Mr. Brash looks at economic developments and their bearing on inflationary
trends Speaking notes of Mr. Donald Brash, Governor of the Reserve Bank of New Zealand,
on the release of the September, 1997 Economic Projections in Wellington on 17/9/97.
Introduction
Good morning, and welcome to this briefing on the Reserve Bank's September
1997 Economic Projections.
You will recall that, in contrast to our June and December Monetary Policy
Statements, which the Bank is obliged to produce by statute, the Economic Projections which we
release each March and September are more in the nature of 'self-initiated' documents. Their
primary purpose is to assist us in assessing economic developments that have a bearing on
inflation trends, and thereby to assist us in forming judgements on how monetary policy should
evolve. In publishing our Projections, we take the opportunity to inform financial markets and
the public generally on what is driving our day-to-day policy decisions. Typically, you can
expect to see in our Economic Projections more discussion of matters such as investment
behaviour, labour market trends, the balance of payments and so on than is to be found in our
Monetary Policy Statements, which concentrate more on assessments of past and future financial
market conditions, and the stance of monetary policy.
However, both documents require us to produce a comprehensive view of the
future trends in the New Zealand economy, and to test our previously articulated views against
the stream of emerging data and opinion. A key ingredient in that process is our new forecasting
and policy system (FPS) -- the system of models we now utilise in developing our Projections.
One important change which that new system of models has made possible was
introduced with our June Monetary Policy Statement. Whereas we had previously projected
inflation on the basis of an assumed track for interest rates and the exchange rate, in June we
shifted to a structure that constrains our Projections of inflation to converge on the mid-part of
the 0 to 3 percent inflation target, while allowing the track of monetary conditions to vary as
necessary to produce that outcome. You can see that process at work again in these Projections .
One point made in relation to FPS when it was first introduced bears repeating.
While it is an important tool which helps shape our view of the economy and its likely future
path, it is not a 'black box'. FPS provides a coherent framework for thinking about the economy,
but considerable judgement is still required to arrive at a final projection. There are clearly a
number of different paths through which the economy can evolve to essentially the same point.
What is portrayed in this document is just one of those paths, but one that we feel is both
realistic and sound as a base for our policy judgements.
The real economy
Shortly after our June Monetary Policy Statement was published, the release of
March quarter GDP data seemed to suggest that the economy was significantly weaker than we
had allowed for. Our subsequent analysis indicated that there were particular factors (notably
that Easter, unusually, fell into the March quarter) which explained much of the small decline in
GDP in that quarter.
Since then, the emerging data have suggested that the economy is a little weaker
than we had portrayed in June, but that it is also resuming a robust growth path. Whereas we
were projecting an annualised growth rate through the first half of calendar 1997 of a little over
1 percent, the estimate incorporated in these Projections is closer to 0.5 percent. Having said
that, data released since we completed the Projections are, if anything, suggestive of stronger
rather than weaker outcomes for June quarter GDP. In any event, we remain of the view
expressed in June that activity will pick up in the second half of the year. Over the year to March
1998, we expect the economy to expand by around 2.5 percent, accelerating further to 4.6
percent growth in the year to March 1999.
The factors driving that expansion include a robust global economy, gradually
increasing household expenditures, improved productivity, stronger exports (partly the result of
a lower exchange rate), business investment and an expansionary fiscal policy -- both from
increased government spending under the Coalition Agreement and from the tax cuts scheduled
for July 1998. Easier monetary conditions since earlier this year are also supportive of stronger
growth.
It seems clear that, in the middle of this decade, the New Zealand economy
became somewhat over-stretched in terms of its ability to support the pace of spending. It seems
equally clear that the economy has entered a period in which there is some spare capacity. Given
the current and imminent expansionary forces that I have described, the spare-capacity phase
should be short-lived, but long enough to take the pressure off inflation, and long enough to
make it unlikely that we will experience the kind of destructive crunch that has so often brought
past cycles to a shuddering halt. In this sense, we are describing a growth profile that reflects the
steadying influence of maintaining low inflation, which in turn should contribute to New
Zealand's future growth potential.
We expect continued job creation throughout the period to March 2000, continued
growth in real disposable household income (averaging over 3 percent per annum through the
projection period), continuing modest fiscal surpluses, further declines in the government's
debt-to-GDP ratio, and an improvement in the current account deficit from nearly 6 percent of
GDP to around 4 percent of GDP.
Inflation
As I mentioned earlier, our new Projections framework takes as given that
inflation should converge on the mid-part of our target range, and derives the monetary
conditions that are needed to achieve that outcome. In that sense there is no particular news in
the fact that we expect underlying inflation to be close to the middle of the target over the
projection period. But there are some aspects of the inflation track that require comment.
In particular, we now expect inflation outcomes over the next two quarters to be
rather higher than was the case in June. There are two principal sources of that upward revision.
First, the last few months have seen a 6 or 7 percent depreciation of the
trade-weighted exchange rate. The increased inflation now expected over the next two quarters
is, in part, a direct consequence of that depreciation.
Secondly, domestic inflation continues to be strongly influenced by the policy
decisions of the Government. We now estimate that, over the next two quarters, policy-related
increases in Housing New Zealand rentals and tertiary education fees could well exceed the
materiality threshold which is applied in determining our measure of underlying inflation. In that
event, underlying inflation would be slightly lower than the estimates given in these Projections.
Policy Implications
We now view an MCI level of 725 as being appropriate for the next quarter. This
is 100 basis points lower than the desired MCI level which has applied for the last quarter, but
roughly equivalent to actual monetary conditions over recent weeks. You will recall that a 100
point reduction in the MCI is equivalent to a 1 percentage point decline in 90 day bill rates, a 2
percent decline in the TWI, or some equivalent combination. You may also recall that the
average MCI for the December 1996 quarter was 1000. The extent of easing over the past nine
months has clearly been significant, although certainly off a high base.
Our Projections point to further, but quite small, easings in the first two quarters
of 1998 before emerging inflationary pressures lead us to expect monetary conditions to enter
another tightening phase. However, as we make clear in our policy assessment section, whether
those further easings eventuate in 1998 is very much dependent on how the economy develops
over the next few months. Financial market participants eager to bring forward the small, and
conditional, easings shown in these Projections clearly do so at their own risk! On the face of it,
with inflation over the next two years, and especially over the next two quarters, being a little
higher than we thought likely back in June, easing now by more than we foreshadowed in June
may seem surprising. The explanation is straightforward, and relates to the lags inherent in the
operation of monetary policy. While inflation is a little higher in the short term than we had
previously expected, it is still well within our target range, and has been boosted by factors
which should be essentially transitory, such as the impact of moving Housing NZ rentals to
market. Of more relevance to the outlook in 18 months to two years' time is the margin of spare
capacity in the economy. That now looks somewhat larger than it did previously, and warrants
somewhat easier monetary conditions. Although activity will be accelerating through 1998, it is
not until 1999 that the inflation pressures associated with strong growth begin to emerge. A
gradual tightening of monetary conditions from mid-1998 fits with that profile.
There are, of course, alternative paths for monetary policy that could deliver
inflation within our target range. As was discussed in June, one alternative path would involve
more aggressive easing now, followed by earlier and more aggressive tightening next year.
Another path would involve holding conditions relatively flat at about current levels until the
latter part of 1998 before beginning a somewhat gentler tightening beyond that date. Inevitably,
there is rather more art than science in selecting the best of these alternatives. What we have
chosen reflects the risks that we see around us at present, and also reflects the benefits we see in
providing a relatively smooth path for monetary conditions over time.
The mix of monetary conditions
On numerous occasions over the past year or two, I have indicated that the
particular mix of monetary conditions was unhelpful -- that the exchange rate was too high,
putting excessive pressure on exporters, and that interest rates remained too low to discourage
borrowing for housing purposes, or to encourage increased domestic savings.
The past quarter has seen a substantial, and welcome, shift in the mix of monetary
conditions in the direction we believed appropriate. The fall in the exchange rate will boost the
incomes of exporters and those competing with imports, and will ultimately increase export
volumes. The projected improvement in the current account balance reflects that. The increase in
interest rates is also helpful, given the continuing pressures we have seen in the domestic or
non-tradeables sector of the economy, and especially in real estate markets. There is no benefit
to New Zealand in seeing real estate prices increase to a point where they become vulnerable to
a sudden, and damaging, correction. (Anyone who has been observing events in South-East Asia
over the past couple of months will be conscious of the enormous damage that can be inflicted in
those circumstances. Our own experience post-1987 is also instructive in that regard.)
The shift in the mix of conditions, while substantial, has occurred in a manner
which is fully consistent with our inflation target, and fully consistent with our use of an MCI in
assessing the overall stance of monetary policy. It is certainly the case that the sharp decline of
the exchange rate will boost inflation to some degree in the short term. That is already apparent
in our Projections. But even with that increase, projected inflation remains well within our target
range. And the increase in interest rates that has accompanied the exchange rate fall will work in
the opposite direction, dampening inflation in the longer-term.
The MCI
At the time when the exchange rate was declining, and interest rates were rising,
we heard a good deal of criticism of our MCI. It was, it was claimed, too rigid; it was forcing up
interest rates at a time when the economy was already in recession; it was based on a
relationship between interest rates and the exchange rate which was no longer valid; and so on.
As I made clear in my speech to the Counties Kiwifruit Growers Association on
22 August, I regard those criticisms as ill-founded. I think the MCI structure has performed
admirably over the past three months. In making that assessment, I think it is important to reflect
on just how volatile international exchange rates have been over that period. Any of the
alternative monetary policy arrangements we could have adopted in place of the MCI would also
have been subject to a good deal of stress. I certainly see no reason to change the MCI approach
at this point.
Likewise, the description I offered in June of how the Bank might react to
deviations in actual market conditions from the central or 'desired' MCI track appears to us to
have weathered the tests of the past quarter rather well. I see no reason to modify that
description now, and our response to evolving market conditions over the next three months will
be consistent with my comments of June.