Legislating for independence
Uncomfortable with the existing Reserve Bank Act 1964, which left the door open to interference by future governments, the new minister of finance, Roger Douglas, resolved to ‘Muldoon-proof’ the Reserve Bank. In 1986 he asked the Reserve Bank and Treasury for advice on remodelling the central bank and redefining its relationship with government. This initiative coincided with the reform and commercialisation of large parts of New Zealand’s public sector, and a global academic debate on the merits of central-bank independence.
West Germany’s Bundesbank, the most independent central bank in the 1980s, was also one of the most successful at containing inflation, but it was not very accountable. One of the principles of public-sector reform in New Zealand was that public-sector entities should be accountable to the government, Parliament or taxpayers. The challenge for the Reserve Bank and the government was to design a framework that combined independence with accountability and delivered low inflation.
Reserve Bank Act 1989
Treasury was inclined to see the central bank as just another state-owned enterprise like the railways. The Reserve Bank countered that it required more autonomy than a state-owned enterprise so that it could resist attempts by governments to subvert sound monetary policy. After considerable argument, and even the threat of a punch-up between Reserve Bank and Treasury officials, a position was reached that was broadly favourable to the central bankers.
The Reserve Bank Act 1989, which came into force in February 1990, assigned the central bank a mandate to strive for price stability and the stability and efficiency of the financial system. There was no mention, however, of other objectives such as full employment or economic growth. The central-bank governor (appointed by the Crown) and the minister of finance were to negotiate periodic policy-target agreements with a view to achieving and maintaining price stability. Once the target was set, the governor – Don Brash between 1988 and 2002 – would have complete freedom to implement monetary policy as considered necessary. If the target was missed, however, the governor could face criticism or even dismissal. The government also retained the power to override the policy-target agreements in extreme circumstances. In addition, the central bank was to become more transparent, releasing timely economic projections and commentary to the public.
The reforms of central-bank autonomy and accountability under the 1989 act were genuine innovations, as was the emphasis on transparency. New Zealand was studied closely by those seeking to reform the Bank of England in the 1990s. The 1989 act set the tone for the Bank of England Act 1998, though in the end the British legislation was less radical.
Muldoon-proofing the Reserve Bank
Roger Douglas told Parliament in the 1988 budget speech that new legislation – the Reserve Bank Act 1989 – would ‘make certain that no future politician can interfere with the [Reserve] Bank’s primary objective of ensuring price stability, or manipulate its operations for their own purposes, without facing the full force of public scrutiny.’1
The Reserve Bank was the first central bank to adopt inflation targeting as a monetary policy framework. During the 1970s and early 1980s some central banks – though not the Reserve Bank – set money supply targets (monetarism), with mixed success. Douglas committed the Reserve Bank to developing a method of targeting inflation directly when he appeared on television on 1 April 1988 saying that he wanted inflation reduced to no more than 1% per annum within a couple of years. The inflation targeting framework was formalised in the 1990 policy targets agreements, which set a target for annual inflation of 0–2% by December 1992.
Monetary policy was directed to achieving the inflation target. Until 1999 the Reserve Bank varied the quantity of ‘settlement cash’ – a special kind of money – available to the banking system, but from 1999 onwards its main policy tool was an interest rate, the official cash rate. Since 1990 the target has been adjusted several times. Later policy targets agreements also committed the Reserve Bank to smoothing economic activity whenever possible. For the most part, the inflation targets were hit and inflation remained very low. In fact inflation had already fallen to less than 5% per annum before the introduction of the new framework.
Many other countries, including the United Kingdom and Canada, followed New Zealand’s lead in the 1990s and targeted inflation. Even the European Central Bank established in 1999 introduced inflation targeting, although Germany already had a monetary target.