Donald T Brash: Inflation targeting 14 years on
Speech by Mr Donald T Brash, Governor of the Reserve Bank of New Zealand, at the American
Economics Association conference, Atlanta, 5 January 2002.
* * *
Mr Chairman, Ladies and Gentlemen
It is a great honour to participate in this session on inflation targeting this morning, and to share the
platform with such distinguished practitioners of that art.
I was asked to speak first because my name comes first, by a rather narrow margin, when the four
speakers are lined up alphabetically. It also happens that New Zealand was the first country in the
world to adopt a formal inflation target, in the sense that we understand the term today, in the late
eighties. Both of these facts give me some latitude about what to talk about, although when Jacob
Frenkel invited me to participate in this panel discussion he stressed that I was not being invited to
address the theory of inflation targeting so much as to talk about some of the lessons we have learnt
from experience over almost 14 years. And that is what I propose to do.
Bernanke et al have defined inflation targeting as
"a framework for monetary policy characterised by the public announcement of official quantitative
targets (or target ranges) for the inflation rate over one or more time horizons, and by explicit
acknowledgement that low, stable inflation is monetary policy's primary long-run goal. Among other
important features of inflation targeting are vigorous efforts to communicate with the public about the
plans and objectives of the monetary authorities, and, in many cases, mechanisms that strengthen the
central bank's accountability for attaining those objectives."1
I am very comfortable with that definition.
Has inflation targeting met its objectives in New Zealand?
Countries usually adopt inflation targeting for one or more of the following reasons:
• A desire to find some credible anchor for monetary policy, often after a period of high
inflation and/or the loss of a previous anchor (perhaps an exchange rate target which proved
impossible to maintain or a money aggregate target which proved both difficult to achieve
and less closely connected to the inflation rate than hoped for).
• A desire to give the central bank instrument independence, but to balance that with some
clearer specification of what the central bank should seek to achieve with that instrument
independence - in other words, to make it possible to balance independence with
accountability.
• A desire to reduce the social and economic costs of disinflation by reducing the inflation
expectations of both financial markets and agents in the real economy.
In New Zealand's experience, I have little doubt that the adoption of inflation targeting helped to
provide an anchor for monetary policy. Certainly, there had been important progress in reducing
inflation between the mid-eighties and the time a specific target was first discussed in April 1988, but
in the year to March that year CPI inflation was still 9 per cent, and predictions by the Reserve Bank
that inflation would fall below 4 per cent within two years were widely ridiculed.
By 1991, inflation was under 2 per cent, and inflation has averaged around 2 per cent over the last
10 years. Of course, lots of other countries have also achieved low rates of inflation over the last
decade, so it is impossible to be dogmatic about the extent to which inflation targeting helped in the
case of New Zealand. But in my own judgement the single focus which inflation targeting required of
the central bank was a material factor in focusing the Bank on that objective. Beyond the first year or
two, we did not spend a lot of time debating what the optimal inflation rate might be. In terms of
making the decisions about monetary policy, that was irrelevant because the target had been agreed.
The only debate was about what degree of monetary policy pressure was needed to achieve that
objective.
In the seventies and eighties, during most of which period New Zealand did not have an inflation
target, New Zealand's inflation was not only markedly higher than it was in the nineties, it was also
higher than inflation in other OECD countries. Inflation targeting helped us to achieve a substantial
improvement in our inflation performance in absolute terms; it helped us to reduce inflation relative to
inflation in other developed countries; it helped to reduce the volatility of inflation; and it helped us to
maintain that improved performance.
Interestingly, and perhaps contrary to some impressions both in New Zealand and abroad, achieving
this marked improvement in inflation performance was not bought at the cost of an increase in output
volatility. Yes, output volatility was higher in New Zealand during the nineties than in, say, Australia or
the United States, but that is hardly surprising: one would expect to see rather more output volatility in
a very small, commodity-dependent, economy than in a much larger and more diversified economy.
But the nineties saw both a decline in inflation volatility and a decline in output volatility in New
Zealand, as compared with the two previous decades.2
Inflation targeting has also come to be seen as an important aspect of the Reserve Bank's
accountability. New Zealand had no tradition of central bank independence prior to the late eighties.
Although more and more people could see the cynical way in which monetary policy could be
manipulated by politicians who gave greater weight to their own re-election than to preserving the
purchasing power of the currency, it was always going to be a challenge to get substantial political
buy-in to full central bank independence. One of the things which made that political buy-in possible -
to the extent that both major political parties voted for the legislation giving the Reserve Bank
instrument independence late in 1989 - was the fact that it was Parliament which mandated price
stability as the Bank's objective, and what that meant was to be formally and publicly agreed in a
Policy Targets Agreement (PTA) between the Governor and the Minister of Finance. In other words,
there was to be full instrument independence but not full goal independence. The legislation was
drafted in such a way that the PTA could have been based around exchange rate targeting, nominal
income targeting, or conceivably even money aggregate targeting, but in the context of the time
everybody understood that the PTA would be based around the inflation target which had been
announced more than 18 months earlier. The Bank was to be accountable for delivering that agreed
inflation target, and the legislation made it clear that the Governor could lose his job for "inadequate
performance" in achieving that objective.
There is no doubt that a desire to change inflation expectations was an important part of the
motivation in the adoption of an inflation target in New Zealand. Then-Minister of Finance Roger
Douglas was very concerned in March 1988 that, with inflation moving into single figures for almost the
first time in 15 years (with the exception of a brief period during which all prices, wages, interest rates,
dividends and rents were subject to tight administrative control), the public would expect the monetary
authorities to ease up, and settle for inflation in the 5 to 7 per cent range. It was in that context that the
Minister announced, during the course of a television interview on 1 April 1988, that he was thinking of
genuine price stability, "around 0, or 0 to one per cent".
It is less clear that the adoption of an inflation target was in fact successful in reducing the costs of
disinflation by reducing the inflation expectations of financial markets and the public - and this despite
the fact that my senior colleagues and I devoted an enormous amount of effort to convincing the public
of the seriousness of our intent. Guy Debelle has done a study of the sacrifice ratio involved in
reducing inflation in Canada, Australia and New Zealand. For New Zealand (which had a specific
inflation target) and Australia (which did not, at least until after its disinflation had been completed),
that study suggests that the sacrifice ratios were similar.3
I would not myself want to put too much store by that result. New Zealand's inflation performance had
been rather worse than Australia's for some years by the late eighties, and one would therefore expect
to find inflationary expectations more deeply entrenched in New Zealand. Moreover, just two years into
the disinflation process in New Zealand the Government introduced a 10 per cent Goods and Services
Tax, which increased the CPI by an estimated 8 per cent. Then, in mid-1989, that tax was increased
from 10 per cent to 12.5 per cent. Both moves presumably had some effect in maintaining inflationary
expectations at a relatively high level.
Although I can not prove it, I believe that the inflation targeting regime did help to change expectations
and behaviour at the margin.
I well recall that, in late 1990, not many months after the Policy Targets Agreement had seen the 0 to
2 per cent inflation target formally agreed between Governor and Minister, the head of the New
Zealand Council of Trade Unions, Ken Douglas, wrote an article which appeared in one of the major
newspapers.4 The article argued that the Reserve Bank was focused on an undesirably narrow
objective (namely, low inflation), but that, as long as that was the case, unions would need to
moderate wage demands to avoid increases in unemployment. In the weeks which followed, he
actively, and with very considerable courage, campaigned for moderate wage settlements as a way of
reducing unemployment. I have little doubt that the inflation target played a part in encouraging
2
"Output volatility in New Zealand", in Independent Review of the Operation of Monetary Policy: Reserve Bank and
NonExecutive Directors' Submissions, Reserve Bank of New Zealand, October 2000.
employers and unions to adjust their wage settlements to levels which were quite quickly consistent
with the inflation target.
There was also a very large reduction in the spread between the yield on New Zealand government
New Zealand dollar long-term bonds and that on US Treasuries. In the mid-eighties, that spread had
peaked at around 1000 basis points. By early 1990, that spread had reduced to around 400 basis
points, and it has been well under 200 basis points for most of the last decade. Of course, most of that
reduction in spreads was presumably simply the result of New Zealand's greatly improved inflation
performance, but that improved performance was, as I have argued, in part attributable to the inflation
targeting framework, while that framework probably also helped, at the margin, to convince markets
that low inflation was likely to endure.
An inflation target agreed by Governor and Minister
In New Zealand's experience, the fact that the inflation target was, and still is, formally agreed
between the Governor of the central bank and the Minister of Finance on behalf of the Government
has been unambiguously positive. And I make this point because some observers have suggested
that this need to agree the inflation target between central bank and executive/legislature is an
undesirable restraint on central bank independence.
There is no question that it is, in principle, a restraint. In our framework, the inflation target is formally
agreed between Minister and Governor, and can be changed either by mutual agreement or by the
Minister unilaterally (if the Governor does not agree to a change) by the use of the so-called override
provision in the legislation.
But, in a world of open capital markets, the fact that the legislation requires the Policy Targets
Agreement, or any override of that Agreement, to be in the public domain means that no Minister can
manipulate the target for cynical political ends. On the contrary, the Minister has every incentive to
make it publicly clear that the inflation target he wants the central bank to deliver is consistent with
price stability and a stable currency. Indeed, it is this obligation to be transparent about the objectives
of policy, and about the modus operandi of policy, that is one of the most important aspects of the New
Zealand inflation targeting framework, arguably as important as instrument independence itself. If a
Minister were, say, to instruct the Bank to ignore the inflation rate and focus instead on increasing the
growth rate - as he could do by invoking the override provision - markets would almost certainly deliver
an immediate increase in interest rates across almost the entire yield curve (the Bank would still, of
course, be able to anchor the overnight rate), together with a sharp fall in the exchange rate. The need
to be transparent ties the hands of both government and central bank unless there are good and
explainable reasons for change.
The fact that the inflation target is a matter agreed between Minister and Governor has effectively
protected the Bank from criticism by the government, and in the almost 14 years during which inflation
targeting has been in place, the number of government ministers who have attacked the Bank can be
counted on the fingers of one hand. Given that the Minister of Finance is involved in agreeing the
inflation target, it is not easy for him or other ministers to attack the Bank for having policy too tight
unless inflation is, or looks likely to be, below the target. Of course, we are not fully protected from
criticism, even from the government: given the long lags with which monetary policy operates, and the
inherent uncertainty, we may still be criticized for the timing or magnitude of policy moves, though in
practice that has been a very unusual event in our experience.
Moreover, agreeing the target between the Minister and the Governor has the important indirect effect
of improving the consistency of monetary and fiscal policies while still leaving the central bank with
instrument independence. By agreeing the inflation target with the Governor, the Minister of Finance is
implicitly agreeing that if fiscal policy is changed, monetary policy may need to change also, potentially
offsetting any stimulus (or restraint) emanating from fiscal policy.
We saw this most dramatically in mid-1990 when the Minister announced an expansionary Budget just
months before the general election scheduled for late that year. Markets were concerned about the
loosening in fiscal policy, and became uneasy about the future direction of policy. This was reflected in
a rise in long-term interest rates and a fall in the exchange rate, to which we responded by tightening
monetary policy. Immediately, an editorial in New Zealand's largest daily paper noted that the Budget
had "rekindled inflationary expectations. The (Reserve Bank) was bound to lift interest rates....
Electors are frequently bribed to their ultimate cost. This time the independence of responsible
monetary control quickly exposes a fiscal fraud."5 The main Opposition party campaigned in the
election on a commitment to get interest rates reduced, not by leaning on the central bank but by
"giving monetary policy some mates" through tighter fiscal policy and deregulation of the labour
market.
Five years later, with several years of fiscal surplus behind it, the Government undertook to reduce
income taxes subject to several conditions being met, one of which was that the Reserve Bank was
satisfied that such tax cuts would not require a significant tightening of monetary policy.
To me, these are good illustrations of the benefit of having the specification of the objective of
monetary policy a matter for formal and public agreement between government and central bank. It
forms a kind of pre-commitment strategy.
The pre-conditions for inflation targeting
There is another issue related to inflation targeting on which I would like to comment, and that relates
to the pre-conditions which must be met before a country can sensibly embark upon it. It has
sometimes been suggested that inflation targeting is such a complicated undertaking that only
countries with lots of economists with PhDs from good American schools, several sophisticated
econometric models, and a good understanding of how the monetary transmission mechanism works
dare to undertake it.
On the basis of New Zealand's experience, I would argue that this is quite incorrect. Of course,
operating any monetary policy is easier, and more likely to be successful, if the central bank has
access to competent people and has a good understanding of how the transmission mechanism
works. But the core elements of inflation targeting are not particularly complex, or rather are no more
complex than operating other approaches to monetary policy. When we embarked on inflation
targeting, we had our fair share of competent staff, but we had no clear understanding of how the
transmission mechanism worked and a rather inadequate economic model. Indeed, the economy had
been subject to such dramatic change over the previous few years that no model based on past
relationships would have been of much use to us. Notwithstanding those deficiencies, we have little
doubt that inflation targeting has been successful in New Zealand. We certainly have no reason to
believe that we would have been more successful if we had been trying to target nominal income or a
money aggregate.
Evolution has been significant
Perhaps because we began inflation targeting at a time when the New Zealand economy was
undergoing so much structural change, it was probably inevitable that our approach to the task would
evolve quite significantly over the years after 1988.
In the early years, we assumed from international experience that raising interest rates would tend to
reduce inflationary pressures and that reducing interest rates would tend to increase inflationary
pressures. But we had no reliable evidence, indeed no evidence at all, which might guide us on the
extent to which an interest rate change in New Zealand would change the inflation rate. For this
reason, and perhaps because some of us retained deeply monetarist sympathies, we began the
process of reducing inflation by adopting a very "quantitative" approach to the task - we determined to
hold the liquidity in the banking system stable, something made relatively easy by the clean float of the
exchange rate (in place since March 1985) and by a government commitment to fund any fiscal deficit
by the sale of bonds. Interest rates across the whole yield curve were completely driven by market
pressures, and fluctuated considerably.
In the late eighties, we realised that, while we did not know in any specific sense what effect a change
in interest rates had on inflation, we did have a reasonable estimate of the effect of exchange rate
movements on the inflation rate. We estimated that a 1 per cent movement in the exchange rate, as
measured by a trade-weighted index, produced a change in the Consumers Price Index of about 0.4
per cent over the following year or so. And from this fact we developed an implementation regime
which was for a time rather heavily oriented to the exchange rate.
5
New Zealand Herald, 3 August 1990.
At no time did we have an exchange rate target in the conventional sense. But we did derive a
"conditional comfort zone" for the trade-weighted measure of the exchange rate which seemed to us,
given all the other factors affecting the inflation rate, to be consistent with progress towards, or later
maintenance of, the inflation target. In other words, the comfort zone was moved up (an appreciated
New Zealand dollar) when domestic inflation was projected to rise towards the top of the inflation
target, and down (a depreciated New Zealand dollar) when domestic inflation was projected to fall
towards the bottom of the inflation target.
We still set no interest rate, but rather made small adjustments to the target for the quantity of
settlement cash in the banking system, with the aim of tightening or easing monetary conditions. And
while we did not announce our comfort zone for the exchange rate, the financial markets usually had a
very clear understanding of where that zone was, both because we were open about the exchange
rate "pass-through coefficient" (0.4) which we were using in our inflation forecasts and because from
time to time we would "clear our throat" to draw attention to the fact that monetary conditions were in
danger of becoming inconsistent with the inflation target. We referred to our use of OMOs in the
implementation of monetary policy - not so much "open market operations" as "open mouth
operations".
We discovered that occasional "open mouth operations" were actually all we needed to implement
policy most of the time, and we left the target for settlement cash unchanged for years at a time. In
other words, the mere fact that the financial markets understood that we could adjust the quantity of
settlement cash in the banking system, thereby tightening or easing monetary conditions, was
sufficient to produce a change in monetary conditions consistent with our objective of meeting the
inflation target, without the need for any actual change in settlement cash. It was in one sense the
ultimate "no hands central banking", where we set no interest rate and no exchange rate, and left the
target for settlement cash unchanged for many months on end. In time, what moved monetary
conditions was our quarterly, published, inflation forecasts, and the widespread knowledge that, if
push came to shove, the central bank was able to inflict financial pain on banks if monetary conditions
did not move in a way consistent with the inflation target. This system also imposed an absolutely
miniscule "monetary policy tax" on the financial system, since the amount of settlement cash in the
system (on which we paid a below-market interest rate to discourage banks from holding excess
balances) was never more than 0.1 per cent of banking system deposits, and was normally well below
that.
As time went by, we moved away from a focus on the direct price effects of movements in the
exchange rate. In part, that was because these price effects became progressively more muted, as
several other inflation targeting countries also found in the nineties. In part too, it was because we
developed a better understanding of the inflation process in New Zealand. We moved our forecasting
horizon out somewhat, beyond the direct price effects of exchange rate movements to the more
medium-term effects of the real exchange rate and real interest rates on inflation through their effect
on the output gap. But we continued to implement policy through our ability to move the quantity of
settlement cash in the banking system, and through making our views about the appropriateness of
monetary conditions known through our quarterly inflation forecasts and occasional "open mouth
operations ".
This worked effectively as a system for keeping inflation under control, but it had disadvantages from a
public relations point of view. Occasionally, monetary conditions would become a bit too easy to be
consistent with our inflation target, and we would draw attention to the fact that conditions should be
somewhat tighter. And conditions would tighten, usually through an increase in market interest rates
and some appreciation in the exchange rate. But we had no quantitative way of informing the market
about how far conditions should tighten, with the result that we often had to make a "that's about far
enough" statement a week or 10 days later. The financial market understood this system, but to the
general public it sometimes led to the perception that the Reserve Bank was having difficulty making
up its mind whether conditions were too loose or too tight. We needed some kind of quantitative
indicator.
So in June 1997, we started expressing our views on the appropriateness of monetary conditions in
terms of a Monetary Conditions Index. We announced that we would use an MCI based on a
movement of 100 basis points in 90 day interest rates being equivalent to a movement of 2 per cent in
the trade-weighted measure of the exchange rate, with the average conditions prevailing in the
December quarter of 1996 being equal to 1000. Had this experience been a total success, I would
have been happy to acknowledge our debt to the Bank of Canada for this experiment!
The experience was not a total failure. In particular, it finally persuaded financial market participants, at
home and abroad, that we had no exchange rate target in the conventional sense. Prior to that time,
and related no doubt in part to the "conditional exchange rate comfort zones" which we had used in
the late eighties and early nineties, there had been quite a widespread perception that we were in
some sense "putting a floor" under the exchange rate, with the result that investing in New Zealand
dollars was a "one way bet".
I well recall a conversation with a fund manager in New York late in 1996, at a time when almost all
observers felt that the New Zealand dollar was considerably over-valued. Referring to the action by the
Swedish central bank to drive overnight interest rates to 500 per cent to defend the krona some years
earlier, he asked me whether we would have "the courage" to do the same, to defend the New
Zealand dollar. I assured him that there was absolutely no way that I would push New Zealand interest
rates to 500 per cent to defend the New Zealand dollar. "Why not?" he asked. "Because we do not
have an exchange rate target; we have an inflation target", I replied. "Clearly, if the New Zealand dollar
falls sharply, this may have implications for the future inflation rate, and this might require us to push
up interest rates somewhat, but the mere fact that the exchange rate declines does not require us to
push rates to 500 per cent." He was appalled, and warned me that if my views became known on Wall
Street, the New Zealand dollar "was done". I urged him to spread the message since, as indicated, the
currency was almost certainly well over-valued by almost any measure at that time.
Adopting the MCI in June 1997, and expressing our views about monetary conditions in terms of a
"desired" level of the MCI, finally ended the view that the Bank had a covert exchange rate target. It
also gave us, for the first time, a quantitative way of telling the market by how much we wanted
conditions to tighten or loosen. But the MCI was quickly, and to some extent unfairly, discredited,
partly because it was introduced at the very outset of the Asian crisis. That crisis hit demand for many
of New Zealand's exports very hard, and it was appropriate that the New Zealand exchange rate
declined to reflect that external shock. We recognised that, and gradually reduced our "desired" level
of the MCI through the second half of 1997 and the first half of 1998. But we failed to recognise the
extent to which the external shock had affected the appropriate exchange rate, with the result that we
reduced the MCI too slowly through that period. Even though we were still not setting any interest rate
directly, the result was a sharp increase in 90 day interest rates to "offset" the sharp decline in the
exchange rate, and we have acknowledged elsewhere that that probably exacerbated the short and
shallow recession which took place in the second part of 1997 and the first part of 1998.
We relaxed the "bands" around the "desired MCI" in the second half of 1998, and in March 1999 finally
moved to a conventional implementation regime, abandoning both the quantity target for settlement
cash and, as a signaling device, the MCI, and adopting instead an Official Cash Rate, whereby the
interest rate on overnight money in the system is kept within a range of plus or minus 25 basis points
from the nominated rate.
Our approach to the inflation target itself evolved somewhat over the 14 years. In 1988, the target was
simply expressed as "0 to 2 per cent". When the first formal Policy Targets Agreement was signed
early in 1990, the target was still 0 to 2 per cent, and there was explicit provision for renegotiating the
target if the inflation rate was affected by what we referred to as "caveats" - large external shocks to
the price level (such as a big change in the international oil price), changes to indirect tax rates, and
similar. The second Policy Targets Agreement, signed shortly after the general election in late 1990,
extended the date by which inflation of 0 to 2 per cent had to be achieved from the end of 1992 to the
end of 1993, and removed the need for renegotiation of the Agreement if the inflation rate were
affected by "caveatable" items. Instead, the Bank was to ensure that CPI inflation excluding such
"caveatable" items was within the target. This led us to calculate and publish what we referred to as
"underlying inflation", which was CPI inflation less "caveatable" items. But this had all sorts of
problems associated with it, not least a perception problem, with the Bank calculating the underlying
inflation rate on which the Governor's performance was to be judged. Now we have a target of keeping
the CPI between 0 and 3 per cent (the target was widened after the general election of November
1996) and a need to have a good explanation if inflation diverges from that target. The Policy Targets
Agreement makes it clear that external shocks, changes in indirect tax rates, and similar factors
constitute valid reasons for the inflation rate to diverge from the target for a time. (The latest PTA,
signed on 16 December 1999, is attached.)
We characterise ourselves as "flexible inflation targeters" rather than "strict inflation targeters", in Lars
Svensson's terminology. But there is debate even within the Reserve Bank itself whether we have
always been flexible inflation targeters or whether perhaps we have evolved to greater flexibility than
we had earlier in our inflation targeting history.
There is little doubt that in the early years our rhetoric was rather "strict". We had the challenge of
convincing a sceptical public, made cynical by years of broken political promises about keeping
inflation under control, that this time there was going to be a serious commitment to keeping inflation
under tight control. So we emphasised that monetary policy had been given only a single goal by
statute, namely "stability in the general level of prices", and I as Governor was liable to be dismissed
for failing to deliver that objective. And we repeated that message, again and again. We recognised
that the more quickly we could convince both financial markets and the general public that we were
absolutely committed to achieving the inflation target, whatever the cost in terms of unemployment and
lost output, the smaller that cost in employment and output would be. Allowing people to think that we
were "soft-hearted", and would back off the inflation target as soon as unemployment started to
increase, seemed a certain way to increase unemployment. (Having said that, and as indicated earlier,
it is not unambiguously clear that demonstrating a strong commitment to a particular inflation target
was in fact successful in improving the inflation/unemployment trade-off during the period of
disinflation, though my personal view is that it helped.)
In those early years, it is probable that none of my colleagues themselves really believed that we
would be able to get inflation within a 0 to 2 per cent target and keep it there.6 But in 1991, two years
ahead of the deadline imposed by the Policy Targets Agreement, inflation fell within the target for the
first time, to the considerable surprise of many people both inside and outside the central bank. And in
1992, inflation was again within the target. And in 1993. And in 1994. By this time, many people, again
both inside the central bank and outside it, were coming to believe not only that inflation could be kept
inside a 0 to 2 per cent target, but also that keeping inflation within the target was not such a difficult
job after all. Economic growth was among the fastest in the OECD; inflation was within the target; New
Zealand dollar 10 year bond rates were marginally lower than the yields on 10 year Treasuries (in the
first part of 1994). It all seemed pretty easy.
In the year to June 1995, underlying inflation increased to 2.2 per cent, outside the target for the first
time since 1991. But that result was influenced in part by an adverse weather pattern in May 1995,
which had sharply increased the price of fresh fruit and vegetables. We still thought that we would
quickly return to within the inflation target. In the