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Monetary Policy Statement December 1997

The Bank’s assessment is that a level of monetary conditions around 650 on the MCI is now appropriate.

Speaking notes for briefing journalists on the release of the December 1997 MPS


Good morning and welcome to this briefing on the Reserve Bank's December 1997 Monetary Policy Statement, the 17th we have issued.

As you will have seen already from reading that Statement, our view of the economy's future growth path has changed quite significantly since September. We now project that growth over the March 1998 year as a whole will be around 2.5 per cent (previously 1.7 per cent), over the year to March 1999 around three per cent (previously 3.8 per cent), and over the year to March 2000 around 3.9 per cent (previously 4.3 per cent). This slower growth than previously projected in the years to March 1999 and 2000 is largely explained by our current assessment of the adverse impact of the difficulties which several of our Asian trading partners are experiencing.

But the essential profile of the economy's growth has not been materially changed: growth in output increases through 1998 and into 1999, before slowing to about its sustainable growth rate through late 1999 and early 2000.

Implications for inflation and monetary conditions

Unfortunately, and despite the economy operating a little below our estimate of its sustainable capacity through much of 1997, inflation in sectors removed from international competition, so-called non-tradeables inflation, has remained remarkably persistent. This has been largely, but not exclusively, a result of continuing price pressures in the housing market and in some parts of the public sector. As a result, and with the disinflationary benefit of a rising exchange rate now behind us, aggregate inflation is projected to be a little higher than previously over the next year or so.

Beyond the immediate future, several conflicting pressures are at work. Working to reduce inflation is the recent period of slower growth. This has created a situation of excess capacity in the economy in recent quarters, which is expected to persist throughout 1998 and assist in constraining inflation for most of the projection period. Working in the same direction is the projected weakness in some import and export prices as a result of the sharp downturn in activity in many parts of Asia.

On the other side, working to push up domestic prices, is the sharp fall in the New Zealand dollar exchange rate over the last six months or so, although we expect that the effect of this may be somewhat muted by some reduction in the margins of importers and distributors built up during the period of exchange rate appreciation.

Taking all factors into account, and on the basis of the monetary conditions projected, we project inflation moving back towards the middle of the target range, after a temporary increase.
Nominal monetary conditions are projected to remain around 650 on the MCI through 1998 and the first half of 1999, before firming gradually beyond that.

Risks and uncertainties

As always, financial markets should not treat our projection of monetary conditions beyond the next quarter as being set in stone. We of course provide a new assessment of desired conditions each quarter, and at that time weigh all of the new information which has come to hand. That enables us to make an assessment of the monetary conditions which then seem appropriate to keeping inflation moving towards the centre of our inflation target.

There are in fact two major uncertainties in the present situation, and those uncertainties point in diametrically opposite directions.

The first and most obvious risk is that the present difficulties in Asia turn out to be even more serious than we have assumed. As the Statement indicates, we have already departed from our usual practice of taking Consensus Forecasts for the six largest OECD countries as the basis for our assessment of the international environment: in particular, we have widened the group of countries factored into our view of the international environment to include 14 countries (including all our major Asian trading partners), and in addition have chosen a sub-set of the more pessimistic forecasters' views.

But, by the nature of the case, any compilation of forecasts will be a little out-of-date in a fast-changing situation. As each day seems to suggest that the Asian situation is worse than envisaged even a few days earlier, it is quite possible that we have still under-estimated the seriousness of the Asian situation. Between New Zealand's direct exposure to Asia and our indirect exposure through Australia and Japan, there is no doubt that a very significant part of our total trade may be affected by developments in Asia. Here, the risk seems to be that we may have under-estimated the disinflationary pressures to which we may be subject in the next few years, and, if this turns out to be the case, the inflation track may turn out to be lower than now projected. Putting the matter in another way, monetary conditions may need to be easier than now projected to keep inflation in the middle of the target range.

The second significant risk relates to the possibility that there will be a further change in the mix of monetary conditions in the direction of a lower exchange rate and higher interest rates than now assumed, perhaps as a result of financial market concern at the continuing increase in New Zealand's current account deficit. There has already been a significant depreciation of the New Zealand dollar, both against the US dollar and on a trade-weighted basis, over the last six months, though interestingly that depreciation has not been any greater since the beginning of the year than that of the Australian dollar, nor even much greater, against the US dollar, than that of major currencies such as the deutschemark or the yen. In other words, the `depreciation of the New Zealand dollar' to date is more accurately thought of as an `appreciation of the US dollar'. The New Zealand dollar certainly has not fallen in the way that many of the currencies in Asia have done.

But the current account deficit is projected to be significantly higher than we thought likely even as recently as September. At that time, we expected the current account deficit to peak at about 5.8 per cent of GDP in the year to March 1998, trending down to 4.1 per cent over the year to March 2000. We now project the deficit to average around 7.7 per cent over the year to March 1998 (including the frigate imported this year) and, while trending down gradually, to still be at around 6.4 per cent of GDP over the year to March 2000.

This markedly higher deficit is a result in part of slightly smaller trade and migrant transfer surpluses over the next few years, in part the result of a slightly higher services deficit over that period, but mainly the result of a significantly higher net deficit on investment income. That larger net deficit on investment income in turn is mainly the result not so much of higher profits earned by foreign companies operating in New Zealand as of a markedly lower projected track for the profits of New Zealand companies operating overseas, suggesting that New Zealand companies have been rather less successful in their investments overseas in the recent past than have foreign companies investing in New Zealand.

Whatever the reasons, the larger current account deficit could prompt a further change in the mix of monetary conditions and, if this were to happen, a lower exchange rate would tend to push prices up as compared with the track now projected. At the same time it is probably fair to note that the higher interest rates which could also result from reduced confidence in the New Zealand dollar might well prompt some downward movement in the housing components of the CPI, thus providing some offset to any exchange rate depreciation. If the exchange rate depreciation were large, however, it might still tend to push inflation above the track now projected, and require monetary conditions to be somewhat firmer than now projected.

Other issues

I want to cover a few other items.

First, despite some doubts which have been expressed about the way in which our Monetary Conditions Index is working, we are entirely happy with it. We are no more confident now than we were a year ago that we know with any degree of precision the comparative influence of interest rates and the exchange rate on medium-term inflation. Nor are we any more confident about the stability of that ratio over time. Clearly, our `two-for-one' assumption is subject to very considerable uncertainty. That is why, even in the immediate aftermath of a new projection, we do not force monetary conditions to conform exactly with `desired'. But the MCI reminds everybody that, in a small open economy, both interest rates and the exchange rate form important parts of the monetary policy transmission mechanism, and gives markets some guide to how we weight the relative importance of those channels. It is especially useful in helping public understanding when, as often in the last 12 months and more, interest rates and the exchange rate are moving in opposite directions. While few other central banks use such an index in a formal sense at this time, it is clear that all central banks, even the Federal Reserve Board in the US, have to take exchange rate effects on inflation into account in determining the appropriate stance of monetary policy.

Secondly, some observers have suggested recently that the Reserve Bank tends to `simply follow' where financial markets lead in terms of monetary conditions. It is certainly true that in recent times the market has tended to anticipate where the Bank wants monetary conditions to be so that, when each new quarterly projection is released, actual market conditions are often closely in line with the conditions which the Bank indicates as `desired'. But as Dr Mervyn King, shortly to be Deputy Governor of the Bank of England, recently remarked, given a clear and publicly-known inflation target, a broad consensus on how the economy works, and access to the same information on the development of the economy, the central bank's conclusions about the appropriate stance of monetary policy should not be a surprise to the markets. Indeed, what would be surprising is if the central bank and the markets were at substantial or frequent variance. Of course, there will be times when the collective judgement of financial markets differs from that of the central bank, and on those occasions the central bank will need to make its own views known, as we ourselves do from time to time. But as a rule those occasions should be few and far between.

Thirdly, as we announced yesterday, a new Policy Targets Agreement has been signed by the Treasurer and me, and that defines the 0 to 3 per cent target in terms of the CPI excluding credit services, or CPIX. That does not involve any change in the way in which monetary policy is formulated or implemented but, because interest rates were by far the most frequent reason for divergences between the official `headline' rate of inflation and the Bank's measure of underlying inflation, moving to the CPIX has enabled the Bank to discontinue its underlying inflation series. Of course we will from time to time still need to give our best estimate of the impact of unusual or temporary disturbances on the CPIX, and from time to time need to explain divergences from the agreed inflation target range, as envisaged in the Policy Targets Agreement. But using the new index as the normal measure of the Bank's inflation performance can only further enhance the transparency of the monetary policy framework.

We are hopeful that, in 1999, we will be able to move to an index of consumption prices, involving not only the exclusion of interest rates from the measure of consumer price inflation but also the replacement of certain asset prices (such as new house and section prices) by an alternative measure of the price of actually using the services provided by those assets. The availability of this index, recently announced by the Government Statistician, will, we believe, be a marked advance.

Fourthly, a house-keeping matter. In the recent past, the timing of the release of our quarterly projections has seemed less than ideal in terms of the timing of the release by the Government Statistician of important data on the CPI, GDP and other matters. In some cases over the last year, indeed, the Bank's projections have been `dated' within days of their release by data which has been unexpectedly at variance with the assumptions on which the Bank based its projections. For this reason, we are intending to change the dates on which we release our projections in 1998. We now plan to release Economic Projections in mid-March (as previously); our next Monetary Policy Statement in mid-May (some six weeks earlier than this year); our second Economic Projections for the year in mid-August; and our second Monetary Policy Statement for the year in mid-November.

Finally, let me respond to a criticism that I still hear occasionally, and that is that if only the Bank were not so single-minded in its focus on keeping inflation low, New Zealand would be able to grow at a faster average rate, would have higher employment, or even would have a smaller balance of payments deficit. Getting sustainably higher economic growth, or more employment, or a lower balance of payments deficit are all worthy objectives. Unfortunately, there is not the slightest evidence, from New Zealand's own experience or from the experience of other countries, that they can be achieved by tolerating more inflation. If anybody thinks that they have such evidence, I'd be very keen to see it. So far nobody has produced any.

Don Brash
Reserve Bank of New Zealand