The impact of monetary policy on growth

ARCHIVED: This document does not necessarily reflect the current views or practices of the Reserve Bank of New Zealand.

Published June 2001

Throughout the 1990s and into this decade, New Zealand has enjoyed the benefits of price stability. Investors, savers, borrowers, consumers and people making contracts now have far greater assurance that the purchasing power of their money is stable and predictable. However, the concern has been expressed that the "price" of price stability has been too high. Some commentators have said that monetary policy has put the New Zealand economy in a straight jacket, with growth being damaged by unnecessary volatility in output, interest rates and the exchange rate. Also, some observers have worried that the Reserve Bank has imposed a growth limit on the New Zealand economy which is well below the economy's actual capacity to grow. In this booklet, Reserve Bank Governor Don Brash responds to these concerns and answers questions about the impact of monetary policy on economic growth.

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What influence does monetary policy have on economic growth?

It's important that the Reserve Bank does not claim that it can deliver miracles when it cannot. Many factors go into making an economy successful, and monetary policy has no influence on most of them. Raising or lowering interest rates won't make the soil more fertile, the weather better, our workforce better educated or motivated, our transport system more efficient, our commercial law easier to understand, our tax system easier to comply with, and so on. The weather cannot be controlled, and the rest are influenced by decisions made by governments or individuals, and not central banks.

However, monetary policy can still make an important contribution. Monetary policy done badly can cause distortions in the way the economy works, and can therefore hinder growth. By avoiding these distortions, monetary policy done well helps growth.

In essence, monetary policy is the process that determines the buying power of money. Over the centuries, various benchmarks have been used to do this, such as a unit of gold. The current benchmark in New Zealand is not gold, but goods and services in general, as described in the Consumers Price Index calculated by Statistics New Zealand. Thus when money is holding its value, prices on average are stable. This confers significant economic advantages. People can then more effectively plan their decisions to invest, save and consume. For example, if prices are stable on average, then the parties to an employment contract can be more confident that after 12 or 24 months the costs and benefits to both sides will be similar to when the agreement began. This kind of predictability makes sound business decisions easier and encourages people to invest in the economy.

On the other hand, inflation can damage growth in a number of ways. To begin with, when inflation is high price signals within the economy, by which people decide what to buy, sell, make and invest in, become confused. This makes economic decisions harder. For example, look at graph 1 on the opposite page. This shows "nominal" house prices and "real" house prices from 1968 to now. Nominal house prices are the actual listed prices on the day - what houses buy and sell for. However, if there is inflation then over time nominal prices can easily deceive.

Thus, if you buy a house for, say, $100,000 and then some years later sell it for $130,000, you appear to have made $30,000. But if during that period there's been 30 per cent inflation then in reality you've made nothing at all. That's because the buying power of your money has fallen by 30 per cent. To work out whether the purchase really made money, you need to subtract inflation from the sale price, which gives what's called the "real" return.

Graph 1 shows that throughout the high inflation 1970s and 1980s house prices seemed to be going up, yet actually there were significant periods when real house prices were falling, most notably from late 1975 to late 1980. Misperceptions of this kind can easily lead to poor investment decisions.

Graph 1

High inflation also interacts with the tax system to discourage investment in the things that best help the economy to grow. For example, let's assume no inflation, a bank paying interest on deposits of 3 per cent and income tax at 33 per cent. Then the real after-tax rate of return on a deposit in that bank is 2 per cent, given that 33 percent income tax on a 3 per cent return would be 1 per cent of the total. However, if the rate of inflation is 9 per cent, and, as one would expect, the interest rate rises so that the real return to the saver remains 3 per cent (ie, 9 per cent plus 3 per cent, giving 12 per cent), then the saver has to pay 4 per cent in tax, ie 33 per cent of 12 per cent. Given that the real return before tax is still 3 per cent, the saver is now making a real after-tax 1 per cent loss. Thus, if inflation is high, the tax system provides a powerful disincentive to save.

Even worse, inflation and tax provide an incentive to borrow. If a person borrows and then can claim interest payments on that borrowing as tax deductible, then if inflation is high his or her deduction may be larger than the real interest payments. Thus inflation creates a powerful incentive to borrow.

The interaction of inflation with the tax system also leads, in many situations, to the over-taxation of company profits. There are several reasons for this, but the most important probably relates to the treatment of depreciation for tax purposes. Depreciation for tax purposes is based on the purchase price of an item at the time of purchase. However, if inflation is high the price of replacing the item when it wears out is much higher, yet this is not recognised in the allowable depreciation claim. This creates a strong disincentive to investing in plant and equipment.

In addition, the tax system and inflation together create another undesirable result, so-called "fiscal drag". As inflation erodes the value of money, employees often earn higher nominal wages, even though their buying power has not gone up at all. Because New Zealand taxes income more heavily as incomes increase, inflation sees more and more people have more and more of their income taxed at higher rates as their nominal, but not real, income rises. This is despite no decision having been taken by any government to increase the rate of tax. The evidence suggests that increasing taxes relative to total income tends to discourage growth.

On the other side, for at least circumstantial evidence that price stability and growth can go together, look at New Zealand's own economic record. New Zealand suffered from high and variable inflation in the 1970s and 1980s. We then restored price stability in the 1990s. Real GDP growth averaged 1.8 per cent annually in the 1970s, 1.7 per cent in the 1980s and 2.5 per cent during the 1990s. In the Reserve Bank's judgement, the New Zealand economy is now able to grow at an average of 3 per cent annually without generating inflation, which is better than in the 1970s and 1980s. There are many reasons for this improvement, but one of the factors is that average prices in New Zealand are now fairly stable. Note also that we did well in the 1990s compared to many other countries, as the table below shows.

Real GDP growth over the 1990s

Country	Average annual growth over the decade
Ireland	6.8%
Australia	3.5%
Norway	3.3%
USA	3.2%
Netherlands	2.9%
New Zealand	2.5%
Spain	2.5%
Canada	2.4%
Denmark	2.2%
Belgium	2.1%
Germany	2.0%
United Kingdom	2.0%
France	1.7%
Finland	1.7%
Italy	1.4%
Sweden	1.3%
Japan	1.3%
Switzerland	0.9%

Source : Datastream , Statistics New Zealand

If the Reserve Bank tolerated a little more inflation now, wouldn't we get more growth?

Indeed, inflation can stimulate the economy, but only while the rate of inflation is going up. After inflation stabilises at a higher rate, any temporary positive effect on growth is lost, and indeed the negative effects of inflation then come into play.

This works as follows. If monetary conditions are eased at a time when inflationary pressures are NOT falling, then lower interest rates increase demand relative to the goods and services available. Retailers and those producing goods and services soon realise this and raise their prices, and therefore their profits which then trigger expanded economic activity. Note that as price rises flow into the general cost of living, the living standards of the workers producing the expanded production fall. It is their reduced living standards that have paid for the increased profits that result in expanding economic activity.

Of course, this only works for as long as employers' labour costs remain static or rise more slowly than prices. As soon as staff realise that profits are up and the cost of living is up, they demand compensatory pay rises. Once these claims are achieved, the extra profitability is gone and with it the incentive to expand production and hire more staff. Unless the rate of inflation continues to rise, the overall level of economic activity then falls back to its original level. If inflation could be somehow steady at, say, 10 per cent, workers would require and probably get a pro forma after-tax 10 per cent pay increase every year, and output would be no greater than if inflation was steady at zero. Indeed, it could very well be less, because of the ways in which inflation damages growth, as discussed.

In addition, any temporary gain when the rate of inflation is rising is usually less than the economic cost later when the rate of inflation comes down again. When inflation goes up unexpectedly, it typically doesn't take long for workers to realise that they have been short-changed, and to demand pay increases as compensation. The gain in output and employment therefore tends to be small and short-lived. By contrast, when inflation is being reduced, workers are usually very reluctant to accept smaller increases in remuneration than they have experienced in the high inflation period, so that even as price rises taper off wage increases tend to continue for a while at least. The flow-on effect is that usually output declines by more as inflation is falling than it increases when the inflation rate was rising. The aggregate effect of a rise and then a fall in inflation is usually negative.

You say that on average the economy can grow at close to 3 per cent annually. What if you are wrong and potentially it can grow at 5 per cent, or even 6.8 per cent like Ireland? Is your misplaced 3 per cent limit holding us back?

Percentage growth rates can be misleading. For example, when a country has been devastated by war, its percentage growth rate after the conflict can appear phenomenal because the starting point is so low. The same is true for a country that grows rapidly from a position of relative under-development. As was seen in post-war Asia, when a country is technologically backward with a large population desperate to work, then it can achieve remarkable growth in percentage terms, as it employs already-available technology and cheap labour to catch-up. Ireland in the 1980s had some of the characteristics of post-war Asian economies, with a substantial proportion of the population unemployed. To some extent, Ireland in the 1990s has been in a catch-up phase.

However, once nations have caught up with their competitors, maintaining very high growth rates becomes much more difficult. The US has been through a very successful growth phase in recent years, and yet over the decade this amounted to only slightly above 3 per cent annually.

Remember also that our estimate of New Zealand's sustainable growth capacity of about 3 per cent is an average over the whole business cycle. It is not the peak or high point, which is likely to be much higher, as illustrated in 1994 when real GDP growth peaked at over 6 per cent. As an average, growth of close to 3 per cent would be a good result for New Zealand and better than we achieved in the 1970s and 1980s.

But what if, nonetheless, the Reserve Bank has got this wrong, and the New Zealand economy has the capacity now to grow much faster, if only the Reserve Bank would let it? What would happen then?

First, it is correct that New Zealand's economic performance could be damaged for some considerable time if the Reserve Bank was persistently wrong in its estimation of the economy's capacity for sustainable non-inflationary growth, whether we over- or under-estimated it. One of the key factors in setting monetary policy is estimating the economy's capacity to grow sustainably. We then compare that with the economy's actual growth, as a guide to whether inflationary pressures are likely to increase or decrease. If the Bank, for example, under-estimated the economy's sustainable growth capacity, then it would interpret any particular growth rate as potentially a greater inflation risk than actually it was and would run monetary policy too tightly as a result. The converse would happen if we over-estimated the economy's sustainable capacity to grow.

However, to make this error for a significant period the Reserve Bank would have to consistently fail to recognise the clues that an economy gives if it is under-performing or over-heating. The most important clue would be that the Bank's expectations for inflation, which it makes public, would be consistently wrong.

Let's think about how this works. If the Reserve Bank for an extended period under-estimated the economy's growth capacity, and as a result ran monetary policy too tightly, then the economy would be likely to operate at below its sustainable capacity. Unnecessarily high interest rates over time would result in the economy not fully utilising its available labour, plant and machinery, and other resources. In that situation, unemployment would grow, firms would build up stockpiles, and retailers would have unsold stock accumulating on their shelves. Then inflation would fall and, if the Reserve Bank failed to rethink its growth assumptions, then, in time, the country would potentially face deflation, which is when prices are falling on average.

The reverse could also happen. In the short term, economies can be made to grow faster than their sustainable capacity, and recklessly loose monetary policy can temporarily create this effect. Fuelled by cheap money, excessive demand within an economy can be temporarily met by workers working longer hours; plant and machinery having maintenance deferred and being run flat out day-and-night; farms carrying more stock than the land can sustain and so on. But this process can't last. Eventually, pushing an economy like that would result in shortages. Stocks of materials would be used up; machinery would begin to break down; soil fertility would decline; and, as workers got fed up with working long hours, firms would try to hire more staff and find that they couldn't without bidding up wages. The result would be shortages, which would push up prices, leading to inflation and the serious economic and social damage that comes with that. This scenario could occur if the Reserve Bank consistently over-estimated the economy's sustainable capacity to grow.

Ideally, monetary policy targeted at price stability should ensure that neither of these scenarios occurs. However, it's important to acknowledge that accurately calculating the economy's sustainable capacity to grow is not simple and the results are not precise. One cannot always tell what is driving inflation at any given moment, so it is not easy to tick off every other possible explanation for an unexpected inflation result and by that conclude that one's estimate of potential growth is wrong. This is made yet more difficult by the time delays between cause and effect, which may be longer in the case of under-estimating rather than over-estimating the economy's capacity for sustainable growth. This is because inflation does not fall as readily as it rises. Merely averaging past business cycles isn't good enough because circumstances change.

We also know that there have been some substantial errors, as well as successes, in the past. For example, around the end of the 1960s or early 1970s in the US and elsewhere, productivity growth slowed. As a result, the US economy's capacity to grow sustainably fell back too. However, this was not initially recognised, and attempts to keep the US economy growing at previous rates generated serious inflation. Later, in the mid-1990s, US productivity growth lifted again. This time, the Federal Reserve, which is the US central bank, was alert to the signs and did not raise interest rates as growth expanded beyond previous estimates of the economy's capacity to grow. The US boom of the 1990s followed - a boom without inflation. In other words, central banks don't always gets these things right.

However, in New Zealand the record is that, since the Reserve Bank began inflation targeting in 1988, inflation has never got close to zero, as shown in graph 2. This suggests that we are not consistently under-estimating the economy's potential growth rate.

Graph 2

Also look at graph 3, which shows GDP growth through the last business cycle. See how short-lived the low point in late 1998 was, compared to the preceding "recession" of the early 1990s. The economy's capacity nowadays to bounce back quickly and the inflation outcomes that have gone with that do not suggest that monetary policy, targeted at price stability, is grinding the economy into the ground or imposing a "speed limit".

Graph 3

When the Reserve Bank puts up interest rates, the high cost of credit penalises those who want to invest in new businesses, which, if successful, would increase the potential output or capacity of the economy. Increasing economic capacity reduces inflation, so doesn't your way of fighting inflation actually help cause inflation, the cumulative effect being reduced growth?

It is a fact that when interest rates are high, that affects those needing to raise credit to fund investment in new businesses. However, one needs to look at the full effect over the complete business cycle. When the economy is expected to be on the down-swing, typically the Reserve Bank reduces interest rates to stimulate the economy and thereby ensure that deflation does not occur. At this point, monetary policy is assisting any new enterprise needing credit to get started. Over the business cycle, these two effects offset each other, assuming the Reserve Bank has calculated the economy's sustainable growth capacity correctly. Thus there isn't a monetary policy bias against using credit to invest in productive capacity.

This can be thought about at another level too. Even aside from the inflationary consequences, having the cost of credit artificially low is not good for the economy long term, because, as with any other distorted price, the result is distorted use. In this case, artificially cheap credit encourages people to be wasteful with capital - to make excessive investments in plant or real estate, rather than looking carefully at whether investments and industrial processes are truly productive.

A typical balance between debt and equity in many industries is 50/50, but if credit is, in effect, subsidised, then the temptation is to take on more debt, which means greater financial risk. More generally, the historical evidence is that, if you regulate down the price of credit, as New Zealand did in the 1970s, then savers become loath to save, as artificially low interest rates have to apply to savers as well as borrowers. This creates credit shortages, as we saw in the 1970s, which restrict investment in new enterprises. Recall the old adage, back then, that the only people that could borrow were people who didn't need to. In other words, in those days getting a bank loan was very difficult. As well, in the 1970s, one saw a flourishing financial sector outside the banks, successfully meeting the demand for credit, yet paying and charging much higher interest rates.

Some people say that when it comes to inflation, the Reserve Bank is "trigger happy". Is this true, and does it hold back growth?

Central bankers have been described as being like grumps at a party who, just when people are starting to have fun, take away the punch bowl. Thus people say "Just when the economy is starting to do well, that's when central banks always put up interest rates, at just the wrong moment, killing the recovery."

I think this perception comes from people not realising that there is a considerable time delay between an interest rate change - up or down - and that change affecting demand in the economy. We estimate that it takes somewhere between one and two years for an interest rate shift to have its full impact. This means that when the Reserve Bank adjusts the Official Cash Rate, our decision is based not on where the economy is now, but where we think it will be, in terms of inflationary pressures, one to two years ahead.

This misunderstanding is strongest when the economy is beginning an upward cycle and a monetary policy tightening - never popular - is required. People then accuse the Reserve Bank of "killing the recovery before it is properly established". In saying this, they forget that an action now has its effect in the future, which, in the context described, means much further into a recovery phase.

But, nonetheless, during recovery periods should the Reserve Bank wait longer to ensure that the economy is getting traction, before reacting to mounting inflationary pressures? The answer is that sometimes delay can be very costly. If inflation starts to gain momentum, the Reserve Bank then has to be aggressive in putting up interest rates to regain control. In that situation, there would be a growth loss. Thus, if the Reserve Bank is able to make its decisions early, the overall scale of the interest rate cycle is likely to be less, as will any resultant exchange rate cycle or disruption of economic activity.

This fits with the Reserve Bank's Policy Targets Agreement, which in clause 4(c) requires that "In pursuing its price stability objective, the (Reserve) Bank shall ... seek to avoid unnecessary instability in output, interest rates and the exchange rate."

Could we set one interest rate for people wanting to invest in the nation's productive capacity and a higher one for people wanting to borrow to consume? Would that give us more growth? And what about having one interest rate for regions that are prospering and another for regions that are struggling? Would that help the economy grow?

Intuitively, these ideas may seem attractive, but actually they are either impractical or impossible.

First, let's consider different interest rates for borrowing to invest and borrowing to consume. If we could find an effective way of deterring consumption and encouraging investment in the nation's productive capacity, then, indeed, the current account deficit could be reduced and probably growth would be enhanced. However, administering differential interest rates would require an army of bureaucrats and red tape, with all the costs and time-wasting that would result.

To illustrate, one would have to distinguish between someone borrowing on a mortgage to add to the house or buy a boat (which we may want to discourage), or to buy computer gear to help run a small business (which we may want to encourage). Banks can't tell the true purpose of money secured by way of a mortgage, even if they ask. Aside from straight deception, consider the following. If we make concessional business finance available, somebody running a small business might borrow, say, $20,000 for a new computer system when in fact he or she could have paid for the computer out of the revenues already being generated from the business. However, because a lower-interest business loan is available, the $20,000 already in the business could be used to buy a recreational boat and the borrowed credit used to buy the new computer system. This would be legal, yet our desire to curtail borrowing for luxuries and encourage borrowing to fund productive investments would have been thwarted.

Having different interest rates for different parts of the country is impossible as long as we have a single national currency. Inevitably, an interest rate set by a central bank has to be a compromise reflecting the state of the economy as a whole.

But also, it's a moot point as to whether different interest rates for different parts of the country would even be desirable. When one part of the country is doing well relative to other regions, then the likely result will be shortages of labour, plant and machinery in the area that is prospering. Likewise, if a part of the country or the economy is doing badly, it is likely to have surpluses of labour, plant and machinery. The ideal is for people and other resources to move from where there are surpluses to where there are shortages, or for companies that can utilise those surpluses to move to where they are available. This helps ensure that the economy is directing its efforts towards activities that can generate the best returns. Different regional interest rates would tend to slow this adjustment process.

It's been said that monetary policy is an art and not a science. Does having a rigid inflation target force you to do things that aren't actually in New Zealand's interests or that hold back growth?

I have not seen any circumstance since I became Governor in 1988 in which New Zealand's interests or the need for sustainable growth were at odds with the Reserve Bank doing its best to ensure price stability.

It's important, when thinking about this, to separate the Bank's inflation target, agreed to by the Government and me, from the way the Reserve Bank has operational independence in achieving that target. The inflation target is clearly specified, but the detail of how it is implemented is the Reserve Bank's responsibility. The Bank is certainly required to think about the public good in the way it implements monetary policy.

The sharp point of this is how the Reserve Bank responds if and when inflation goes outside the target range. Then the policy choice is about how quickly the Reserve Bank gets inflation back inside the range. When inflation was above the band in 1996, we made the conscious decision that getting inflation back in the target range as fast as possible was not in the national interest. We concluded that the economic disruption that this would require was undesirable. A more gradual return to price stability was judged to be better, and our subsequent monetary policy decisions reflected this. We were also conscious that, had we tightened monetary policy very aggressively, with a view to bringing inflation back within the target band very quickly, we ran the risk of driving inflation through the bottom of the target.

More recently, the Bank has indicated that, with inflationary expectations now "better anchored", we think that people are less likely to put up prices at the first opportunity. At the time of writing (June 2001), this is being put to the test, as we wait to see how people respond to higher headline inflation, caused in part by increased oil prices. Part of the art of monetary policy is making these kinds of judgements.

Surely just talking about GDP growth is not enough. New Zealand is not paying its way in the world. How do you answer the charge that our very large current account deficit indicates monetary policy misjudgements?

Yes, we have a significant current account deficit, but, firstly, does it matter? Some well-respected economists argue that we shouldn't worry. They say that the current account deficit simply means that spending, including investments, exceeds our income. In our case, since the public sector is running a surplus, the current account deficit largely reflects the decisions of countless individual New Zealanders to spend more than they earn. In the longer-term, so the argument goes, this process will be self-correcting, as either we New Zealanders decide not to take on additional debt or sell additional assets, or foreigners decide not to extend us additional credit or to buy additional New Zealand assets. This view, in which the balance of payments is expected to adjust relatively smoothly, without the involvement of governments or central banks, is taken by such eminent economists as Max Corden and John Pitchford in Australia and Milton Friedman in the United States.

Even economists who are not so sanguine concede that deficits are of much less concern today, given a floating exchange rate and the abolition of most distortions which previously affected investment allocation. Prior to 1984, current account deficits were often the result of substantial fiscal deficits and had to be covered by government borrowing overseas in foreign currencies. Today, the government's accounts are in surplus and the government has no net foreign-currency-denominated debt.

One should not, however, assume that having a current account deficit is riskless. At some point, foreign savers may decide that they no longer wish to invest in New Zealand.
Any sharp outflow of capital, whether triggered by foreigners or by New Zealanders, would necessarily result in a sharp increase in interest rates. This would be because those selling New Zealand securities and other financial assets would be forced to reduce prices and thereby increase the yields offered on those assets in order to find buyers.

If such an outflow of capital happened on a large scale and over a short period, companies carrying debt and not benefiting from an offsetting exchange rate fall would be put under pressure, and some might well collapse, notwithstanding their initially strong balance sheets. Household borrowers, especially those with variable rate mortgages, could also face some very sharp adjustments to their spending patterns. Of course, a combination of a sharply lower exchange rate and markedly higher interest rates would quite quickly reduce the current account deficit, though at some real economic and social pain.

Has this been happening recently? The answer is "probably", though thankfully in a sufficiently moderate way that substantial economic disruption has not occurred. Recently, the amount of foreign capital coming into New Zealand has been relatively low, and as a result, the exchange rate has been lower and our exporters encouraged. This has tended to ameliorate the current account deficit in a welcome and non-destructive way.

To those who still say the Reserve Bank should do something about the current account deficit, I reply "What would you have the Bank do?" If one was determined to act, would one tighten monetary policy or ease it? The answer is not obvious. A tightening would tend to slow down domestic spending and therefore imports (making the current account deficit better) but push up the exchange rate (making the current account deficit worse). Easing monetary policy would tend to push down the exchange rate, decreasing imports and increasing exports (making the current account deficit better) but accelerate domestic spending, including on imports (making the current account deficit worse). Neither are long-term solutions and monetary policy can't have an enduring impact on the current account.

More generally, New Zealand has had a current account deficit in every year since 1974, through a range of monetary policy regimes. Indeed, the largest deficit relative to GDP over that 25 year period was in the mid-seventies, with another very large deficit in the mid-eighties and again recently. So the idea that the present monetary policy framework has made the current account deficit worse does not fit the facts.

Was the low exchange rate during 2000 some kind of monetary policy failure?

Certainly during 2000 we experienced a marked decline in the New Zealand dollar exchange rate, with a slight recovery in early 2001. From November 1996 to late 2000, our exchange rate against the US dollar went from a peak of more than 71 US cents to under 40 US cents - a depreciation of some 44 per cent over less than four years, which is substantial in anybody's language. Against the trade-weighted index (TWI), which measures the New Zealand dollar against a basket of five currencies, the fall from 69 in late April 1997 to around 47 was a depreciation of 32 per cent. Measured either way, by late 2000 the New Zealand dollar was close to its lowest level ever.

But was that a monetary policy failure? I don't think so. Of course monetary policy was involved, but there are times when an exchange rate should fall. As a core principle, the exchange rate should broadly reflect the country's trading fortunes, both in terms of what we earn from our exports and pay for our imports and in terms of our attractiveness as an investment destination. The fall in the late 1990s and into 2000 did that, partly cushioning New Zealand's exporters from the fall in world commodity prices that followed the Asian crisis. This spread the "pain" of that fall across the rest of us, as our New Zealand dollars could buy fewer imports than before. Without a floating currency, our exporters would have had to suffer the full pain of that fall in international prices, with more job losses and reduced output.

As for why the New Zealand dollar fell so far, many explanations have been offered. A selection includes:

1. our interest rates were no longer high relative to other countries, reducing demand for our currency and therefore its price;
2. our likely growth rates were seen as modest relative to others, reducing both the desire to invest and the expectation that higher New Zealand interest rates would be required to offset inflation; and
3. our current account deficit was judged as a risk.

All of these arguments carry some weight, but also have to be questioned. Specifically:

1. the counter-argument to the interest rate claim is that, in recent times, Japanese interest rates have been well below those in the United States, yet the Japanese yen has been relatively stable against the US dollar;

2. to the growth argument, one can reply that Australia's exchange rate fell despite its economic growth being very similar to that in the United States, whereas Japan's exchange rate has not fallen to any great extent despite Japanese growth falling well short of America's; and

3. regarding the current account deficit, New Zealand's exchange rate rose strongly through the mid-nineties despite our large current account deficit, while the United States has had its largest current account deficit for many years and a strong currency.

What one can draw from all this is that the reasons why exchange rates rise and fall are never simple and many factors are always involved. Monetary policy can be part of the mix, in that if our interest rates are higher or lower than elsewhere, that affects demand for our currency and therefore the price. However, monetary policy is only one of many factors.

That said, a lower exchange rate brings benefits, as well as costs. At the time of writing, the low New Zealand dollar is encouraging the production of exportable goods and services and discouraging the consumption of imported or exportable goods and services. We have seen some prices spike, but so long as this is not translated into generalised domestic inflation, we can expect stronger growth in exports, slower growth in imports, and thus a reduction in New Zealand's current account deficit.

It's important also to get this in an historical context. Look at graph 4, on the opposite page, which explains "real" exchange rates. The blue line is the "nominal" exchange rate and the red line is prices in New Zealand relative to prices in the domestic economies of our trading partners. When you combine these, you get the green line, which is our "real" exchange rate, ie our exchange rate once you take out the difference between New Zealand's inflation rate and that of our trading partners. For exporters, it's the real exchange rate that matters because exporters have to pay for inputs, such as fuel. If prices go up following an exchange rate fall, then for exporters some of the benefits of that exchange rate fall are lost.

As you can see in graph 4, the real exchange rate typically moves over a cycle. Both the high exchange rate of the mid 1990s and the low exchange rate more recently fit that cyclical pattern, have happened before and will happen again.

Graph 4

Nonetheless, sometimes, the view is expressed that, relative to other economies, the New Zealand exchange rate cycle is too volatile, so that our exporters face an unfair disadvantage. This doesn't fit the facts, however. Look at graph 5, which compares currency appreciations experienced by various countries during the 1990s. What's revealed is that "the flight of the kiwi" in that period, while strong, was not markedly different from elsewhere.

Graph 5

The plea I make to farmers and other exporters is that they need to think of the real exchange rate cycle as a commercial fact of life and plan accordingly, just as farmers plan for weather cycles. Indeed, enterprise in New Zealand is now much better able to manage exchange rate risks. Prior to 1985, we had a pegged exchange rate and companies often borrowed overseas, often at interest rates much lower than those within the then high-inflation New Zealand economy. As a result, some companies suffered spectacular losses when the New Zealand dollar was devalued from time to time, or when, though pegged to a basket of currencies, the New Zealand dollar depreciated against the particular currency in which the loan was denominated. Borrowing in Swiss francs was particularly popular, and, at times, particularly painful for some companies.

Since March 1985, the New Zealand dollar has been freely floating, and over that period the Reserve Bank has not intervened directly in the foreign exchange market. Since then, the incentive to borrow offshore in foreign currencies has been substantially reduced, even though overseas interest rates have frequently been lower than those in New Zealand. Though many companies and banks still borrow overseas, none do this in the belief that there is no currency risk involved. As a result, almost all arrange "hedges" to offset the risk of loss caused by an exchange rate shift. As a consequence, there have been few companies hurt by the recent depreciation of the New Zealand dollar and most exporters have been delighted. Our banks weren't caught out by the depreciation, and, to the best of my knowledge, none incurred losses as a result. Everyone knew that the New Zealand dollar was freely floating and was careful to avoid taking on unhedged positions in foreign currency. That is as it should be.

Nonetheless, the mid-1990s were very hard for the nation's exporters and those who compete with imports, which must have affected our growth rate. Are you saying that's just the way it is?

Exchange rate cycles are a fact of life. However, there were some specific factors in the mid-1990s that made matters worse, which probably won't be repeated.

In the mid-1990s tight monetary policy meant that our interest rates were much higher than in other countries. While, as I have already noted, interest rate differences between countries do not always produce exchange rate effects, it seems clear that they did so at that time, resulting in the very high dollar, as so called "hot money" came into New Zealand chasing our higher interest rates.

So the question then is why did monetary policy have to be so tight. Many factors went into the mix, but there were two "one-offs" that made the period special. First, private consumption was boosted by a marked one-off increase in household debt. Prior to the liberalisation of the banking sector in the mid-1980s, interest rates in New Zealand were regulated to artificially low levels, while at the same time the availability of credit was restricted as governments attempted to control inflation. The effect was that back then household debt in New Zealand was quite low relative to household income. With the changes in the 1980s, banks were free to compete for deposits and lend according to what they thought the market would stand. The result has been much easier access to credit. In response, New Zealand households have been steadily increasing their levels of debt, as shown in graph 6. Typically in economies like ours average levels of household debt are now at about 100 - 120 per cent of annual household income, and New Zealand is about normal.

Graph 6

The strong increase in household debt led to strong growth in consumption and residential construction, which had a one-off inflationary effect, requiring an additional monetary policy response.

However, with New Zealand matching the international norm, it is likely that from here on households will be more cautious about increasing their average indebtedness, so that this inflationary influence, at least, will probably not be repeated.

Secondly, in the mid-1990s, a sharp migration inflow occurred, and this put pressure on the housing market. As graph 7 shows, migration into New Zealand picked up strongly in the early to mid-1990s, with most new migrants settling in the upper part of the North Island. Following its peak in 1995, net migration fell sharply over the following three years, in part due to changes in immigration policy in 1996. On the upswing, immigration fuelled speculative investment in the housing sector, as also shown on graph 7, which added to the need for tighter monetary policy.

Graph 7

There were other factors at work in the economic surge that led to the sharp currency appreciation of the mid-1990s. Demand overseas for our products was strong, commodity prices were good and the exchange rate was low in the early 1990s. As well, the economic reforms appeared to be delivering long-awaited beneficial results and there was a strong increase in investment as the economy evolved in new directions. These were stimulatory also.

We will continue to see exchange rate cycles in the future. However, the run-up in household debt and the scale of the immigration surge in the mid-1990s were exceptional, creating a compound effect. Those influences, at least, are unlikely to be so strong again.

The Reserve Bank of New Zealand

The Reserve Bank of New Zealand is New Zealand's central bank, and, as such, it provides banking services to the government and commercial banks.

The Reserve Bank has three main functions. These are:

operating monetary policy to maintain price stability;
promoting the maintenance of a sound and efficient financial system; and
meeting the currency needs of the public.

Under the Reserve Bank of New Zealand Act 1989, the Reserve Bank is required to independently manage monetary policy (management of the supply of money and credit) to maintain overall price stability. Overall price stability is defined in a separate agreement with the Government as inflation of between 0 and 3 per cent annually.

This is achieved largely through influencing short-term interest rates, which in turn influence the saving and borrowing behaviour of the public and businesses. Decisions on short-term interest rates also influence the exchange rate, and therefore prices of imports and exporters' returns as measured in New Zealand dollars.

Price stability contributes to New Zealand's overall economic success by protecting the value of people's incomes and savings, and encouraging investment in the nation's productive capacity, thereby contributing to employment, growth, export competitiveness and a more just society.

The Reserve Bank also provides cash, debt management and foreign exchange services to the government, and manages the nation's foreign exchange reserves.

The Reserve Bank is responsible for the registration and prudential supervision of registered banks, based on a high degree of public disclosure. The Reserve Bank issues New Zealand's currency.

For further information please contact:
Paul Jackman
Corporate Affairs Manager
Reserve Bank of New Zealand
PO Box 2498
Wellington
Telephone 04 471 3671, fax 04 471 2270, E mail Jackmanp@rbnz.govt.nz
http://www.rbnz.govt.nz

ARCHIVED: This document does not necessarily reflect the current views or practices of the Reserve Bank of New Zealand.