Mr. Brash discusses fluctuations and long-term trends in exchange rates and
their effects on export commodities and comments on the Reserve Bank's Monetary
Conditions Index Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald
Brash, to the Counties Kiwifruit Growers Association in Pukekohe on 22/8/97.
Mr Chairman, I am delighted to be back in Pukekohe, though I must admit I'd
rather be next door in my orchard instead of in here, explaining the impact of monetary policy
on the fruit-growing industry!
Two months ago, when you asked me to speak this afternoon, you asked me to
focus on exchange rates. In particular, you suggested I speak about 'fluctuations and long term
trends in exchange rates and their effects on export commodity pricing'. I am happy to do that,
but I also want to make a few comments on the Reserve Bank's Monetary Conditions Index,
both because it is relevant to the subject you have asked me to address and because the MCI has
become the subject of a good deal of public discussion and debate over the last month or two.
Indeed, some claim it is only the Reserve Bank's obsession with the MCI that has seen
exchange rate and interest rates pushed around in a rather volatile manner over the last couple of
months.
The exchange rate
First let me talk a little about the exchange rate. Here the concerns seem to be
partly about fluctuations in the exchange rate and partly about the long-term trends, as your
suggested subject for my speech indicates.
I have to say that I do not have a great deal of sympathy for those who complain
about the fluctuations in the exchange rate, and that for two quite different reasons. First, and
most obviously, there is now a very well-developed market in forward foreign exchange
contracts, so that it is readily possible for exporters to fix the exchange rate at which they sell
their products long before they actually want to repatriate the proceeds to New Zealand.
Exporters may, of course, choose not to use that market and instead gamble that they might get
a more favourable exchange rate at some stage in the future. They should be free to make that
choice. But it is important to recognise that they are deliberately taking on foreign exchange
risk in the hope of getting something better in the future. They are not obliged to gamble in this
way.
This point is perhaps particularly relevant at the moment, when a number of
farmers are lamenting the fact that, while the exchange rate is now much more attractive, that
doesn't help farmers because few have stock to sell at the moment. But there is nothing at all
stopping farmers who have no stock to sell, or meat companies on their behalf, from buying
foreign exchange forward at the currently prevailing rates, and locking in current exchange
rates. By doing that, they eliminate the risk that the exchange rate may rise before their stock is
ready for sale, but of course they also pass up the additional benefit they might get if the
exchange rate were to fall further.
Secondly, although the New Zealand dollar has been subject to quite marked
fluctuations over the last few months, by and large the New Zealand dollar is not a volatile
currency by the standards of other floating rate currencies. Certainly measured on a
tradeweighted basis, the New Zealand dollar has in recent years been less volatile on a week-to-week
basis than, say, the Australian dollar, the US dollar, the pound sterling, or the Japanese yen.
What about the longer-term trends? Since at least the beginning of the seventies,
the trade-weighted measure of the New Zealand dollar has tended to move to reflect differences
between inflation in New Zealand and inflation in our trading partners (graph 1).
Graph 1: Relative Consumer Prices and Nominal TWI
(1970 - June 1997 average equals 100)
Index Index
160 160
Nominal TWI
140 140
Foreign/Domestic price level
120 120
100 100
80 80
60 60
40 40
70 72 74 76 78 80 82 84 86 88 90 92 94 96
In other words, when inflation was higher than in our trading partners, the New
Zealand dollar had a tendency to depreciate. When inflation was lower than in our trading
partners, the New Zealand dollar had a tendency to appreciate. Occasionally, the exchange rate
Graph 2: Nominal and 'Real' Trade Weighted Exchange Rate
(1970 - June 1997 average equals 100)
Index Index
160 160
Nominal TWI
140 Foreign/Domestic price level 140
'Real' exchange rate
120 120
100 100
80 80
60 60
40 40
would depreciate a little faster than seemed warranted by a relatively poor inflation performance
in New Zealand, and exporters enjoyed the experience. Occasionally, as in the period from early
1993 to early 1997, the exchange rate appreciated faster than seemed warranted by a relatively
good inflation performance, and exporters found the experience anything but enjoyable (graph
2).
If historical relationships hold, one would expect the New Zealand dollar to
move broadly in line with inflation differentials over the longer term, and a few months ago this
led a number of commentators to suggest that, at that time, the New Zealand dollar was clearly
over-valued. Last December I also expressed the view that, at that time, the New Zealand dollar
did indeed seem somewhat over-valued on that basis, though it should be noted that, to the
extent that productivity growth is higher in New Zealand than in our trading partners, one
would expect to see the exchange rate rise somewhat faster than inflation differentials alone
would suggest.
I have no difficulty at all in acknowledging the fact that the appreciation in the
New Zealand dollar from its floor of around 53 (on a trade-weighted basis) in January 1993 to
69.3 in March 1997, an increase of some 30 percent over just four years, put significant pressure
on a great many exporters. But four points need to be made in qualification.
First, it is very likely that an exchange rate of 53 on a trade-weighted basis was
as unsustainable as an exchange rate of 69.3. Neither represents an 'equilibrium' level of the
exchange rate, so to measure exchange rate appreciation from that artificially low level risks
creating quite a false impression.
Secondly, while acknowledging the pressure which the rising exchange rate from
1993 to early 1997 placed on exporters, I am bound to express a degree of cynicism about the
way in which some producer boards have described this impact. To hear some tell it, the impact
of the rising exchange rate on the gross incomes of farmers and orchardists is the same as the
impact of the exchange rate on their net incomes, and of course that it not correct. Granted, our
land-based export industries are not heavy users of imports, but they do use diesel, they do use
tractors, they do use fertilisers, and they are heavily affected by the costs of transport to and
from the farm-gate. And from their net incomes they still spend money on petrol for the family
car, they still buy clothes, they still buy other goods which are imported. The New Zealand
dollar price of all these items would have been significantly higher over the last few years had it
not been for the appreciation of the currency. Indeed, it is very likely that wage increases would
also have been significantly higher if there had been no currency appreciation. So while the
increase in the New Zealand dollar in recent years has undoubtedly had a severe impact on
gross farm incomes, the impact on farmers' living standards was rather less severe.
Thirdly, while the exchange rate appreciation has clearly made matters worse, the
basic problem facing our land-based exporters is that the inflation-adjusted, or real, price of
many of the items which they produce has been declining, and that for a long period. The New
Zealand Meat and Wool Boards' Economic Service tells me that between 1948 (prior to the
Korean War boom) and 1996, the inflation-adjusted price of lamb fell by 45 percent in the US
market; the price of dairy products fell by 55 percent; the price of beef fell by 69 percent; and
the price of wool fell by 79 percent. I don't know that anybody was noticing the price of
kiwifruit in the US market in 1948, but I can still recall that in 1982, just 15 years ago, the
orchard-gate price of New Zealand kiwifruit was $11 per tray. Nobody yet knows what we will
realise in 1997, but if the orchard-gate price for this year's crop is, say, $4.30 per tray, that will
be an inflation-adjusted fall in the orchard-gate price of some 85 percent in just 15 years - and
that over a period during which the New Zealand dollar has fallen quite substantially against the
currencies of virtually all our trading partners, and especially against the Japanese yen and the
German mark, the two currencies of most direct relevance to kiwifruit exports. The basic reality
is that the market price of kiwifruit has fallen substantially over that time.
And in case New Zealand exporters feel hard done by by this reality, remember
that very substantial falls in inflation-adjusted prices are common for most commodities, and
indeed for a great many other goods and services as well. Productivity improves, and
international competition often ensures that the benefit of that improvement is passed on to
consumers, rather than retained by producers. Reflect on the huge fall in the real price of
computers - a fall which dwarfs the falls suffered by New Zealand land-based exporters - or the
price of television sets, or of motor vehicles, or of international air travel, or of long-distance
telephone calls. Large price falls are by no means unique to the products which New Zealand
exports. To remain viable, all producers must be constantly seeking new ways to improve
productivity or add value, and if they do that successfully, they can maintain profitability
despite a trend decline in prices.
Finally, apart altogether from the tendency for the prices of many commodities to
decline in the long term, commodity prices tend to be volatile and in recent years this volatility
has tended to swamp the impact of exchange rate trends. The best illustration is the experience
of beef farmers in the three years to the middle of 1996: of the fall in the farm-gate price of bull
beef over that period, more than three-quarters was caused by a fall in overseas market prices,
and less than one-quarter by the rise in the exchange rate. In other words, the fall in the market
price of bull beef was substantially greater in its impact on farmers than the effect of the
increase in the exchange rate. Our land-based exporters operate in inherently volatile markets,
and would face major swings in prices even if, in some way, the New Zealand dollar could be
held absolutely stable. This should influence what can sensibly be paid for farming and
orcharding assets.
So yes, monetary policy does have an impact on the exchange rate, but that in
turn has much less impact on exporters' net incomes than on gross incomes, and has been of
very much less significance to land-based exporters than the fluctuations in international
commodity prices and the long-term decline in the real prices of many of the commodities
which New Zealand exports.
The Monetary Conditions Index
But what of the Reserve Bank's Monetary Conditions Index? Is the MCI, as some
have suggested, really to blame for much of the current economic slowdown, or at very least for
the sharp increase in interest rates recently?
Before answering those questions, it is worth recalling briefly that, once every
three months, the Reserve Bank does a comprehensive projection of the New Zealand economy
and of inflation for a period of two or three years. That projection takes into account all the
information available to the Bank at that time - the official statistics covering GDP, prices,
wages, employment, imports, exports, and all the rest; the data collected by the Bank itself on
the money and credit aggregates, and the path of interest and exchange rates; the survey data
covering business and consumer confidence; the views expressed to us, formally and
informally, about individual businesses and the economy; and much more. At the end of that
process, we reach a view on how firm monetary conditions need to be to keep inflation moving
towards the middle part of the 0 to 3 percent inflation target we have agreed with Government.
But of course neither we nor any other central bank can control the mix of
monetary conditions. In other words, we can tighten monetary conditions, but we can not
determine whether that tightening takes the form of an increase in interest rates with little or no
increase in the exchange rate; or an increase in the exchange rate with little or no increase in
interest rates; or an increase in the exchange rate with a decrease in interest rates; or an increase
in interest rates and a fall in the exchange rate. The mix depends on the perceptions and
reactions of a great many people, here and abroad, and indeed on what other central banks are
doing or are expected to do.
What to do? In a small open economy like New Zealand, it is impossible to
ignore the fact that monetary policy affects inflation through both interest rates and the
exchange rate, and for a number of years we have factored that into our policy setting. What the
Monetary Conditions Index seeks to do is to give the public and financial markets a broad
indication of how we see the relative impact of interest rates and the exchange rate on
medium-term inflation with a 'rule of thumb' combining both. Nobody can be dogmatic about
the precise nature of this relative impact - it clearly differs between economies depending on the
importance of international trade, and almost certainly varies depending on the stage of the
economic cycle. On the basis of research to date we believe it is reasonable to suggest that a
1 percent increase in 90 day interest rates has roughly the same effect on inflation, in the
medium-term, as a 2 percent increase in the (trade-weighted) exchange rate. This ratio is
particularly helpful in helping us to assess how the overall degree of monetary restraint is
evolving when interest rates and the exchange rate are moving in opposite directions, as has
often been the case over the last year.
In June this year, we expressed this relationship in numerical form, called it the
Monetary Conditions Index, and indicated that our projected inflation track was based on
monetary conditions being at 825 on that Index through the September quarter.
Has this increased openness been constructive or destructive? On balance, I have
no doubt that it has been constructive. Financial markets now know explicitly what in the past
they could only guess at, namely how we 'translated' movements in exchange rates into
movements in interest rates in assessing their effect on inflation. In the last few months, we
have experienced the sharpest decline in the New Zealand dollar since late 1991 without any
kind of drama or crisis. Interest rates have adjusted upwards to offset the effect of that
depreciation on the medium-term inflation rate, and that with only a couple of brief comments
from the Reserve Bank. Of course, a sharp fall in the exchange rate is almost inevitably going to
be associated with rising interest rates, since the fall is likely to prompt many investors to want
to withdraw funds from New Zealand investments, and this inevitably leads to higher interest
rates. But the fact that interest rates moved to keep the MCI broadly unchanged - certainly over
the sharpest movements in the exchange rate - suggests that the system has worked well. For the
record, I think the MCI is working at least as well as other approaches - better in some respects
- and I am in no hurry to change it.
Let me put this another way. I'm sure that if the Reserve Bank had not published
an MCI actual monetary conditions would have evolved in a broadly similar way, but probably
with more anguish. Without the early interest rate reaction, the exchange rate fall would have
left monetary conditions very much looser than we wanted. We would then have had to move to
recover the lost ground by tightening policy, probably requiring specific policy actions. In other
words, the MCI is only an indicator. It isn't driving events in a substantive way, so people
blaming the MCI are misdirecting their complaints. Give me stick, if you want, for misreading
inflationary pressures out there, but 'don't shoot the messenger', for that's all the MCI is.
What of criticism that the Bank has been operating the MCI mechanistically, or
robotically, and thus causing excessive volatility in financial markets? Should the Bank have
been more willing than it has been to allow actual monetary conditions to diverge from its
announced 'desired' conditions of 825, or, alternatively, should we have adjusted policy
instruments to ensure that actual conditions kept within the plus or minus 50 points of 825
announced as 'desired' on 27 June?
It is perhaps worth recalling what I said on 27 June, in releasing our latest
Monetary Policy Statement:
'It is clear that deviations from desired monetary conditions can be very large
indeed without threatening either edge of our inflation target if those deviations
are of relatively short duration. This suggests that the Bank should be relatively
tolerant of quite large deviations from desired. On the other hand, large
deviations, even for relatively short periods, may raise doubts - either about the
Bank's determination to achieve the inflation goals we have been set or about the
possibility that the Bank, in accepting those large deviations, may have changed
its view of desired conditions. These doubts can create uncertainty, and that
uncertainty has real costs, both short-term and long-term. We already allow
monetary conditions to move within a range, without reaction from the Bank,
which is at least as wide as that allowed in other developed countries.
I am reluctant to be too precise about how much deviation we are willing to
accept and for how long. Much will depend on the circumstances in which the
deviation occurs. We may, for example, be more tolerant of deviations which
appear to arise out of sharp movements in overseas exchange rates, where local
interest rates or exchange rates may take a brief period to adjust. We may be
more tolerant of deviations during the weeks immediately preceding our next
quarterly inflation projection, since it is at that time when our last comprehensive
review of desired conditions is, by definition, getting most dated. We are likely
to be less tolerant if monetary conditions change very rapidly, and appear to be
building some momentum, without any obvious explanation in terms of overseas
exchange rates or changed prospects for inflation.
As a very approximate guideline, we would expect actual monetary conditions to
be within a range of plus or minus 50 MCI points from desired in the weeks
immediately following a comprehensive inflation projection. As more data
comes to hand over the ensuing three months, and as our last comprehensive
inflation projection recedes into history, we may be rather more tolerant. But this
is not, repeat not, a binding rule which the market can expect us to follow under
all circumstances, and those expecting us to do so are likely to be disappointed.'
That is what I said on 27 June, and looking back with the wisdom of hindsight I
think the comments have stood the test of time rather well. Did we signal a tight band of plus or
minus 50 points around 'desired'? Hardly. On the contrary, we made it clear that we would
judge monetary conditions in the light of emerging data, and the factors we believed were
driving conditions. Should we therefore leap to change the target for settlement cash as soon as
conditions stray by more than 50 points from the designated level? Absolutely not, and nobody
should expect us to do so.
My only regret is that I did not mention, as one reason for being tolerant of
deviation of actual monetary conditions from desired monetary conditions, the complication
created by a sharp change in the mix of conditions. Clearly, the Index is based on the
assumption that a 1 percent movement in interest rates is equivalent, in medium-term effect, to a
2 percent change in the exchange rate, and that is our best estimate at this stage. But it is only an
estimate, and we recognise that the relationship may well change over time and in response to
very sharp movements in either interest or exchange rates. In the jargon, the relationship may
not be linear. It is partly for this reason that we have been willing to accept quite a marked
divergence between actual and desired conditions in recent weeks.
It is important also to recall that, as indicated a moment ago, we can not control
the mix of monetary conditions. This was very clearly indicated between September 1996 and
March 1997. Over that period, 90 day interest rates fell from around 10 percent to around 7.5
percent, while the exchange rate rose from around 66 on the Trade-Weighted Index to over 69.
On the face of it, this period of rising exchange rate and falling interest rates was the very
reverse of what might have been desirable - given that there was already little or no inflation in
the export and import-competing sectors of the economy, and plenty of inflation in the domestic
sectors - and I expressed my unhappiness about this mix on several occasions, all to no avail.
For a whole host of reasons - perceptions of the likely trend of monetary policy in New Zealand
and overseas, perhaps concerns about the balance of payments deficit, perhaps general concern
about currencies in this part of the world - the mix has changed quite sharply in the last few
months, with an increase in interest rates, which has taken them about half way back to where
they were last September, and a sharp fall in the exchange rate. Overall, conditions have eased
considerably, and I am sure that there won't be an exporter in the country who is not a good
deal happier with the present mix than with the one we had three or four months ago.
But aren't monetary conditions still too tight, given the low level of business and
consumer confidence, the general flatness of the economy, and the fact that, on the Reserve
Bank's own figures, we will have inflation at or slightly below 1 percent by the end of this year
and into 1998?
In less than a month, the Bank will be publishing its next comprehensive inflation
projection, so I don't want to give a substantive answer to that at this stage. But let me just
remind you of a couple of relevant points.
It is hardly surprising, or a matter for regret, that our June Monetary Policy
Statement projected that inflation would fall to 1 percent by the end of this year: through all of
last year, until 10 December, we were targeting inflation at between 0 and 2 percent, with a
mid-point of 1 percent, because that's what our Policy Targets Agreement with the Government
required at that time. We were battling to reduce inflation, which had been somewhat above the
top of that range throughout 1996. Given that it takes a minimum of 12 months for monetary
policy to have its impact on inflation, it would be surprising if inflation were not projected to be
moving towards 1 percent at the end of this year.
The inflation projection which the Bank published at the end of June was not
only based on monetary conditions being around 825 on the MCI during the September 1997
quarter, it was also based on a particular combination of interest rates and exchange rate. We
assumed that, during the September quarter, the trade-weighted exchange rate would average
around 67.3, and 90 day interest rates would average around 7 percent. We also explicitly
recognised that if the mix of conditions changed, the short-term track of inflation could be
different. With the exchange rate in fact significantly lower than assumed in the June Monetary
Policy Statement, and interest rates significantly higher than assumed, it is possible that the
immediate inflation track may be a little higher than projected in June because of the impact
which the lower New Zealand dollar may have on the prices of goods like television sets, cars,
and other imports. In other words, a lower dollar may increase inflation more quickly than
higher interest rates will reduce it.
Although there are many people who feel that monetary conditions are
inappropriately tight, and some who just feel that the combined wisdom of financial markets is
more likely to be right than is the Reserve Bank, it is worth recalling that for the first four
months of 1997, until the very end of April, financial markets kept monetary conditions
appreciably tighter than the Bank had indicated was necessary or appropriate, despite our saying
that we would be happier if conditions were somewhat easier. In other words, financial markets
are not infallible. It is interesting that in the latest Consensus survey of New Zealand
forecasters, representing views in mid-July 1997, 39 percent felt that conditions were unduly
firm, but 54 percent felt that they were about right - and conditions have eased somewhat since
that survey was conducted.
Monetary conditions have eased substantially over the last six or eight months
from an average of 1000 on the MCI in the December 1996 quarter to an average during the
first half of August of 730. Put in more familiar terms, conditions have eased by the equivalent
of a 2.7 percent fall in interest rates with unchanged exchange rate; or by the equivalent of a 5.4
percent fall in the exchange rate, with unchanged interest rates. This is a considerable easing in
monetary conditions, which will not have its main effect on activity and inflation until well into
1998 - at about the time the economy is also experiencing a strong stimulus from reduced tax
rates and increased government expenditure. In other words, the suggestion that the Reserve
Bank has been braking the economy in recent months is factually wrong. In fact, over recent
months the opposite is true.
We will, of course, be weighing all these factors and more in reaching our
judgement for the appropriate level of monetary conditions in the December quarter. We will
publish our considered judgement on 18 September. Unfortunately, given the long lags between
actions taken by the Reserve Bank today and the impact of those actions on inflation, nobody
will know until at least the second half of next year whether we should have eased rather more
in June 1997, or indeed whether we should have kept things a little firmer.
Of one thing you can be certain. We will do everything in our power to keep
inflation within the target which has been agreed with the Government. That will not guarantee
you a profit in fruit-growing, or in exporting more generally. It will, however, be the best
contribution which the Reserve Bank can make to the creation of an environment where you
and others can make rational investment decisions, to the ultimate benefit of all New
Zealanders.