Donald T Brash: Monetary policy in "Interesting Times"
Address by Mr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the managers of
small and medium-sized businesses, Whangarei, 21 November 2001.
* * *
Ladies and Gentlemen
About seven or eight years ago, I was visited by a share-broker who told me what a great job the
Reserve Bank had done in explaining its actions to the banks and the big corporates. I felt good, until
he said "But frankly, you have done a lousy job communicating with the small and middle-sized
businesses in New Zealand." True, I protested, but I can't even get a good mailing list to cover the
tens of thousands of smaller businesses. "Fair enough", he replied, "but every small business has a
bank account. Put it on the banks to invite their small business clients to meetings which you host, and
to which you speak."
And from that conversation grew the idea of this meeting. We had meetings of this kind for the first
time in 1995. We repeated the idea again in 1998. And now we are doing it for the third time this year.
In part, we want to use this meeting to tell you how we see the world. And in part, we want to learn,
from your questions and comments when I have finished, how you see the world. We are acutely
aware that the health and vitality of the New Zealand economy depends to a huge degree on the
health and vitality of the small and middle-sized businesses represented in this room.
We live in "interesting times"
You will recall the ancient Chinese curse "May you live in interesting times". Sadly, these are
"interesting times" and we all know why. Just one week after the terrible events of 11 September, the
Reserve Bank made an unscheduled and largely unexpected interest rate cut, from 5.75 per cent to
5.25 per cent. Within the Reserve Bank, we briefly debated whether I should hold a press conference
to explain what we had done. We decided not to, in large part because there would have been very
little I could usefully have said. Essentially, what I could have said at that time was "We don't know yet
what the economic consequences of these events will be, and we certainly don't know what they mean
for inflation in New Zealand. All we can say is that confidence has taken a huge knock; this is more
likely to reduce prices than to increase them; and under these circumstances there is scope for lower
interest rates." That would not have made for a very productive press conference.
Time has moved on, and there is more we can say now. Last week, we issued our latest assessment
of the outlook for the economy and for inflation, and reduced the Official Cash Rate by a further
50 basis points to 4.75 per cent.
Why did we do that? Interestingly, when we looked over our shoulder at the historical data available to
us, it was hard to see a justification for any cut in interest rates. The latest comprehensive information
we had on economic growth showed that, in the first half of this year, the economy grew by 2.3 per
cent, equivalent to an annual growth rate of more than 4 per cent. The latest information we had also
showed that unemployment was at its lowest level in 13 years. Job advertisements, as surveyed by
the ANZ Bank, were running at a high level. Many businesses were reporting that they had little
unused capacity to meet increased demand. In some parts of the country, there were reports of great
difficulty finding skilled and even unskilled staff. The world prices for many of our commodity exports,
while lower than a few months earlier, were holding up surprisingly well. And to top it all off the
exchange rate was not far above its all-time record low, which meant that, in New Zealand dollar
terms, our exporters and tourist operators were being substantially insulated from the slow-down in the
world economy.
To some extent, this was the same picture that we had painted in our August Monetary Policy
Statement. There we had suggested that there might have been a case for an early increase in the
Official Cash Rate were it not for the threatening clouds in the international economy. And that was
weeks before we knew just how strongly the economy had grown during the first half of the year.
But three months on, and notwithstanding the relatively robust historical data, we have cut the Official
Cash Rate by a total of 1 per cent. We have done that because, despite the relatively strong position
that the New Zealand economy is now in, we see the real prospect of the economy slowing down quite
significantly over the next year or so. And if that slow-down occurs, interest rates can be lower than
previously without jeopardising the price stability objective which the Reserve Bank is required to
achieve.
The basic cause of this rather abrupt change in the outlook for our own economy relates to a fairly
substantial change in the outlook for the world economy. Back in early August, as our previous
Statement went to press, the Consensus forecasts for the 14 countries which dominate our export
trading suggested relatively slow growth this year but quite a marked pick-up in growth next year
(figure 1). As we went to press with last week's assessment, the general expectation was for growth to
be significantly slower this year than previously expected, and growth next year to be even more
markedly lower than previously expected (figure 2). And this deterioration in the world outlook seems
to get somewhat worse with every passing week.
Figure 1
Export partner GDP growth -
August 2001 Monetary Policy Statement
(annual average percentage change)
Source: RBNZ, Consensus.
Figure 2
Export partner GDP growth -
November 2001 Monetary Policy Statement
(annual average percentage change)
Moreover, the deterioration is not confined to a single country. Most economists are now expecting a
recession in the United States. Almost all economists are expecting a recession in Japan. Several of
our biggest trading partners in Asia are clearly in recession already. Europe continues to slow down.
Only Australia, among our main trading partners, seems to be enjoying reasonably robust growth for
the moment. (Figure 3)
Figure 3
Sum of 2001 and 2002 export partner GDP growth
(annual average percentage change)
Source: RBNZ, Consensus.
And this slowdown in the world economy is bound to have an impact on the New Zealand economy, in
particular by reducing the demand for our exports and reducing the prices of those exports. We are
beginning to see that already, and as it occurs we expect to see both some reduction in growth in New
Zealand and some downwards pressure on prices - including some reversal of the very strong
increase in the price of things like meat and dairy products, which in recent months has done so much
to push up the price of the average food-basket. So it seems reasonable to believe that inflation will be
much less of a problem as we look forward 12 months than it has been over the last 12 months.
Having explained our decision to reduce the Official Cash Rate last week, let me use this situation to
make four points.
Price stability means neither inflation nor deflation
The first point I want to make is that the Reserve Bank is just as serious about keeping inflation above
zero as it is about keeping it below 3 per cent. Dropping interest rates now is about preventing inflation
falling too low. And if inflation threatened to go negative, you can be sure we would be very active
indeed in stimulating the economy.
It's been said that any fool can keep inflation down, and that's true, but our task is much more
demanding than that. I know our rhetoric is mostly about the economic and social costs of inflation,
rather than about the economic and social costs of deflation. That's because, at least in New Zealand,
inflation has been much the more common problem, certainly for the last 60 years. Also, because New
Zealand went through a period of quite high inflation in the seventies and eighties, we have had to
work hard to persuade people that we are serious about keeping inflation down, in order to bring down
inflationary expectations.
But make no mistake. Inflation going below zero would be just as much a breach of the Reserve
Bank's inflation target as having it go above 3 per cent. Deflation causes its own set of economic
problems and distortions, doing social and economic damage. And our policy deliberations are always,
without exception, mindful of both risks. We are always trying to find the policy setting - the interest
rate - which will deliver an inflation outcome which is neither too hot nor too cold.
Preventing deflation is also part of the law under which I operate. The Reserve Bank Act 1989 makes
it clear that monetary policy must deliver "stability in the general level of prices". And the Policy
Targets Agreement which I have with the Minister of Finance, a requirement of the Reserve Bank Act,
defines "stability in the general level of prices" as inflation measured by the Consumers Price Index of
between zero and 3 per cent. Deflation is not "stability in the general level of prices", any more than
inflation is.
This means that, once price stability has been achieved, and as a very rough rule of thumb, the
inflationary raising
Reserve Bank's monetary policy will be seeking to restrain pressures by interest
rates roughly half the time, and will be seeking to restrain disinflationary pressures by lowering interest
rates roughly half the time - as we did in the second half of 1998 and as we have been doing through
most of this year.
New Zealand goes into this world slowdown in a strong position
Secondly, although New Zealand will be affected by the world slowdown, we are not completely
hostage to external events. It is important that we don't talk ourselves into a gloomy frame of mind just
because the slowdown in the world economy could be substantial, and could last well into next year.
When the world slowdown began, many sectors of the New Zealand economy were in rude good
health economically, as I have mentioned - and I haven't even mentioned such other advantages as a
strongly capitalised banking system and a government running fiscal surpluses. In other words, we
start into the slowdown from a good position.
Figure 4
Prices of New Zealand's export commodities
(denominated in US dollars)
Source: ANZ.
Yes, export prices look likely to fall, and indeed have already done so in a number of cases, but in
US dollar terms they have, on average, been at relatively high levels for much of the last year or so
(figure 4), and in New Zealand dollar terms they have been pushed up even further by the low level of
the kiwi dollar (figures 5 and 6). This low exchange rate provides very useful insulation from the
downturn in the world economy, by propping up returns to New Zealand exporters (and indeed returns
to those competing with imports) despite weaker prices abroad.
There has been a sharp decline in net confidence in the business sector in recent months, as
measured by both the National Bank Business Outlook survey and by the quarterly survey undertaken
by the Institute of Economic Research (figure 7). And businesses have become less confident not only
about the economy in general, but also about the outlook for their own businesses.
Figure 5
Prices of New Zealand's export commodities
(denominated in US and NZ dollars)
Source: ANZ.
Figure 6
NZD/USD exchange rate and the TWI
Source: RBNZ.
Figure 7
New Zealand business confidence
But at least as of late last month, more businesses continued to expect an improvement in their own
business over the year ahead than expected a deterioration. As you can see from the graph (figure 8),
the National Bank survey for September, taken prior to the tragic events of 11 September, showed that
only 6 per cent of businesses expected that their own business would deteriorate over the year ahead.
By the October survey, that had increased to 16 per cent expecting a deterioration. In both surveys,
roughly half of all respondents expected no change in their business over the period ahead. And
despite the increased gloom, roughly twice as many businesses were expecting their business to
improve as were expecting a deterioration, even in October.
Figure 8
Expected business activity
(September and October 2001 surveys)
Source: National Bank Business Outlook.
Interestingly, surveys conducted in September by both the Employers and Manufacturers Association
in Auckland, and the Canterbury Manufacturers Association in Christchurch, showed a remarkably
upbeat mood in both cities. And both surveys were conducted after the events of 11 September. A
survey conducted by Bancorp in late October found respondents (134 in all) more optimistic about
general business conditions, and more confident about increasing investment expenditure, than a
similar survey four months earlier. A more limited survey of the top 20 listed companies undertaken by
the New Zealand Business Times, also in late October, found that, with only a single exception,
corporates had not changed budget allocations or staff hiring intentions since 11 September - and the
exception was "a company that is subject to a particular restructuring in its business."1
Moreover, if the slowdown in the global economy affects us more adversely than we currently expect,
there is scope to stimulate additional demand without causing inflation to accelerate. Typically,
monetary policy is these days the policy instrument of choice for providing temporary stimulus to the
economy. We have now eased monetary policy by reducing the Official Cash Rate from 6.5 per cent
early this year to 4.75 per cent currently. There is little doubt that that reduction will help to cushion the
effects of the international slowdown. But if we need to reduce the Official Cash Rate further, there is
clearly plenty of room to do so, and in that respect we are in a very much easier position than the one
in which the Japanese central bank finds itself, with official interest rates already at zero, and with no
further reductions possible.
So there is good reason for businesses in New Zealand to be more optimistic about the future than is
the case in many of our trading partners: New Zealand starts from a situation of relatively strong
growth, and there is ample scope for monetary policy to stimulate the economy if that should be
needed, without jeopardising price stability.
1
New Zealand Business Times, 2 November 2001.
But unfortunately policy is unable to provide complete protection
But thirdly, having said that, it is unfortunately quite impossible for policy-makers, whether in the
government or in the Reserve Bank, to protect your business from all the effects of the global
slowdown.
In part that is because policy - whether government fiscal policy or Reserve Bank monetary policy -
works with what in the trade we call a long lag, or delay. In other words, the time between when the
Reserve Bank changes the Official Cash Rate and when that change impacts your business will
almost certainly be many weeks and probably many months. I have heard that some businesses
believe that a change in the Official Cash Rate can have an almost instantaneous impact in the
market, because of the effect which such a change can have on confidence. But that is surely the
exception rather than the rule. In most situations, the lag or delay between a change in monetary
policy and the impact of that change on the economy is typically more than a year.
To make life even more complicated, the lags are not only quite long but are also variable - they vary
somewhat from situation to situation.
This means that, if we had to offset the effect of, say, a world economic slowdown on the New Zealand
economy by easing monetary policy, we would need perfect ability to see the future for more than a
year ahead, perfect understanding of precisely where the economy is now, and perfect understanding
of how the economy works.
Well, we do our best, and I am fortunate to have some of the brightest economists in New Zealand on
my staff, trying to discern the future. We study 6,000 data series. We look for relationships which look
realistic in recent history. We talk to businesses up and down the country - about 50 or 60 before each
quarterly Monetary Policy Statement. We use some sophisticated economic models, but stir in very
large amounts of judgement. We are constantly looking to update our assessment of the real economy
outside the Reserve Bank's doors. We get a steady flow of data relevant to New Zealand from
overseas economies. We believe we are as well-informed about the economy as any other
organisation in New Zealand, and better informed than most.
But we can still get it wrong. Let me illustrate. One of the most reliable relationships in recent
economic history is that the world prices of the commodities New Zealand exports tend to rise when
the economies of our trading partners are buoyant, and tend to fall when the economies of our trading
partners are subdued. That sounds pretty much what one might expect on the basis of common
sense, and that is consistent with the data (figure 9).
Figure 9
NZ's export partner growth and world commodity prices
Figure 10
World export price index projections
(previous Monetary Policy Statements)
Source: RBNZ. November 2001 is central projection.
So since at least the December 2000 Monetary Policy Statement, we have been expecting the prices
of our commodity exports to decline (figure 10). And we projected the same thing to happen in March
this year, even though in the intervening period prices had risen some more, despite a steady
weakening in the world economy. And we projected prices to fall in our May Statement, even though
they had risen some more, despite still more weakening in the world economy. And in our August
Statement, we again projected world prices to fall, even though by August they had risen still further
and the world economy was looking quite seedy! And in the Statement we issued last week, we still
projected that the slowdown in the world economy would produce a fall in our export prices! Indeed,
had we not expected our export prices to fall, the case for reducing the Official Cash Rate last week
would have been non-existent. Should we have changed our expectation about export prices because
over most of the last year the traditional relationship between export prices and the growth of our
trading partners has broken down? Obviously we don't think so, but the example is a good illustration
of the difficulty of forecasting the economy even in "normal" times.
And of course these are anything but normal times. No economic model, and no economic forecaster,
could have foreseen the events of 11 September. By definition therefore, given the long and variable
lags between a change in monetary policy and the impact of that change on the real economy, and the
inability of even the most experienced central bankers to foresee the future, we will sometimes fail to
adjust policy sufficiently quickly to protect your business from a sharp downswing - or for that matter,
from a sharp upswing (though that may well cause fewer complaints!).
There is another reason why monetary policy can not protect your business from all the adverse
effects of world events. Even if we had super-human ability to see into the future, the reality is that
world events have quite different effects on different industries and different regions. Monetary policy,
with its single interest rate instrument, can only react to the balance of inflationary pressures in the
economy as a whole, not to the pressures in individual industries. In other words, we can't have a high
interest rate to restrain the very buoyant conditions in the dairy industry but a low interest rate to
support the software export sector, which has been adversely affected by the sharp deceleration of
spending on information technology in the United States. We can only have an interest rate which
seems appropriate to the economy as a whole - and must accept that that interest rate will seem far
too high for some parts of the economy and will be arguably too low for other parts.
We saw that situation rather clearly in the mid-nineties, when the building sector was experiencing
quite strong inflationary pressures, but many export industries were experiencing quite strong
disinflationary pressures. It would have been great to have been able to have a high interest rate
applicable to the building sector but a low one applicable to export industries. But as long as we have
a common currency throughout New Zealand, that is not an option.
So the Reserve Bank can help your business by trying hard to anticipate developments in the New
Zealand economy, and can adjust monetary policy quickly if it looks likely that inflationary or
deflationary pressures will emerge. But we can't provide complete protection, either for the economy
as a whole or, even more clearly, for each industry and region.
Monetary policy doesn't determine the economy's long-run growth rate
Finally, it is important to be aware of what monetary policy can and can not do for the economy's
long-run growth rate.
There is now virtually unanimous opinion among economists and policy-makers around the world that
central banks can't engender faster economic growth by being more tolerant of inflation. On the
contrary, there is a virtually unanimous view that the best thing that monetary policy can do for
economic growth is to keep inflation low and stable.
It is a myth, though one clearly believed by some New Zealanders, that the United States economy
has grown faster than the New Zealand economy over the last decade because the US central bank
has a mandate to encourage growth and maintain price stability, whereas the New Zealand central
bank has only a mandate to maintain price stability. The reality is that in both countries it is now fully
recognised that the best thing which monetary policy can do to encourage growth is to keep inflation
under control. In that respect, the Federal Reserve and the Reserve Bank of New Zealand think and
operate in the same way.
This is not the place for a comprehensive discussion on the determinants of trend growth in output.
Essentially, economic growth depends on growth in inputs of labour and capital, and advances in the
productivity with which that labour and capital are employed. And most of the things which impact on
those factors are quite unrelated to monetary policy. Some studies have suggested that high levels of
taxation discourage growth through their effect on incentives to work, save and innovate. Others have
pointed to the importance of protecting private property rights if growth is to be dynamic. Still others
note the importance of human capital, and highlight the role of education as a determinant of
economic growth. And of course there are many other relevant factors, such as the rules and
regulations which may make undertaking new investments a slow and cumbersome process. Getting
policies in all of these areas right is crucial if trend growth is to be increased, and none of them are
policies susceptible to central bank influence.
Conclusion
So in conclusion, in these "interesting times" -
• First, the Reserve Bank is as committed to avoiding deflation as to avoiding inflation, and
that means that we will always be leaning against the wind to the best of our ability, tending
to tighten policy if inflation looks likely to rise in the future, and tending to ease policy if
inflation looks likely to fall below the bottom of our target.
• Second, the New Zealand economy is well-placed to weather the international slowdown,
with moderate growth, low unemployment, an exchange rate which is providing useful
support for export and import-competing industries, and ample scope for further easing of
monetary policy if that should prove necessary.
• Third, even with the best will in the world, the best economists in the world, the most regular
contact with companies up and down the land, monetary policy can never provide you with
complete protection against the vagaries of life, whether these vagaries come in the form of
international crises or in the form of some dramatic domestic development.
• And fourth, monetary policy doesn't determine the economy's long-term growth rate - that is
determined by a whole range of factors which have nothing directly to do with the Reserve
Bank.
Sometimes the Reserve Bank will need to leave monetary policy unchanged for months on end.
Sometimes we will need to adjust interest rates in small incremental steps, as earlier in the year. And
sometimes we will need to adjust rates more aggressively, as over the last couple of months. Different
circumstances will require different responses.
But what I can say is that, in "interesting times" as in normal times, the role of monetary policy is to
help and not to hinder, and that is what we are committed to doing.