Monetary Policy Challenge


When setting monetary policy it is important to consider what the future path of the economy might look like. Economists use forecasting to build up a picture of how demand and inflation pressures may evolve in the future. These forecasts allow economists to assess how appropriate current monetary policy conditions are, given the time lags involved in setting monetary policy.

The lags of monetary policy

Monetary policy takes time to have an effect on inflation. When the Reserve Bank makes a change to the Official Cash Rate, it can take nine to 12 months for this change to affect demand, and hence the output gap. It can take a further nine to 12 months for a change in the output gap to affect inflation. So changes to monetary policy can take one and a half to two years to affect inflation.

change in Official Cash Rate >> change in output gap >> change in inflation rate

The lag between a change in the output gap and a change in inflation is demonstrated in the following graph:

Figure 5: The output gap and non-tradables inflation

In this graph, the output gap has been moved three quarters ahead to show how a change in the output gap causes a similar change in inflation, on average, about three quarters later. Note that the relationship is far from exact. This is because the lags can vary and the output gap is not the only factor that can influence the inflation rate.

You will note that in the graph the measure of inflation we have used is not headline CPI inflation but non-tradables inflation. Non-tradables inflation simply excludes all CPI components that are imported or directly compete with imports (all the ‘tradable' components). The relationship between domestic capacity, or the output gap, will be stronger with domestic or non-tradables inflation, than with overall CPI inflation. This is because the tradables components in overall CPI are less responsive to domestic pressures. Rather, they tend to move more with the exchange rate and international price movements. Thus the relationship between CPI inflation and the output gap is really driven by the relationship between price movements in non-tradables components of the CPI .

Setting monetary policy

As mentioned several times already, the rate of inflation tends to increase when the overall demand for goods and services exceeds the economy's capacity to sustainably supply these goods and services. In other words, when demand is stronger than supply and the output gap is positive, inflation tends to increase. Conversely, the rate of inflation tends to decrease when productive capacity is greater than demand and the output gap is negative.

The primary goal of monetary policy in New Zealand is to keep inflation "on average over the medium term" between one and three percent as defined in the current Policy Targets Agreement.

If it looks as though demand pressures will push inflation above the top of the band in one and a half to two years time, policy will need to be set so the output gap is negative in three to four quarters' time, thereby decreasing the future inflation rate. Conversely, if it appears inflation will move through the bottom of the target band, policy will need to be set so that the output gap is positive in three to four quarters' time, thereby increasing the inflation rate.

Monetary policy is not the only factor that influences the output gap. Other influences include government spending and taxation (fiscal policy), and the international trading conditions facing New Zealand exporters. To set monetary policy in a way that will achieve balance between supply and demand in the economy, these other influences also need to be taken into account. This is where economic forecasting comes in.


As outlined above, one way of predicting future inflation is by constructing an output gap. A forecast for the output gap is obtained by forecasting the output gap's two variables - GDP (demand) and potential GDP (supply) as outlined below. While teams do not necessarily have to provide a forecast for the output gap, it is a good idea to form a view on the approximate position of the output gap to backup your assessment of inflation pressures.

Potential GDP

Potential GDP or potential output, is that level of economic activity that corresponds with the economy's productive assets, people and machines, working at a maximum sustainable rate. By sustainable, we mean that people are working at the rate they want to, and machines are working at the rate they are designed for. The growth rate for potential GDP is forecast on the basis of estimates of the quantity and the quality of the resources of the economy. The growth of the quantity of resources is dependent on the population growth rate and the growth rate of the capital stock, which is investment in buildings, machinery and equipment, roads and the like. We normally take natural resources as a given, but that of course would not be the case if there were, for example, a major oil discovery. Growth in the quality of resources is determined by the population's skill level, its management performance, and the rate of technological advancement in the economy. We often refer to these quality improvements as growth in productivity.

The Reserve Bank's latest view on the annual growth rate of potential GDP is that it is running at around three percent per annum. Teams may wish to use this as a starting point and alter it depending on their own views on how the labour force, capital stock and productivity will grow in the year ahead.

Figure 6: The annual growth rate of potential output

Actual GDP

Along with potential output, it is also necessary to forecast demand, that is, actual GDP, in order to forecast the output gap.

There are many different ways to forecast actual GDP growth. As part of the Monetary Policy Challenge we suggest teams to look closely at the data and graphs on the various activity measures that make up expenditure GDP, that is GDP = C + I + G + X – M in order to build a view of where growth is likely to be in the near future. (The economic data relating to the components of GDP is in the Data section.) Various economic indicators, such as some of those mentioned below, may come in useful for forecasting the components of expenditure GDP.

Economic indicators

An economic indicator is a source of information, usually statistical, that casts light on past, present or future economic conditions. To give you an idea of how these indicators can be used, a selection of indicators have been graphed against the GDP components they relate to (see below).

Some economic indicators operate with a lag (i.e. the indicator has been advanced some amount of time). This simply means that movements seen in the indicators take time to show up in the sectors they relate to. For example, Figure 7 shows how the NBBO survey measure of ‘own activity' is related to business investment. The NBBO series has been advanced by nine months. This means that any change in businesses' confidence about their own outlook takes about nine months to flow through into actual business investment. A lag in the relationship tends to help with forecasting. For example, if we see the business confidence measure improve, we may expect to see actual business investment improve in nine months time. If we think this improvement may be substantial then we might expect GDP, and the output gap to also increase, possibly leading to increased inflationary pressures.

The following is a list of some useful indicators that will help with forecasting actual GDP. Each indicator has been graphed against either expenditure GDP or one of expenditure GDP's components to illustrate the relationship. Note: some indicators are more useful than others at forecasting actual GDP, can be seen by comparing the correlations on the charts below.[1]

National Bank Business Outlook (NBBO) own activity

This is a survey of businesses' expectations of their own activity for the next 12 months. The reported statistic is the percentage of respondents expecting their own activity to increase minus the percentage of respondents expecting their own activity to decrease.

Figure 7 Annual investment growth and firms' own activity outlook

WestpacTrust-McDermott Miller Consumer Confidence Survey and Index

This survey asks consumers a range of questions to derive an index number for consumer confidence. A reading above 100 indicates consumer optimism, while a reading below 100 indicates consumer pessimism.

Figure 8: Annual consumption growth and consumer confidence

Retail trade (as reported by Statistics New Zealand (SNZ))

This statistic reports the total sales of goods and services by all New Zealand's economically significant retailing enterprises (those with annual sales above $30,000 or three or more employees). Both real and nominal retail sales data are available, with the nominal data coming out every month and the real data every quarter. The data section of this website only gives the quarterly real data, so if you want to look at the monthly nominal data you will need to look for it on the Statistics NZ website (

Figure 9: Annual consumption growth and retail trade growth

Building consents (SNZ)

The total number of building consents issued for new houses and flats, ie residential construction. Note that Statistics NZ also produces building consents data for non-residential construction. It also gives value data (nominal) building consents as well as the number of consents as provided in the Data section.

Fig 10: Residential investment and building consents (excluding apartments)

Merchandise export and import trade (SNZ)

This data covers the total value of exports and imports of goods (but not of services).

Figure 11: Annual growth in exports of goods

Figure 12: Annual growth in imports of goods

Quarterly Survey of Business Opinion (QSBO) Capacity Utilisation

This New Zealand Institute of Economic Research (NZIER) Survey asks a range of questions about firms' business intentions. One question concerns the level of productive capacity at which the firm is operating. The responses are aggregated and the result is reported as a percentage, where for example, 90 percent indicates that firms are operating at 90 percent capacity. Note that the statistic should not be taken literally. It is possible to have a positive output gap when capacity utilisation is below 100 percent. The data should be interpreted in the light of what the past relationships have been.

Figure 13: QSBO Capacity utilisation and the output gap

The QSBO also queries firm's expectations regarding their trading activities over the past three months. (Firms are also asked about their expected trading activities over the next three months.) The domestic trading activity statistic is the net percentage of firms reporting an increase in their own trading activity over the past three months. A positive reading indicates that more firms increased their domestic trading activity than decreased their domestic trading activity over the past three months.

Figure 14: Annual average GDP growth and QSBO domestic trading activity

Visitor arrivals (SNZ)

This series measures the number of arrivals of non-New Zealand residents to the country who intend to stay for less than 12 months.

Figure 15: Exports of services and monthly visitor arrivals

Short-term departures (SNZ)

This series measures the number of departures of New Zealand residents who intend to be out of the country for less than 12 months.

Fig 16: Imports of services and monthly departures of NZ residents

Economic indicators

The following is a list of economic indicators that teams may wish to use in their forecasting. The list is by no means extensive, so feel free to use other indicators if you wish.

Activity measure

Possible indicators


NBBO businesses' confidence of their own activity.
Westpac McDermott Miller consumers' confidence.

QSBO domestic trading activity


Retail trade.

Westpac McDermott Miller consumers' confidence.

Business investment

NBBO businesses confidence of their own activity.

Residential investment

Residential building consents.

REINZ house sales.

Government expenditure

Operating balance.

Exports of goods

Merchandise trade.

Exports of services

Visitor arrivals.

Imports of goods

Merchandise trade.

Imports of services

Short-term departures.

Output gap

Unemployment rate.

QSBO capacity utilisation.

CPI inflation

Output gap.

Import prices.

Other information

To help with forecasting both actual and potential output, we recommend you keep a close eye on what's happening in the economy right now. This means reading the daily newspaper, particularly the business section, and reading the weekly business papers to keep up-to-date with recent developments. You could also try talking to a local business or consumers to find their views about the future.


Newspapers can provide a wide variety of reports that give clues on where the economy is going. Most big investment projects get some coverage in the newspaper. For example, the construction of the Sylvia park retail complex in 2006 provided a significant boost to business investment. Also, newspapers often quote private sector economists on their views of the effects and implications of various economic occurrences.

Business information contacts (BICs)

In addition to studying numerous data series in the preparation of each of its Monetary Policy Statements, economists at the Reserve Bank also visit 40 to 50 businesses. This is to help supplement and confirm or contradict any trends or patterns that may have been seen in the data. One of the major benefits of BIC information is that it is more timely than macroeconomic data, especially given that business people will often provide clues about the future.

Teams may even want to try performing their own BIC visits (just remember to avoid any confidentiality problems in your reports). Ask questions such as:

Where do you see activity in your sector going?

Is it very difficult to find staff?

Is there much tourism spending taking place?

Have climatic conditions been favourable (if agriculturally based) in recent times?


Forecasts of the output gap can be used to predict inflation. Remember the graph displayed earlier in this section that showed the relationship between the output gap and inflation. If the output gap looks to be strongly positive in nine to 12 months' time, then there is a risk that inflation will also increase. This may lead teams to recommend an increase in the Official Cash Rate. Of course, an increase in the Official Cash Rate would alter the forecasts of the output gap, since a change in the Official Cash Rate affects the level of aggregate demand (generally about three quarters later), thereby bringing inflation back to the centre of the band in, say, six to eight quarters' time.

[1] The set of indicators provided here should not be regarded as exhaustive, and Monetary Policy Challenge participants may make their own assessments as to the usefulness of any particular indicator. The underlying data for many of the variables graphed here are available in the spreadsheet data section.