John McDermott: The future of inflation targeting?
Comments by Mr John McDermott, Assistant Governor of the Reserve Bank of New Zealand,
prepared for the BIS Research Workshop "Globalisation and inflation dynamics in Asia and
the Pacific", hosted by the Bank for International Settlements, Hong Kong representative
office, 19 June 2012.
* * *
Introduction
Inflation targeting as a monetary policy framework has been largely successful at keeping
inflation in check in the many countries that have adopted it over the past 20 years or so.1
Certainly the inflation performance in New Zealand has been far superior under the inflation
targeting regime (figure 1).
I expect inflation targeting is very familiar to most people here but let me briefly recap what
that framework entails in the New Zealand context. Then I will use the most recent business
cycle in New Zealand to illustrate how the framework coped with some very significant
shocks to the New Zealand economy.
Figure 1
Headline CPI inflation
Source: Statistics New Zealand
What inflation targeting looks like in New Zealand
Inflation targeting frameworks have a number of elements including an explicit numerical
target to be met over a defined time horizon, as well as typically specifying a process for how
the central bank is to be held accountable for its monetary policy actions and how it is
expected to communicate its monetary policy decisions.
In New Zealand, we aim to keep future consumer price inflation between 1 and 3 per cent on
average over the medium term.2 Like many other central banks we have a range of
publications we can use to provide our view of inflationary pressure and explain our
Monetary Policy Statement.
monetary policy actions. The most prominent is the quarterly
Although the principles of inflation targeting are the same across countries there are some
differences in the details. For example, New Zealand has a different accountability structure
in that we have a single decision maker rather than a committee for monetary policy
decisions. We also differ to most central banks in that we publish an interest rate track that
we think would be necessary to achieve our inflation target. These differences do not appear
have made a difference in the ability to achieve the inflation target.
How did the inflation targeting framework cope with the most recent business cycle in
New Zealand?
The most recent business cycle in New Zealand was one of the longest and largest in the
past 60 years.3 The Reserve Bank has been analysing this cycle to help assess its monetary
policy. This analysis provides a useful case study on the use of inflation targeting in a small
open economy, like New Zealand's. An analysis of the drivers of the business cycle was
published in the Bank's March Bulletin while a discussion of monetary policy over the
business cycle will be published in the Bank's June Bulletin in a few weeks.
In summary, that analysis notes that the New Zealand's economy expanded from 1998 to
2007 and then had a six quarter recession in 2008-09. From 1998 to 2007 there were a
number of significant shocks that determined the shape of the business cycle (figure 2). First,
there was a strong and unexpected increase in population growth from net immigration in
2002/03. Second, there was a significant boost to the economy from a rising terms of trade
from 2000, which accelerated late in the period. Third, oil prices roughly doubled from
mid2007 to mid-2008. Fourth, government spending rose rapidly from 2005. This came at a time
of pre-existing excess demand in the economy.
Net permanent and long-term Real Dubai oil prices (1998
migration prices)
Source: Reuters, Haver Analytics,
Source: Statistics New Zealand
RBNZ calculation
Terms of trade Government spending
(consumption plus investment,
percent of annual GDP)
Source: Statistics New Zealand
Source: Statistics New Zealand,
RBNZ calculations
In setting monetary policy we had to take a view both on how these shocks would unfold and
how they might change the inflationary pressure in the economy, as summarised by our view
Bulletin
of the output gap. As our forthcoming article4 notes, throughout the recent boom we
expected the output gap to dissipate rapidly. However, as it turned out the output gap
remained positive for an extended period (figure 3).
Output gap estimates from June quarter Monetary Policy Statements
(percent of potential output)
Source: Statistics New Zealand, RBNZ calculations
With an extended period of excess demand pressure, average inflation tracked in the upper
half of our target zone. While the persistent component of inflation was higher than we would
have ideally liked during the business cycle expansion, it did remain anchored within the
target zone. That outcome was far superior to our experience of the 1970s when inflation
was persistently at double-digit levels.
The difficulty of anticipating how long an inflationary shock will last is central to the
forecasting process required for monetary policy. In many models that are used for monetary
policy analysis, the output gap often quickly returns close to zero following a simple
aggregate demand shock, and it is natural to think in those terms.5 However, the interaction
of a persistent aggregate demand shock and inertia in the economy can considerably
prolong the time for which the economy is in a state of excess demand pressure. Figure 4
illustrates this point by showing the response of an aggregate demand shock with a half-life
of only two quarters in a stylised model of monetary policy with typical parameter settings.
The point is that excess demand can remain material in the economy long after the
underlying shock has gone.
Response of output gap and inflation to a persistent aggregate demand shock
RBNZ calculations
Of course, the shocks we face in the economy can be far more complicated than in this
simple illustration. Three of the shocks shown in figure 2 delivered ongoing pressure to the
economy. Even the relatively short-lived large inflow of migrants in 2002/03 had ongoing
impacts. The housing stock cannot be increased as quickly as the changes in migrant flows.
Consequently, house prices rose and, even after the boost to population subsided, continued
to rise beyond all forecasters' expectations. Higher house prices in turn stimulated a large
construction boom which put further pressure on resources. Private sector credit started to
expand well in excess of the nominal growth in the economy (figure 5). In line with
conventional wisdom, we put relatively less weight on credit data than on interest rates.6 Had
we had a higher weighting on credit growth data, our view of the persistence of pressure on
resources would likely have been stronger much earlier in the boom.
Excess of domestic credit growth over nominal GDP growth
Source: Statistics New Zealand, RBNZ calculations
Monetary policy in New Zealand is also complicated by exchange rate issues. In a small
open economy the inflation target is a complement to a floating exchange rate regime.
During the boom period expectations of tight monetary policy to offset the excess demand
pressure probably contributed to the persistently high exchange rate throughout the period,
causing considerable discomfort and worries about the sustainability of parts of New
Zealand's tradable sector.
After the global finance crisis there are new challenges for monetary policy to deal with. The
current recovery in the business cycle, both in New Zealand and in other advanced
economies, is proving weaker than historical precedents. Our forecasting frameworks need
to be expanded so we can examine possible sources of the disappointing recoveries, such
as say the impact of the overhang of public and private debt on the economy.
Inflation targeting works, and other lessons for the future
Despite the challenges and the ongoing shocks to the economy, monetary policy did what it
was supposed to do, keep inflation low. The framework maintained the Reserve Bank's focus
on the target and the frequent publication of forecasts forced us to constantly update our
views of the economy and the inflation pressure within it.
The Bank's analysis on the recent business cycle underscores that the inflation targeting
framework is an effective way to conduct monetary policy under a range of testing
circumstances and that the framework is a useful tool for future inflation control.
With low inflation and the credibility of inflation targeting came much lower volatility in the
general level of prices. That is helpful for resource allocation, affecting longer term
performance, and for macroeconomic stability over the medium term. This credibility was
very helpful when the global financial crisis hit. To help offset the very large negative shock
the Bank started lowering interest rates even while annual inflation was above its 1 to
3 percent target.
Of course, that is not to say the framework cannot be improved in any way. Over the course
of the past 20 years or so the framework has evolved to reflect lessons learned and is likely
to evolve further in response to new developments. In particular, our monitoring of monetary
and credit information has increased in the wake of the global financial crisis. The Reserve
Bank has also been looking into the effectiveness of some macroprudential instruments that
may limit build-ups of problems in future periods of rapid credit growth.7