Monetary Policy Statement for March 1997
Speaking notes for briefing journalists on the release of the March 1997 Economic Projections
Good morning and welcome to this briefing for journalists on the Reserve Bank's March 1997 Economic Projections.
Before I comment on the content of this document, I want to remind you once again that the numbers in this document are conditional projections, and not unconditional forecasts. In other words, on the basis of explicit and publicly announced assumptions about monetary conditions and fiscal policy, we project the course of the economy - its real growth, employment, fiscal outcomes, balance of payments outcomes, and of course inflation.
We do not imagine for one moment that all of those assumptions will hold true through the next three years but, since we have some ability to influence the course of monetary conditions at least, it makes sense to project the course of the real economy and inflation on the assumption that monetary conditions remain as assumed. It is then much easier for all to see what needs to be done to keep inflation inside the target range.
I am particularly keen to dispel any notion that, by assuming an unchanged trade-weighted exchange rate through the period covered by the projection, we are in some way providing a `quasi-guarantee' of a stable currency over that period. We are doing no such thing, any more than we are providing a `quasi-guarantee' of a stable 90 day interest rate by assuming an unchanging 90 day interest rate over that period. I guess this is most clearly seen by looking back over the last few months: last September, for example, we made a projection on the assumption that the TWI would remain at 65, and that 90 day interest rates would remain at 10 percent, over the forecast period. In December, we made a projection on the assumption that the TWI would remain at 66.5 and that 90 day interest rates would remain at 9.0 percent. Of course neither happened - the exchange rate rose quite strongly and interest rates fell quite strongly. There was no `quasi-guarantee' of either. There is no `quasi-guarantee' that the exchange rate or the 90 day interest rate will remain as assumed in these projections.
On this occasion, we are assuming that the trade-weighted exchange rate remains at 68, and that 90 day interest rates remain at 7.5 percent, during the whole of the period covered by the projections. These were, approximately, the exchange rate and 90 day interest rate prevailing at the time we began work on the projections last month.
Our view of the future has been rather different from that embodied in the December Monetary Policy Statement for some time and this new view is set out in the document. In particular, we have now factored in the new track of fiscal policy announced in the Coalition Agreement, the estimated impact of the increased minimum wage which came into effect on 1 March, the somewhat higher track for import prices which seemed indicated by the September quarter data, and the somewhat easier monetary conditions which we announced when the December Monetary Policy Statement was released. (As I have just mentioned, the inflation projections in the December Monetary Policy Statement were based on a TWI of 66.5 and 90 day rates of 9.0 percent but, because that delivered an inflation track lower than seemed necessary to have inflation around the middle part of our inflation target, we announced on releasing the Monetary Policy Statement that desired monetary conditions were those consistent with a TWI of 66.5 and 90 day interest rates of 8.5 percent.)
The outlook for the real economy
And the result? As a country, we do seem to have achieved the proverbial `soft landing', in the sense that we project that the real economy will bottom out with positive real growth of about 2 percent. From there, we project growth in the real economy of about three percent between the March quarters of 1997 and 1998, and of about four percent between the March quarters of 1998 and 1999.
We project some slow-down in the growth of employment but, with an expected slow-down also in net immigration and a fairly small increase in participation rates, the rate of unemployment is projected to rise only slightly, and to fall to about 5.5 percent later in the period.
The projections do not incorporate the latest fiscal numbers released last week in the Budget Policy Statement because these were not available to us when our projections were finalised but, as mentioned, they do incorporate the fiscal numbers announced in December with the Coalition Agreement. As you know, the Budget Policy Statement proposes that the increase in government spending will be somewhat less than previously proposed in the 1997/98 fiscal year, and somewhat more than previously proposed in the 1999/2000 fiscal year. Other things being equal, this will result in somewhat less inflationary pressure in 1997/98, and somewhat more inflationary pressure in 1999/2000, than we have incorporated in these projections.
We project rather lower fiscal surpluses than does the Treasury because we have a somewhat weaker macroeconomic track than Treasury does, but we nevertheless project operating surpluses of some two percent of GDP throughout the period covered by the projection.
We devoted quite a lot of effort to assessing the outlook for imports and exports, not least because of the recently strong rise in the exchange rate and the pressure which that has put on both the export sector and those competing with imports. We do not see export volumes falling off, and indeed we see some modest continued export growth, although at a lower rate than in the early part of the decade, and at a lower rate than some others project. The volume of imports is projected to continue rising but, with a modest improvement in our terms of trade projected, the overall balance of visible trade is projected to remain broadly unchanged (abstracting from the impact of the importation of the two ANZAC frigates).
The balance of payments deficit on current account is, however, projected to reach close to 6 percent of GDP (or around seven percent of GDP if migrants' transfers are treated as a capital item, as the IMF now recommends), the highest current account deficit in more than a decade. This outcome reflects the worsening deficit on account of invisibles.
The outlook for inflation
And finally to inflation. The December Monetary Policy Statement suggested that on the basis of the assumptions used in those projections inflation would shortly start to fall and then decline quite rapidly. While we still expect inflation to decline, that decline is less sharp in the immediate future and is no longer expected to be sustained throughout the projection period.
In the early part of the period, the somewhat higher inflation now projected reflects both the unexpectedly muted impact of the recent rise in the exchange rate on the domestic price of imported goods and services and the continued buoyancy of inflation in the non-traded sectors (particularly housing and government and related charges). In the later part of the period, inflation rises in comparison to our last published projection, in part because we are assuming a somewhat easier set of monetary conditions than that underlying our published December projections but largely because of the additional fiscal stimulus now assumed for 1998/99 and 1999/2000.
Taking everything into account and on the basis of the assumptions which have been made, we see underlying inflation falling through 1997 to the point where it reaches 0.8 percent in the year to June 1998, and then rising back towards and through the middle of our new target range in 1999. By the end of the period - currently beyond the period over which monetary policy has its main impact on inflation - the 12-monthly inflation rate is projected to reach 2 percent, with quarterly inflation running at an annualised rate of some 2.5 percent.
There are the usual risks around this projection for inflation but three are worth particular mention.
First, there is obvious risk in relation to the degree of net fiscal stimulus. For example, if net government spending were to exceed that announced, then inflationary pressures would be greater than those foreshadowed here and monetary policy would need to be somewhat firmer to ensure that inflation is kept within the limits agreed with the Government. Conversely, if net government spending were less than currently envisaged, or if the increase in government spending were offset by some form of compulsory savings scheme (something which we have not assumed in these projections because any such scheme is dependent on the outcome of the September referendum), inflationary pressures would be less than foreshadowed in these projections, and monetary policy could be correspondingly somewhat easier.
I welcome the Government's recent reaffirmation about the importance of ensuring that fiscal policy does not require unreasonably tight monetary policy: clearly having fiscal and monetary policy pulling in opposite directions is painful for the real economy, and especially those exposed to international markets.
Secondly, there is, as always, uncertainty about the direct effect of exchange rate movements on domestic prices. As you know, we have been concerned for some time that we have been seeing less downward pressure on domestic prices from the rising exchange rate than we would have expected and it is still unclear why that is the case. However, the data released earlier this week was moderately encouraging, and at this stage we continue to work on the basis that a 1 percent appreciation in the exchange rate will, in due course, lead directly to a fall of 0.3 percent in the CPI.
Thirdly, there is the possibility that we may see a different mix of monetary conditions from that assumed here - perhaps in response to increasing concern about the size of the current account deficit. This different mix, which would presumably be in the direction of lower exchange rate and higher interest rates, would, providing it were still on the same `trade-off line', produce the same effect on inflation as the conditions assumed here in the medium term.
But the short-term path of inflation might be rather different because, in addition to the exchange rate's medium-term effect on inflation, it also has a direct effect on domestic prices, as indicated by our discussion of the pass-through coefficient. The risk would be that a lower exchange rate might result in rather less downward pressure on inflation than we have projected, and that this might not be fully offset by the deflationary impact of rather higher interest rates. That risk is mentioned in the document. (The uncertainty in this area is well illustrated by noting that an alternative scenario would have a lower exchange rate having relatively little adverse effect on inflation precisely because importers, expecting some downward correction in the exchange rate, have been boosting their margins to an abnormal degree and would not seek to recover the full effect of a lower exchange rate through higher prices. If in this situation higher interest rates were to result in falling house prices, the overall impact on inflation of such a change in monetary conditions would be small - indeed, it might even be beneficial.)
All things considered, we believe that, with so many uncertainties, and with both the real economy and inflation having been rather stronger than previously projected, a cautious approach is warranted until we can be confident that, even after an easing, inflation would still turn down towards the middle of the 0 to three percent target range in a clear and sustained manner.
Accordingly, we see no scope for an easing in desired monetary conditions. The monetary conditions which we seek at the present time are unchanged from those announced on 17 December, namely conditions consistent with a trade-weighted exchange rate of 68 and 90 day interest rates of 7.5 percent (closely similar, on the basis of our announced `trade-off line', to the announced preference for a trade-weighted exchange rate of 66.5 and 90 day rates of 8.5 percent in December).
Having said that, it is clear that since December actual monetary conditions have been somewhat firmer than the Bank has been seeking. In recent weeks, conditions have tightened further, and at this stage have become inappropriately firm. We will be looking to see conditions ease towards those we are seeking.
Before concluding, you will be aware that last Friday the Bank released a technical paper on monetary policy implementation and signalling. Given that we have explicitly put this paper out for market comment prior to 4 April, and have not yet made any decision on which way we will proceed, I am not planning to answer any substantive questions on this issue this morning.