Monetary policy and inflation

To compete in the Monetary Policy Challenge, you need to understand what price stability, inflation (and deflation) are, and how monetary policy acts to control inflation in the New Zealand economy.

The Reserve Bank uses monetary policy in order to maintain price stability. Price stability occurs when goods and services, in general, aren't getting rapidly more expensive (that's inflation) or less expensive (that's deflation). At present price stability is defined as keeping inflation "on average over the medium term" between one and three percent in an agreement set out between the Minister of Finance and the Reserve Bank Governor, called the Policy Targets Agreement (PTA).

The Reserve Bank adjusts the Official Cash Rate in order to influence prices in the economy, and ensure price stability is maintained.

The role of money
What is price stability?
What causes price stability, inflation and deflation?
How do we measure inflation and deflation?
Why is price stability better than inflation or deflation?
What about deflation?
How does the Reserve Bank control inflation and avoid deflation?
What is the Output Gap?
How does the Reserve Bank influence short-term interest rates?
How does the exchange rate affect inflation?
How does monetary policy affect the exchange rate?
Putting it all together

The role of money

A long time ago, people traded by barter. When people barter they directly exchange goods and services for other goods and services. Money was invented because it solved many of the severe limitations of bartering. With money a person can buy from and sell to different people much more easily. Money also allows production and consumption to more easily happen at different times. It gives people the ability to save money and spend it later.

However, for money to work well it must be a reliable standard of value – just as a metre is a universal standard of length and a kilogram is a universal standard of weight. To perform that role, money needs to be an effective store of value. To be willing to exchange goods and services for money, you need to have confidence that the money will be of roughly the same value at a later date when you want to spend it.

What is price stability?

Price stability exists when prices overall are stable (ie, money is an effective store of value). This does not mean that prices are frozen, but rather that taken on the whole they are stable. In an environment of price stability, you would expect some prices to be rising but others to be falling.

What causes price stability, inflation and deflation?

The rate of inflation tends to increase when the overall demand for goods and services exceeds the economy's capacity to sustainably supply goods and services. Likewise, when productive capacity is greater than demand, the rate of inflation tends to decrease, and, if the excess capacity persists, deflation can occur.

By "demand" we mean the desire for goods and services that is supported by the means to purchase those goods and services.

By "the economy's capacity to sustainably supply those goods and services" we mean the level of production that can be sustained without shortages occurring.

Thus, throughout the economy, if factories are working flat out to meet demand, inflationary pressure may emerge. Factory staff will work longer hours, which may require overtime payments, thereby forcing firms to put up their prices.

Conversely, if factories are producing more goods than they can sell, then to get rid of the stock that is building up they may have to reduce their prices. If enough do this the rate of inflation will start to fall.

To see how inflation results in money becoming a less useful standard of value, consider that since the New Zealand dollar replaced the New Zealand pound in 1967 it has lost over 90 percent of its purchasing power, as shown in Figure 1.

Figure 1: The purchasing power of the NZD - 1967 to 2006

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How do we measure inflation and deflation?

In New Zealand the most prominent measure of the general level of prices is the Consumers’ Price Index (CPI), which is calculated by Statistics New Zealand. The CPI measures the prices of goods and services purchased by households, but not those purchased by firms. Movements in the CPI therefore measure changes to the average level of prices paid by the average New Zealand consumer.

Under the Policy Targets Agreement (PTA) the Reserve Bank is required to keep future CPI inflation outcomes between one percent and three percent on average over the medium term, although it is acknowledged that isolated price movements can justify outcomes outside the one to three percent range. (For more information on the PTA go to http://www.rbnz.govt.nz/monetary_policy/.)

The CPI is created by choosing a mix of goods and services purchased by a typical New Zealand household. Prices are combined according to how much each household buys, on average. For what currently goes into the CPI, and in what proportions, see Figure 2.

Figure 2: Weights in the Consumers Price Index

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Food has an 18 percent weighting in the CPI. This means that the average New Zealander currently devotes 18 percent of their total spending to food.

Prices of individual goods and services can move in directions and by amounts that are quite different from the rate suggested by ‘the inflation rate'. For example, in the September quarter 2006, the price of petrol went up by over 15 percent, whereas prices on average (ie, the CPI) increased by only three and a half percent. When an individual item in the CPI changes price we call it a relative price shift; that is, the price of one good has changed relative to the prices for other goods. Relative price shifts are important, as they signal to consumers the relative scarcity of goods or services and are therefore essential for achieving an efficient rationing of resources according to how plentiful or scarce they are. To take another example, in the dry cold winter of 2001, there was an electricity shortage owing to low lake storage levels. This shortage caused the price of electricity to increase, which made it economical for energy generators to bring more higher cost thermal generation on stream. It also led to some industrial firms cutting back on production, and therefore on electricity consumption, which left more electricity for those with more critical needs, and avoided blackouts. Without a rise in the relative price of electricity, these desirable outcomes might not have been achieved.

Why is price stability better than inflation or deflation?

Price stability helps create an environment where economic growth may occur more easily. It does this by enabling money to work as the means by which people and businesses transact and contract with one another. When inflation is high, firms and businesses face uncertainty about the future, and this changes the way in which they behave.

Consider, for example, how people may change the way in which they save. When inflation is high, there are good reasons to avoid placing deposits with financial institutions. The amount deposited is expressed in units of money, and if money is losing its buying power, the real value of the amount saved will decline. Even if the institution pays a rate of interest that includes compensation for the loss of buying power, that interest will be treated as income for income tax purposes, so in after-tax terms, the saver is still disadvantaged. In these circumstances it makes sense for savers not to place deposits with saving institutions, but to buy assets whose prices can be expected to rise with inflation, such as real estate.

The result is savers invest directly, instead of depositing funds with financial institutions that on-lend those deposits to households and firms with borrowing needs (for housing and to develop their businesses). In effect, the tendency is for savers to adopt a ‘do-it-yourself' approach to investing their savings, rather than have a specialised institution do this. While that is sensible from the standpoint of the individual saver - in that it enables them to avoid being penalised by inflation - it almost certainly results in the country's economic resources being used less effectively and efficiently than they could be. Economic growth suffers as a result.

Another way in which inflation impacts on the economic system is by clouding relative price signals. When inflation is high it also tends to be very volatile. Figure 3 shows the volatility of the New Zealand inflation rate during the 1970s, 80s and 90s.

Figure 3: Annual inflation - March 1967 to December 2006

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When inflation is volatile it becomes less clear whether a price change reflects a change in the relative demand or supply of that individual good or service, or whether it is just part of a generalised movement in prices across the board. As mentioned earlier, relative price changes provide useful information for producers when deciding whether they should produce more or less of a particular good or service.

Consider, for example, a company that sees its competitors raising the price of their product. The company may conclude that demand for its product has increased and that it should therefore produce more and invest in new machines to do so. But if the product price increase is a result of inflation - that is, there has been no change in the demand for its product relative to that for other goods and services - then it will find that it is unable to sell the increased output. Resources will have been misallocated.

As you can see, the uncertainty caused by inflation hinders economic growth. In the extreme case, that of hyperinflation, price signals become so confused and financial contracts based on money are so unreliable that people may stop participating in the market economy altogether.

On the other hand, if prices are stable, people and firms are able to make their investment, saving and consumption decisions without having to worry about protecting themselves from the effects of inflation. This enables resources to be allocated more effectively.

What about deflation?

Deflation causes many of the same problems as high and variable inflation. It also creates a powerful incentive not to invest (and thus increase productive capacity). If average prices are falling then the value of money is rising. In that circumstance, possibly the best investment will be to hold money. As more and more people hold money, a deep deflationary cycle can set it. Historically, the run-away effects of deflation have been devastating. There was a strong element of this in the Great Depression of the 1930s. More recently in Japan, there has been concern about the way in which falling consumer prices are undermining demand in that economy. The Reserve Bank of New Zealand is just as concerned about inflation moving below the lower bound of the target band as inflation moving above the upper bound, because this could lead to deflation.

How does the Reserve Bank control inflation and avoid deflation?

As mentioned above, the balance between the overall demand for goods and services and the economy's capacity to sustainably supply them determines inflation. In the jargon of economists, the difference between demand and the economy's capacity to supply is known as the output gap. Monetary policy can't affect the economy's capacity to supply. However, monetary policy can stimulate or dampen demand. This is done by adjusting short-term interest rates. The Reserve Bank tries to influence the output gap so the amount of pressure on resources causes inflation to remain within the one to three percent inflation band.

What is the output gap?

The output gap is the difference between demand and the economy's capacity to supply. This is the difference between the ‘actual' level of output (GDP) and the economy's ‘potential' level of output (potential GDP).

If the economy is running above capacity (GDP > potential GDP) the output gap is positive. Conversely, if the economy is running below its full capacity (GDP < potential GDP) the output gap will be negative.

Figure 4: A stylised representation of the output gap

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Remember that ‘potential' output is not an upper limit on the level of output. Rather, think of potential GDP as the economy's efficient level of output. Running the economy below potential GDP is inefficient because there are some resources that are not employed. Running the economy above potential GDP is also inefficient because resources are over-utilised (eg, machinery is being made to work too hard causing it to wear out too quickly).

While it is efficient to have the economy running at potential, quite often it does not. Resources can be over- or under-utilised, which will translate into inflationary or disinflationary pressure (over-utilisation will push future inflation up, while under-utilisation pushes future inflation down).

How does the Reserve Bank influence short-term interest rates?

The Reserve Bank of New Zealand influences short-term interest rates, including floating mortgage interest rates, by adjusting the Official Cash Rate. The Reserve Bank has the opportunity to adjust the Official Cash Rate eight times a year.

The Official Cash Rate influences short-term interest rates in the following way. When an Official Cash Rate is announced the Reserve Bank undertakes to pay commercial banks an interest rate 0.25 percent below the Official Cash Rate for money deposited in Reserve Bank settlement accounts. The Reserve Bank also undertakes to provide overnight cash to commercial banks against good security, charging interest at 0.25 percent above the Official Cash Rate. Most importantly, the Reserve Bank sets no limit on the amount of cash that it will take in or lend out, at 0.25 percent above or below the Official Cash Rate.

The effect of this is that no commercial bank is likely to offer short-term loans at a rate significantly higher than the Official Cash Rate. That's because other banks would undercut that, using credit from the Reserve Bank. Similarly a bank is not likely to lend short-term at below the Official Cash Rate because the same bank can lend to the Reserve Bank and receive interest at the Official Cash Rate level.

The key point is that the Reserve Bank is able to lend or borrow overnight money in whatever volumes are needed to hold the market interest rate at the Bank's Official Cash Rate level. By controlling short-term interest rates in this way, the Reserve Bank can influence short-term demand in the economy and therefore influence prices.

The Official Cash Rate has a ripple effect on interest rates in general, including longer-term interest rates. When commercial banks set interest rates for longer terms, they need to think about how short-term interest rates will move during the relevant period. Homeowners also need to take into account what they think will happen to interest rates when choosing between a fixed or floating mortgage rate.

How does the exchange rate affect inflation?

New Zealand is a small open economy. By open we mean that exports and imports make up a large proportion of New Zealand's income and spending and New Zealand's financial markets are open to cross-border financial flows. Because of this, the exchange rate is important to the New Zealand economy.

Movements in the exchange rate can have both a direct and indirect effect on inflation.

  1. Changes in the exchange rate directly affects the prices of the things we import. For example, if the New Zealand dollar depreciates, or loses value against other currencies, then the price of goods we import, such as petrol and electronics, becomes relatively more expensive in New Zealand. An increase in the price of imported goods and services, will contribute to increases in inflation.

  1. Exchange rate movements also have an indirect effect on inflation. If the New Zealand dollar depreciates then New Zealand products, (eg, a holiday in New Zealand) become relatively cheaper for foreigners and demand for our exports will increase. For example we may see an increase in the number of tourists visiting New Zealand. The associated increase in demand for New Zealand goods and services can contribute to spending exceeding potential output, causing inflationary pressure.

Both these influences work in the opposite direction when the value of the New Zealand dollar increases, or appreciates.

How does monetary policy affect the exchange rate?

Often, but not always, an increase in domestic interest rates will cause the exchange rate to also rise or appreciate. If interest rates are relatively higher in New Zealand than in other economies, overseas investors will be more likely to invest in New Zealand as they receive a relatively larger return for their money. However, before overseas investors can invest in New Zealand, they must exchange their foreign currency into New Zealand dollars. This increase in demand for New Zealand dollars will cause the New Zealand dollar to appreciate.

Many other factors also affect the exchange rate. One such factor will be changes in the world market for the goods and services that New Zealand exports. Also, financial market expectations of future developments can have an important influence on the exchange rate. All these factors make forecasting exchange rates movements notoriously difficult.

The effect that monetary policy is having on the exchange rate and the effect that the exchange rate is having on the economy may be matters that Monetary Policy Challenge teams will need to take into account when making their Official Cash Rate recommendation.

Putting it all together

We have established that:

  1. Price stability occurs when overall prices are not rapidly increasing (high price inflation) or decreasing (deflation)
  2. In an economy where prices are relatively stable, money retains its value and this helps to create an environment where economic growth may occur more easily
  3. The rate of inflation tends to increase when the overall demand for goods and services exceeds the economy's capacity to supply goods and services (or the output gap is positive).

So how does adjusting interest rates affect the output gap, thereby encouraging price stability?

Let's imagine that inflation is too high. In this scenario, interest rates will need to be increased to lower the inflation rate.

When the Reserve Bank increases the Official Cash Rate, commercial banks will earn a higher return from overnight cash deposits, and pay a higher overnight interest rate when borrowing from the Bank. As a result, the short-term interest rate used between commercial banks will increase. The will put upward pressure on short term interest rates banks offer to customers, and will also push rates higher through the wider financial system and to longer-term interest rates.

Both the cost of borrowing and the benefit of saving increase for the broader economy. Borrowers tend to reduce their spending as the cost of credit increases, and savers have an incentive to save more, because their interest returns are higher. These effects both lead to less spending in the economy, pushing the output gap lower and subsequently inflationary pressures will ease.

Monetary policy also has a psychological effect. When the Official Cash Rate is increased it is a signal to everyone that the Reserve Bank is taking measures to reduce the rate of inflation. If people believe the Reserve Bank is committed to low inflation and that the Bank will be successful, they incorporate a lower future rate of inflation into the contracts they enter into, such as in wage contracts. In this way, expectations of lower inflation can assist in lowering the actual inflation rate in the future. In effect, the expectation of lower inflation is self-fulfilling. Conversely, if people think that inflation will rise, or remain high, that can make it more difficult for monetary policy to reduce inflation.

Today people believe the Reserve Bank is serious about containing inflationary pressure. However, when the Bank was first mandated to deliver and maintain low inflation, many were sceptical. This meant that the Bank had to maintain much higher real interest rates to get and keep inflation down compared to today.

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