Dr. Brash explains the Reserve Bank of New Zealand's new inflation target, and
Address by the Governor of the
New Zealander's expectations about inflation and growth
Reserve Bank of New Zealand, Dr. Donald T. Brash, to the Canterbury Employers' Chamber of
Commerce in Christchurch on 23/1/97.
Introduction
As perhaps you know, this is the fourth time on which I have been invited to address
the Canterbury Employers' Chamber of Commerce at your first luncheon meeting of the New Year
and I want to use the occasion to talk about two issues.
First, I want to talk about the new Policy Targets Agreement, amending the inflation
target from 0 to 2 percent to 0 to 3 percent, signed last month. And secondly, I want to talk about the
expectations which we New Zealanders have about both inflation and economic growth. In some
important respects, I believe that those expectations are quite unrealistic.
The new inflation target
First, the new Policy Targets Agreement. There have been two changes made in the
new PTA, but I suspect that to the general public the only difference between the new Agreement and
all of the earlier ones is that the new Agreement has changed the 'definition' of price stability from 0
to 2 percent to 0 to 3 percent, while making it clear that delivering that price stability remains the
single objective of monetary policy and constitutes the best way in which the Reserve Bank can
contribute to New Zealand's economic development.
Some will ask in anger why the inflation target is still so low, and why the Bank will
continue to focus monetary policy on delivering that target, when there are other objectives - such as
economic growth, employment, and export competitiveness - which are at least as important and in
many respects more so. Others will feel betrayed that the ceiling of the inflation target has been raised
from 2 to 3 percent, or that the mid-point of the target has been raised from 1 percent to 1.5 percent,
particularly given the fact that the two largest parties in Parliament were both strong advocates of a
mid-point of 1 percent during the last election campaign. I want to try to respond to both groups of
critics.
In many ways the easiest critics to respond to are those who feel that the inflation
target is still too low, or that, given the extent to which the economy has been slowing in recent
months and the extent of the pressures on the export sector, the Bank's objectives should have been
widened to include those other objectives. For there is in fact no evidence that monetary policy can,
by tolerating a little more inflation, engineer a sustainably higher rate of growth, or a sustainably
higher level of employment, or a sustainable improvement in export competitiveness. To be sure,
monetary policy can engineer faster growth, higher employment and improved exporter
competitiveness in the short term - by tolerating a bit more inflation right now, there is not much
doubt that growth and employment would be a little higher in 1997 than otherwise, and that exporters
would enjoy the benefits of a lower exchange rate. Most of that faster growth and higher employment
would be bought at the cost of tricking working New Zealanders into accepting a reduction in their
real wages, as prices rose ahead of wages. However, it would not last. Before too long, people would
recognise the deception and would demand compensation in the form of higher wages and salaries.
Within a very short time, inflation would be rising, growth would be back to its previous, lower, level
and we would be left contemplating the cost of reducing inflation again - and nobody should forget
the very substantial one-off costs, in terms of unemployment and lost output, incurred in reducing
inflation from levels above 15 percent in the mid-1980s to our current situation of price stability in
the early and mid-1990s.
Not only is there no evidence that tolerating more inflation can engineer sustainably
faster real growth, there is now overwhelming evidence that high inflation positively damages the
way in which the economy works - reduces the capacity for sustainable growth and higher
employment, and of course also does huge social damage, through the arbitrary redistribution of
income and wealth which it creates.
There is also very considerable evidence that even quite low rates of inflation do
damage to growth and employment, and virtually no evidence that inflation actually helps those
objectives. This is why the second of the two changes in the Policy Targets Agreement makes clear
that it is precisely in order to enable monetary policy to make its maximum contribution to
sustainable 'growth, employment and development opportunities' that the Bank is directed to focus
on maintaining a stable general level of prices.
But isn't there some concern, fostered in the popular media by the American
economist Paul Krugman, that if inflation is too low it may actually damage growth? In other words,
even if we accept that high or even moderate inflation is damaging, isn't it possible that central banks
which are excessively obsessive about achieving no inflation might actually be harming the economy
and the society they claim to be helping?
This brings me to the second group of critics, who are concerned that in changing
from 0 to 2 percent to 0 to 3 percent we have betrayed the intention of the Reserve Bank Act,
requiring that monetary policy focus exclusively on delivering 'stability in the general level of
prices'.
There is quite intense debate going on at the moment around the world among central
bankers and academic economists about what the best specification of a low inflation target should
be. There are two broad schools.
The first school accepts that monetary policy should be focused on delivering
predictably low inflation but argues that for several reasons that target is best expressed as inflation in
a range of 1 to 3 percent. The best known advocate of this 'low positive inflation' school is probably
Stanley Fischer, formerly of MIT and now Senior Deputy Managing Director of the International
Monetary Fund. He is visiting New Zealand next month, and it is likely that his views will receive
appropriately wide media coverage at that time. He argues for this 'low positive' inflation target for
various reasons, of which three are particularly important: The way in which inflation is measured
results in quite a significant over-statement of actual inflation. Estimates of this over-statement in the
United States have suggested that, in that country, the 'bias' in the measurement of inflation is
between 0.7 and 2.0 percent, with bias of 1.1 percent very recently estimated by a group chaired by
Michael Boskin on behalf of the United States Senate Finance Committee. For this reason, central
banks should target measured inflation of at least 1 percent, because to target anything lower than that
would be to target de facto deflation.
Because at some stage in the cycles through which all economies go it may be
necessary in the interests of maintaining a high level of employment for there to be some reduction in
inflation-adjusted (or real) wages, having a low positive level of inflation is more desirable than
having absolutely no inflation. This is because, with some inflation, real wages can be slightly
reduced by simply giving no increase in nominal wages, whereas with no inflation reducing real
wages involves having to actually reduce nominal wages. Real wages can still be reduced, even with
no inflation, but only at the expense of higher unemployment.
Similarly, it is argued that at some stage in the economic cycle it may be desirable for
inflation-adjusted interest rates to fall below zero to provide a strong stimulus to demand and, since it
is not generally practical for nominal interest rates to fall below zero, it is helpful if inflation is some
low positive number to make negative real interest rates possible.
The second school of thought argues for a lower inflation target, often characterised
by 0 to 2 percent but sometimes expressed as the level of average prices remaining stable over time.
Those who favour this view discount the arguments advanced by the 'low positive' school. They
acknowledge that there is an upward bias in the way in which inflation is measured, but argue that in
most countries outside the United States that bias is almost certainly less than 1 percent and certainly
could not justify a target with a mid-point of 2 percent. (The New Zealand Government Statistician is
strongly convinced that there is less bias in the measurement of the New Zealand CPI than there is in
the measurement of the US CPI.) They acknowledge that it has not been easy to adjust nominal
wages downwards in recent years, but argue that in substantial part that is a result of the persistently
high inflation most countries have experienced in recent decades, so that that should be no more than
a transitional problem. Moreover, even though it may be difficult to reduce the wages of an individual
employee, that does not prevent a significant reduction in unit labour costs as a result both of
unchanged wages and positive productivity, and of natural turnover in the labour force. Critics of the
'low positive' school challenge the assertion that monetary policy occasionally needs to reduce real
interest rates below zero, and note other ways in which monetary policy can stimulate demand,
particularly in very open economies where movements in the exchange rate play an important role in
influencing aggregate demand in the short term.
Those favouring very low inflation (0 to 2 percent) argue that not only are there no
advantages in tolerating a 'low positive' rate of inflation there are also significant disadvantages of
even quite low rates of inflation. Thus for example Martin Feldstein of Harvard University (and
current president of the National Bureau of Economic Research in the US) argues strongly that even
very low levels of inflation significantly exacerbate the biases in the tax system which encourage
consumption, discourage saving, and encourage excessive investment in residential property. In a
recent paper he argued that reducing measured inflation from 3 percent to 1 percent in the United
States would result in a permanent increase in the level of US GDP of 1 percent, a very large gain in
economic well-being even if there is some temporary loss of output required to reduce inflation to
that level. Others have also argued that the interaction between inflation on the one hand and tax and
financial reporting systems geared to historical cost accounting on the other creates a significant bias
against capital-intensive investment projects and all investment with a long pay-back period, and a
bias in favour of highly-geared companies and investments with a short pay-back period.
This debate is by no means concluded. At a major conference I attended last August
in the United States, it seemed to me that a majority of those who expressed an opinion favoured a 0
to 2 percent target, and that has been my own clear predilection. But given that there are very
experienced central bankers and monetary economists in both schools, it is at this stage quite
inappropriate to be dogmatic, and in my own view a target which involves doing our utmost to keep
measured inflation between 0 and 3 percent is certainly consistent with the intention of the legislation
within which monetary policy is operated.
Indeed, irrespective of where the mid-point of the target range should be, there may
be some advantage in having a slightly wider inflation target than the original 0 to 2 percent target. A
number of observers have suggested that a target with a width of only 2 percentage points requires an
excessive degree of activism on the part of the central bank, and that a slightly wider band, whatever
its mid-point, would be sensible. This has been argued, for example, by David Turner, an OECD
economist. The tension is between, on the one hand, choosing a target range which effectively
anchors inflation expectations at a low level but which is so narrow that it provokes excessive policy
activism and risks loss of credibility by being frequently exceeded; and on the other, a target range
which does a less effective job of anchoring inflation expectations, but which requires less policy
activism and protects credibility by being rarely breached. A 0 to 3 percent range seems a reasonable
compromise.
But whether there is any benefit at all from a wider target band depends significantly
on how a wider band, with a higher 'ceiling', affects the public's expectations of future inflation. If
people understand the new target as meaning that the Bank, under Government instructions, is now
willing to accept 1 percent more inflation than previously, then nothing positive will have been
achieved at all - and indeed there will almost certainly be net cost involved in the change. This is
because any increase in inflationary expectations would tend to feed into slightly higher pricing
decisions, slightly higher wage settlements, slightly greater eagerness to borrow, slightly less
enthusiasm for saving. If the Bank were willing to accept this behaviour, 'accommodate' it in the
jargon, we would end up with somewhat higher inflation but no other result (though of course the
higher inflation would have all the negative consequences for the real economy referred to earlier). If
the Bank were in fact not prepared to accommodate this increase in inflationary expectations - which
it would not be I hasten to emphasise - then the end result of increased inflationary expectations
would simply be higher real interest rates, somewhat lower economic growth, and somewhat higher
unemployment. If that were the end result, the widening of the inflation target would not only provide
no benefit it would be positively damaging.
So I think it is crucially important that nobody misunderstand what the Reserve Bank
is doing. Let me be absolutely clear. The Reserve Bank has not gone soft on inflation. We will not be
targeting an inflation rate of 3 percent, or even an inflation rate close to 3 percent. The Reserve Bank
will be striving to keep inflation well inside the 0 to 3 percent range, and we best do that by trying to
have inflation as close to the middle part of the range as possible.
That does not mean, of course, that we will always hit the target, any more than we
always hit 0 to 2 percent. But it does mean that we will be constantly implementing monetary policy
with the intention of having inflation as defined around the middle part of the target. If we do this, the
number of occasions on which we miss the target should be minimised. Indeed, given the wider target
range, there should be fewer breaches than in the past.
Inflation and growth expectations
And this leads naturally into the second major theme of my address today, about New
Zealanders' expectations about inflation and growth. It is my contention that expectations about both
need to become a lot more realistic.
First, let's look at expectations of inflation. Yes, there are some encouraging signs
that New Zealanders' expectations of future inflation have fallen substantially over the last decade as
actual inflation has fallen. Surveys of inflation expectations currently suggest that, on average,
householders now expect year-ahead inflation to be around 3.9 percent, well down on the levels of
the late 1980s (year-ahead inflation expectations were 12.5 percent on average towards the end of
1987, and were still 8.3 percent near the end of 1989), while 10 year bond yields are slightly lower
than 10 year bond yields in Australia and less than 1 percent higher than 10 year yields in the US.
Wage settlements in recent years have also been one of the areas where inflation expectations seem to
have been subdued, with a great many wage settlements concluded at levels which have, until
recently at least, put little upward pressure on prices.
However, other indications are not nearly as encouraging and suggest that New
Zealanders' inflation expectations are still showing the effects of the two decades of high inflation we
endured in the 1970s and 1980s.
Look at New Zealanders' saving behaviour for example. Among those with financial
assets, how many are locking in the high real interest rates they purport to see by investing in
long-term fixed interest instruments, such as term bank deposits or government bonds? The short
answer is 'very few'. To be sure, our bond yields are now comparable to international bond yields,
and I used to deduce from that that the new monetary policy framework had produced a profound
reduction in inflationary expectations. I now believe that I was unjustifiably optimistic, because it is
foreign savers who have bought our bonds in huge volumes, thereby reducing bond yields to
international levels. More than half the New Zealand government bonds on issue are now held
overseas, and the proportion of some of the longer-dated bonds held overseas is even higher. (In
recent months, for example, more than 70 percent of the longest-dated nominal bond held by the
market has been held by overseas investors.) If we look at the term structure of the New
Zealandsourced deposits of any major bank, we will see that overwhelmingly New Zealanders are holding
their cash and fixed interest investments at very short term, the great bulk with a maturity of less than
12 months. Indeed, most banks have close to 90 percent of their total deposits maturing within six
months, and very few have more than 5 percent of their deposits maturing beyond 12 months. By and
large, most New Zealanders do not invest their savings in long-term fixed interest securities at all,
despite what are, on the face of it, very attractive inflation-adjusted interest rates.
What are we doing with our savings? Though the data on saving behaviour in New
Zealand is not very good, anecdotal evidence strongly suggests that New Zealanders invest any
available saving in some form of equity investment, most typically property: a bigger house to live in,
another house to rent out, a bigger farm, another piece of farmland, perhaps a block of flats, a
beach-side section, an industrial property, a commercial building, perhaps a forest block, anything
which, the best-selling books and advertisements constantly tell us, will protect us against inflation.
Protect us against inflation? But we've hardly had any inflation for the last six years and, despite the
biggest change in New Zealand's constitutional arrangements this century, we have just had the new
Coalition Government re-affirm the strong commitment to price stability. True, but we've certainly
had two decades of high inflation in the memory of all adult New Zealanders and we all know of
people who lost most of their life's savings over that period by 'making the mistake' of investing in
'secure' fixed-interest investments.
I've told the true story of my uncle so many times that I am almost embarrassed to tell
it again, but in my view it contains the explanation of much of the current approach to saving in New
Zealand, so I will tell it again. After a life-time of orcharding in the Nelson area, he sold his orchard
in 1971 and invested the sale proceeds 'safely' to provide income and security for his retirement. To
be absolutely safe, he invested the entire proceeds in 18-year government stock, at the then-interest
rate of 5.4 percent. Perhaps fortunately, he did not live until those bonds matured in 1989, but if he
had done the $30,000 he received from selling his orchard in 1971 and which matured in 1989 would
have bought him by that time just one Toyota Corolla car (with a little change). In 1971, $30,000
would have bought him 11 Toyota Corollas. In the space of just 18 years, he had lost some 90 percent
of his retirement nest egg, all by making the mistake of assuming that inflation would stay at the
relatively low level of 1971.
As I say, most adult New Zealanders know stories similar to that one. Or they know
stories which tell the same message in another way. Stories about people who bought a property with
borrowed money in the early 1970s and watched the price of the house increase perhaps eight- or
tenfold over the next 20 years, with the value of the equity actually invested in the house (after allowing
for the money borrowed to help finance the purchase) increasing perhaps 30 times. Perhaps we have
had an experience like that ourselves. Even if we have not, we are assailed by books and
advertisements on all sides which assure us that property investment is the best way of 'protecting
you against inflation', to say nothing of making the most effective use of the tax system. Even if we
are not familiar with the detail of the statistics, we know that in recent years residential property
prices have risen hugely in much of the country, most obviously in Auckland. According to REINZ
data, the median price of house sales in the Auckland district rose by 53 percent over the three years
to December 1996, by 36 percent in the Southland district (including Queenstown), and by 29 percent
in the Waikato/Bay of Plenty district. Even rural land prices, which have come back markedly in
some areas in recent months, rose by 45 percent over the three years to the first half of 1996,
according to Valuation New Zealand data. Is it any wonder therefore that New Zealanders who claim
to believe that consumer price inflation is more or less under control continue to borrow money
enthusiastically at 9, 10, and 11 percent to acquire property?
Lest there be any misunderstanding, I am assuredly not against investing in property,
let alone against home ownership. I own a home and a small amount of other property myself. I am
merely saying that inflationary expectations are alive and well in the minds of most New Zealanders
and that, until that situation changes, we will inevitably be looking at interest rates which look high in
comparison to current consumer price inflation. Conversely, of course, as inflationary expectations
abate, and particularly as expectations of property price inflation abate, the overall level of interest
rates will tend to be lower also.
Alan Greenspan, chairman of the US central bank, has on several occasions suggested
that price stability obtains when economic agents - businesses and private individuals - no longer take
account of the prospective change in the general price level in their economic decision-making. It is
clear that we still have a little way to go.
What about New Zealanders' expectations for economic growth? Are these too quite
unrealistic? I believe that they are, at least based on current policies and attitudes.
In the early 1990s, New Zealand achieved real economic growth of more than 5
percent per annum for two years in succession. We were told that we were growing faster than any
other OECD economy, and at growth rates comparable to those achieved by the East Asian 'tiger'
economies. We began to believe that, as a result of the economic reforms of the last decade, we too
were capable of 5 or 6 percent growth indefinitely and all of us wanted to believe that. Sadly, we can
not, or at least there is no evidence yet that we can. The very fast growth of 1993 and 1994 was the
result in part of the one-off productivity gains resulting from the micro-economic reforms of the late
1980s and early 1990s, and in a greater part of the economy having available a large number of
unemployed and underemployed people, and unutilised industrial capacity, as a result of the recession
of 1991 and early 1992. As these people and this capacity were brought back into productive work,
the rate of growth of real output jumped well above its sustainable rate. The rate of unemployment
fell very sharply from almost 11 percent to just over 6 percent in little more than three years and,
while everybody hopes that unemployment falls further, it is clearly impossible to reduce the rate of
unemployment by 5 percentage points every three years indefinitely.
As I told the members of the Auckland Chamber last year, economic growth depends
primarily not on monetary policy but on real factors - on how fast the labour force is growing, on
how skilled the labour force is, on how much capital that labour force has to work with, on the
technology embodied in the capital, on the efficiency of the price system in signalling where capital
can be most productively invested, on the nature of regulations and restrictions which inhibit the
effective working of the price system, and a host of other factors. Prices which are, on average, stable
assist the pricing system to work effectively, and thereby help to ensure that investment takes place in
the most economically sensible places. Prices which are, on average, stable tend to encourage saving,
and thereby help to finance additional investment. But stable prices won't make the labour force grow
more quickly, or make the labour force more skilled, or improve the technology embodied in the
capital equipment which the labour force uses, let alone make public sector enterprises more efficient;
or improve the quality of the education system; or move resources out of highly protected sectors into
those which can be competitive on international markets; or improve the marketing of commodity
exports; or even give us East-Asian-type savings rates.
I would argue strongly that price stability has been helpful to the improved
performance of the New Zealand economy in recent years, but I have never claimed for a moment
that price stability has been the sole reason for our better performance, nor that price stability
guarantees us strong growth in the future. In addition to our ability to bring back into productive
work people and capital equipment that had become unemployed during the recession, our very much
improved growth performance in recent years has been the result of a whole range of policy changes
- of reduced protection and regulation in the private sector, of corporatisation and privatisation of
many formerly inefficient public sector enterprises, of a vastly less distorting tax structure, of port
reform, of labour market reform, and all the rest.
If we want to build on that achievement in the years ahead, we must constantly be
seeking areas where productivity can be further improved. At this stage, the aggregate numbers for
the economy as a whole have led the Reserve Bank to base its economic projections on trend labour
productivity growth of no more than 1.25 percent per annum. If that turns out to be the case (and 1.25
percent is close to productivity growth in other mature economies, such as the United States1 and
Australia), total growth in GDP could well be around 3 percent per annum because of growth in the
labour force. But growth in real income per head, which must surely be the real objective of
economic policy, will not exceed 1.25 percent annually. If we want faster growth in spending than
that, we can in the short term borrow to supplement our income but, as we learned in the 1970s and
1980s, that is ultimately futile. In the longer term, higher incomes per head, and the higher spending
that that can bring, can only come from finding ways to accelerate productivity growth.
And how do we do that? Certainly not by debasing the currency through tolerating
inflation. The very rapid growth of the countries of East Asia is in part simply the result of their being
able to pick up 'off the shelf' modern technologies, which have taken decades to develop elsewhere.
In other words, there is a substantial element of 'catch-up' in the fast growth of East Asia. But the
growth which has occasioned so much envy on the part of some New Zealanders has also been
achieved in a particular cultural environment - a cultural environment which places enormous
emphasis on family self-reliance, which abjures reliance on the state, which as a consequence
generates a savings rate roughly double the New Zealand rate, which pursues education and training
with a passion, which regards material affluence as a highly desirable goal. New Zealanders have,
implicitly at least, chosen a slower growth path, by placing little emphasis on saving, by placing a
more modest value on education and training, by valuing other goals more highly than affluence.
I recall seeing a television programme three or four years ago about Asian students in
our schools. The programme included comments from two New Zealand children that they resented
the fact that the Asian children worked much harder than they did. I don't think New Zealand
children should be forced to work as hard as Asian children do, but I think it is important for our
children to realise that they live in a world where those who work hard will end up with higher
incomes and more wealth than those who choose to work less hard. If we are only prepared to pay for
beer, we won't be drinking a lot of champagne. The sooner we acknowledge that reality the better for
all concerned. By not doing so, the risk is not only that private spending will constantly be running up
against income constraints, but also that successive governments will be under considerable and
unreasonable pressure to satisfy demands for increased public expenditure. Both will have serious
implications for our ability to finance development from our own savings.
Conclusion
Mr. Chairman, let me conclude by summarising my main points.
First, I am confident that the new inflation target set me by Government is consistent
with the legislation under which the Bank operates and consistent with monetary policy continuing to
make the best contribution of which it is capable to New Zealand society and the development of the
New Zealand economy.
Secondly, whether the slightly wider target band enables the economy to operate with
slightly less central bank activism depends heavily on how the change affects the expectations which
people have of future inflation. If people assume that, on average, inflation will be 1 percent higher
than they assumed previously, there is a real danger that, far from providing additional flexibility, the
wider target will actually harm the way in which the economy works. Let it be clearly understood,
therefore, that the Bank will be implementing monetary policy with the intention of having inflation
as defined in my agreement with the Minister around the middle part of the 0 to 3 percent target. If
we do this, the number of occasions on which we miss the target should be minimised. It would
clearly be very damaging if the impression were created that we might be content with inflation
outcomes near the top of the target.
Thirdly, we still have some work to do in convincing New Zealanders that our money
is a predictably safe store of value for the relevant future. Until that is achieved, the interest rate at
which the willingness to save in the form of financial assets is matched by the willingness to borrow
will continue to look high by international standards, and our companies will continue to seek
unrealistically high rates of return on investment projects. That will tend to mean that investment is
lower than it might otherwise be, and that the exchange rate will be higher than otherwise.
Fourthly, it is important that, while constantly aspiring to improve our national
growth performance, we all have realistic expectations about the speed at which the New
Zealand economy can actually grow. Recent reforms have undoubtedly increased our sustainable
growth rate above that which was possible in the past: after several decades of growing much
more slowly than other developed economies, we now seem capable of growth comparable to,
and probably a little higher than, growth in many other mature economies, such as the United
States and the United Kingdom. But we will probably never be able to equal the growth rates
achieved recently by the 'catch-up economies', while growing faster than we currently can will
depend not on the central bank being a little more tolerant of inflation but on continuing
improvement in many other policy areas and on sustained productivity growth.
The Reserve Bank makes its greatest contribution to New Zealand society by
achieving and maintaining public confidence in the stability of the unit of value, predictably,
dependably, reliably.