Tuesday, August 25, 2009

Despite its enormous influence on the economy, the Federal Reserve’s performance is difficult to assess.

One problem is that by statute, the Fed pursues three separate goals: moderate long-term interest rates, maximum employment and stable prices. But the three objectives tend to conflict.

At present, for example, the federal funds rate is approaching 0.1 percent; unemployment is at its highest level in decades; and prices, as measured by the Consumer Price Index (CPI), are in decline. Out of concern for unemployment, the Fed is unwilling to raise interest rates. At the same time, it is creating a serious threat of future inflation.

A second problem is that the Fed’s three goals are not strictly defined in any numerical sense. Numerical goals are not part of the public record, nor did Fed officials respond to requests from the American Institute for Economic Research for rigorous definitions of the central bank’s goals. As a consequence, the only apparent channel for accountability appears to be political, in the form of a new nominee for Fed chairman.

In comparison, the mandate of the Reserve Bank of New Zealand (RBNZ) provides a clearer and more successful alternative.

Since 1990, the RBNZ and its governor have been subject to an explicit and publicly announced core criterion. The RBNZ is to maintain price stability by holding inflation within an agreed target range for a medium term of 18 to 36 months. Initially, the target range for inflation was 0 percent to 2 percent. Since 2002, the range has been 1 percent to 3 percent.

New Zealand’s emphasis on price stability does not preclude a desire from Parliament for increased employment. Rather, the policy asserts that the central bank shouldn’t be burdened or distracted by responsibilities beyond its primary purview.

To achieve the stipulated objective, Gov. Alan Bollard, the RBNZ’s counterpart to Fed Chairman Ben S. Bernanke, must commit to a Policy Targets Agreement. The defined targets can only be adjusted by the minister of finance and the governor in a bilateral and transparent manner. Thus, all parties, including the public, are clear on the central bank’s goal.

Consequently, political jockeying is limited to the initial agreement — leaving little room for manipulation around the election cycle.

The governor has operational independence. If he meets the inflation target, he can keep his job. If he does not meet the target, he must satisfactorily explain his failure. Otherwise, his initial five-year appointment will be terminated, and a new governor will be appointed.

Despite initial pessimism, the results of New Zealand’s Reserve Bank Act of 1989 have been positive, with the annual rate of inflation declining markedly from an average of 11.5 percent in the 1970s and 11.7 percent in the 1980s to 2.4 percent after the new system was put in place in the 1990s. To put that change in perspective, New Zealand went from having twice the rate of inflation of the United States in the 1980s to having consistently lower inflation beginning in the 1990s.

In addition to lower inflation, in the 20 years since the law was enacted, New Zealand has experienced almost uninterrupted growth in employment and economic activity. Even now, after 1 1/2 years of recession, New Zealand’s unemployment rate stands at just 6 percent, according to Reuters, a 10-year high.

The U.S. Fed is in a precarious position, facing both current deflation and the prospect of severe inflation, along with continued high unemployment. However, the Fed’s lack of objective criteria and its politicized and obscure process of accountability mean it is predestined to an ineffectual and murky mix of neither success nor failure.

Other countries, notably Canada and Australia, already have sought to emulate New Zealand’s system, which combines a clearly defined mission with a politically restrained, results-oriented approach to central bank leadership.

Fergus Hodgson is a visiting research fellow at the American Institute for Economic Research in Great Barrington, Mass. He has taught and tutored economics at Boston University, the University of Waikato in New Zealand and Waikato Institute of Technology.

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