Independent Review of the Operation of Monetary Policy in New Zealand: Report to the Minister of Finance

In May 2000, the Treasurer/Minister of Finance invited me to review the operation of monetary policy in New Zealand and provided me with the Terms of Reference. In undertaking the review, I have read the wide range of submissions provided to me and have met with a number of submitters and other interested parties. I visited New Zealand for two weeks in November 2000 in order to observe the operations of the Reserve Bank …rst hand and collect material for the review. I have also had discussions with a number of key people in the area of monetary policy from other countries. In order to judge whether the operation of monetary policy has been e¤ective, it is important to understand what monetary policy can and cannot do. People typically ask too much of monetary policy—no less in New Zealand than elsewhere. In the long term, monetary policy can only control nominal variables such as in ‡ation and the nominal exchange rate. It is beyond the capacity of any central bank to increase the average level or the growth rate of real variables such as GDP and employment, or to a¤ect the average level of the real exchange rate. At best monetary policy can reduce the variability of these real variables somewhat. An attempt to increase the average level or growth rate of GDP or employment would trigger ever-rising in ‡ation, at increasing cost to the economy in terms of less e¢cient resource allocation and arbitrary and inequitable redistributions of incomes and assets. For these reasons, an increasing number of countries have speci…ed price stability as the primary goal for monetary policy. In the short and medium term, monetary policy has e¤ects on both nominal and real variables. However, the complex transmission mechanism of monetary policy, the varying lags and strength of the e¤ects through di¤erent channels, unpredictable shocks and inherent uncertainty combine to prevent the use of monetary policy for any …ne-tuning. There is considerable agreement among policymakers, academics and researchers in the monetary policy area that so-called ‡exible in ‡ation targeting is the best monetary policy setup. Then in ‡ation is stabilized around a low in ‡ation target in the medium term rather than at the shortest possible horizon, and a gradual and measured policy response avoids creating unnecessary variability in the real economy. Because of shocks, uncertainty and imperfect control, considerable variability may remain in the real economy, …