Graeme Wheeler: Reflections on 25 years of inflation targeting
Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to a
Reserve Bank of New Zealand and International Journal of Central Banking conference,
Wellington, 1 December 2014.
* * *
It is now 25 years since the Reserve Bank of New Zealand Act came into force. The Act
established the operational independence of the Reserve Bank (Bank) in respect of
monetary policy, and specified price stability as the single monetary policy objective. A month
later, the Minister of Finance and the Governor signed the first Policy Targets Agreement,
which specified an annual inflation target of 0 to 2 percent.
Through this reform New Zealand became the first country to formally adopt inflation
targeting as its monetary policy regime - that is, setting the Reserve Bank the explicit goal of
maintaining inflation in a range consistent with overall price stability, giving the Bank the
independence to pursue that goal, and holding it - through its Governor in New Zealand's
case - accountable for reaching the price stability objective.
In the lead up to this reform there was extensive debate within the Bank over the goals and
transmission of monetary policy. Consistent with emerging international thinking, the concept
of a long-run Philips Curve trade-off was rejected, as were policy rules around monetary
aggregates, and targeting nominal GDP. The literature on policy credibility and time
consistency was explored in depth, along with insights from writings on corporate
governance. On the design front, considerable effort went into defining price stability,
agreeing a target range for inflation (as price level targeting was ruled out), and establishing
caveats whereby it might be acceptable for inflation to be outside the target range for short
periods1.
At the time, these developments were highly controversial. The reforms were viewed by
many here and overseas, as ambitious yet desirable. They were in line with efforts being
pursued in many countries to rein in high inflation, and were consistent with domestic reforms
under way to strengthen public sector performance by holding public agencies accountable
for reaching clear contractual objectives. But others questioned whether it was appropriate,
or even feasible, to have the Bank pursue price stability as its primary responsibility, and to
hold the Governor accountable for an outcome not directly under the Bank's control.
Twenty-five years on, a new generation has grown up with low and stable inflation as the
norm. Much the same has occurred elsewhere in the world, with all of the major central
banks viewing low inflation as their main objective. But, beginning in the US in 2007, and
spreading globally during 2008, we saw the worst financial meltdown since the Great
Depression. The Global Financial Crisis (GFC) presented major challenges to policy makers
and raised important questions about the conduct and focus of monetary and financial
policies.
This then is an appropriate time to take stock of our experience with inflation targeting: how
have monetary and financial policies moved forward over the last 25 years, including in the
aftermath of the GFC; and what issues and challenges lie ahead? I will offer some insights
from the past 25 years.
i) Inflation targeting has delivered price stability without reducing our long term
growth rate
The Bank continues to hold firmly to the view that the most important contribution monetary
policy can make to promoting efficiency and the long-run growth of incomes, output, and
employment is the pursuit of price stability. Price stability preserves the purchasing power of
the currency and enables producers and consumers to plan with greater certainty for longer
periods, including by responding to relative price changes that would otherwise be obscured
during times of high inflation. Price stability also reduces the inflation risk premium in interest
rates, facilitates long-term borrowing, lending and contracting, and reduces the need for
speculative investments designed to protect against inflation risks.
It is uncertainty around the long run price level that generates the costs associated with
inflation. Inflation, particularly unexpected inflation, is a hidden tax, affecting most severely
those with fixed incomes and holders of cash rather than inflation-protected assets. Price
stability cannot by itself resolve concerns about inequality, but it does reduce the insidious
toll that inflation exacts on the more vulnerable and less financially sophisticated.
Unwinding deeply engrained inflation expectations and transitioning to the target band for
inflation involved difficult adjustment costs. This adjustment contributed to the depth of the
1991 recession, which was also due to a marked slowdown in global growth. New Zealand's
annual inflation rate fell from 7.4 percent at the start of 1990 to 2 percent two years later.
Real GDP declined by 1.6 percent in 1991 and the unemployment rate increased from just
over 7 percent in 1990 to 11 percent at the start of 1992.
Nevertheless, New Zealand's macroeconomic record before and after the Reserve Bank Act
came into effect indicates that its price stability objective has been met without any
diminution in our economy's long term growth rate. In the 20 years before the Act, annual
real GDP growth averaged 2.2 percent while annual inflation was volatile around an average
of 11.4 percent. Since 1990, annual inflation and real GDP growth have averaged 2.3 and
2.6 percent respectively and there has been a marked decline in inflation variability.
Figure 1
Inflation and GDP growth (annual)
International experience points in the same direction. We see this, for example, in the
number of countries that now place the maintenance of low inflation at the core of their
overall policy framework2. Even in countries where central banks face multiple statutory
objectives, the importance of the price stability goal as a precondition for reaching broader
objectives is well accepted.
ii) Low and stable inflation expectations increase monetary policy's
effectiveness
Like other central banks, the Reserve Bank pursues flexible inflation targeting. This approach
has been reflected more explicitly through time in the Policy Targets Agreements - notably
by emphasising that, in pursuing its price stability objective, the Bank "should seek to avoid
unnecessary instability in output, interest rates and the exchange rate" (included as of the
1999 PTA), and in specifying the inflation target as one to be met "on average over the
medium term"(included as of the 2002 PTA.)
The effectiveness of monetary policy measures in influencing the short-term path of variables
in the real economy is linked closely to policy credibility, which is reflected in the Central
Bank's record in achieving inflation goals and shaping expectations as to future inflation
outcomes. Stabilising and anchoring inflation expectations close to the price stability
objective provides the Central Bank with greater freedom in addressing inflation shocks and
scope to take policy actions that influence output and employment growth in the short term.
This means that if economic shocks or a monetary policy action result in inflation moving
outside its target range, wage and price setters will expect it to return to its target band within
an acceptable period. Without this credibility, such shocks and policy actions would lead
mainly to variations in the rate of inflation - as we tended to see in New Zealand in the past.
This flexible, medium-term approach to policy was drawn on at the onset of the GFC, when
the Bank lowered the Official Cash Rate (OCR) by 575 points in 2008-2009, even though
headline inflation was initially well above the target band. By focusing on the medium-term
inflation outlook, the policy stance was able to cushion the impact of the crisis. In a similar
vein, the Bank "looked through" the October 2010 increase in the Goods and Services Tax
rate (from 12.5% to 15%) because it believed it would have limited impact on medium-term
inflation expectations.
iii) The long term path of the real exchange rate is unaffected by the monetary
policy and exchange rate regimes
Monetary policy affects consumer and investor behaviour through many channels including:
the cost of borrowing; the tolerance for risk taking (which affects asset prices and borrowing
capacity); expectations about future inflation; and movements in the exchange rate. In a
small open economy like New Zealand, the exchange rate is a particularly important
monetary policy transmission mechanism - albeit one that is often stronger and less
predictable than we would wish. In recent years, New Zealand and many other economies
have experienced an appreciation in their real effective exchange rate, driven in part by
spillovers from the stimulative monetary policies pursued by the major central banks3.
Despite a recent decline in the nominal rate, the high level of New Zealand's real effective
exchange rate remains unjustified and unsustainable.
Real exchange rate appreciations produce mixed results. They benefit consumers by
lowering inflation in the tradables sector; make it cheaper for firms to import capital goods
and new technologies; and can thereby support growth in innovation and productivity. But
real appreciation can make life difficult for exporting and import-competing firms, especially if
they have little ability to adjust their prices to compensate for exchange rate changes. And
exchange rate fluctuations impose significant uncertainties and costs on firms when they are
forced to exit and re-enter markets due to changes in their competitiveness.
Since the float of the New Zealand dollar in 1985, New Zealand has experienced four major
exchange rate cycles, including the current cycle. Each cycle has been characterised by a
significantly over-valued exchange rate, followed by an initial correction, then a rapid
depreciation.
Figure 2
New Zealand's real effective exchange rate
While we recognise the pressures associated with exchange rate overshooting, there is little
the Bank can do to sustainably alleviate an overvalued real exchange rate, whether through
monetary policy actions or the choice of exchange rate regime. New Zealand has tried
various exchange rate regimes over the past 40 years, including a fixed rate, crawling peg,
and now a floating rate. We have found, however, that the choice of regime has had little
impact on the medium-term level of the real effective exchange rate. Past policy attempts to
give the exchange rate more weight in monetary policy decisions tended to generate more
interest rate volatility, with little lasting effect on the real exchange rate.
Instead, the appropriate policy response often lies elsewhere - for example, through
measures to improve domestic saving, boost competiveness, and raise the growth rate of
potential output. I will take up these points next.
iv) There are limits to what monetary policy can do: supportive structural and
fiscal policies are also needed
Monetary policy can complement but not substitute for other policies that influence long-term
economic performance, including growth, employment, and the real exchange rate.
Longterm growth is primarily a function of the economy's structural characteristics and policies,
including the quality and quantity of labour and capital inputs available to the economy,
coupled with the productivity and innovation associated with their deployment. Similarly, the
level of employment over the long run reflects the characteristics of the labour market,
including skill levels, productivity, and institutional practices.
Monetary policy cannot substitute for structural adjustment policies, nor can it deliver
"desired" long term social equity, or distributional outcomes. Such policy considerations often
arise in respect of the housing market. By influencing mortgage rates and the demand for
credit, monetary policy can affect the demand for housing and thereby help ease imbalances
in the market while housing supply is increased. But monetary policy cannot free up more
land constrained by zoning regulations, address procedural and pricing issues around
planning consents, or raise productivity in the construction sector.
Fiscal policy also plays an important role in the economy's long-term performance. For
example, a constrained fiscal stance can help increase private saving, take pressure off
interest rates and the exchange rate; and provide the economy with a buffer against shocks
by restraining the build-up of public debt. The stance of fiscal policy also affects inflation
expectations and investor judgements as to the degree of coordination among policy makers
over macroeconomic policy.
New Zealand's varied economic experiences over the last 40 years illustrate how policy
choices interact to either hold back or support long-term growth. The prolonged period of
weak growth that the economy experienced in the 1970s and 1980s was partly triggered by
terms of trade shocks, and especially the rapid rise in international oil prices in the early
1970s and the decline in commodity export prices. But the inflexibility of the New Zealand
economy, including its wage and price setting practices and external trade constraints,
hindered its capacity to counter these external pressures. In these circumstances, fiscal and
monetary policies were relatively ineffective in preventing the slowdown. Instead, the main
macroeconomic legacy was a substantial rise in public debt and double-digit inflation for
most of the period from the mid-1970s to late 1980s4.
In contrast, reforms pursued since the mid-1980s - directed in particular at macroeconomic
stabilisation and wide-ranging market deregulation- increased the capacity of the economy
to adjust and grow in response to changing external and domestic conditions. For example,
the economy has responded well to the growing importance of East and South Asia in
international trade and investment, and in recent years has withstood shocks such as the
GFC, the Christchurch earthquakes, drought, and the shifting global demand for our dairy
products and other commodities.
v) Monetary policy independence requires a high level of accountability and
transparency
The widespread move towards inflation targeting around the world has been accompanied by
reforms to increase central bank independence. To counterbalance their greater
independence, central banks faced stronger demands for transparency and accountability -
to government, markets, and the public in general - over their policy performance.
Transparency has two main dimensions. It enables governments and the public to assess
whether the Bank has met its objectives and to hold it to account. Transparency also
increases the efficiency and effectiveness of monetary policy by boosting its predictability.
Transparency is enhanced through regular publications such as the Monetary Policy
Statement and Financial Stability Report, publication of research and policy pieces, and
through extensive communications outreach. A recent international survey ranked New
Zealand second among 120 central banks for transparency5.
Multiple checks and balances are in place to monitor the performance of the Bank and hold
the Governor accountable. The Reserve Bank Board meets 9 times a year to monitor and
provide oversight on the Bank's operations and policy decisions, and the Bank's Governors
appear before the Finance and Expenditure Committee 7 times a year. There are numerous
other accountability measures: for example, the Board can recommend that the Minister of
Finance remove the Governor due to inadequate performance; the Bank must have regard to
any policy direction issued by the Minister in relation to government policies; the Bank places
considerable weight on communications; and, as part of these, publishes full economic
projections, and since 1997, indicates an endogenous interest rate path.
The Bank has a broader set of responsibilities than most central banks, and although it has a
single decision maker model, a Governing Committee was established in 2013 to make
major policy decisions. The committee comprises the four governors, and it reviews all major
monetary and financial policy matters falling under the Bank's responsibilities, including
decisions on monetary policy, foreign exchange intervention, liquidity management policy,
prudential policy (both micro and macro) and other regulatory policies. The Governor retains
a casting vote and, to date, formally retains sole decision making power. Several policy
committees, each chaired by a governor, provide advice to the Governing Committee.
The decision to establish a Governing Committee follows similar moves by the Bank of
Canada, which also has a single decision maker model for monetary policy under its
legislation. There is no evidence of the performance of the RBNZ, or other central banks
where the Governor is formally accountable for policy decisions, being any weaker or more
volatile than that of central banks where accountability rests with a committee. However, the
Governing Committee functions very effectively and the case for decision making by
committee rather than individuals is premised on the relative strengths afforded by groups
and the possible risk-reducing attributes of group decision making.
vi) Monetary policy needs to be supported by sound prudential policies
With the onset of the GFC the world again witnessed the destructive power of dysfunctional
financial markets. Financial sector instability can arise from many sources, including
unrealistic expectations as to the sustainability of future yields on financial assets, excessive
risk taking by investors, poorly designed macro-economic and regulatory policies, and
through regional or global contagion associated with failures in offshore financial systems.
The GFC showed how negative externalities can arise when financial institutions take on
excessive leverage and do not bear the full cost of their activities. These externalities can
have huge economic and policy consequences. For example, more than 6 years after the
onset of the GFC most of the advanced economies have policy rates close to zero and the
major central banks have undertaken around USD7 trillion of quantitative easing. Although
the Federal Reserve has discontinued its bond purchase programme, global quantitative
easing in 2015 is expected to be greater than at any time since 2011. Bank bail-outs during
the GFC have imposed enormous costs on taxpayers (close to 30% of GDP in the case of
Ireland) and at home we saw the large fiscal costs associated with the support for South
Canterbury Finance.
Sound prudential policies relating to capital adequacy, liquidity management, core funding,
disclosure requirements, and stress testing of balance sheets cannot always prevent
financial crises and the need for unconventional monetary policy, but they can lower the risk
of systemic failure.
vii) The emergence of macro-prudential policy
One of the insights from the GFC was how rapidly instability could develop even though an
economy might be growing close to its potential, and be experiencing sound fiscal policy and
price stability.
An environment of low interest rates, rising leverage, aggressive competition among lending
institutions, and a widespread search for yield by investors usually translates quickly into
rising asset prices - especially when the global economy is growing at a rapid rate, as was
the case during 2003-07. When financial crises occur, asset valuations decline and the lower
asset prices may be unable to support the debt that financed their acquisition.
We are currently seeing considerable appreciation in asset prices (including fixed income
securities, equities, and real estate) in many countries as a result of extensive monetary
accommodation and investors aggressively searching for yield. Many central banks and
regulatory agencies have turned to macro-prudential policies in an attempt to reduce risks to
financial stability, including those associated with an overheated housing market.
In view of these concerns, the Reserve Bank introduced macro-prudential policy in the form
of speed limits on high loan-to-value ratio (LVR) lending for existing residential property on
1 October 2013. House prices were already significantly overvalued based on historical and
international indicators and were accelerating rapidly in Auckland and Christchurch (which
account for around half of the national market) and gaining considerable momentum in
several other regions. In addition, the ratio of household debt to household disposable
income at 156 percent was high, and banks were competing aggressively to provide
mortgages to borrowers with small deposits.
Macro-prudential policy requires policy makers to be clear about its goals, the duration of the
measures, and how such measures might interact with monetary policy. These measures
often complement monetary policy when the real and financial cycles are in sync (i.e. with a
strong outlook for inflationary pressures and the asset and credit cycle, or the opposite)6.
Although LVR speed limits were introduced for financial stability purposes, they have been
an important consideration in our monetary policy assessment. We believe the dampening
impact of LVRs on house price inflation and credit, and the diminished "wealth effects" have
reduced consumer price inflation pressures by an amount similar to a 25-50 basis point
increase in the OCR. The introduction of LVR restrictions moderated excesses in the housing
market, thereby enabling the Bank to delay tightening interest rates, and reducing the
incentive for further capital inflows into the New Zealand dollar in search of higher returns.
The impact of LVRs will weaken over time and they will be eased when housing pressures
moderate and the Bank is confident that there will not be a resurgence in house price
inflation. But the Bank cannot prevent or control housing cycles. It can only hope to influence
the demand for mortgage lending and the availability of credit, and buy time for the housing
supply to increase. In the end, the challenge of rising house prices needs to be met through
increases in housing supply. But, this often requires other issues to be addressed such as
the approval procedures around land use decisions and building consents, and other matters
such as the tax treatment of savings, the taxation of investment in real estate, and ways to
increase productivity and reduce costs in the building sector7.
viii) Future challenges
Considerable progress has been made in reducing inflation and lowering inflation
expectations since the introduction of the RBNZ Act. However, the implementation of
monetary policy continues to pose many challenges. These relate to the difficulties in fully
understanding economic linkages and assessing the need for and scale of policy change.
These policy judgements are particularly sensitive in light of the significance of cross-border
financial flows, and their impact on exchange rates and long term interest rates.
As with many other central banks, the Reserve Bank developed a quantitative structural
model (a dynamic stochastic equilibrium model) for forecasting purposes. However,
irrespective of the complexity of their models, all central bank models are at best rudimentary
in their capacity to model the financial sector and integrate it into the real economy.
Policy judgements involve assessments of the rate of growth of potential output and the
output gap, and the extent to which the current policy rate differs from the neutral rate (or the
policy rate that is neither stimulatory nor contractionary). Although the "rate of potential
output growth' and "the neutral interest rate" are critical for evaluating the need for policy
adjustment, they are model-based concepts and neither are observable. This means that
policy makers often need to "feel their way" through an interest rate tightening phase,
especially given uncertainties around the lags before policy adjustments affect inflation and
output.
Global forces can have an enormous influence on inflation and other relative prices such as
exchange rates and interest rates. Inflation pressures have been moderated by structural
changes in the global economy such as: the absorption of low cost producers into the global
trading system; the dramatic reductions in the costs of processing, storing and transmitting
information; falling capital goods prices; new forms of competition (e.g. associated with
online selling); and cost reductions associated with global supply chains. Productivity growth
tends also to be higher among producers serving regional or global markets rather than
domestic consumers only.
With integrated global capital markets, currency volatility and movements in long-term
interest rates can be heavily influenced by cross-border transaction flows around capital
movements, trade financing, remittances and price arbitrage, and risk transfer instruments.
Empirical studies show changes in long-term interest rates are highly correlated across
countries. This means that central banks operating in floating exchange rate regimes,
particularly in smaller countries, are significantly constrained in their ability to run
independent monetary policies. They can influence short-term rates but cannot set their own
long-term rates. Instead, international investor activity has a greater influence over long-term
rates.8 We see this at present. The Reserve Bank raised short-term rates during the period
March to July 2014 but longer-term mortgage rates have fallen as a result of the decline in
long rates in the major economies.
This means that macro-prudential policies may need to be called on to help prevent asset
price booms and complement monetary policy. But there is still much to be explored around
the nature of the interaction of monetary and macro-prudential policies, the costs and
benefits of such interventions, and the circumstances where such policy initiatives are likely
to be successful. Particularly important in this regard will be considerations as to how best to
coordinate monetary policy and macro-prudential policy decisions when economic and
financial cycles are out of sync and the policies are not complementary.
Concluding comments
Monetary policy's focus on price stability has played a vital role in the more stable and
responsive economic climate that has emerged in New Zealand over the last 25 years.
Under this climate, the economy has been able to take advantage of new trading
opportunities in Asia and elsewhere; there has been strong growth in new sectors of activity
- including in the information technology area; and the economy has been resilient in the
face of severe external and domestic shocks, notably from the GFC and the Christchurch
earthquakes. Moreover, the ability of monetary policy to help offset short-term shocks to
output and employment has grown as inflation expectations have stabilised at a low level and
as policy credibility and transparency have increased. New Zealand is not alone in these
experiences: all major central banks now see price stability as their main objective and the
most important contribution they can make to stronger long-term economic performance.
While much has been achieved in these first 25 years of the Reserve Bank Act, important
issues and challenges remain. The global economic environment remains difficult, we have
experienced rapid increases in house prices, and we face the longer-term need to improve
domestic productivity and savings and rein in the economy's external imbalances.
These global and domestic challenges serve as a reminder of what can and cannot be
achieved through monetary policy to counter the sorts of pressures the economy may face in
the years ahead. For example, monetary policy is relatively powerless to offset the spillovers
that global economic and policy developments can impose on our exchange rate and
commodity export prices. But, monetary policy can complement structural and fiscal policies
in supporting the economy's flexibility and adaptability, and help counter short-term economic
fluctuations. Moreover, recent financial sector reforms, including the new macro-prudential
policy framework, have given the Bank additional tools for containing systemic risks and
promoting macroeconomic stability. There is still much to learn in this area, including in the
interactions between prudential and monetary policies, but the Reserve Bank is now much
better equipped to help build a stronger and more resilient economy than we were prior to
1991.