Mr Brash addresses the question: What can New Zealanders expect of monetary policy in the long term?  (Central Bank Articles and Speeches, 25 Mar 1999)
Central bank: rbnz | Type: speech | Date: 1999-03-25

## Mr Brash addresses the question: What can New Zealanders expect of monetary policy in the long term?Address by Donald T Brash, Governor of the Reserve Bank of New Zealand, to the North Club, Auckland on 25 March 1999.

## Introduction

## Mr ChairmanToo often, both in the Reserve Bank and, I suspect, in financial markets, we are incli sight of the longer-term, or strategic, issues of relevance to monetary policy.

We get with whether the Official Cash Rate should really have been set at 4.50 per cent rath 4.25 per cent, as if this detail had any enduring significance for the real economy and ordinary New Zealanders.

I don't want to imply that the short-term tactics are irrele from it - but they are very much less relevant than the longer-term issues, particular Official Cash Rate itself is explicitly up for review on a regular basis.So today I want to address the question, What can New Zealanders expect of monetary po the long term?

## The monetary policy framework is profoundly democraticThe first point to note in answering that question is that the answer depends on what wants monetary policy to deliver.

It is sometimes suggested that the Reserve Bank seems law unto itself, and that Don Brash seems to run the country.

Nothing could be further truth.

In New Zealand, the Reserve Bank is subject to an Act of Parliament, and Parlia change that legislation by simple majority.

This is also true in Australia, the United United

States

and

many

other

countries,

of

course,

but

it

is

not

now

true

in

much

o (where the European Central Bank is a creature of the Maastricht Treaty) or in those where the central bank has been given essentially unlimited independence under the constMoreover, that Act of Parliament requires that, within the general directive prescribed the

Governor

of

the

Bank

must

sign

a

written

agreement

with

the

Treasurer

setting

o explicitly what the Governor must achieve during his or her term of office, the so-cal Targets Agreement.

That Agreement can be changed by mutual agreement at any time during Governor's term of office, and can be overridden by Order-in-Council if the Government change and the Governor does not.So what monetary policy will deliver in the years ahead is essentially a matter for through

Parliament,

to

determine.

The

Reserve

Bank

and

I

as

the

Bank's

Governor

are accountable for our performance in delivering the objectives which Government and Parl have chosen, through a requirement to produce regular Monetary Policy Statements and to regularly before the Finance and Expenditure Committee of Parliament.Having said that, as long as the present Act remains in place at least, the Governme change the objective laid down for monetary policy without telling the public.

In other change in the objective must be totally transparent and, given that inflation is essenti theft, that seems entirely appropriate.

All this seems profoundly democratic, and make that the Reserve Bank and Don Brash are servants of Parliament.Since 1989, the Reserve Bank Act has made it clear that monetary policy must be used to and maintain 'stability in the general level of prices', with the meaning of this dePolicy Targets Agreement.

The present Agreement, signed when I was reappointed Governor at the end of 1997, defines 'stability in the general level of prices' as meaning that monetary should be aimed at keeping inflation as measured by the CPI excluding credit charges, or CP between 0 and 3 per cent over each 12-monthly period, though the Agreement also recognise that there will be some circumstances where inflation may legitimately be allowed to fall ou that range.But what, I am often asked, happens after the election?

Fundamentally, that depends on what next Parliament decides.

It is not inevitable that anything (related to monetary policy) will after the election.

Almost all political parties are on record as supporting the present le and indeed supporting the present 0 to 3 per cent target.

While the Policy Targets Agreem could be changed by agreement between Governor and any new Treasurer, there should be no presumption that that will occur.

Consistency and continuity are attractive in monetary pol elsewhere, and I shall certainly not be promoting a change.

It is perhaps worth noting that central banks with a price stability objective and a quantitative inflation target all have t fall within the 0 to 3 per cent range - and to the best of my knowledge, there are none th outside it.

But, to repeat, it is for Parliament to decide in the final analysis.

## The present Policy Targets AgreementWhat does the present Policy Targets Agreement imply about the way in which the Reserve Bank will formulate monetary policy in the years ahead?

Without going into great detail, it mean we will be aiming to keep CPIX inflation close to the midpoint of the 0 to 3 per cent target two years ahead.We aim close to the midpoint because we recognise that, in an uncertain and fast-changing wo aiming at the midpoint maximises the chance that we will be able to keep inflation in the range.

Aiming near either edge of the target would run too high a risk that unexpected sh would throw us outside the target.And we aim to keep inflation near the midpoint not this quarter or next, but in one to two time, because we recognise that monetary policy has most of its impact on trend inflation this kind of time horizon.It follows that in implementing policy we would in principle be willing to accept the prosp inflation outcomes close to the edges of the target, and conceivably even outside the target next few quarters if we were reasonably confident that inflation would be back near the cent the target within one to two years.

Clearly, we will not lightly sanction breaches of the target - indeed, we will do our utmost to avoid such breaches, of either side of the target pretend that we can at all times and in all circumstances keep inflation within the target w to promise more than we can deliver.

Indeed, we learnt that in the mid-nineties.As an aside, we are reasonably certain that headline inflation, the CPI including interest ra fall

below

zero

for

several

quarters

this

year.

In

the

12

months

to

December

1998,

head inflation was only 0.4 per cent, the lowest level for several decades.

We expect the 12 m 'increase' to be negative very shortly.But

it

is

important

that

nobody

misunderstands

the

significance

of

this.

Having

the

head inflation figure go below zero is not a breach of the Policy Targets Agreement, any more th was a breach when the headline figure rose to 4.6 per cent in mid-1995.

The inflation target Policy Targets Agreement is explicitly defined in terms of the CPI excluding interest rates, very

good

reason

that

an

interest-inclusive

CPI

target

would

quickly

have

the

Reserve

Ba chasing

its

own

tail,

tightening

monetary

policy

(increasing

interest

rates)

in

responseincrease in measured inflation which was itself caused by increasing interest rates ea year, and vice versa.

Both the negative headline inflation figure we now project and figure experienced in the mid-nineties are simply the result of the inclusion in New headline inflation figure of interest rates.Most economists are agreed that interest rates should not be in the inflation figure major countries already exclude them.

The Government Statistician has agreed to remove from

the

official

CPI

from

later

this

year.

Thankfully,

this

will

end

the

potentia confusion inherent in the present situation.

But in the meantime we ignore the interes headline figure, as we have done all decade.

Of course, we could prevent the headline figure

turning

negative

very

easily

-

by

aggressively

increasing

interest

rates!

I anybody is strongly arguing for this!

## Growth and inflationWhy not add a growth objective for monetary policy?

Surely, the most important objectiv economic policy must be to encourage growth, so why isn't the same true for monetary pol a

fundamental

sense,

it

is.

It's

just

that

we

now

realise

that

the

most

constructi monetary

policy

can

do

to

encourage

growth

is

to

deliver

price

stability,

so

that planning what products to produce can distinguish relative price movements from the n general inflation, so that savers can sensibly plan how to invest their savings, so t distortions

created

by

the

interaction

of

inflation

and

a

tax

system

geared

to

his accounting can be avoided, and all the rest.We now know that inflation damages economic growth, to say nothing of the social dama also does through the capricious redistribution of income and wealth which it produces.It is for this reason that the present Policy Targets Agreement makes it clear that Bank is to deliver price stability 'so that monetary policy can make its maximum contri sustainable

economic

growth,

employment

and

development

opportunities

within

the

N Zealand economy'.In other words, price stability is not simply an end in itself but a means to an end, a better growth, better employment, and indeed a more just society.The Governor of the Reserve Bank of Australia, Mr Ian Macfarlane, expressed it well late when he said that 'the other way of expressing an inflation target is to say that monet set

in

a

way

which

lets

the

economy

grow

as

fast

as

possible

without

breaking

the objective, but no faster.' 1The Governor of the Bank of England, Mr Eddie George, also put it very clearly in a sp month:'We're

often

described

as

a

lot

of

'inflation

nutters',

or

even

as

'pointy-headed hooligans'

who

don't

care

at

all

about

real

economic

activity

or

jobs

…

That

view profoundly and fundamentally wrong.'The

implication,

of

those

who

take

that

view,

is

that

they

think

there

is

a

tradeinflation

and

the

rate

of

economic

growth;

they

think

that

if

only

we

would

let

up controlling inflation then we could all enjoy higher activity and lower unemployment a1 Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the CEDA annual general me dinner, Melbourne, 28 November 1996.living standards, which are, of course, the really good things of economic life.

At the ver they say, if you were a bit less manic in your pursuit of low inflation, we could avoid some worst damage that is currently being inflicted upon agriculture, upon large parts manufacturing, and even some service sectors.- 'And that might even be true for a time.

The trouble is that, in anything other than the sho it would be likely to mean more rather than less economic damage, and lower rather than hig growth and employment …'We are every bit as concerned with growth and employment as we are about price stability anyone in their right mind must be.

Permanently low inflation is a necessary means of achie growth and employment sustained into the medium and long term.' 2I totally agree.

## The control of inflation, and output variabilityMost of us now accept that monetary policy can not, by tolerating a little more inflation sustainably faster growth.

In other words, keeping inflation low is the best contribution monetary policy can make to growth in the longer term.But it is also widely accepted that there may be a trade-off between the variability of infla the variability of output.

In other words, it may be that attempting to keep inflation at 1.5 per cent at all times might lead the Bank to throw interest and exchange rates around vigorously - and output around quite vigorously as a result.In recent years, the distinction between 'strict' inflation targeting and 'flexible' inflatio has grown up in the economic literature, with 'strict' inflation targeters being those who keep inflation very close to a narrow target at all times, and 'flexible' targeters being t are willing to accept a little more variability in inflation outcomes for the sake of redu variability of interest and exchange rates, and of economic output. 3 I am not sure that any central banks are in fact 'strict' inflation targeters, but the distinction is useful in highlight central banks are more or less 'flexible' inflation targeters.The Reserve Bank of New Zealand has never been a 'strict' inflation targeter.

From the very Policy Targets Agreement, reasons why actual inflation might legitimately fall outside the band - the so-called caveats - were recognised.

At no stage have we treated the centre of inflation target band as a fetish.Early in 1996, after inflation fell outside the then 0 to 2 per cent target by 0.1 per cent to March 1996, I wrote to the Minister of Finance and explained that, although we were confid that inflation would be back within range by the following year, I was not confident that f breaches of the target could be avoided in the immediate future without a very aggressive fu tightening of monetary policy.

I noted that under all the circumstances I could not recomm such an aggressive further tightening, and indeed noted that tightening to the extent which have been needed to reduce the risk of further breaches of the top of the inflation targe2 Speech by Mr E A J George, Governor of the Bank of England, at Hertfordshire University, 18 February 1999.3 See Lars Svensson, 'Inflation targeting in an open economy: strict or flexible inflation targeting?', R Bank of New Zealand Discussion Paper, G97/8.immediate future ran the risk of throwing the inflation rate through the bottom of th target further into the future. 4So there is plenty of evidence that we have been 'flexible' inflation targeters from th But I suspect that we may be even more willing to be 'flexible' inflation targeters no were

in

the

late

eighties

and

early

nineties,

when

we

were

at

the

beginning

of

our targeting experience.

This is a direct result of the fact that inflation and inflation now much more firmly anchored at a low level than was the case a decade ago.

At that t were coming out of a period of nearly two decades of high and variable inflation, a per which governments had repeatedly promised to reduce inflation and had repeatedly broken promises.

It was hardly surprising that, initially at least, the public greeted the new approach to delivering low inflation with a high degree of scepticism.Today,

by

contrast,

even

those

who

criticised

the

commitment

to

low

inflation

init persuaded that low inflation is likely to be around for a considerable time to come.

Bu longer

assume

that

they

will

be

able

to

increase

prices

more

or

less

automatically Consumers no longer assume that they must buy this month because next month prices wi higher.

Those

negotiating

wage

and

salary

increases

strike

agreements

consistent

wit prices.

Long-term interest rates are nearly back to their levels in the sixties.

Even are beginning to realise that house prices go down as well as up.

As a consequence of t firmly-anchored inflation expectations, the Bank can afford to respond rather more mode the

prospect

of

small

changes

in

the

inflation

rate,

confident

that,

even

if

in temporarily depart from the midpoint of the target, this is not likely to produce an longer-term changes in pricing and wage-setting behaviour.

## We live in an uncertain worldThis anchoring of inflation expectations is of considerable assistance in the way monet operates, and should mean that interest rates may not need to move around as strongly a in the past.But does that mean that the Bank will be able to formulate policy with perfect fore without

controversy,

in

the

future?

Of

course

not.

Inevitably,

sometimes

things differently than expected.For example, 90 day interest rates rose from an average of 4.6 per cent in February 19 per cent in December that year.

At the time, that increase in rates seemed to be ample inflationary

pressures.

But

with

the

wisdom

of

hindsight

it

is

probable

that

we

sh tightened

policy

earlier

and

more

aggressively

than

we

did;

had

we

done

so,

we

migh nipped inflationary pressures in the bud at an earlier stage, and it may have been poss policy earlier than was in fact the case.

Not many people complained, in 1993, that we tightening policy sufficiently quickly.Late in 1995, we thought we could see inflationary pressures abating in 1996, and so ad Government that there seemed no reason from a monetary policy perspective to abandon t reductions proposed for mid-1996; in retrospect, we were rather too optimistic, and in pressures

continued

throughout

that

year,

with

the

tax

cuts

and,

later,

additional spending adding to those pressures.

Again, not many people complained at the time.4 Letter to the Minister of Finance dated 19 April 1996, published in Monetary Policy Statement, June 1As President Harry Truman once said, 'Any schoolboy's hindsight is better than the Presiden foresight.'You would be disappointed if I did not mention the introduction of the Monetary Conditio Index

with

'bands'

at

the

end

of

June

1997

as

another

innovation

which,

with

the

benefit experience, has proved less useful than we had hoped.

In the extreme test provided by the A crisis, we believe that the MCI with 'bands' produced unnecessary volatility in short-term in rates in the 12 months or so after it was first introduced (that volatility began to dimini second half of 1998 as we more explicitly relaxed the 'bands' around desired conditions), that sense we believe that the MCI was not as helpful in the implementation of policy as believe the Official Cash Rate will be.But we have not abandoned the MCI as an indicator of monetary conditions, and we intend t continue using it to illustrate how we see monetary conditions evolving over the period cov by our projections.Moreover, we do not accept that the MCI 'caused' the brief recession in the first half of The monetary conditions relevant to the level of activity in the first half of 1998 were t 1996 and early 1997, not those in the second half of 1997.

If monetary policy carries any p the blame for that early 1998 recession, it was monetary policy in 1996 and the first part o which was to blame; the MCI was introduced at the end of June 1997.

In 1996, notwithstandin that inflation was slightly above the then 0 to 2 per cent target and notwithstanding the and increased government expenditure, we were projecting inflationary pressures to abate o 1997

and

1998,

with

a

period

of

positive

but

below-trend

growth.

In

other

words,

we

we projecting the proverbial soft landing.

On this basis, we began easing, in December 1996.

W turned a soft landing into something much harsher was the Asian crisis and the drought, b unpredicted and unpredictable in 1996.In fact, judging from the inflation outcomes it is not at all obvious that monetary policy was too tight.

CPIX inflation has been close to the middle of the inflation target since t quarter of 1997, and indeed, had it not been for the widening of the target from 0 to 2 per 0 to 3 per cent at the very end of 1996, inflation outcomes in much of 1998 would have b rather uncomfortably close to the top of the band.

On this basis, it is certainly hard to a policy in 1996 was too tight.But there have been mistakes in the past, as I have indicated.

And there will be mistakes future.

Without a crystal ball, this is quite inevitable, given the huge amount of uncertain surrounds the way in which policy must of necessity be implemented, namely looking forward one to two years.There is uncertainty about where the economy is when we begin each projection.

The projecti which we published last week was finalised on 1 March, and yet the latest comprehensive data have on economic activity is for a quarter which finished five months earlier, and we know data for that quarter may be revised, and revised again, for many quarters to come.

Of cours try hard to offset this problem by studying a very large number of more up-to-date stati series, by talking to scores of businesses all over the country, by talking to audiences parts of the country, by assessing the implications of several surveys of business and con confidence, and by asking our seven non-executive Directors for their assessment of the econo As I remarked on a previous occasion, I sometimes suspect that God made economic forecaster to make weather forecasters look good, but at least weather forecasters can look out the wi and see what the weather is like today!

Economic forecasters do not have that luxury.There is also a great deal of uncertainty about 'how the economy works', in other wor how people and businesses react to circumstances.

For example, our latest projections that household expenditure will grow more slowly as the economy grows out of the earl recession

than

it

did

as

we

grew

out

of

the

recession

of

1991/92.

We

made

that

ass because people now carry a great deal more debt, relative to their incomes, than was decade ago.

We are assuming that they will take on rather less additional debt over th years.

That seems an entirely reasonable assumption, but of course nobody can know th certainty,

particularly

given

that

low

interest

rates

of

the

kind

now

prevailing

ha experienced in New Zealand for many years.

There is perhaps even more uncertainty about lies

around

the

corner'.

Will

the

US

share

market

continue

rising

over

the

next

yea stabilise at present levels, or fall substantially?

The answer to that question, on whi views no doubt, will almost certainly have a material bearing on the growth of US c spending and potentially therefore on world economic growth.

But should we formulate mon policy on the basis that the US share market will correct downwards, or will not?

Sim developments in the Japanese economy.

Even within New Zealand, there may be all kind totally

unpredictable

events.

Another

drought

perhaps?

Unlikely

surely,

but

certa impossible.All these sources of uncertainty mean that, when we look back on the way in which mo policy was formulated in March 1999 from the vantage point of, say, 2002, what seeme well-founded decisions as we finalised our decision on the Official Cash Rate last w seem hard to justify.

Because of the delay between monetary policy action and the effec action on the real economy and, through those effects, on inflation, we have no alternat formulate policy in full recognition of this inherent uncertainty.This has several implications, and this is not the place to spell out all of them.

B ways in which we try to reduce the risks associated with the inherent uncertainty of policy formulation is by publishing our quarterly projections and the key assumptions they are based. (Indeed, we have published considerable information about the model on our projections are based.) This helps markets to interpret new information as it emer adjust monetary conditions even before we adjust the Official Cash Rate.

Of course t works because financial market participants understand the objective of monetary policy Zealand and, on the basis of our track record over the last decade and more, understand we are committed to delivering that objective.What

this

means

in

practice

will

no

doubt

be

illustrated

tomorrow.

In

our

Monetary Statement last week, we indicated that when we finalised our projection on 1 March we e that

GDP

would

have

increased

by

0.6

per

cent

in

the

December

1998

quarter

(seaso adjusted).

It is possible that, when the figure for December 1998 quarter GDP is relea Government

Statistician

tomorrow,

it

will

show

growth

of

exactly

0.6

per

cent.

Possi unlikely.

But in an important sense that doesn't really matter.

Not only is there ample to adjust policy long before any mis-assessment has the slightest relevance to infla second half of next year, but financial markets themselves may adjust conditions withi of

the

announcement.

Thus

if

the

December

quarter

GDP

figure

turns

out

to

be

appre stronger than the Bank projected, and if this is seen by markets as being relevant to outlook, monetary conditions might well tighten quickly.

And vice versa.

This is preci happened, for example, on the announcement of the GDP figures for the March quarter of 1 the end of June, for the June quarter at the end of September, and for the September q the end of December.

In each case, monetary conditions moved in a broadly appropriate di

## ConclusionAt the beginning of my address I asked what New Zealanders can expect of monetary policy i the long term.

I would hope that they can expect monetary policy to become so totally predict as

to

be

boring

-

stable

average

prices

year

after

year

after

year

-

because

that

is

t environment for growth in output and employment.Interest rates will still move up and down to some degree of course, reflecting changes i balance

between

savers

and

borrowers.

But

the

week-to-week

volatility

of

short-term

inter rates should be diminished by our move to implement monetary policy through an Official Cas Rate, and our progressively longer track record of low inflation should make it unnecessary to push interest rates to the levels seen in the early stages of disinflation in the mid-eighThe New Zealand dollar will also fluctuate of course, certainly against individual currenci even against the trade-weighted index.

As I discussed in a speech to the Canterbury Employe Chamber of Commerce at the end of January, that appears to be a fact of life which nobody yet found a way of avoiding.So I suppose that, with interest rates and the exchange rate still moving up and down, mon policy will never seem totally boring.

But with luck monetary policy will at least come to b for what it is when it is formulated with skill, namely a useful contributor to a prosperous but not nearly as important as a whole host of other matters - policies on education, polic the labour market, policies on taxation, our access to international markets, the quality managers,

and

all

the

rest.

Those

are

the

things

which

will

really

determine

our

longer prosperity.