It is hard to tell whether politicians have forgotten New Zealand’s pioneering work in inflation targeting and the central bank independence needed to back it up. Or if they simply fail to see the risks.

Members of Cabinet should not air views on the operation of monetary policy either publicly or privately to the Bank. And especially not when the Finance Minister is deciding whether the interim Governor of the Bank should be granted a longer-term appointment.

The Prime Minister’s discussions with Mike Hosking about interest rate policy are concerning.

But first a bit more of that history.

In the 1970s and 1980s, inflation had gotten out of control. Governments had too much influence over monetary policy.

When Parliament influences monetary policy, it is hard to maintain low inflation.

In the short term, an unexpected spike in inflation can reduce unemployment. Governments thought that they could exploit that short-term relationship.

But in the longer term, inflation does not ease unemployment. It instead messes up everyone’s plans. And so, too many countries have experienced high inflation coupled with high unemployment.

Using monetary policy to maintain artificially high levels of employment does not just require high inflation. It requires continued increases in inflation that outpace public expectations. People are not stupid. If everyone knows that governments will be tempted to inflate, people will expect more inflation. It does not end well.

The problem is ultimately one of credibility.

If every business and household were confident that the inflation rate would be steady at 2%, then achieving 2% inflation would be relatively easy – at least on average. Weird shocks come and go, but if everyone trusts central banks to keep inflation at around 2%, the central bank’s job is much easier. It does not have to work to convince everyone that it is serious about getting inflation back to 2% while also actually working to get inflation back to 2%.

But if everyone expects that the government of the day will prefer higher inflation and has influence over monetary policy, the job is a lot harder.

New Zealand’s solution was elegant. The government would tie its own hands. It would give its central bank operational independence over monetary policy while telling it to achieve an inflation target.

In other words, the government of the day could tell the central bank what inflation rate to target – and that target range would be public knowledge. But the central bank could decide for itself how to reach it.

Oscar Sykes at the excellent Works in Progress web magazine recently detailed the history. It really should be part of the secondary school curriculum. Kiwis often like to imagine that the whole world watches New Zealand policy. In the case of our inflation targeting regime, it is true. Others followed New Zealand’s example, sustaining a period that came to be called The Great Moderation.

All of it hinges on everyone knowing that the Reserve Bank has an inflation target, that the Bank really wants to meet it, and that politicians will not interfere with the Bank’s work.

Even giving the appearance of interfering in monetary policy decisions is a bad idea. The Bank must both be independent in setting monetary policy and be seen to be independent in setting monetary policy.

Part and parcel of operational independence is accountability for meeting agreed inflation targets. Otherwise, a government’s tacit interference with Reserve Bank operational independence can be coupled with tacit agreement that the Bank’s inflation targets need not really be met.

If people start to believe that the government of the day has some influence over monetary policy, or that the Bank no longer takes its Remit seriously, credibility erodes. People start baking expectations of higher future inflation into their current planning. Then the central bank’s job becomes much harder.

Prime Ministers and Ministers of Finance will always have views on monetary policy. Sir John Key was active in financial markets prior to becoming Prime Minister. Former currency traders will always have views on where they think interest rates might go.

And, in the late 2000s and early 2010s, fellow econ-blogger Matt Nolan and I worried about the Prime Minister’s airing of those views. They could be perceived as giving the Bank a steer about the government’s preferences over monetary policy.

It all seems rather tame and innocent in retrospect.

The Covid period brought high inflation without consequences to the Bank for the Bank’s failure to meet its inflation target. At the same time, the Bank’s prudential regulation strayed into politicised areas that have little to do with systemic prudential risk and are outside of its remit. The Bank’s credibility eroded, as evinced by a hefty increase in household expectations about future inflation.

The Reserve Bank surveys households about what they think the current inflation rate is, and what they think it will be in coming years. In data going back to 1995, the median household had never, before Covid, expected inflation in a year’s time to exceed 4.5%.

In December 2021, the median household expected that inflation in one year’s time would be 4%. In March 2022, that one-year-ahead median expectation increased to 5% - two full percentage points above the top of the Bank’s target range of 1% to 3%. And from June 2022 through June 2023 inclusive, the median household expected 7% inflation one-year-ahead.

The Reserve Bank had to increase interest rates considerably not just to bring inflation back down to the target range, but also to reset expectations about future inflation. It had to work to re-establish credibility that it had lost.

Eroding credibility is expensive. Governments signalling that they have strong preferences about where interest rates should go are risky for that credibility.

On Monday, Prime Minister Luxon had a chat with Newstalk ZB’s Mike Hosking. He told Hosking that he meets the Governor before interest rate announcements and gives his ‘reckons and perspective’. Hosking argued that the Bank should have cut much earlier and by more; Luxon said that he agreed and that this was ‘pretty much’ what he had told the Bank – without saying at which meeting.

It was not direction to the Bank. As he put it, “I can give my views, but I respect the independence of the Reserve Bank.”

The Reserve Bank’s Monetary Policy Committee decides on interest rates. The interim Governor of the Bank chairs and has one vote on that committee. He would also like to be appointed to a full term as Governor. The Minister of Finance decides on that appointment after receiving a nomination from the Board.

The Prime Minister will not have intended such comments as giving a steer to the Bank about the government’s preferences – or at least not one that he would have expected them to need to weigh.

But a government potentially worried about re-election in a year’s time should not be signalling anything about its preferred interest rates. And particularly not to an interim Governor who wishes appointment to a full term. And especially when the Reserve Bank is just coming out of a period when inflation was more than double the top of the inflation target range.

New Zealand pioneered modern inflation targeting, supported by central bank independence. New Zealand’s politicians should be less quick to undermine it.

To read the full article on the Newsroom website, click here.