John McDermott: Forward guidance in New Zealand
Speech by Dr John McDermott, Assistant Governor and Chief Economist of the Reserve Bank
of New Zealand, to the Goldman Sachs Annual Global Macro Conference 2016, Sydney,
4 February 2016.
* * *
Accompanying figures can be found at the end of the speech.
Introduction
I would like to thank Goldman Sachs for the invitation to speak here in Sydney today. It is a
pleasure to take the trip across the Tasman to be part of your annual Macro Economic
Conference.
The focus of my comments today will be the Reserve Bank of New Zealand's approach to
forward guidance, and in particular, the publication of an endogenous outlook for the 90-day
interest rate. I'll touch on the benefits of this approach and how we aim to minimise the potential
costs. I'll highlight the importance of understanding the conditional nature of our forecasts. And
I'll finish by providing an illustration of the Bank's conditional forward guidance in practice.
Over the past few decades, transparency has become much more valued in the conduct of
monetary policy. Transparency can improve the effectiveness of monetary policy, and
increases the accountability of the central bank. Transparency is a value held in high regard
at the Reserve Bank of New Zealand, which is seen as one of the most transparent central
banks in the world.1
This value is applied to the way we conduct forward guidance, where the Bank is very open
about its monetary policy outlook.2 In New Zealand, this includes the publication of a forward
projection for the 90-day interest rate, comments on the outlook for policy, discussion of risks
in our Monetary Policy Statement and the presentation of alternative scenarios. The Bank is
one of only a handful of central banks that publish forecasts for the short-term interest rate.3
This is a practice we have maintained since 1997.
The publication of the 90-day interest rate projection can improve the effectiveness of monetary
policy in a number of ways.
First of all, informing the public on our thinking about the transmission of monetary policy and
a possible path of for interest rates can help individuals and businesses make more informed
decisions.4 There are times when the Bank will know more about the economic situation and
outlook than does the public or financial market participants. Every so often this will relate to
1
Dincer and Eichengreen (2014), "Central bank transparency and independence: updates and new measures",
International Journal of Central Banking, Vol. 10, No. 1, pp 189-253, March 2014. For a discussion of the New
Zealand experience see Bascand (2013), "Communication, understanding and credibility", comments from
Reserve Bank of New Zealand Deputy Governor Bascand, December 2013.
2
The practice and definition of forward guidance can vary between both central banks and academics. Forward
guidance can range from brief qualitative statements on the policy outlook in central bank communication, time
or state dependent policy outlooks like those adopted by the United States Federal Reserve and the Bank of
England post crisis, or the full publication of an endogenous interest rate forecast like at the Reserve Bank of
New Zealand.
3
These central banks include New Zealand, Czech Republic, Israel, Norway and Sweden.
4
See Rudebusch and Williams (2008), "Revealing the Secrets of the Temple: The value of publishing central
bank interest rate projections", Asset Prices and Monetary Policy, University of Chicago Press.
some research or insight we hold, but more typically this extra knowledge relates to knowing
what the Bank itself plans to do.
Second, the entire yield curve, rather than just the current level of the 90-day interest rate, has
an influence on economic behaviour. Publishing the Bank's projection for the 90-day interest
rate can help shift the entire yield curve towards levels consistent with medium-term price
stability, improving the effectiveness of monetary policy.5
Third, the publication of the 90-day interest rate projection helps accountability. Under the
Policy Targets Agreement (PTA), the Bank is required to keep future average inflation close to
the mid-point of the 1 to 3 percent target range, whilst avoiding unnecessary instability in
output, interest rates and the exchange rate, and having regard for financial stability. This
multitude of considerations influences the Bank's judgement about how monetary policy should
be adjusted to help move inflation towards its medium-term target.6 The publication of a 90-day
interest rate projection, together with an inflation projection, conveys the Bank's view of what
it considers appropriate when making these considerations, and how this changes when new
information becomes available.
The Bank uses a range of modelling techniques and expert judgement to prepare a forecast
for the 90-day interest rate. Our structural model, NZSIM7, is used to summarise all the new
information provided by recent data, financial market developments, indicator models and our
discussions with New Zealand businesses. Judgement is then added to this framework after
the deliberation of our Monetary Policy Committee and Governing Committee.
The 90-day interest rate projection, based on a range of assumptions, provides a guide of what
monetary policy settings may be needed to return or keep inflation at target. We feel that this
is a more informative approach than assuming a constant or market path for interest rates -
which may present an interest rate path that is inconsistent with the Bank's price stability
mandate.
Forward guidance - avoiding potential pitfalls
This transparent approach comes with potential costs. First, research highlights that increased
transparency, in some cases, can be detrimental to the economy. This is particularly the case
if the public takes the Bank's information as definitive, despite it being noisy or imperfect.8 We
aim to minimise such instances by offering a full discussion of the assumptions and risks that
underpin our projections, to clearly highlight the limitations in our knowledge.
Second, some research claims that when a central bank provides an endogenous interest rate
projection, fears of credibility loss may lead it to stick to a previously published policy path,
even when faced with new economic developments.9 I can say, from my experience, that this
has never been a problem at the Bank.
5
For further discussion, see Woodford (1999), "Optimal Monetary Policy Inertia", The Manchester School
Supplement, Vol.67, Issue S1, pp 1-35.
6
See Ford, Kendall and Richardson (2015), "Evaluating Monetary Policy", Reserve Bank of New Zealand Bulletin,
November 2015.
7
See Kamber, McDonald, Sander and Theodoridis (2015), "A structural model for policy analysis and forecasting:
NZSIM", Reserve Bank of New Zealand Discussion Paper, DP2015/05.
8
These points are expanded on in: Morris and Shin (2002), "Social value of public information", The American
Economic Review, Vol. 92, No. 5, pp1521-1534; Dale, Orphanides and Osterholm (2011), "Imperfect central
bank communication: information versus distraction", International Journal of Central Banking, Vol.7, No. 2,
pp 3-39, June 2011.
9
This issue is discussed in: Mishkin (2004), "Can central bank transparency go too far?", NBER Working Paper
10829; Goodhart (2009), "The interest rate conditioning assumption", International Journal of Central banking,
Vol. 5, No.2, pp 85-108, June 2009.
Third, some have argued that it may be difficult for a central bank to reach consensus on an
entire path for interest rates.10 Practically, this has not been a problem at the Bank. Committee
practices are efficient enough for the Governing Committee to reach an agreement on a
qualified projection for the 90-day interest rate.11
More broadly, it is important that financial market participants and the public understand the
90-day interest rate is a conditional projection. It is not a commitment from the Bank to a
specific set of actions. The effectiveness of monetary policy can be hampered if the public and
financial market participants take the forecast as a commitment.12
The 90-day interest rate projection shows how interest rates may need to evolve to achieve
price stability if the economy evolves in line with the Bank's forecasts. Of course, the
uncertainties faced in forecasting mean that the economy will almost always evolve differently
to what the Bank expects. Cyclical factors like the strength of the international economy,
movements in oil and other commodity prices, and the exchange rate can develop in
unexpected ways. For example, at the current juncture, the economy is faced with a number
of unique supply-side developments which add additional uncertainty to the outlook. These
include reconstruction activity in Canterbury, the recent sharp fall in oil prices, a rapid rise in
inward migration and the potential impacts of El-Nino.
In addition to these business cycle developments, structural aspects that may be linked to
factors such as globalisation, technology and demography can also have major impacts on
economic growth and inflation. In normal times these structural aspects move relatively slowly.
However they are important in determining how interest rates might affect inflation and the
cycle in output and can move sharply in a crisis. All of these factors can affect the neutral
interest rate, potential output and inflation expectations.13
If financial market participants understand the conditional nature of our forecasts, the 90-day
interest rate projection can help participants understand how we are likely to respond to
changes in the economic outlook.
Every three months we provide a new projection for the 90-day interest rate. The changes in
this projection, and the analysis in the Monetary Policy Statement (MPS) on the state of the
economy, illustrate how unforeseen events have shaped the Bank's outlook for policy.
Over time, this should help financial market participants understand the Bank's "reaction
function" - that is, how economic events affect the outlook for inflation and the implications we
draw for monetary policy. If financial market participants have a good understanding of our
reaction function, and share similar views on the economy, interest rates should adjust to levels
10
For example, see Goodhart (2009).
11
Approaches to aggregating committee views are discussed further in: Svensson (2003), "The inflation forecast
and the loss function", Central Banking, Monetary Theory and Practice: Essays in Honour of Charles Goodhart,
Vol. 1, pp 135-152.
12
Bergstrom and Karagedikli (2013), "The Interest Rate Conditioning Assumption: Investigating the Effects of
Central Bank Communication in New Zealand", Reserve Bank of New Zealand, mimeo, find that if the public
interpret interest rate forecasts as conditional, the forecasting performance of private agents for short-term
interest rates is improved at short horizons. If the communication is interpreted as the central bank deviating
from its interest rate rule, the forecasting performance of the public for short-term interest rates is again
improved, but the forecasting performance for macroeconomic variables is worsened.
13
The Bank has recently published a range of research on these factors. For more information see: Lienert and
Gillmore (2015), "The Reserve Bank's method of estimating 'potential output'", Reserve Bank of New Zealand
Analytical Note, AN2015/01; Richardson and Williams (2015), "Estimating New Zealand's neutral interest rate",
Reserve Bank of New Zealand Analytical Note, AN2015/05; Armstrong (2015), "The Reserve Bank of New
Zealand's output gap indicator suite and its real time properties", Reserve Bank of New Zealand Analytical Note,
AN2015/08; Lewis (2016, forthcoming) "Inflation expectations curve: a tool for monitoring inflation expectations",
Reserve Bank of New Zealand.
consistent with medium-term price stability without the need for constant comment and
intervention from the Bank.
We try to facilitate this understanding by presenting a description of key judgements and
alternative scenarios in our Monetary Policy Statements. These help illustrate how monetary
policy would likely need to respond if judgements were to prove incorrect or if risks to the
outlook were to crystallise.
Financial market participants seem to have had a good understanding of the conditional nature
of our projections. Figure 1 illustrates the point for the period since 2004. The red line in the
chart shows how the market implied 1-year-ahead 90-day interest rate moves from the day
after a Statement to the day before the next Statement. This change represents how market
participants have interpreted the incoming economic data and events and how they think the
Bank will respond.
The blue line shows how the Bank revised its 1-year ahead 90-day interest rate projection from
one Statement to another. The blue line gives an indication of how the Bank interpreted new
economic events and the subsequent monetary policy response.
Generally, market participants change their outlook for interest rates in a similar way to the
Bank as new economic and financial information becomes available. The majority of the move
in interest rates occurs before we have provided financial market participants with our
interpretation of new events. This suggests market participants have a good understanding
about how new information changes the Bank's own outlook, the conditionality of the Bank's
projections and the Bank's reaction function.
Conditional commitment in action - changes in the policy outlook since 2014
The changes in the Bank's policy stance since the beginning of 2014 provide a good illustration
of the conditional nature of forward guidance in practice. At the March 2014 Statement, the
90day interest rate had averaged 2.85 percent in Q1 2014, and the Bank was projecting it to rise
to 5.5 percent by Q3 2017.
However, a number of factors led to a moderation in the outlook for inflationary pressure over
the quarters that followed. Both cyclical and structural aspects of the New Zealand economy
evolved in unforeseen ways. These events included significant falls in the prices of oil and New
Zealand's commodity exports, a stronger-than-expected exchange rate,
weaker-thanexpected capacity pressures (and stronger potential growth), and weaker non-tradables
inflation.
Despite these developments, by the December 2015 Statement the Bank was projecting even
stronger economic growth than had been expected in March 2014 (figure 2). This is not
because the fundamental outlook had improved, but because this new information led the Bank
to change its outlook for monetary policy and provide more stimulus to the economy. Indeed,
the December 2015 Statement projected that the 90-day interest rate would be 2.6 percent in
Q3 2017, almost 300 basis points lower than was forecast in March 2014 (figure 3). Given the
weaker starting point for inflation, stronger growth was needed to bring inflation back to target.
However, as discussed, this projection for stronger growth is conditional on a set of certain
assumptions, and the Bank may need to change its activity and policy outlook if new events
were to unfold.
The changes in the 90-day interest rate projection over this time illustrate how flexible inflation
targeting operates in practice. The forecasts evolved to ensure that medium-term price stability
would be maintained. Therefore, despite inflation being weaker than expected and the revision
to the 90-day interest rate outlook, the credibility of the monetary policy framework has been
maintained. Medium-term inflation expectations have fallen over the past six months, but are
currently near the 2 percent target midpoint (figure 4). External forecasters also expect inflation
to return to target over the medium term.
Crucially, the Bank is - and perceived to be - committed to its inflation target, which helps
anchor inflation expectations. When formulating monetary policy, the PTA directs the Bank to
have a forward-looking focus, irrespective of past inflation outcomes. The projection, at any
time, seeks to ensure that price stability can be achieved while avoiding unnecessary instability
in output, interest rates and the exchange rate. The Bank will continue to adjust monetary
policy as conditions evolve to ensure that price stability is achieved over the medium term.
Conclusion
When it comes to communication, central banks use a diverse range of practices, and best
practices differ from country to country. For New Zealand, we find it beneficial to publish a
projection for the 90-day interest rate. It supports transparency, and its evolution over time
contributes to market participants' understanding of how the Bank responds to unexpected
economic events.
The projections are conditional in nature, reflecting the many challenges faced in forecasting
the New Zealand economy. It is important financial market participants understand that these
forecasts are not a commitment to a certain path of policy. Indeed, financial market participants
generally have a very good understanding of the conditional nature of our forecasts.
The experience since the beginning of 2014 highlights the conditional nature of our interest
rate forecasts. Unforeseen economic events led to weaker-than-expected inflationary pressure
in the economy. As a result, we significantly revised down the outlook for short-term interest
rates. The Bank will continue to adjust monetary policy as conditions evolve to ensure that
price stability is achieved over the medium term.
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