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Learning to Control Inflation in New Zealand: Inflation Targeting
Before reductions in the inflation rate occurred in New Zealand in the late 1970s, this country experienced inflation that was relatively high among developed countries. The average inflation rate in New Zealand between 1977 and 1986 was 13% per year—much, higher than in the United States, for example (see Figure 17.7). However, the inflation rate was reduced in New Zealand to 3.3% per year in the 1990-92 . period, and to 2.3% in the 1993-96 period, in part, this reduction in inflation was brought about through changes.in the legal structure within which the Reserve Bank of
New Zealand (RBNZ)—the central bank of New Zealand—was constrained to operate, as discussed in a working paper by Michael Hutchison and Carl Walsh.1
The changes in the rules governing the operation of the RBNZ were enacted in the RBNZ Act in December 1989, which went into effect in. February 1990.. Under the Act, "the primary function of the Bank [the RBNZ] is to formulatéand implement monetary policy1 directed tqi the economic objective of achieving and maintaining stability in the general, level of prices." This
(continued)
statement of-the, goals of the centrál bank is: quite restrictive, because left out are any . Keynestan-type objectives ,'stich ás""fuil employment"': ór "sustained'growth,''whichjiré.,' goals that!often find their way into the lán- ■ guage of central bankers., Given that the ■ objective of the. RBNZ as defined by the RBNZ' Act'is to achieve price stability, how should this be done? The Act also specifies that the finance minister (a cabinet member .
■ in the. government of New' Zealand) negotiate a Policy Target Agreement (PTA) with ■the .governor of the1 RBNZ (the-counterpart of the chairman of the Fed) at the-beginning of the.governors term of office. This PTA specifies explicitly .what price stability means, in terms .of numerical objectives, for the governor's term. These objectives are then publicly-announced. Should the governor, be judged by the prime minister of New
,,2lealattd. to:have failed to meet the goals set.
; .puť in" the PTA, he or she can. be removed
■  from office.       .
_,,,,;,. Tft.practic«!, thePJAs that have beenne-
:v'g^tíktóÍ,.tí,Ofi:sišt of;explicit inflation targets. -
iKEdŕre^á'mple;-'the,first PTA1 agreed tô under'
the RBNZ Act specified a target range for
the inflation rate oify-Qty per annum.to be . •
achieved, by December 1992. As mentioned
above j the RBNZ Act appears-to have been very successful in meeting its intended goal of reducing inflation in New Zealand. Inflation, targeting in-this instance seems to have been much-, more successful than was the targeting of monetary aggregates in some countries in the 1970s.and 1980s. . ' The rules in the RBNZ. Act governing the operation of New Zealand's central bank put-an unusual.amount of structure on monetary policy relative to what governs most central banks in the world. For example, in the United States, the Federal Reserve Act is quite vague about the policy objectives of the Federal Reserve System, and the chairman of the Fed can certainly not be fired by. the President during his or her term of office because of monetary policy errors. New Zealand was highly innovative in central banking by setting up explicit objectives and penalties for its. central bank. Other central banks, including the Bank of Canada and the Bank of England, have since introduced inflation targeting, though in a less restrictive structure than in New Zealand.
1See M. Hutchison and C Walsh, 1998. "Disinflation in New Zealand," working paper, "University of California, Santa Crus.