alan bollard : everyone needs to play their part – inflation and recession in the new zealand economy speech by dr alan bollard, governor of the reserve bank of new zealand, to the wellington chamber of commerce, wellington, 10 december 2008. * * * the world economy faces some significant challenges. finance markets have been going through turmoil, the pace of global expansion has slowed abruptly, and policymakers have focused on preventing a more pronounced slowdown. for some commentators, concerns over inflation appear to have taken a back seat, for now at least. as the global economy has weakened, commodity prices have fallen, substantially in some cases. many commentators are of the view that lower commodity prices and weak economic activity will drive inflation significantly lower. it is worth remembering that for the moment, however, inflation rates in new zealand ( and many of our trading partners ) remain very high. in the september 2008 year cpi inflation reached 5. 1 percent, the highest rate since 1990. the higher rates of inflation are broadbased. these reflect some common drivers : • a strong run - up in world commodity prices, which have had a direct inflationary impact. oil prices increased nearly tenfold in usd terms in the decade to july 2008, with global food prices also rising strongly. prices of the milk, cheese and eggs category rose 18 percent over the last year. • the long - running expansion in domestic demand contributed to a build - up of pressures on capacity and high rates of domestically generated inflation. so far, weaker demand conditions have been slow to feed through into lower domestic inflation. in the building industry for example, rising prices for raw materials and strong wage inflation have continued to underpin high rates of construction cost inflation. • there have also been sizeable price increases in areas not directly exposed to a high degree of competition over the past few years. increases in local authority rates have run well in advance of overall cpi inflation for a number of years. cost increases in some utilities have also been notable, particularly electricity. • in the banking sector, the cost of international funding has risen significantly and become less assured. however, since july the reserve bank has cut the official cash rate by 3. 25 percent. short term mortgage rates have been cut, but not by this much. banks should not expect to be able to maintain high profit margins in the current environment. table 1 consumer price inflation over the 3 years to 2008q3 cpi component average annual rate for the 3 years to september 2008 quarter annual percent

appreciation of the krona after the middle of the year, the effect of lower global fuel prices on the price level, and the fact that wage settlements made in the middle of the year did not provoke wage drift on the scale that the bank had forecast in july. the first two factors were hardly foreseeable, and it should be pointed out that the bank ’ s overforecast for wage drift was not far from that made by the social partners themselves when the wage settlements were signed. be that as it may, the economy was no less overheated than forecast in mid - 2006, as witnessed by the current account deficit and tight labour market. thus it is untenable to claim that the central bank ’ s policy rate hikes in 2006 were unwarranted. on the contrary, a higher policy rate was the main precondition for the krona to hold relatively strong, and contributed to subduing demand growth. had the central bank not raised its policy rate, there is little doubt that inflation would be higher than at present. some commentators who were surprised by the december policy rate hike apparently considered that the central bank had underestimated the scope of the turnaround in the economy in the second half of the year. national accounts statistics for q3 that were published in mid - december, supposedly showing a substantial slowdown in economic activity, were repeatedly cited as evidence. the central bank considers it imprudent to draw sweeping conclusions solely from preliminary estimates in the quarterly national accounts, which tend to undergo sharp revisions. for this and other reasons, a broader range of indicators contributed to the december policy rate decision, including the current account deficit and labour market conditions. the scenario today is that commercial bank analysts expect the cycle of policy rate cuts to begin later this year than they were forecasting towards the end of 2006. in other words, they consider that more underlying pressures remain in the economy than they may have thought at the time. interest rate assumptions in central bank forecasts various changes have been made to the exchange rate and interest rate assumptions behind the central bank ’ s forecasts in recent years. in the early years of inflation targeting, forecasts were based on the assumption of an unchanged exchange rate and unchanged policy rate over the forecast horizon. by showing how developments would unfold if the bank left the policy rate unchanged, they indicated whether it needed to be changed. in december 2004, the first alternative scenarios to the baseline forecast were presented which assumed changes in the exchange