Case Study Inflation in New Zealand

STUDENT : Aille Kimberly COURSE CODE : AC46200 SEMESTER/ SEASSIONS : 2022/2023 Sessions Inflation Case Study in New Zealand: How Does the Central Bank Decide on the Inflation Target Percentage? Sometimes, decisions that shape the future of the world's economy are made in grand fashion and receive widespread attention. Other times, they are made through a quick and unanimous vote by New Zealand Parliament members who are eager to go home for Christmas. That's what happened when New Zealand became the first country to set a formal target for how much prices should rise each year, zero to 2 percent, in its initial action. This practice was so successful in putting high inflation in the 1970s and 1980s behind it that all the most advanced countries in the world have followed suit in one form or another. The 2 percent inflation target has now become the norm in most of the world, even as the worrying possibility becomes clear: what if it's wrong? what if it's one of the reasons the global economy has been stuck in five years of slow growth? some economists are beginning to consider the possibility that 2 percent inflation at all times leaves the central bank with too little flexibility to combat deep economic downturns. To understand that thinking, it is worth understanding how the 2 percent target in New Zealand became so ingrained in the global economic order from the beginning. The story began in the Southern Hemisphere country in the summer of 1989 with a kiwi farmer and banker named Don Brash. When Mr. Brash resigned as chief executive of the New Zealand Kiwifruit Authority to lead the country's central bank in 1988, he took over the economic helm that had gone through two decades of difficulty, with high inflation and disappointing growth. Mr. Brash tells the story of an uncle who sold an apple orchard in 1971 and put the money into long-term government bonds to fund his retirement, only to see inflation wipe out 90 percent of his life savings when the bonds matured. In the years before Mr. Brash took over the leadership of the reserve Bank of New Zealand, his predecessor had made progress in reducing inflation and making the bank more independent of political desires. But that independence had not been codified in law. That's what the Reserve Bank Act of 1989 was supposed to do. It directed the finance minister and central bank governor to achieve a formal target for how high inflation should be and gave the central bank political independence to guide interest rates to that inflation level. The central bank governor could be fired for failing to meet the inflation target. For David Caygill, New Zealand's finance minister at the time, a key part of the law was to establish the bank's independence from the political process. "Inflation targeting wasn't seen from our point of view as the main point of the action," he said in an interview this month. The debate over the law is controversial. Labor unions are worried that the sharp focus on inflation will lead to higher unemployment. Some business interests agree. However, in the end, the leaders of the majority party in Parliament decided to ignore those concerns. This helped cause one of the strongest opponents of the bill to be hospitalized and Christmas is near. But once the law is enforced, there are difficult questions about what should be the target inflation. Zero percent? Two percent? Five percent? Mr. Brash and Mr. Caygill got an early answer from a comment made during a television interview in 1988. Roger Douglas, Mr. Caygill's predecessor as finance minister, had tried to prevent New Zealanders from thinking that the central bank would be satisfied with high inflation, and he said in an interview that he aimed for inflation around zero to 1 percent. With Mr. Douglas's figure as a starting point, Mr. Brash and Mr. Caygill agreed that the best approach was to expand the range to give them more manuvering room, but only slightly. New Zealand would target inflation between zero and 2 percent. Not surprisingly, the enactment of the law to reform the governance of the central bank in the island nation of 3.4 million people did not receive coverage in major American newspapers. But in the closely knit world of global central bankers, people began to take notice of Kiwi monetary policy experiments. After all, central bankers have long regarded the mystique behind the curtain as one of their tools of power. The inflation target may have reduced that mystique, but it created a kind of magic of its own. By announcing its goal for inflation, and giving independent authority to the central bank to achieve that goal, New Zealand made it a reality. One of the approaches would imply that the appropriate target is zero, or perhaps 0.5 percent or 1 percent, given the difficulty of measuring inflation accurately. But there is an alternative view that keeping inflation that low may be dangerous. The person who made the strongest argument for this at the Federal Reserve in the 1990s was a Fed governor named Janet L. Yellen. Behind the large doors of the federal reserve's meeting room on constitution avenue in Washington, a struggle over whether the world's largest economy should emulate Canada and New Zealand took place in 1995 and 1996. Yellen, who now runs the institution, worried that announcing an inflation target would make the Fed focus solely on inflation and ignore its responsibility to promote growth and jobs. She feared that zero inflation could cripple the economy, especially during downturns, and felt that inflation was necessary. When there is little inflation, employers can hold workers' wages steady during downturns but still lower them in inflation-adjusted terms. Inflation creates an adjustment mechanism: An assembly-line worker can continue to earn exactly $20 an hour through a downturn, but in inflation-adjusted terms, wages fall 2 percent a year, which can make the factory less likely to lay off workers. The United States experienced a mild recession in 2001, and the Fed cut interest rates to 1 percent to help spur recovery. Then came the global financial crisis of 2007 to 2009, driving a sharp downturn around the planet and causing central banks to cut interest rates. If they set it slightly higher, say at 3 or 4 percent, they might be better able to fight severe recessions because they could cut inflation-adjusted interest rates more deeply. At 2 percent inflation, the value of a dollar falls in half over 35 years, while at 4 percent it falls in half every 18 years. On the other hand, inflation was also in the range of 3 to 4 percent until the mid-1980s, hardly remembered as an economic nightmare. A shift in the target, moreover, could cause disruption in financial markets and potentially raise long-term interest rates sharply and suddenly, which could slow growth. Current central bank governors regard the cost of raising the target too high as too high to pay. Fed Vice Chairman Stanley Fischer reiterated his support for the 2 percent target earlier this month and Ms. Yellen gave no indication that she wanted to rethink her target.