Alan Bollard: The crisis and monetary policy - what we learned and
where we are going
Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the
Canterbury Employers' Chamber of Commerce, Christchurch, 29 January 2010.
* * *
Background paper by Dr Alan Bollard, Governor, and Mr Felix Delbruck, Economics Department, Reserve Bank
of New Zealand.
1. Introduction
Inflation targeting is a monetary policy framework that was developed in response to the high
inflation and macroeconomic instability of the 1970s and 1980s. Twenty years ago, New
Zealand was the first country to formally adopt key elements of this approach - such as an
explicit inflation target and various accountability and monitoring structures - in the Reserve
Bank Act 1989. The framework has been durable, even as we've continued to learn how the
economy works and continued to adapt and refine the way we do monetary policy.
The past two decades have included one of the longest periods of growth that New Zealand
has seen in decades, as well as droughts, migration shocks, terms of trade changes, an
Asian crisis, a dot-com boom and bust, and, most recently, the worst global economic and
financial crisis seen in generations. This speech looks back over those two decades of
inflation targeting to see what lessons we can draw from these experiences, as well as
outlining some of the challenges ahead.
2. Assessing two decades of learning
The framework we put in place in 1989 and refined in the following two decades has now
been adopted in its main features by over 20 countries. In looking back, I will focus on the
New Zealand experience, but the main conclusions I draw are not unique to New Zealand. I
will argue that inflation targeting has done well on the price stability front, and has given
central banks a lot of flexibility in helping steer the economy through turbulent waters.
However, in itself, it has not guaranteed balanced growth or macroeconomic stability. Other
factors matter: neutral fiscal policies, monetary settings in the major global economies, and a
stable financial system. It is in the interplay of the financial system and macroeconomic
stability that most learning will need to be done in the coming years.
Price stability has been broadly achieved
In terms of
what it was directly designed to achieve, namely price stability, inflation targeting
has been a success. Consider the range of conditions under which inflation has been
contained within a fairly narrow range. These include an early period of restructuring, a
"benign" period of rising global integration and rapid growth in information technology, where
energy prices were low and the costs of a wide range of manufactured goods were falling
rapidly; a challenging period of sharply rising commodity and asset prices in the past few
years; and the extreme ructions of the global financial crisis. This can be seen from figure 1,
which shows New Zealand CPI inflation since 1980, as well as a survey measure of 2-year
ahead inflation expectations. In particular, while inflation expectations crept up in the boom
years, and fell back sharply in late 2008 as the financial crisis hit, they have remained
well-anchored across that time period.
Figure 1
New Zealand inflation and surveyed inflation expectations
Source: Statistics NZ, RBNZ
Inflation targeting has supported, but not guaranteed, macroeconomic stability
In taming inflation expectations, the inflation targeting framework has removed a major
source of economic volatility. It has also allowed for active macroeconomic stabilisation in a
broader sense. Most notably, once the global financial crisis hit, we were able to respond
with significant policy easing swiftly, cutting the OCR by more than 5 percentage points and
providing banks with emergency liquidity at rates consistent with the OCR, at a time when
the international wholesale funding markets were severely impaired. We were able to provide
this degree of support because the inflation targeting framework allowed for a flexible
response, and inflation expectations were well anchored.
However, the extent of the financial crisis makes it clear that inflation targeting monetary
policy has not been sufficient to guarantee comprehensive macroeconomic stability. Recall
the decade or so from the second half of the 1990s to the late 2000s that many
commentators called the "Great Moderation" or the "Goldilocks" economy, when many
economies experienced an extraordinarily long stretch of unbroken strong growth. Even then,
we continued to see large movements in commodity prices, house prices, interest rates, and
exchange rates. There were also significant shifts in the composition of growth, from the
traded to the non-traded sector, and big increases in household and external indebtedness.
Some of these changes were structural, such as the rise in the global demand for agricultural
and other commodities from the late 1990s onward, or the surge in migration to New Zealand
in the early 2000s. Some of the price movements were beneficial in helping the New Zealand
economy adjust to those changing conditions. But we also saw growing economic
imbalances, and the commodity and asset price rises in the years leading up to the financial
crisis were among the hardest challenges faced by central banks over the past 20 years.
From 2004 to 2008, international oil prices quadrupled in US dollar terms. What was the best
way to respond to this development? Should we continue to let the direct inflation
consequences of the shock pass through (as we would do with a more temporary price
shock), or should we try to offset them with higher policy rates? This was a very delicate
balancing act, made more difficult by uncertainty around what level of oil prices was
ultimately sustainable. In the event, we monitored a wide range of indicators, including "core"
inflation measures and inflation expectations. Despite significant rises in short-term CPI
forecasts, these underlying inflation trends remained relatively stable, so that we were largely
able to "look through" the oil price spike and set policy appropriately for a changing growth
outlook in 2008.
The rise in house prices posed an even greater challenge. When any asset price rises
sharply in the context of subdued overall inflation, monetary policy needs to decide whether
to raise interest rates now - even though inflation pressures are subdued - to prevent
potential asset bubbles that might have deleterious consequences later. In New Zealand,
while we do not "target" house prices, we have been able to identify a clear link between the
housing market and broader household spending, and have therefore always monitored the
housing market as an important indicator for the inflation outlook. However, in an
environment of low perceived risk, willing capital markets, and widespread expectations of
capital gains, short-term interest rates turned out to have only limited leverage over housing
activity. The difficulty was exacerbated by a tax system which favoured investment in
housing, and by expansionary monetary and exchange rate policies in the major global
economies which fuelled a global carry trade. Thus the NZ dollar appreciated while mortgage
rates remained relatively low until quite late in the piece (figure 2).
Figure 2
OCR and effective mortgage rate
Source: RBNZ
The grass is not always greener
For all the difficulties we faced, as we look back, we can see that alternative monetary policy
frameworks would not have provided the flexibility that we had to navigate these waters, and
may in fact have made it harder to maintain price stability while avoiding unnecessary
volatility in the wider economy. This is particularly clear if we think about policy approaches
that target the exchange rate in one way or another.
Consider an ANZAC dollar. The NZ dollar has fallen by over 10 percent against the AU dollar
since 2006, a period in which Australia experienced an unprecedented minerals boom and
very strong growth. If our currency had been pegged to the AU dollar, New Zealand's
exchange rate to the rest of the world would have been higher, interest rates would have
risen three times already, and our recession would probably have been deeper. The
argument is even stronger for other currencies, such as the US dollar. Australia and New
Zealand are not the same, but we are far more similar to each other than to Europe or the
US. If our currency had been pegged to the US dollar over the past decade, interest rates
would have been lower for longer in 2003 and 2004, exacerbating the housing boom
(figure 3). Some of the challenges of a currency union can now be seen in Euro area
economies such as Ireland, Greece and Spain, where monetary policy settings have been
unable to lean against unsustainable domestic booms, or against the deep recessions that
followed.
Figure 3
Policy interest rates in NZ, the US, and Australia
Source: Bloomberg
Figure 4
GDP growth in Euro area economies
Singapore's monetary policy regime is sometimes pointed to as an alternative to inflation
targeting that has maintained stability in the currency while achieving a track record of low
and stable inflation. Over the past two years, of course, this has not been the case, with
inflation approaching 8 percent in 2008 and prices falling in 2009. Over a longer period, it
does appear that Singapore has generally managed to guide its exchange rate to keep
inflation stable. But a range of special factors made this possible - Singapore's
extraordinarily high trade ratio, its large stock of domestic savings and foreign exchange
reserves, and a range of supplementary stabilisation instruments and capital controls. In
particular, in New Zealand, with its much larger non-traded sector, a Singaporean regime
might potentially have required greater swings in the exchange rate than we actually saw to
achieve similar inflation outcomes.
Global policies, the tax system and financial stability also matter
A lesson from this period is that while monetary policy can always achieve price stability,
whether this occurs in the context of balanced growth also depends on other factors. As the
housing boom has shown, these factors include global policy settings and the structure of the
tax system.
Looking back over two years of crisis, perhaps the key lesson is that financial stability cannot
be ignored when thinking about macroeconomic stability and the conduct of monetary policy.
We've been reminded that financial system developments have the potential to complicate
monetary policy enormously, and that stable prices do not guarantee a sound and efficient
financial system - well-functioning financial markets and soundly managed institutions which
make decisions based on a long-term outlook for earnings. In some economies such as the
US, financial system dysfunction during the crisis rendered the standard monetary policy tool
partially or wholly ineffective as spreads blew out and policy rates hit the zero lower bound.
We, too, have had to take into account movements in financial market spreads and credit
rationing in our policy deliberations over the past year, to an extent we would not have
envisaged a decade ago. And the crisis has shown what enormous macroeconomic damage
can result if financial market participants do not adequately price and manage financial
system risks.
3. Stabilising the economy in the future
Inflation targeting has proven to be a monetary policy framework that combines the discipline
of focus that is needed to ensure a stable level of prices, with an operational flexibility that
enables the economy to better cope with a wide range of shocks. But as we have seen, it
has not eliminated economic imbalances or liberated central banks from difficult tradeoffs.
Can we do better, and can those tradeoffs be made easier in future?
We know that the difficulty of our job ahead will in part depend on policy choices made by the
major global players as they exit from current stimulatory policy settings. As the world
emerges from recession, central bankers around the world are weighing the need to provide
ongoing support for a very fragile recovery against the need to be ready for more normal
conditions. This will be yet another delicate balancing act, made more complex in economies
like the US by the need to unwind "quantitative easing", and other unconventional policy
support measures. At the same time, choices will need to be made about when to withdraw
fiscal stimulus. Unlike the synchronised policy easing that we saw in late 2008, the removal
of stimulus will occur at different times in different parts of the world, reflecting different
recovery paths. Australia has already embarked on the exit road, the United States and
Europe are still at the door.
How deftly this process of normalisation is handled will be crucial to whether the global
economy recovers in a balanced way, and how stable recovery is likely to be in
New Zealand. If US monetary policy settings remain too easy for too long, and if exchange
rates in China and the big surplus economies remain low even in the face of a dramatically
improved economic outlook, we will risk facing conditions similar to those during the years
leading up to the crisis: abundant global liquidity searching for returns in the wrong places,
feeding unsustainable asset booms and growing economic imbalances. Against this is the
risk of a slower, more fragile recovery. It will be some years before we can judge how
appropriate this normalisation has been.
The difficulty of our job will also depend on the wider domestic policy context. In particular,
achieving both low inflation and balanced growth is considerably easier in an environment of
fiscal discipline, and where the tax system is neutral with respect to households' and firms'
investment decisions. In this respect, a failure to gradually remove the recent fiscal stimulus
would put added pressure on monetary policy over the coming period. We are also hopeful
that the recently released report of the Tax Working Group will lead to a more efficient and
even-handed tax system. Tax policy is complex and needs to meet multiple objectives. Our
concerns are to minimise tax-fuelled property investment and consumption that might detract
from more balanced savings and growth.
Another important part of the domestic policy context is our financial policy framework. A lot
of work is being done in this space internationally. Central banks, financial regulatory bodies,
the Basel Committee on Banking Supervision and the Financial Stability Board are working
out ways to strengthen and improve the prudential supervision of financial institutions. This
includes raising the quantity and quality of minimum capital buffers held by banks, and
improving the resilience of banks to liquidity shocks. It includes measures to make banks
easier to restructure and unwind should they become insolvent. Financial regulators are also
working on designing a "macro-prudential" architecture for bank regulation. This essentially
means taking into account the impact of individual banks on the riskiness of the financial
system as a whole. For example, a large systemically important bank needs larger capital
buffers than a smaller player. Similarly, larger buffers may need to be built up in boom times,
when banks are more vulnerable to a systemic downturn.
In New Zealand, the financial system is a lot simpler than in other parts of the OECD, and
has not seen the same types of excesses. Nevertheless we have taken steps to make our
banks more resilient to financial system shocks. In implementing the Basel II capital
framework, we have ensured that banks' assessment of risk is based on a
"through-thecycle" approach rather than just on the period of recent growth. We have also put in place a
new prudential liquidity policy for banks which is intended to make the system less vulnerable
to a drying up of international funding markets, such as we saw in late 2008 and early 2009.
Can prudential instruments such as minimum capital and liquidity requirements also help
monetary policy? This depends on the link between those instruments and bank funding and
lending, and also between bank lending and the behaviour of housing and other asset prices.
In the case of housing, the link between mortgage lending and market prices is fairly clear.
What is less clear is the extent to which the instruments themselves may constrain bank
lending and housing demand in an emerging boom.
At this stage, we believe that the new liquidity policy and in particular the Core Funding Ratio
could usefully contribute to the monetary policy task by limiting the banks' ability to fuel credit
growth using cheap and plentiful short-term wholesale funding during boom periods, as was
the case from 2003 to 2007. In this respect, the Core Funding Ratio could potentially act as
an automatic stabiliser and reduce the required hikes in the OCR during economic upturns.
The role for a macro-oriented minimum capital requirement in promoting macro-financial
stability (as opposed to individual bank resilience), and also assisting monetary policy, is less
clear. The relationship between capital requirements and loan pricing is highly uncertain,
particularly as the large lenders in New Zealand (as elsewhere) target capital holdings well in
excess of current regulatory minima.
At best, these instruments could supplement the role of the OCR, but will not fundamentally
alter it. Ideally, they would change the mix of monetary conditions and take some pressure
off the exchange rate. Overall monetary conditions would still need to be set appropriately to
keep inflation stable.
We must also be realistic about the learning that still needs to be done in the macro-financial
area. Central banks do not yet understand enough about the properties of prudential
instruments to use them as an adjustable policy lever, and doing so could raise coordination
issues between monetary policy and prudential policy decisions. More broadly, economists
have a relatively good understanding of inflation and the real economy, but the unknowns are
much greater when we try to model macro-financial variables. We still have much to learn
about how price stability and financial stability outcomes move together, about the
relationship of CPI and asset price inflation, and about the interplay of credit and economic
activity.
As a small, flexible and full-service central bank, the Reserve Bank is in a good position to be
at the forefront of progress in integrated macro-financial policy design. We have joint price
and financial stability objectives and joint powers to achieve these objectives. Our prudential
supervision, financial market and payments system functions provide us with useful skills and
information to draw on. But we need to be cautious about what we claim to understand and
what we can influence.
4. Conclusions
The inflation targeting framework has performed its primary task reasonably well over two
decades, achieving price stability through both good and bad times. While it has been in
place, inflation expectations have remained anchored, and it has proven flexible in
responding to rapidly changing economic conditions. Major alternatives that dilute the focus
on medium-term inflation and target other macroeconomic outcomes would risk reducing
confidence in the future level of prices and would have led to worse overall outcomes at key
points over the past 20 years.
Nevertheless, price stability alone is not sufficient to ensure a stable and balanced economy.
For that to work best, we need to maintain a flexible approach to monetary policy. But we
also need a conducive global financial environment, and support from other domestic
economic and financial policies that have a bearing on asset markets and financial leverage.
We need to be realistic. The world is not ours to influence, and it is unlikely to offer us perfect
conditions. But in New Zealand, we will be seeking less distortion from future tax policy, and
an increased macro-orientation of prudential policy.