Mr. Brash addresses the topic 'living with low inflation: farming for profit' in New Zealand  (Central Bank Articles and Speeches, 2 Apr 98)
Central bank: rbnz | Type: speech | Date: 1998-04-02

## Mr. Brash addresses the topic 'living with low in flation: farming for profit ' inNew Zealand Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald T.

Bra to the Foresight in New Zealand Agriculture Summit in Wellington on 2/4/98.

## IntroductionThank you very much for that kind welcome.I must, however, immediately ask your forgiveness, in that I am going to chan topic of my address from that which is printed in the very elegant programme which you have you.

When I came to prepare this address I went back to the title suggested for me performance and investment; redefining the industry' - and I could see the thrust of what asked for, but my heart dropped.You see, I could regale you with old war stories about when I tried to assis marketing of kiwifruit.

I could give you my frank assessment of the performance of the board with which I have most personal contact, the Kiwifruit Marketing Board, or whatever i called.

I could tell you I am still successfully losing money as an absentee kiwifruit gr talk about added-value.

I could chant the mantras - which you all know - saying there's no selling undifferentiated commodities.

I could say we all need to be in the business o top-of-the-line brands.

I could claim that, if we did that, then, regardless of the exchan state of the world economy, all would be well.

I could say the rich and the famous would to buy our products - top-of-the-line, nuclear-free, greener-than-green, designer food natural fibres, all sanctioned by Xena the Warrior Princess and Peter Blake.I could say all that, and it would all be true, but from me it would just be that I am not in the marketing business, except perhaps of price stability.

As a central b I should talk about the things I know best, under the title 'Living with low inflation: profit.'Moreover, I suspect that what I'm going to say is germane to what this summ trying to achieve.

## The exchange rateIn

the last two or three years, the Reserve Bank has been acutely aware t policies have been causing, or appearing to cause, the nation's export farmers a whole lot Often, in despair, farmers would tell us that the rising dollar was driving them into the for some it was.

Between the low point in early 1993 and the high point in early 1997, Zealand dollar rose against the US dollar by nearly 40 per cent, while even on a trade-weig the increase was some 30 per cent, big increases by any standards.Having acknowledged that, I must also say that sometimes farmers, and unfortuna some of their representatives, blamed the exchange rate when the real villain was low wor over which monetary policy could have no influence.

As I have noted on other occasion example, roughly three-quarters of the fall in the farm-gate price of bull-beef over the t June 1996 was a result of the fall in US beef prices, with only one-quarter of the fall expl rise in the New Zealand dollar.

Moreover, while I would not deny for a moment that the ri exchange rate between early 1993 and early 1997 put huge pressure on many farmers, it is i to recall, for what I am going to say in a moment, that that rise had at least some advantages:

the price of fuel was lower than it would have been otherwise, as was the tractors, the cost of off-farm transport, and quite probably the cost of farm and off-fawell.

I've sometimes felt that, for some marketing agencies at least, the Reserve Bank h convenient whipping boy, or a way to pass the buck - pardon the pun.Now export farmers are feeling much better, or at least those who have escape impact of the drought are feeling better.

The exchange rate has fallen sharply, and some feel it will fall further yet.

Hopefully, as a result, the New Zealand dollar incomes of e will rise.

I'm sure many farmers are now saying it's time to reinvest in their farms.

If t I'm delighted.But I want to sound a warning note to farmers.

Yes, everything else being equa end of the court is now favoured, just as it was back in the early 90s.

But it is important that exchange rates go both up and down, and you should not assume that, just because t dollar has fallen sharply over the last six to nine months it will stay down at t permanently.

Indeed, if our economy prospers, we should expect to see a gradual appreciati exchange rate over the long-term.Perhaps farmers need to think about the exchange rate the way Canterbury far think about rain.

Sooner or later, droughts are going to happen.Consider what we call 'the real exchange rate'.

The real exchange rate is Zealand's nominal exchange rate, adjusted by the difference between inflation in New Zeal inflation in our trading partners.

This is more relevant to exporters than simply loo nominal exchange rate: clearly, if inflation within New Zealand is markedly higher than t trading partners, even a falling exchange rate is of little help to exporters, while if markedly lower than that in our trading partners, exporters can cope with an appreciating rate.

When the real exchange rate rises, or in other words when the nominal exchange rate more than the difference between our inflation rate and that of our trading partners, expo under real pressure.

And vice versa.

Now have a look at Graph 1.Graph 1

## Nominal and 'Real' Trade Weighted Exchange Rate(1970 - March 1998 average equals 100)˝The

solid line is the nominal Trade Weighted Index, in other words the nom exchange rate.

The dotted line shows the difference between inflation in New Zealand and in our trading partners.

As you can see, over long periods of time, the nominal exchange ra reflect the difference between our inflation rate and that of our trading partners: when was relatively high, our exchange rate tended to depreciate; when our inflation was relat our exchange rate tended to appreciate.Of course, there have been divergences between the two lines, sometimes for pe of three or four years at a time, and that is illustrated by the dashed line, or real exc over the whole period shown, nearly 30 years, there has been no persistent tendency for exchange rate to rise or fall, and that is true despite the fact that through the first h the exchange rate was essentially pegged to the US dollar (with periodic devaluations) whi last 13 years the currency has been floating.

The dashed line - the real exchange rate - h around a pretty flat trend-line.

Back in the late 1980s, farmers were in despair, and part for that was that the real exchange rate was at a peak in 1987/88.

In the early 1990s, by was relatively low, and farmers were feeling much better.

In the mid 1990s, it was up again its coming down again.

Note how enduring this cycle is, irrespective of the exchange rat Farmers need to remember this, when judging what investments are worthwhile.A good Canterbury farmer knows that droughts are inevitable, and plans accordi Likewise, a good exporter knows that fluctuations in the real exchange rate are also inev plans accordingly.

I would like to be able to say that the Reserve Bank can reduce the am these fluctuations, but since fluctuations in the real exchange rate have been of broa magnitude in, for example, the United States, Japan, Australia and the United Kingdom in years, I can give you no confidence at all in this regard.

## Interest ratesMy

staff tells me that 12 months back they were often fielding calls from farmers, wanting to vent their spleen about the exchange rate.

Those calls have dried up calls of distress are often coming from Auckland - people upset that interest rates aren't days ago an Auckland talkback host was telling me in no uncertain terms what he thought ab and monetary policy because he couldn't sell his house.

Out in the vast hinterlands of talkback radio, I'm becoming a bit of a villain again.

I'm consoled by the comment of American central banker who once said that an unpopular central bank governor is not neces good central bank governor, but a popular central bank governor is almost certainly a bad oSo maybe farmers are a bit happier, for a while at least.

However, too oft afraid, farmers do have something in common with that Auckland talkback host.

And this le to the amended title of my address.

At the beginning of this year my staff and I were wre that old faithful: 'Why does New Zealand have such high interest rates relative to other Now the conventional explanation is:

'The New Zealand economy has been more buoyant th others, pushed along by a fiscal loosening, strong immigration and so on.

As a result, un we had to have monetary policy tighter than elsewhere and that meant higher interest r elsewhere.'That is fine as an explanation, as far as it goes.

But a key part of the sto been that insatiable desire to borrow that still afflicts us New Zealanders, so that, as so available at under 10 per cent, we rush down to the bank saying: 'Give us more', forcing th Bank to tighten monetary conditions to contain inflation.Why is that?

Are New Zealanders irrational?

I doubt that.

But hold on - we'v price stability since 1991.

Yet, clearly, if you look at our willingness to borrow eve˝amounts at apparently high rates of interest, it's taking a long time for that lesson to the meantime, monetary policy has had to be pretty tight.

What's been happening?Well, one young economist in our Economics Department recently came up with a interesting graph.

She compared our real estate inflation with Australia's.

She then offset the mortgage rates in the two countries and something very telling emerged.

People don't b buy the basket of goods and services that go into the Consumers Price Index.

Mostly they b buy property.

Measured against property inflation, our real interest rates have been much theirs have, at least until recently (Graph 2).

That's to say, our mortgage rate minus ou property inflation has, until recently, been much lower than Australia's mortgage rate m property inflation.

So, in the mid 1990s, it made more sense to borrow to the hilt to buy New Zealand than in Australia.

New Zealanders weren't being irrational.

They were re perfectly sensibly to the incentives that property inflation was giving them, though, I ha has come to an end now, and I fear there may be tears, as happens whenever a fall in prope affects people who have borrowed heavily in the expectation that prices will continue indefinitely.Graph 2Real mortgage interest rate (Mortgage interest rate less ex-post house price inflation)

## Living with low inflationLet's peel this back further.

Why did property inflation continue in the 199 achieved price stability measured by the CPI in 1991.

Those representing both sides negotiations quickly understood what that meant.

I well recall Ken Douglas saying - and I will forgive me if I report this a bit roughly - that he didn't support this new Reserve Ba with price stability, but if that was going to be the fact of the matter, then double digi a thing of the past.

Likewise, retailers and the providers of services quickly surr traditional cost-plus attitude of the 1970s and early 1980s.However, strangely, we have been far less successful with property ownership, have to say, this applies both in town and in the countryside, as Graph 3 illustrates: fo˝last decade, both house prices and farm prices have risen markedly more quickly than the rate of CPI inflation.

Far too many people still see getting heavily into debt to buy a se as the best way they can save for their retirement, even though, in my view, they disappointed.House prices and rural land prices Graph 3(indexes rebased to a March 1988 value of 100)Source VNZ.

' Other NZ' series is derived by RBNZ from VNZ data.Lest I be misquoted yet again, I'm not criticising home ownership.

Owning your place is normally a good thing to do because it provides a secure home.

It also provides a people, particularly in their retirement, assuming it is financed rationally.

I own a home have done so for most of my adult life, for all the normal reasons that apply to most New Z However, my concern is that - forgive me pinching a great line - New Zealanders' 'ir exuberance' for getting into debt, in the hope of making money out of now non-existent inf still distorting the New Zealand economy.So, the question remains, why that passion for debt to finance speculative rea Why have people, when it comes to their personal finances, failed to learn the lesson inflation that they have learnt very well indeed in the work place?One of my staff has come up with an interesting proposition.

He says it's Reserve Bank's fault.

Maybe we've sold the message wrongly.

Maybe our advocacy has been fault.Certainly, I've given innumerable speeches about the worth of price stabili always as a public good or as a benefit that applies to society as a whole.

I've talked economies perform better if people making investments have a stable currency by which to m the value of commercial decisions over time.

I've talked about social justice, and the wa harms the poor and benefits the rich, and so on.

Maybe what we, the Reserve Bank, have fail is talk about the value of price stability as a private good.

More specifically, maybe we take the lead in saying: 'All right, low inflation is here to stay.

This is what you need in personally managing your affairs given that fact.'˝As we bounced this idea about, another staff member said: 'Yes, just this wee my father - he's got a few properties - said: 'Back when there was inflation I knew how money - but now I don't'.' At the moment we are investigating some media strategies to star about this.

I don't know if anything will come of it, but I do think there is an importan The virtue of price stability as a private good is a case that hasn't been won yet, or at have failed to explain the implications of low inflation at the individual level.For example, people need to think about questions like: 'Does that second pro make sense if, over time, its value will increase at little more than the average rate indeed for some properties at less than the average rate of inflation?

Given the exten property prices have risen faster than incomes over the last few years, is there a risk of fall in property prices over the next few years?

Would I be better investing in financia earn interest?

Does putting that deck on the house make sense given low inflation, or over-capitalised?

This mortgage is stretching my finances to the limit, so can I endure i my debt won't be wiped out by inflation in five years' time?'Am I just seeking to re-educate townies doing up old villas in Grey Lynn, not b they want to live in them, but because they plan to sell next year?

Well, no. When farmer distress about non-tradable inflation and the 'blunt instrument of monetary policy', I and others on the receiving end, said: 'Hold on, what about the runaway prices for farm land? been going up just as fast or faster that property in town.' 'Not fair,' replied vari representatives. 'That's a cost of production we have to face, not a price we control,' theWell maybe.

But for the most part farmers sell land to and buy land from farmers.

It seems to me that many farmers are like people in the cities when it comes to t finances.

Too many still haven't internalised the lesson that, by hook or by crook, price here to stay.

This is part of why, to put it bluntly, the price of farm land is still ver irrationally high, if one is assessing the business of farming in terms of the annual earned on the investment.

The Meat and Wool Board's Economic Service reports that the r return on the market value of farm assets used in farming sheep and beef averaged just 0.8 1995/96, and 1.7 per cent in 1996/97.

Indeed, that rate of return has not reached 6 per year since 1979/80.

And this in an industry where the trend of world market prices h inexorably downwards since the Second World War.

Why, on that basis, would anybody inves farming?Of course, the answer, in part, is that farming people have non-commercial r for wanting to be in this business, as well as commercial reasons, and that's perfectly leg of other people make similar decisions.

I recognise also that, in part, the reasons for th return on sheep and beef properties in the years cited were related to temporary factors, strong demand for land suitable for planting in forestry and, on the other end of the sp land suitable for conversion to dairying.

However, also, I suspect that too many farmer farming for capital gain.

Too many farmers still think, okay, my life will be pretty basi working career, but the life-style is good, and I will have a gold-plated retirement when IHere I come right back to the wider theme of this summit.

I don't think farmi capital gain does farming any good at all.

I think it is based on delusion, in that from capital gains won't be there, because inflation has been contained even for farm land pric Graph 3 indicates as much over the last couple of years, while many observers are predict fall in land prices from current levels).

However, in the meantime, the entry costs of farming are still too high, which excludes fresh blood and innovation.For example, why would anybody take seriously advice to improve the marke acceptability of the meat they produce, or the wool they produce, if the real crop is˝property to the next guy?

Why would the pursuit of excellence, that this summit is promot any relevance, if the primary goal is property speculation?The answer, ladies and gentlemen, is no reason at all.My worry is that, as the profitability of producing meat, and wool, and m gradually restored with a lower exchange rate, farmers will quickly capitalise that profitability into the price of land once more.

If that happens, the profitability of farmi low indefinitely: farm-owners may have substantial wealth, but the rate of return on that remain very low.

Eventually, this process only ends when people refuse to invest in an where the rate of return is so low and the risks - of weather, disease, and market considerable, and put their money in the bank instead.

Farming doesn't come to an end at t land prices fall to the point where the rate of return on farming seems attractive relative˝