1998 Annual Report
Throughout the year to June 1998, inflation measured by the Consumers Price Index excluding credit services (CPIX) was close to the middle of the 0 to 3 per cent target which I have agreed with the Government to be the appropriate target for monetary policy.
But because of the long lags between monetary policy action and the effect of that action on inflation, this pleasing outcome has a great deal more to do with the stance of policy during 1996 than anything which the Bank did subsequently. Whether monetary policy has been appropriate over the last 12 months will not be clear for another year or two.
The challenge in formulating monetary policy over the last 12 months was to ensure that overall monetary conditions remained appropriate in the face of powerful and conflicting forces, and considerable uncertainty.
In July 1997 the Thai baht fell sharply, triggering a period of turbulence in the financial markets of East Asia. Many currencies declined precipitously, along with share markets and real estate prices. The banking sectors of the countries most affected were severely damaged, and real economic activity fell, in some cases sharply, for the first time in decades. The direct effect on the New Zealand economy was adverse and substantial, and looks likely to continue for some time. The indirect effect, through business and household sector confidence, was also significant. The impact of the Asian situation reduced inflationary pressures in New Zealand markedly.
On the other hand, increased government spending, substantial tax cuts and the abolition of the surcharge on National Superannuation constituted a significant fiscal stimulus. The challenge facing monetary policy was to make the right judgement about the aggregate effect of these conflicting forces. On balance, during the year under review the Reserve Bank sanctioned a significant easing of monetary conditions, which took the form of a substantial fall in the exchange rate, initially partly offset by some increase in interest rates.
The marked fall in the New Zealand dollar was not surprising, as by early 1997 it was widely regarded as being overvalued. Indeed, during much of the period through which monetary policy was being tightened, from early 1994 to late 1996, it was the exchange rate which increased rather than interest rates. When policy was eased, that process inevitably reversed. The resultant change in the mix of monetary conditions will encourage resources to move out of domestic sectors of the economy into export and import-competing sectors, which in time will reduce the balance of payments deficit.
The net effect of the easing will be to stimulate the economy overall and, even with the deflationary influences from Asia, it seems unlikely that inflation will fall below the bottom of our target range in the foreseeable future. The Reserve Bank takes its obligation to keep inflation above zero just as seriously as keeping it below 3 per cent.
T h e re has been debate, both here and abroad, about whether New Zealand, with its large current account deficit and accumulated external liabilities, might become the next ‘Asian domino’. Indeed, there has been debate about whether unregulated international capital flows, and the current account imbalances which often result, are inherently dangerous. In my view, open capital markets deliver far more benefits than costs, but they do put a large premium on sound macro- and micro-economic policies. Unregulated financial markets may not always punish poor policy quickly, but punishment when it comes is likely to be severe, and often affects those quite unconnected with the faulty policies.
Fortunately, New Zealand does not have a pegged exchange rate regime, a weak banking sector, and large, sometimes politically-driven, investment projects of low economic value - as do many of the Asian countries most affected by recent crises. With monetary policy firmly committed to delivering stable prices, and with ongoing fiscal surpluses, a robust banking sector, a freely floating exchange rate, and generally strong corporate balance sheets, the New Zealand economy is well placed to weather the current storm, though I don’t pretend that it will all be easy.
There has also been debate as to where New Zealand’s interests lie in the Asian context. Let me place on record my support for New Zealand assisting our Asian trading partners get through this difficult period. In this context, Deputy Governor Murray Sherwin has attended numerous meetings of central bankers in the region and the Reserve Bank is well focused on events in Asia. I have no doubt that being disengaged from these events is not an option, and would not be in our interests if it were.
On a wider front, the advantages of having an explicit, publicly-announced, numerical inflation target are increasingly recognised around the world. This was the consensus view of most central bankers and academic economists who attended a conference on ‘monetary policy rules’ hosted by the Swedish central bank in Stockholm in June. Several members of the Executive Board of the European Central Bank are on record saying that that institution will aim to deliver inflation between 0 and 2 per cent once it begins operation at the beginning of January 1999.
Within the New Zealand financial system, the most significant single event during the 1997/98 year was the inauguration in March of a real-time gross settlement system for inter-bank settlements. This had been under development by both the banks and the Reserve Bank for several years, and its completion took substantially longer than expected. Having said that, New Zealand now has a payments system for handling high-value transactions which very considerably reduces the risk of systemic difficulties if one bank were to get into strife.
It is now almost a decade since the passage of the Reserve Bank of New Zealand Act 1989. These years have been tumultuous, but all the Bank’s staff, past and present, can take pride in what has been achieved. From the beginning, it was my hope that we could develop the Reserve Bank as a centre of excellence in everything that we did. I believe that we have come a long way in building that reputation, based on inflation outcomes since 1991, our new approach to banking supervision, and the improved efficiency of all our operations.
This has real value. In some countries, central banks have built reputations so strong and enduring that they are accepted by the public as being something in which they can have absolute confidence, regardless of whatever else is happening in politics or the economy. The Reserve Bank aspires to the same reputation in New Zealand. The empirical test of how much we have achieved is the degree to which people take for granted that stable prices are a fact of life that never needs to be questioned or even thought about.
To some extent, the Reserve Bank is now in a period of consolidation, refining and honing the things we do. This offers fresh challenges. Simplistic thinking never endures, and all our assumptions must go on being scrutinised and tested, as indeed they are. Complacency is not an option. All Reserve Bank staff can and do contribute toward s achieving the goal of a central bank in which the public can have complete confidence, as a reliable, predictable, professional agency serving the public interest. In that way, they make an important contribution to the well-being of all New Zealanders, and I record my thanks to them for this.
Finally, 1997/98 marked the end of Dick Lang’s long career at the Reserve Bank. Dick first joined the Bank in 1956 and became Deputy Governor in 1991, a position he held until retiring on 3 July 1998. He made an enormous contribution to the Bank, especially in driving the efficiency improvements of the late eighties and early nineties. To Dick especially I owe very sincere thanks
Donald T. Brash