Policy assessment
New Zealand, more than most other developed economies, has suffered the consequences of inflationary booms and busts. The experiences of the 1970s and early 1980s demonstrated vividly that tolerating more inflation cannot assure stronger growth or greater competitiveness, or dampen economic cycles. If anything, the opposite is closer to the truth. We also saw that breaking an ingrained inflation habit is hard, and certainly not the kind of experience one would want to repeat.
In the current economic cycle, New Zealand has tried to do things differently. In particular, monetary policy responded early to signs of emerging inflation pressures, rather than waiting until inflation had already escalated. The Bank’s foresight was not perfect; inflation did rise above the top of our target range. But the fact remains that, for the first time in a generation, New Zealand has managed to have a sustained period of economic expansion without a major acceleration of inflation.
Containing the upward pressures on inflation has proven to be a tougher task than most expected. And, for a variety of reasons discussed in this Statement, a disproportionate share of the burden of restraint has in this cycle tended to fall on the export sector. Less restraint would not necessarily have helped shift the burden elsewhere, but it would certainly have made the task longer and, ultimately, more difficult for all.
The policy has, slowly but surely, been whittling away at the upward pressures on inflation. Indeed, the evidence suggests that the pace of spending and the productive capacity of the economy are once again nearly in balance. As a result, there are increasing signs that inflation has stabilized and is beginning to weaken.
Monetary policy takes time to have its full effect on activity and inflation. Policy therefore works best if it is run in a forward-looking manner. This implies that, during an economic upswing, monetary conditions should be tightened in response to the pressures that generate increasing inflation, rather than waiting until inflation has already clearly risen. Similarly, in the current circumstances, monetary policy needs to adjust to signs that inflation is likely to fall, rather than waiting until the numbers confirm it.
In view of these considerations, and on the basis of the projections presented in this Statement, the Bank’s assessment is that a modest easing in the stance of policy is warranted by the prospect for declining inflation. At the time of writing, it seems evident that financial markets have reached a similar assessment.
The extent to which an easing of conditions takes place through lower interest rates rather than through a decline in the level of the New Zealand dollar is beyond the Bank’s control. How the mix of conditions evolves will depend, inter alia, on movements in foreign interest rates and on changes in foreign and domestic investors’ appetites for New Zealand dollar assets.
The key point so far as monetary policy is concerned is that somewhat different combinations of interest rates and the TWI exchange rate can produce an overall level of monetary conditions consistent with returning to price stability in the medium term. The projections in this Statement, for example, are based on a level of monetary conditions involving a 90-day interest rate of 9 percent and a TWI of 66.5. A roughly similar level of overall conditions could be achieved with a lower exchange rate but higher interest rate, or vice versa. Broadly speaking, the effect of a TWI level about 2 percent lower (ie around 65.2) could be approximately offset by a 90-day rate about 100 basis points higher (ie around 10 percent).
At this stage, the signs of declining inflation pressures in the economy are still too tentative for the Bank to sanction a more substantial easing of conditions. The prospects for further loosening in monetary conditions will depend on how quickly inflation pressures recede.
In this context it should be emphasized that, at the time of writing, a new government has yet to be formed. The policy assessment in this Statement is predicated on the degree of fiscal stimulus implied by the fiscal initiatives announced by the last government. If the next government’s programme differs substantially in terms of its likely impact on spending pressures in the economy, the outlook for inflation and, therefore, the prospect for monetary conditions will inevitably be affected.
Donald T Brash
Governor