The Labour Party wants the RBNZ to target unemployment in addition to inflation. No one likes unemployment, but this does not make it a good policy change. It has been used before and failed everywhere.
Most probably, the policy meant to target the unemployment rate in the short-run (over the business cycle or maybe over the election cycle). A reduction of the short-run unemployment rate below the Natural Rate of Unemployment (NRU) requires the RBNZ to generate higher inflation. According to the Phillips curve, there is a negative relationship between wage inflation and unemployment. The celebrated Phillips curve was first introduced by a Kiwi, Bill Phillips in 1958.
Politicians liked that relationship because it meant that they could trade-off more inflation for lower unemployment. Unfortunately, it is not that simple. It is a textbook economics that the Phillips curve shifts up and down every time the expectations about the inflation rate change. And, what matters for work is the real wage rate – the wage adjusted for inflation – not the nominal wage; in other words, the purchasing power of the money wage.
The unemployment rate changes in the short run: (1) because firms hire labour as long as the real wage paid to workers is below labour productivity (the marginal productivity of labour); stop hiring when the real wage rate is equal to labour productivity; and layoff labour when real wages increase above labour productivity. And, (2) because workers accept job offers when the real wage rate is higher than the reservation wage, and don’t when it is lower (here). The reservation wage depends on the generosity of unemployment and other benefits.
The RBNZ comes into the picture because it can affect real wages via expected inflation. Workers and employers take this expected inflation rate to calculate the purchasing power of the offer (i.e., the real wage).
This policy will not work according to the traditional Phillips curve because the relationship between inflation (money wages) and unemployment is unstable, especially in New Zealand because the RBNZ has successfully removed the trend from inflation (stationary). The plot (RBNZ data) shows no negative relationship to be exploited.
The relationship between inflation and unemployment changes overtime. It has been observed to be positive, or even zero. Therefore, there is no guarantee that the RBNZ can reduce unemployment in the short run by increasing inflation; quite the opposite could happen. The U.S. and most of the industrial nations followed such policy before and those of who remember the 1970s and the 1980s must remember the double digit inflation rate and the devastation that followed.
So how will Labour design the new PTA policy?
There will be no inflation target as we know it today because they have to inflate the economy to reduce unemployment.
First, how? They either reduce the interest rate, perhaps making it negative as other central banks have done. Or, use quantitative easing, i.e., pump more money into the system by buying securities. Here is the recent IMF view on the effect of negative interest rate on the banking system and financial stability.
I would add that inflating the economy would impact the housing market quite considerably. More money, more inflation, more spending and more demand for housing. That would make the job of the new governor very difficult because the RBNZ also regulates the financial system and formally cares about stabilizing housing prices.
Second, by how much they have to increase inflation, and could they? It will have to be a lot given that monetary conditions defined by the current exchange rate and credit restrictions seem tight.
That said, it might be worse if Labour is thinking about the long-run unemployment. In this case they have an old and a dead idea. The government must come up with an estimate of something called the Non-Accelerating Inflation Rate of Unemployment (NAIRU) to replace the current inflation target. It means a particular inflation rate (not a range and not any number) that does not accelerate and consistent with the long-run unemployment rate. This is not economics, but rather alchemy. If there is no trade-off between inflation and unemployment in the long run, i.e., a vertical Phillips curve, then there is no such an inflation rate because the vertical Phillips curve implies that any inflation rate is consistent with long-run unemployment. The NRU is not the same thing as the NAIRU. The former is determined in the labour market, not by monetary conditions while the latter is about an unstable relationship between inflation and the unemployment. Most people agree that there is no trade-off in the long run. If the policy is indeed about the long-run, not about the short run then we know it won’t work.
The NRU is unknown and the estimates are highly uncertain. So whatever you want to call the long-run unemployment rate, what is that number? A few weeks ago the chief economist of the RBNZ John McDermott gave a speech, where he said that they are looking for the starts, among them I assume is U* - the long-run unemployment rate. No one knows for sure what that number is.
Also, the economic motivation behind this policy is unclear. The Labour Party must have been advised that the relationship between inflation and unemployment is unstable, which is especially true in New Zealand. Also history shows that it never worked, because it generated persistent inflation with no reduction in unemployment, and took considerable efforts and costs to undo. In fact our labour indicators are reasonable OECD.
Because the NRU is determined in the labour market and not by the RBNZ. Politicians must look at labor market policies that encourage work, reduce benefits, increase training and up-skilling, increase matching efficiency, help small businesses, and increase foreign direct investments etc. because monetary policy cannot deliver lower unemployment. In fact the proposed policy may increase volatility and generate higher inflation only.