoire: Appointment Of A Governor - Process And PTA Issues
T2002/1088 (19 August 2002)
Introduction
At 3.00pm Wednesday 21 August you are scheduled to meet with Iain Rennie, Struan Little, and Brendon Riches from the
Treasury to discuss the process for appointing a new Governor and drafting a Policy Targets Agreement.
This aide-memoire:
Summarises the main points for the Treasury's recent report Appointment of a new Governor: policy targets and
relationship expectations (T2002/1068);
Proposes a process for drafting a PTA and confirming a Governor's appointment before you depart overseas on 21
September;
Outlines two possible options for the form, content and structure of the policy targets agreement; and
Suggests that, depending on the option for the PTA that you prefer, the Treasury, in consultation with the Reserve Bank
and your office, provide you with a draft PTA for discussion with the Governor designate.
Summary Of The Treasury's Report
The Treasury report entitled Appointment of a new Governor: policy targets and relationship expectations (T2002/1068)
may be summarised as making 3 key points:
It may be useful to think about the Bank's inflation objective as an average rate of inflation to be maintained over the
medium-term.
Maintaining an average inflation rate of around 2% would be consistent with the average inflation rate over the last 10
years and may, at the margin, better anchor inflation expectations, which in turn may enable a less active monetary
policy.
Forming and maintaining an effective and productive relationship with the Governor through regular consultation on
economic issues is an important element of sound macroeconomic coordination.
Process Issues
a) Appointment of a Governor
We understand that:
you may receive a recommendation for Governor from the Board before the end of August;
there is public speculation that the Governor and the new PTA will be made public by the end of September;
you will be overseas from 2-9 September and 21 September to 2 October; and
a Governor must, under the Act, assume office by 13 November 2002.
While tight, we believe that it is possible for you to confirm the appointment of a Governor and a new PTA prior to your
trip overseas on 21 September.
To achieve this you will need to:
1) Undertake any necessary consultation about the recommended candidate before 2 September. You may also wish to consult
on the PTA process and principles that you will be seeking in a PTA.
You may need to consult with: your coalition partner; your Cabinet colleagues; and United Future. Therefore it is
desirable that you receive the Board's nomination sooner rather than later.
We suggest that you or your office contact the Board to confirm when a nomination can be expected.
2) Take a paper to Cabinet APH/Business Committee on your return - 11 September is the first possible opportunity. This
paper would note your intention to appoint a Governor and could also note the principles that you will be seeking
agreement on. To make the agenda you, or in your absence one of your colleagues, will need to submit a paper to the
Cabinet Office while you are overseas.
3) Take a paper to Cabinet the following week - Monday 16 September.
You may wish to inform your Cabinet colleagues of the new PTA at the full Cabinet meeting on 16 September. It may not be
feasible to provide a PTA for the APH/Business Committee, but you may wish the Committee to note that you intend to
provide a copy at the meeting of the full Cabinet.
To be in a position to provide Cabinet with a draft PTA you will need to meet with the Governor designate to get
agreement to the PTA (but not signed) during the week 9 - 13 September. A draft can then be taken to Cabinet on Monday
16 September.
4) Following Cabinet's consideration request the Board to provide you with an employment contract for the Governor
designate. You should then meet with the Governor designate to sign the PTA and the employment contract.
The alternative to this timetable is to wait until October to finalise the appointment and the PTA. In this case you may
wish to make a public announcement of your expectation of the appointment timetable and reduce unnecessary speculation.
Calendar
Key dates Events/Actions required
21 August - 1 September Meet with the Treasury
Discuss appointment/PTA process and timetable with the Board
Receive nomination
Undertake and complete consultation
2-9 September Overseas
10-15 September Cabinet Business Committee/APH considers appointment (Wednesday 11 September)
Discuss and confirm PTA with Governor designate
16-20 September Cabinet considers appointment and PTA (Monday 16 September)
Caucus consideration
Sign PTA and employment contract with Governor
Public announcement
21 September - 2 October Overseas
13 November Governor's takes office (at latest)
b) The Policy Targets Agreement
Should you wish to revise the existing PTA there are two broad options:
Option 1:
Retain the form, content, and structure of the existing PTA to the largest extent possible and modify only where
necessary to achieve the desired outcome.
The key reasons for making only limited change are that there is a value in continuity and that the risk of inflation
expectations rising can best be managed by retaining a strong link to previous targets.
Or
Option 2:
Retain the intent of the existing PTA but alter its form and content to include, for example, the following elements:
the Government's economic policy objectives and the role of monetary policy within that;
the specific inflation objective;
the nature of the relationship you expect to have with the Governor; and
the accountability of the Governor.
The key reason for making more extensive change would be to signal to the Board and the public that a more consultative
approach, consistent with operational independence, is to be adopted.
Clearly, if you favour the latter option, considerably more attention will need to be given to drafting a suitable
agreement. One approach could be for the Treasury to work though your office and in consultation with the Reserve Bank,
to undertake this work during your first absence overseas.
The Treasury has given some thought to how an agreement under each option might look. To assist in progressing this
further the following table seeks your feedback on the main issues raised in this PTA and on the options for a PTA.
Some possible changes to the PTA Agree/disagree or indicate alternative preference
The inflation objective be expressed and interpreted as a medium-term objective such as "over the medium-term ahead".
The policy target (over the medium-term ahead) be an average of about 2% per year.
The target have bounds of +/- 1% where the Bank must take particular care to explain the circumstances for the
divergence and how inflation will get back to target.
The PTA recognise that while the Bank has a duty to act independently, this does not mean acting alone or in isolation,
and that the Bank will undertake regular consultation with the Government and other external parties (such as employer
and business groups, and employee groups).
Options for the form, content and structure of the PTA
Changes to the PTA be limited to the inclusion of the amendments proposed above.
The PTA be revised more substantially to reflect a move towards a more relationship oriented agreement, while retaining
continuity where appropriate.
Elements of this agreement could include:
a statement of the Government's economic policy objectives, the role of monetary policy within that;
the relationship of the Government and the Bank;
specification of the price stability target and recognition of the flexibility implied by that specification; and
how the Governor will be held accountable for his/her performance, including the role of any bounds around the target,
the role of the Board, Parliament and transparency in achieving that.
Recommendations
We recommend that you:
a. note that a new Governor needs to assume office by 13 November 2002.
b. note that it is feasible to confirm the appointment of a new Governor and a new PTA by mid-September, but that the
timeframe is quite tight and will require consultation to be completed prior to your departure abroad;
c. note that it is feasible to inform your Cabinet colleagues of the new PTA and of your intention to appoint a Governor
at the Cabinet meeting on 16 September. It may not be possible to provide a PTA for the APH/Business Committee the
preceding week, but you may wish to note your intention to provide a PTA to the full Cabinet;
d. note that the alternative is to wait until your return in early October to confirm a new PTA and the appointment of a
new Governor; and
e. agree that you or your office contact the Board to confirm when a nomination can be expected.
Struan Little
for Secretary to the Treasury
*************************
Appointment of a New Governor: Policy Targets and Relationship Expectations
T2002/1068 (14 August 2002)
Executive Summary
The appointment of a new Governor of the Reserve Bank provides an appropriate and timely opportunity for the Government
and the Governor (designate) to set out clearly their mutual understanding of the operation of monetary policy in New
Zealand.
You have expressed some concern that the Reserve Bank is interpreting the Policy Targets Agreement (PTA) in a manner
that differs from your understanding. You have signalled your intention to revise the PTA in a way that makes clear your
intentions with respect to the flexible management of monetary policy, consistent with the maintenance of price
stability, so as to be supportive of maximising growth.
This report considers how the PTA could better incorporate these features and limit the potential for differences in
interpretation to arise in the future.
This report makes the following points:
Price stability is important for sustained economic expansions.
Considerable gains have been made in generating broad acceptance that price stability will be an enduring feature of the
New Zealand economy.
The optimal degree of price stability is generally considered to be consistent with average inflation rates of between 1
and 3 percent per year.
In practice, most inflation targeting central banks have inflation targets, or target mid-points of either 2% or 2½% per
year.
When inflation expectations are firmly held, or well anchored, the central bank has some latitude to allow inflation to
deviate from its target in the short-run without an immediate or large response. A gradual and measured policy response
to disturbances helps to reduce variability in the real economy.
The measure of CPI inflation the Reserve Bank targets has averaged around 2% over the last 10 years. Available evidence
suggests that medium-term inflation expectations are also around 2%.
Greater specificity of the expected average inflation rate than provided by the current 0 to 3 range may provide a
better anchor for inflation expectations. This may enable a less active approach to monetary policy.
We understand that you wish to retain the 0-3% range for inflation outcomes but make it clear that the full range will
be used. One way this could be achieved is to make explicit the medium-term nature of the target. This would make it
clear that the benchmark for accountability is inflation outcomes over a run of years and would reduce the significance
of single outcomes outside the range.
However, there may be advantages in more clearly identifying the average rate of inflation that monetary policy should
seek to achieve. In practice the Bank will choose an operational target from within the agreed range that best enables
it to meet its medium-term objective of delivering inflation outcomes within that range. Financial markets will also
choose a point from within the range that reflects their expectations of inflation outcomes.
By shifting the focus of the target more clearly to a medium-term average level of inflation you will reduce the risk of
a divergence between the Bank's medium-term accountability and its operational target. For example, in Australia the
benchmark for performance is whether the Bank has achieved 2-3% inflation on average, over the cycle. In the UK the
operational target, as specified by the Chancellor, is an underlying inflation rate of 2½% per year.
A clear focus on the medium-term average inflation rate can be achieved while also retaining the 0-3 percent range of
acceptable inflation outcomes, and there is a range of specifications of the PTA that can achieve this. These include
emphasising the medium-term nature of the current target and the "soft" nature of the edges of the range.
The Treasury's preferred specification of the target is:
An explicit "medium-term" horizon for achieving the inflation target. This will encourage flexibility by ensuring that
accountability is for inflation outcomes over a run of years.
The medium-term inflation objective be focused on an explicit rate. An explicit medium-term average of around 2% would
be consistent with medium-term inflation expectations and may provide a stronger anchor for inflation expectations.
The medium term target have bounds of +/-1 per cent that encompasses the outcomes for inflation that are most likely to
occur and where the Bank must give particular attention to reporting on outcomes, or expected outcomes, outside the
range and what it intends to do to bring inflation back to target, so that the public can be assured that inflation is
on track to achieve its objective.
There is a risk that financial markets and the public perceive a change to the PTA as leading to higher average
inflation rates. If inflation expectations are raised this will be reflected in higher nominal interest rates. This risk
can best be managed by reaffirming the Bank's operational independence in pursuit of its inflation objective and by
demonstrating the Government's commitment to price stability.
The Policy Targets Agreement is an important step in helping to build your relationship with the Governor. There is a
limit though to what a PTA can achieve. It is hard to specify in a PTA document those aspects of monetary policy that
are qualitative and judgemental. This means that both the PTA and operational independence should be seen to support a
broader relationship that enables you and the Governor to discuss and consider the medium-term objectives of monetary
policy. They also support a relationship that encompasses the other functions of the Bank.
Developing opportunities for discussion on monetary policy, and economic developments more generally, outside of the
current Monetary Policy Statement briefings may help facilitate this kind of interaction. We suggest a number of other
actions that could you help build an effective and productive relationship while maintaining the Bank's independence.
The Reserve Bank Board of Directors has an important role in monitoring the performance of the Bank and ensuring that
the Governor is held accountable for her/his performance in meeting the policy targets. Clearly the Board needs to also
share the interpretation of the PTA if the Governor is not to receive mixed signals. Regular discussions with the Board
will help minimise the possibility of mixed signals.
The Treasury can assist you in building and maintaining these relationships in a number of ways. We can monitor and
provide alternative advice on issues and developments relevant to monetary policy, provide advice on Board appointments,
and prepare briefings to facilitate your meetings with the Board.
There are a number of practical steps required to finalise a new PTA and formally appoint a Governor. These include
consultation with the Board about when you can expect a recommendation for appointment, discussion about the PTA with
the Governor designate, and informing your Cabinet colleagues of the person you intend to appoint as Governor. Appending
the new PTA to the Cabinet paper on the Governor's appointment would be one means of keeping your colleagues informed of
your intentions. We suggest that you or your office discuss with the Board the process you intend to follow.
We have discussed the views in this paper with the Reserve Bank.
Recommended Action
We recommend that you:
i) note the contents of this report;
ii) agree to discuss this report with the Treasury and how we can assist you further in the process for agreeing a PTA
and appointing a new Governor; and
agree/disagree
iii) agree that you or your office discuss with the Board the process you intend to follow.
agree/disagree
Struan Little
for Secretary to the Treasury
Hon Dr Michael Cullen
Treasurer/Minister of Finance.
Treasury Report: Appointment of a Governor: Policy Targets and Relationship Building
Purpose Of Report
1. The purpose of this report is to advise you of the possible benefits and risks of a revised Policy Targets Agreement
(PTA). We also consider the desirability of building a relationship with a new Governor that fosters a shared
understanding of the objectives of monetary policy and reaffirms the Governor's duty to exercise independent authority.
Introduction
2. At present there appears to be some concern that the Reserve Bank is interpreting the Policy Targets Agreement in a
manner that differs from your understanding. You have announced your intention to seek to revise the PTA so that it
clearly expresses the Government's intentions with respect to the flexible management of monetary policy, consistent
with the maintenance of price stability, so as to be supportive of maximising sustainable economic growth.
3. This report tries to give some practical content to this policy. It considers a range of factors that emphasise the
importance of maintaining inflation expectations at their present levels. We also emphasise the importance of
reaffirming the Governor's independence in building and maintaining an effective and productive relationship with the
new Governor.
Price Stability And Monetary Policy
4. Monetary policy in New Zealand is governed by the Reserve Bank Act 1989. This Act, while recognising the Crown's
right to determine economic policy, provides for the Reserve Bank to be responsible for implementing monetary policy
that promotes price stability.
5. Section 9 requires the Treasurer/Minister of Finance, before appointing a Governor, to agree with the Governor
designate, "policy targets for the carrying out by the Bank of its primary function during that person's term of office,
or next term of office, as Governor".
6. The Policy Targets Agreement makes the price stability objective operational. The PTA is a public document that forms
a central component of the Bank's mandate and accountability. The Governor's responsibility to independently determine
monetary policy that is consistent with the PTA promotes public confidence in the Bank's ability to deliver on its
mandate.
7. Since the Act came into effect in 1989 the policy targets have been expressed in terms of a target for inflation. An
increasing number of other countries have adopted the "inflation targeting" approach to price stability. There are
alternatives to an inflation target but it is not clear that they are superior, and some alternatives, such as monetary
targets, are likely to be inferior.
8. There is broad agreement that over long time horizons the economic impact of monetary policy is largely confined to
the prices of goods and services. By seeking to stabilise prices monetary policy contributes to a stable environment for
businesses and households to make saving, investment, and consumption decisions. An inflation target contributes to a
stable environment for the real economy by providing a nominal anchor: an anchor for prices and wages; and expectations
of future prices.
9. Equally, there is broad agreement that over shorter time horizons monetary policy has a significant economic impact
on real factors such as the quantity of goods and services produced and sold. This means that monetary policy can also
help to stabilise the real economy.
10. An environment of stable prices will help to maximise the length of economic expansions. There is considerable
evidence that countries can only have sustained expansions if they are accompanied by low inflation. Thus another way of
expressing the aim of monetary policy is to say that its aim is to maximise the length of the economic expansion and
delay and reduce the size of any subsequent recession.
11. In the past, particularly over the 1970s and early 1980s, New Zealand's monetary policy contributed to the boom and
bust cycle that characterised the economy. This experience showed that monetary policy that is expansionary or
contractionary for too long requires a larger adjustment than would otherwise be necessary.
12. In contrast, recent research by the Treasury suggests that over the 1990s monetary policy has helped to stabilise
the economy 1. The experience over the 1990s showed that monetary policy best achieves its goal of prolonging expansions
by responding early to clear signs of inflationary or deflationary pressure. That is, monetary policy will be tightened
earlier if monetary policy is aiming to prolong the expansion than if it is only seeking higher growth for a year or so.
13. Responding early, or pre-emptively, to inflationary pressures needs to be tempered where there is uncertainty about
the outcomes. In this case a more gradual approach may be beneficial. Over the 1990s the Reserve Bank has enhanced its
credibility and reputation for delivering low and stable inflation, which has led to reduced inflation expectations.
With inflation expectations low and firmly anchored the Bank has been able to take an increasingly gradual and moderate
approach to monetary policy, aiming to achieve its inflation target at longer horizons. It also accepts that inflation
will sometimes be away from its target, sometimes by quite a bit.
14. We agree with conclusion of the Independent Review of the Operation of Monetary Policy in New Zealand that the
Reserve Bank's current approach is "entirely consistent with the best international practice of flexible inflation
targeting" 2. Many financial market commentators also support this conclusion.
15. However the Independent Review did make a number of recommendations for improving further the operation of monetary
policy. On the PTA Svensson argued that:
The policy target should be interpreted as a medium-term target, consistent with flexible inflation targeting;
A point target provides a superior anchor for inflation expectations;
The policy target in the PTA should be interpreted as a point-target of 1.5%; and
The edges of the target should be interpreted as "soft", in the sense that they do not constitute thresholds for policy
adjustment.
16. Svensson could not find any strong evidence suggesting that 1.5% might not be an appropriate level for the inflation
target. He saw a risk that an increase in the target level for no good reason might easily be interpreted as lessening
the commitment to price stability and be detrimental to the credibility of the monetary policy regime.
17. We agree in large measure with Svensson but in our judgement aiming to maintain average inflation at around 2% would
be more credible and enduring. We detail the reasons for this below.
The Inflation Target
18. The appropriate level of inflation to target can be motivated by considering the costs and benefits of inflation.
Changes to the target may also impose costs and benefits and it is important to consider these.
19. There are a wide range of expert opinions and a long literature about what the optimal degree of price stability is.
Views range from the undesirability of any inflation to there being little real harm of rates of stable inflation up to
about 8%. However, the weight of opinion appears to be that aiming to achieve average rates of inflation of between
about 1 and 3 percent appropriately balances both the costs and benefits of inflation.
20. In practice most countries that have adopted explicit inflation targets have chosen targets centred on either 2%
(Canada, Israel, and Sweden), or 2½% (Australia, UK, Iceland, and Norway) 3. Within these targets there is considerable
variation on whether a band or point is specified, and whether the target applies continuously or over the medium term.
21. The three most commonly cited reasons for an inflation target above zero are:
Inflation is difficult to measure accurately and is thought to overstate the true rate of inflation. Improvements in the
quality of goods and services over time and the ability of consumers to substitute away from goods whose prices have
risen, or towards shops with lower priced goods are difficult to capture in CPI measures. Recent work in New Zealand
suggests that the CPI may overstate the true rate of inflation by about 1% per year 4. Past estimates have suggested a
figure of about 0.5% per year.
Nominal wage reductions are relatively unusual so some inflation may allow employers to lower real wages. Without a
mechanism for lowering real wages in times of economic stress employers would have to lay off workers. The implication
is that some inflation may assist the operation of the labour market and permit a higher level of output and employment
to be sustained. There is some New Zealand evidence to support the view that money wage reductions are relatively
infrequent 5.
Low average rates of inflation accompanied by low nominal interest rates may restrict the ability of the central bank to
stimulate an economy out of recession. Because nominal interest rates cannot fall below zero the Bank may find it
difficult to engineer negative real interest rates and so promote demand in the economy.
22. In New Zealand the probability that the zero bound on nominal interest rates would prove binding is at present quite
low. Nominal interest rates are currently considered to be neutral at rates of around 5.5% to 6.5% providing substantial
room for interest rate cuts to stimulate the economy. The exchange rate also has a powerful influence on aggregate
demand in the economy and provides an additional means for stimulating the economy. Nonetheless, monetary policy becomes
more difficult when interest rates hit zero because the normal channels for policy are no longer operative.
23. The importance of inflation for helping the labour market to adjust is more difficult to assess in New Zealand. We
have a reasonable degree of product and labour market flexibility; generally considered to be less than the US, about
the same as Australia, and more than the EU 6. This suggests that while it may be an important factor to consider we
should not overstate its importance.
24. This leads us to concur with the international evidence that an appropriate average for an inflation target in New
Zealand is probably between 1 and 3 percent. Within the 1 to 3 percent range there is no strong evidence to suggest any
substantive differences in long-term economic performance arising from different average levels of inflation.
25. This does not mean that we should be indifferent about rates of inflation within this range. There is no reason to
accept higher average rates of inflation than at present if there are no benefits. Rather having regard to the past
costs of achieving current low levels of inflation we should continue to seek ways to ensure that we remain in a
position to reap the benefits.
Locking in expectations
26. The following graph shows that since inflation fell below 2% at the end of 1991 the targeted rate of inflation
(which has not always been headline CPI) has never been below 1%, it has sometimes been below 1.5%, and most of the time
it has been between 1.5% and 2.5% per year (over 60% of the time). Inflation has been between 1% and 3% per year about
90% of the time. The average inflation rate over the period 1992-2002 is around 2%. Since 2000 the average has been
about 2.5%.
27. Medium-term measures of inflation expectations, which look though the impact of business cycles on inflation, such
as Consensus and the Aon 7-years-ahead inflation expectations survey show inflation expectations to have been around 2%
since 1997. However these surveys only measure the expectations of financial market analysts and may not be
representative of the expectations of the wider population.
28. Broader shorter horizon surveys such as the National Bank 12-month ahead survey show that inflation expectations
tend to move in the same direction as the inflation rate. Inflation expectations in this survey have averaged about 2.5%
since the start of 1997. Although not too much can be read into these survey measures together they suggest to us that
medium-term inflation expectations are probably anchored at around 2%.
29. When inflation expectations are firmly held, or well anchored on the inflation target, the central bank has some
latitude to allow inflation to deviate from its target in the short-run without an immediate or large response. This is
because expectations of low inflation create a strong tendency for actual inflation to revert back to target and,
everything else equal, means that monetary policy needs to be less active. When inflation expectations remain stable
interest rates and output need to move less to bring inflation back to target. A gradual and measured policy response to
bring inflation back to the target helps avoid unnecessary variability in the real economy, particularly when the
economic outlook is uncertain.
A flexible inflation target
30. We understand that you wish to retain the 0-3% range for inflation outcomes but make it clear that the full range
will be used. One way this could be achieved is to make explicit the medium-term nature of the target. This would make
it clear that the benchmark for accountability is inflation outcomes over a run of years and would reduce the
significance of single outcomes outside the range. This may reduce the proclivity for a monetary response whenever
inflation threatens to go above the target.
31. By explicitly shifting the focus of accountability to the medium-term, greater flexibility in terms of the desired
time horizon for bringing inflation back to target, may also be encouraged. Consistent with current practice it would
better recognise that the desired horizon balances risks to both output and inflation and it would reinforce the
incentives on the Governor to operate policy in this way.
32. Because there is no clearly specified horizon for meeting the inflation objective a medium-term focus could be seen
to weaken the accountability of the Governor. But to a large degree this change would reflect current practice although
it would help to make clear that practice. It would also be more consistent with the length of the Governor's term of
office, when performance must taken into account when considering reappointment.
33. One difficulty with a broad range is that in practice the Bank will choose an operational target from within the
agreed range of acceptable outcomes that best enables it to meet its medium-term goal. This is the primary reason the
Bank currently targets the mid-point of the range.
34. Being more specific about the average rate of inflation that the Bank should aim to achieve will reduce the risk of
a divergence between the Bank's medium-term accountability and its operational target. For example, in Australia, the
benchmark for performance is whether the Bank has achieved 2-3% inflation on average, over the cycle. In the UK the
operational target, as specified by the Chancellor, is an underlying inflation rate of 2½% per year 7.
35. Another good reason for providing greater specificity of the inflation goal than provided by the 0 to 3 percent
range is that it would, at the margin, provide a better anchor for inflation expectations. As noted above, the better
anchored are inflation expectations on the target, the less quickly monetary policy needs to respond to inflationary
shocks and the more gradual and measured its response to return inflation to target.
36. In our view explicitly aiming for average inflation outcomes of around 2% over the medium-term has a number of
advantages:
It would be in line with current inflation expectations. This would overcome the concern that monetary policy needs to
continue to work through higher interest rates and lower output to achieve inflation expectations anchored on the
current mid-point;
It would be consistent with inflation targets in other countries, reducing the risk that it is seen as "too low";
It might enhance the ability of the Bank to anchor inflation expectations and permit a less active approach to policy;
and
It would reduce the risk of a divergence between the Bank's medium-term accountability and its operational target.
37. The key disadvantage is that it would be higher than the mid-point of the current range creating a risk that
inflation expectations increase. This is particularly likely if this change creates a perception that further upward
revisions will be made in the future. Reaffirming the duty of the Governor to act independently, and the accountability
of the Governor for achieving the target can help mitigate these risks. Demonstrating the Governments commitment to
price stability, such as by maintaining an appropriate fiscal policy, may also be beneficial.
Some options for the inflation target
38. Adopting the goal of maintaining medium-term inflation at around 2% in each case, there are a number of options for
specifying the target:
a. 12 monthly increases in the CPI of between 0 and 3 percent over the medium term.
In practice the Bank would operationalise this by choosing a specific operational target. The mid-point is the natural
target although an asymmetric operational target such as 2% is feasible. But an asymmetric target would indicate a
preference for outcomes above 1%. The argument could then be made that, in the interests of transparency, it would be
better if the "true" range of 1% to 3% were explicit.
b. 12 monthly increases in the CPI of between 1 and 3 percent over the medium term, with an explicit operational target
of 2% (as in Canada). Alternatively, expressed as an Australian style thick point, the target would be inflation between
1½% to 2½% on average, over the cycle.
Both approaches increase the focus on 2% as the medium-term outcome and may therefore better anchor inflation
expectations. They exclude inflation below 1% as an appropriate medium-term rate of inflation. In the Canadian approach
the bounds around the central point should be interpreted as encompassing the range of inflation outcomes that are
likely to occur most of the time. They should the seen as expressing the inherent uncertainty in forecasting inflation
and not as a measure of indifference to inflation outcomes within the range. The Australian approach de-emphasises the
mid-point and does not say much about the variance of inflation but can be interpreted as meaning that inflation will
fluctuate around a stable mean of somewhere around 1½ and 2½ percent.
One disadvantage with the expressing the target as medium-term or as an average is the potential for confusion about
whether this means that inflation outcomes above target need to be offset with outcomes below target. This is unhelpful;
the target should always be considered in a forward-looking context as something that monetary policy is constantly
striving to achieve regardless of past undershoots or overshoots.
c. 12 monthly increases in the CPI of around 2% over the medium-term.
This has similar advantages to b) in that it provides a clear anchor for expectations, encourages flexibility and
conveys some of the imprecision associated with inflation targeting. It also has the advantage of eliminating the
current bands and the potential for policy changes as inflation nears the edges of the band.
It may be helpful though to specify a range of +/-1% either side of the central target (similar to that in the UK) where
the Bank must give particular attention to reporting on outcomes, or expected outcomes, outside the range and what it
intends to do to bring inflation back to target. The purpose of the range and the reporting requirement is to provide a
mechanism to reassure the public that inflation is on track to achieve its medium-term objective. The requirement to
report on large divergences from the target is different from the present range because it puts the appropriate focus on
the average inflation rate rather than on the edges of the band.
The main disadvantage of a point target is that it may appear to limit the flexibility of policy. By emphasising the
medium-term uncertainty of inflation forecasting the necessary flexibility should be provided.
39. The Treasury prefers the third option for the reasons detailed in paragraph 36 above.
Relationship and Communication
40. The appointment of the new Governor will also have important implications for the operation of monetary policy. The
qualitative and judgemental nature of many monetary policy decisions provide some scope for short-term differences in
monetary policy actions even with the same medium-term objectives. The communication style of a new Governor may also
influence public perceptions of monetary policy. A different Governor may emphasise different aspects of the decision
(or the same aspects differently), and may adopt a different public profile.
41. The PTA provides the framework that guides the Governor's decisions but cannot capture all that is important or
relevant to the operation of monetary policy. Both the PTA and the operational independence embedded in the Act support
a broader relationship that enables you and the Governor to discuss and consider the medium-term objectives of monetary
policy and the Reserve Bank more generally. To build this relationship with a new Governor it will be important for you
to affirm and respect the Governor's duty to act independently while also making him/her aware of your expectations for
the conduct of policy.
42. At present we believe there is a good flow of information between you, the Reserve Bank, and the Treasury across the
range of the Bank's activities. This is facilitated by the transparent flow of formal information from both the Treasury
(e.g. Budget Policy Statements and six-monthly Treasury economic and fiscal forecasts) and the Reserve Bank (the PTA and
Monetary Policy Statements), and is built upon by other less formal arrangements, such as meetings between officials
from the Treasury and Reserve Bank. The transparency of information ensures that both fiscal and monetary policies are
formulated in the knowledge of their interdependencies.
43. There is room to improve on current process though. Much of your current interaction with the Governor takes place
through formal processes such as those surrounding the release of the Bank's Monetary Policy Statement. By developing
opportunities for interactions that are less constrained by concerns about immediate policy decisions a broader and
deeper discussion of economic and financial issues could emerge.
44. The Reserve Bank Board has an important role in monitoring the performance of the Bank and ensuring the Governor is
held accountable for her/his performance in meeting the policy targets. Clearly the Board needs to also share the
understanding of the policy targets agreement if the Governor is not to receive mixed signals. Regular discussions with
the Board will help minimise the possibility of mixed signals.
45. The Treasury can assist you in building and maintaining these relationships in a number of ways. We can monitor and
provide alternative advice on issues and developments relevant to monetary policy, provide advice on Board appointments,
and prepare briefings to facilitate your meetings with the Board.
Specific expectations
46. We have identified a number of practical actions that you may wish to discuss with an incoming Governor and the
Bank's Board:
The Reserve Bank inform you of the release of material into the public domain that may be likely to cause public
comment. This may include speeches, responses to FEC, working papers, Bulletin articles and Monetary Policy Statements;
To minimise the scope for surprises the Governor, where a policy decision is likely to surprise, inform you of the
decision as soon as is practical;
Opportunities for you to discuss with the Governor issues relating to monetary policy, and economic developments more
generally, outside of the current MPS briefings;
Opportunities for you to meet with the Reserve Bank Board from time to time to discuss matters relating to the Bank;
The Reserve Bank and the Treasury should regularly exchange views on the economy, its current performance, the outlook
and developments in the structure of the economy; and
The Reserve Bank should provide timely briefings or reports to you on other matters of interest, particularly on
financial market activity.
47. The development of this level of interaction is consistent with the principles of good relationship management for
agencies in the state sector with a responsibility to exercise independent authority, and with the practice of other
central banks. It should help build the trust and understanding necessary to maintain a constructive and effective
relationship.
48. These relationship expectations could form part of the Governor's performance agreement. You could request the
Bank's Board to review performance against these expectations and advise you and the Governor of the outcome of that
review.
Consultation
49. We have discussed the recent performance of monetary policy with a number of economic commentators. In general they
consider the Bank to have performed very well over the past two to three years or so. We believe that changes that
reinforce the current operation of monetary policy and bring New Zealand's inflation target into line with other central
banks would not be widely perceived as negative. Nevertheless any change that is seen as weakening the Government's
commitment to price stability and leading to a materially higher average inflation rate, would be likely to be received
negatively.
50. We have discussed the views in this paper with the Reserve Bank.
Next steps on the PTA and appointment process
51. There are a number of practical steps that will be required to finalise a new PTA. You or your office may wish to
ensure that the Board is aware of the process that you intend to follow.
52. Prior to the process of formally agreeing with a Governor the details of the PTA you may wish to consult with your
Cabinet colleagues and coalition partners on the general principles you will be seeking to incorporate. The Treasury can
also provide more detailed PTA drafts if that would be useful. You may wish to inform the Board of these principles so
that they can make potential candidates aware of your objectives before they make their final recommendation.
53. A Cabinet paper informing other Ministers of your intention to appoint a Governor will be required. A copy of the
agreed PTA could be appended to this to ensure your Cabinet colleagues are informed before a public announcement is
made. The Treasury can provide you with a draft of this Cabinet paper.
54. Closer to the time that a new Governor and PTA are publicly announced you will need to consider how to communicate
to the public the impact of the new PTA on the operation of monetary policy.
55. We would welcome the opportunity to discuss and where necessary clarify any of the points in this report with you.