like big changes in international prices and changes in indirect taxes. we used to refer to these things as “ caveats ”, and to calculate the inflation rate excluding the impact of such “ caveatable ” shocks. for convenience, we used to refer to the inflation rate excluding such caveatable shocks as the “ underlying inflation rate ”. in the agreement i signed with the present minister of finance, the hon dr michael cullen, in december last year, as in the agreement signed with the rt hon winston peters in late 1997, the wording is slightly different from the wording used in 1990, but the substance is the same, namely that : “ there is a range of events that can have a significant temporary impact on inflation as measured by the cpi, and mask the underlying trend in prices which is the proper focus of monetary policy. these events may even lead to inflation outcomes outside the target range. such disturbances include, for example, shifts in the aggregate price level as a result of exceptional movements in the prices of commodities traded in world markets, changes in indirect taxes, significant government policy changes that directly affect prices, or a natural disaster affecting a major part of the economy. when disturbances of ( this ) kind … arise, the bank shall react in a manner which prevents general inflationary pressures emerging. ” and the reserve bank is directed to ignore, or “ look through ” in the jargon, the price effects of such events not in order to make my life easier but to make your life easier. in other words, the bank is directed not to react to such one - off price shocks on the grounds that trying to offset them would involve more economic cost than would be warranted. for example, while monetary policy could in principle be tightened aggressively so that other prices in the economy would fall sufficiently to offset the direct price effects of an increase in the international price of oil, the minister has decided, and i have agreed, that doing that would involve more economic and social damage than could be justified. we no longer calculate “ underlying inflation ” in the way we used to do, and that is true for a whole raft of reasons, including the fact that there was always some public suspicion that “ underlying inflation ” was a reserve bank invention to help don brash keep his job. but the reality which that term reflected is as valid today as it was a decade ago. in other words, we are not interested in trying to use monetary policy to suppress the price changes which emanate from international oil

have produced a much smaller impact on inflation than that, for reasons which are not entirely clear. the same relatively mild impact of exchange rate movements on inflation has been observed in australia, canada, and the united kingdom in recent years. but whether the impact is as big as we thought it was in the early nineties or as small as it seems to have been more recently, we now recognise that this short - term impact of movements in the exchange rate is not something which always calls for a monetary policy response. this is because the effects of such exchange rate movements on the inflation rate may have come and gone before adjustments in monetary policy can have much offsetting effect on the inflation rate. but again, the reserve bank ’ s ability not to react to the temporary inflation movements associated with exchange rate changes depends on whether we new zealanders accept that the direct price effects of exchange rate depreciation are not matters which justify our seeking compensation through higher incomes. if we collectively seek such compensation, then the bank is faced not with a one - off price level adjustment but with the potential for ongoing upwards pressure on prices. in that event, we would have no alternative than to lean against that by running a somewhat tighter monetary policy than otherwise. the second way in which the exchange rate is relevant to inflation is through the effect which the exchange rate has on the demand for new zealand - produced goods and services. when the exchange rate depreciates, goods and services produced in new zealand become cheaper relative to the price of goods and services produced abroad. foreigners seek to buy more of the goods and services produced here, and so also do new zealanders. in other words, our exports become more price - competitive overseas, and domestically - produced goods and services become more price - competitive vis - a - vis imports. those producing exports and import - substitutes see an increase in their sales. if they are operating at full capacity, they will seek to expand production by increasing investment and hiring more staff. and this is great - until such time as the demand for additional resources from exporters and those producing import substitutes collides with the demands for resources emanating from the domestic, so - called “ non - tradable ”, parts of the economy. if the total demand for resources is greater than the resources available, then at some point inflation will begin to develop. so in assessing the appropriate stance of monetary policy, the reserve bank can not ignore these indirect effects of the exchange rate on the total demand