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Monetary policy worked well in crisis

New Zealand's inflation targeting monetary policy has proven flexible, durable and successful, but economic growth requires more than this, Reserve Bank Governor Alan Bollard said today.

New Zealand was the first country to formally target inflation. This was in response to the high inflation and macroeconomic instability of the 1970s and 1980s, Dr Bollard said in a speech delivered to the Canterbury Employers' Chamber of Commerce in Christchurch.

"It has now been tested through a long period of growth, as well as droughts, migration shocks, terms of trade changes, an Asian crisis, a dot-com boom and bust, and, most recently, the worst global economic and financial crisis seen in generations.

"In terms of what it was directly designed to achieve, namely price stability, inflation targeting has been a relative success."

Alternative monetary policy frameworks would not have provided the same flexibility to navigate through the crisis, and may in fact have made it harder to maintain price stability while avoiding unnecessary volatility in the wider economy.

"Our flexibility meant that, once the global financial crisis hit, we could respond swiftly, cutting the OCR by more than 5 percentage points and providing banks with emergency liquidity, when international wholesale funding markets were gridlocked."

Dr Bollard said that inflation targeting works best in conditions where global economic conditions are stable, domestic fiscal and tax policies are neutral, and the financial system is stable.

"We know that our job will in part depend on policy choices made by the major global players as they exit from current stimulatory policy settings. Central bankers around the world are balancing the need to provide ongoing support for a very fragile recovery against the risk of keeping monetary and fiscal conditions too easy for too long.

"In New Zealand, successful removal of the recent fiscal stimulus would ease pressure on monetary policy. We are also hopeful that the recently released report of the Tax Working Group will lead to a more even-handed tax system when it comes to investment and consumption decisions."

He said the key international lesson from the crisis was that financial instability can cause problems for the real economy. Authorities were now working out ways to strengthen and improve the prudential supervision of financial institutions.

"In New Zealand, the financial system is a lot simpler than in other parts of the OECD, and has not seen the same types of excesses. Nevertheless, we are taking steps to make our banks and finance companies more resilient to financial system shocks.

"In implementing the Basel II capital framework, we have ensured that banks' assessment of risk is based on a ‘through-the-cycle' approach rather than just on the most recent period of growth. We have also put in place a new prudential liquidity policy for banks to make the system less vulnerable to a drying up of international funding markets, such as we saw in late 2008 and early 2009."

Dr Bollard said that, as a small, flexible and full-service central bank, the Reserve Bank is in a good position to be at the forefront of progress in integrated macro-financial policy design.

He concluded that, at best, new policy instruments could supplement the role of the OCR, but will not fundamentally alter it. "Ideally, such instruments might change the mix of monetary conditions and take some pressure off the exchange rate. Overall monetary conditions will still need to be set appropriately to keep inflation stable."

Media contact:
Mike Hannah
Head of Communications
Ph 04 4713671, 021 497418, [email protected]