Speaking notes for briefing journalists on the release of the May 1998 MPS
Outlook for the real economy
Good morning. This morning we are releasing our 18th Monetary Policy Statement.
Broadly speaking, the Bank's outlook for the real economy is much the same as it was in March, when we released our last Economic Projections. We believe that the economy has been weak over the March and June quarters, indeed rather weaker than we were projecting in March. In the very near term, this subdued growth is expected to continue, with weak world prices for our exports and restrained domestic spending. Since March, the outlook for Japan, our second largest export market, has deteriorated further; house prices have stabilized or fallen a little; and consumer and business confidence have weakened. At the same time, prospects continue to look good in the United States, Australia, and generally in Europe.
Looking further forward, we see economic activity picking up in the second half of 1998 and into 1999. In part this will be a response to the tax cuts scheduled for 1 July this year, and to one-off events such as the demutualisation of the AMP Society. Activity is also expected to respond to the sharp fall in the real exchange rate which has occurred over the last year or so, and the effect that this has had on increasing the competitiveness of New Zealand production. Internationally, the consensus view is that world economic growth may pick up somewhat faster in 1999 than previously expected, and this too is projected to assist New Zealand's growth in 1999 and 2000.
Our best estimate at this stage is that growth in the year to March 1999 (year average basis) will be 2.2 per cent, and in each of the two following years 4.0 per cent and 3.5 per cent.
Outlook for inflation and monetary conditions
Largely as a result of this somewhat weaker growth in the first half of 1998, we now project there to be somewhat more spare capacity in the economy over this year and into 1999. This will further reduce inflationary pressures over 1999 and into 2000, and makes it appropriate to ease monetary conditions by 150 points from the 500 previously projected for the June quarter, to 350 for the September quarter. This is an additional easing from that projected in March (when we projected monetary conditions to be around 425 in the September quarter). As often in the past, financial markets have fully anticipated this move in recent weeks.
If we had not sanctioned this additional easing for the September quarter, and a little more easing further out than we had previously projected, the projected inflation track would have shown a more pronounced cyclical pattern. As it is, and after factoring in the expected impact of recent and projected easing in monetary conditions, we expect CPIX inflation to stay pretty close to the middle part of our 0 to 3 per cent target range throughout the forecast period.
In this current June quarter, we expect CPIX inflation to be quite a bit lower than we expected in March (0.2 per cent instead of 0.5 per cent). In large part this is a result of one-off factors such as a fall in world oil prices and increased competition in petrol retailing. The recently-announced abolition of tariffs on motor vehicles also pushes prices down, although the overall effect of the Budget on inflation is relatively small in the short-term, given the offsetting increases in excise tax on petrol and cigarettes. (In the longer term, the micro-economic reform measures announced in the Budget, such as the abolition of restrictions on parallel importing, and the introduction of the community wage, seem likely to reduce inflationary pressures somewhat, but at this stage we have not tried to estimate the extent of these effects.)
Another factor which is expected to put downward pressure on CPIX inflation in the June quarter, and indeed beyond, is the more subdued outlook for house prices. Previously we had projected house prices to rise slowly in nominal terms (to remain roughly constant in real terms), but some fall in house prices now appears more likely, and a small fall has been built into our projections.
Uncertainties
Just how the economy develops over the next few years will depend heavily on how households respond to the tax cuts and AMP demutualisation, on how the situation in Japan and Asia evolves, and on whether the United States economy continues to grow steadily. These are all substantial uncertainties. It is possible to envisage circumstances in which the economy grows rather more quickly than now projected, if consumer confidence (and business confidence with it) bounces back in response to the tax cuts. It is not at all difficult to envisage circumstances where the economy grows more slowly than projected, particularly if the Japanese economy fails to respond to recently-announced fiscal stimulus, or if the United States economy slows more sharply than now expected, perhaps in response to a sharp fall in US equity prices.
In our view, the uncertainties around the projected path of inflation are more or less evenly balanced. While economic growth might turn out a little weaker than now projected, the effect of that on inflation could well be fully out-weighed if further easing in monetary conditions took the form of further depreciation in the exchange rate.
Implementation issues
As on several previous occasions, this Monetary Policy Statement explains in some detail how we use the Monetary Conditions Index (MCI). We note that central banks in open economies need to take account of the effects of both interest rates and the exchange rate on economic activity, and so on inflation, and in particular must decide whether to adjust interest rates in response to movements in the exchange rate.
What is different about our MCI approach is the degree to which we have made explicit the relative weighting we attach to interest rates and the exchange rate, and our willingness to publish a conditional projection for overall monetary conditions consistent with the outlook for inflationary pressures. This is consistent with our commitment to remain as transparent as possible about the conduct of monetary policy.
Since our last projection in March, the mix of monetary conditions has shifter further towards a lower exchange rate and relatively higher interest rates. (In absolute terms, 90 day interest rates are little changed from their level just prior to the release of our March projection, which means that all of the quite significant further easing in monetary conditions which has occurred since that time has taken the form of a fall in the exchange rate.)
In the Bank's view, the use of the MCI through the rebalancing of conditions which has occurred over the last year or so has been very helpful in keeping our attention, and that of financial markets, on the level of overall monetary conditions appropriate for maintaining price stability. The rise in short-term interest rates which has occurred since last July has been associated with a fairly rapid fall in the New Zealand dollar over the same period. That depreciation is hardly surprising given the very strong appreciation of the currency over the period between early 1993 and early 1997 (when in general we were tightening policy), and the increasing balance of payments deficit. Recent events in Asia, together with a perception that monetary policy was likely to be substantially eased, provided the catalyst for the depreciation which we have seen.
In due course, as financial markets sense that there is limited further downside risk in the New Zealand dollar, we will tend to see more of any policy easing come about through lower interest rates. Having said that, a lot will depend on developments in Japan, and Asia more generally, and on the course of interest rates in the United States and Australia.
All of this underscores a point that we have made many times before: the Bank can not control the mix of monetary conditions. The specific path for interest rates and the exchange rate projected in this Statement is one of a number of alternatives paths consistent with our assessment of inflationary pressures, and in no way shows some preferred or desired mix of conditions. I stress this point because a surprisingly large number of commentators continue to talk as if we can, and do, target a particular mix of conditions.
The primary issue which the Bank and the markets must always address is not whether interest rates in isolation are at the `right' level, or whether the exchange rate in isolation is at the `right' level, but rather whether overall monetary conditions are appropriate to keep inflation heading towards the centre of the 0 to three per cent target. Those who argue that the MCI approach is leading interest rates to be too high are either lamenting the depreciation in the New Zealand dollar or arguing that monetary policy overall is too tight. The overall appropriateness of policy is always a legitimate matter for debate, but it has nothing to do with the use of an MCI in implementing policy.
Finally, let me address one other implementation issue. I indicated almost a year ago that, in implementing policy, we would not react to temporary spikes in the MCI, especially those stemming from sharp movements in overseas exchange rates which appeared to have no significance for the future course of New Zealand inflation. I further indicated that, as a very approximate guide, we would expect the MCI to be within a range of plus or minus 50 basis points from `desired' in the period immediately following our quarterly projections, with rather more latitude allowed as new information came to light and as the last projection receded into the past.
In addition, of course, our projected MCI track may foreshadow further quarter-to-quarter changes, with this Statement, for example, suggesting a further 75 basis point easing between the September and December quarters. Hence, in deciding on any possible reaction to deviations of actual market conditions from those published as desired, we will also be taking this forward path into consideration as we progress through the roughly three month period until our next Statement. All things considered, this should allow the markets sufficient latitude to adjust financial prices to new information, shocks, and other uncertainties, without threatening the inflation target.
In addition, to make things easier for everyone, we have decided to adopt the general practice of taking any policy action, or commenting on the appropriateness of monetary conditions, just once a week on the morning after our weekly Monetary Policy Committee meeting. Thus, barring any exceptional circumstances, any possible statements or cash target changes will in future be made at 9.00 a.m. on Wednesdays, except where, as next week, a public holiday moves the timing of the Monetary Policy Committee meeting slightly. This change takes place with immediate effect. Of course, if the Bank is broadly satisfied with the way in which monetary conditions have evolved, we will simply remain silent.
Thank you.
Don Brash
Governor
Reserve Bank of New Zealand