Four Lectures on Central Banking - Motu

1 four Lectures on Central Banking Arthur Grimes Motu Working Paper 14-02 Motu Economic and Public Policy Research February 2014 i Author contact details Arthur Grimes Motu Economic and Public Policy Research and the University of Auckland Acknowledgements I wish to thank the NZ-UK Link Foundation for supporting my visiting position, and thank Siddhartha Sanghi and Nicholas Tarrant for excellent research assistance. Helpful comments were provided by Peter Nicholl, Bob Buckle, Michael Reddell and colleagues from Motu and the Reserve Bank of New Zealand. The author, however, takes sole responsibility for the views expressed. Motu Economic and Public Policy Research PO Box 24390 Wellington New Zealand Email Telephone +64 4 9394250 Website 2014 Motu Economic and Public Policy Research Trust and the authors.

2 Short extracts, not exceeding two paragraphs, may be quoted provided clear attribution is given. Motu Working Papers are research materials circulated by their authors for purposes of information and discussion. They have not necessarily undergone formal peer review or editorial treatment. ISSN 1176-2667 (Print), ISSN 1177-9047 (Online). ii Abstract These four Lectures on Central Banking topics were presented in London between September and December 2013. The Lectures were delivered as part of Arthur Grimes NZ-UK Link Foundation Visiting Professorship, based at the University of London s School of Advanced Study. They followed his stepping down as Chair of the Reserve Bank of New Zealand in September 2013 after ten years in that role.

3 The four lecture topics (and the institution at which they were delivered) are: Inflation Targeting: 25 Years Experience of the Pioneer (Bank of England); A Floating Exchange Rate is the Worst Exchange Rate Regime (except for all the others that have been tried) (University College London); How Prudent are Macroprudential Policies? (London School of Economics); Responsibility and Accountability in the Financial Sector (Institute of Advanced Legal Studies). A key theme across all four Lectures is the importance of ensuring that Central bank policies and actions are time consistent. Time consistency requires that a Central bank can commit to implementing the policies that it says it will implement.

4 For instance, if a Central bank commits to delivering low inflation, it will not use its powers to deliver other goals at the expense of low inflation. Similarly, if it commits not to bail out banks in the event of failure, then it (and other official bodies) will not bail out a failed bank. JEL codes E52, E58, H81 Keywords Central Banking ; inflation targeting; exchange rate systems; macroprudential policy; microprudential policy iii Contents 1. Introduction .. 1 2. Inflation Targeting: 25 Years Experience of the Pioneer .. 4 Introduction .. 4 Background .. 5 Monetarist Theory .. 6 Rules versus Discretion .. 6 Which Nominal Target? .. 7 Time Inconsistency .. 11 Fish-hooks .. 14 Defining Price Stability.

5 14 Inflation or Price Level Target .. 14 Target Range .. 14 Caveats .. 15 Time Inconsistency in the Post-GFC Context .. 16 Economic Effects of Inflation Targeting .. 18 Final Observations .. 22 Appendix: Inflation Targeting Economic Outcomes .. 25 References .. 34 3. A Floating Exchange Rate is the Worst Exchange Rate Regime (Except for All the Others That Have Been Tried) .. 38 Introduction .. 38 Alternative Exchange Rate Regimes .. 38 Theory .. 40 Lessons from New Zealand History .. 42 Recent Comparative International Performance .. 46 Further Lessons from the Euro .. 48 Concluding Thoughts .. 54 Appendix: Impacts of the Adoption of the Euro .. 57 References .. 59 4. How Prudent are Macroprudential Policies?

6 61 Introduction .. 61 The Case for Macroprudential Policies .. 62 Analysis of the New Conventional Wisdom .. 64 Housing .. 65 Lending Institutions Incentives .. 67 Monetary Policy .. 70 iv Historical New Zealand Experience .. 71 International Experience with Loan to Value Ratios .. 74 LVRs and the Real Exchange Rate .. 75 LVRs and House Prices .. 83 Conclusions .. 87 References .. 89 5. Responsibility and Accountability in the Financial Sector .. 92 Introduction .. 92 Types of Banking Risk .. 92 Implications of Banking Risks .. 93 Regulatory Responses .. 94 Implications of Regulatory Responses .. 95 Concluding Thoughts .. 102 References .. 104 1 1. Introduction These four Lectures on Central Banking topics were presented in London between September and December 2013.

7 The Lectures were delivered as part of Arthur Grimes NZ-UK Link Foundation Visiting Professorship, based at the University of London s School of Advanced Study. They followed his stepping down as Chair of the Reserve Bank of New Zealand in September 2013 after ten years in that role. The four lecture topics (and the institution at which they were delivered) are:1 - Inflation Targeting: 25 Years Experience of the Pioneer (Bank of England); - A Floating Exchange Rate is the Worst Exchange Rate Regime (except for all the others that have been tried) (University College London); - How Prudent are Macroprudential Policies? (London School of Economics); - Responsibility and Accountability in the Financial Sector (Institute of Advanced Legal Studies).

8 A key theme across the four Lectures is the importance of ensuring that Central bank policies and actions are time consistent. Time consistency requires that a Central bank can commit to implementing the policies that it says it will implement. For instance, if a Central bank commits to delivering low inflation, it will not use its powers to deliver other goals at the expense of low inflation. Similarly, if it commits not to bail out banks in the event of failure, then it (and other official bodies) will not bail out a failed bank. The first lecture , on inflation targeting, traces the history of inflation targeting in New Zealand, the first country to adopt this approach to monetary policy. It elucidates the theories that led to its adoption and analyses why an alternative approach, nominal GDP targeting (in levels or changes), was not adopted.

9 The latter approach is shown to have a number of undesirable properties. Issues of time consistency are discussed in the post-GFC (Global Financial Crisis) context, and an extended theory of time consistency, relating to Central bank interventions following asset price collapses, is proposed. A cross-country econometric analysis of the economic effects of inflation targeting shows that adoption of inflation targeting has been associated with a lift in GDP growth rates. It is also associated with a fall in inflation in countries that formerly had high inflation rates, and with a general convergence of inflation rates towards the OECD average. It finds no evidence that inflation targeting adoption has systematically increased or decreased persistence in real sector variables.

10 The second lecture , on exchange rate systems, discusses the range of exchange rate systems used by countries from a free float to a common currency. It briefly discusses the theory 1 The Lectures are reproduced here in the form in which they were delivered ( as public Lectures ). 2 of how various regimes affect macroeconomic outcomes, and discusses New Zealand s varied history of exchange rate regimes. An empirical analysis of comparative international macroeconomic performance under fixed versus floating regimes shows that the Euro countries have low real effective exchange rate volatility, but another country with a fixed exchange rate (Hong Kong) has a moderately volatile real exchange rate.