Monetary Policy Statement for June 1997
Speaking notes for briefing journalists on the release of the June 1997 MPS
Good morning and welcome to this briefing on the Reserve Bank's June 1997 Monetary Policy Statement, the 16th we have issued since the 1989 Reserve Bank legislation became effective in February 1990.
As you will be aware from earlier announcements, this Statement is different from earlier Statements in two ways.
First, whereas in the past we projected how inflation was expected to evolve given `straight-line' assumptions about how monetary conditions (interest rates and the exchange rate) would behave, we are now projecting how we believe monetary conditions will need to evolve to deliver inflation in the middle part of our inflation target.
Note that I said the middle part of the inflation target: it will be obvious to you when reading the Statement that the projected path of monetary conditions does not mechanistically or immediately drive the inflation rate back to precisely 1.5 percent, as some have apparently expected. The projected path for monetary conditions takes into account our assessment of the outlook for the real economy, and the balance of the risks involved.
It is particularly important to note also that the monetary conditions shown as appropriate beyond the next quarter must be treated as highly conditional - or in other words, with as much caution as our quarterly inflation numbers were treated previously. It is very likely that, as more information comes to hand, we will need to adjust our view of what monetary conditions are appropriate in the future.
The second change in our presentation is that, whereas in our last Monetary Policy Statement we went further than previously by informing the market how we saw the relative impact of interest rates and the exchange rate on the medium-term inflation rate, and indeed by informing the market precisely how firm monetary conditions needed to be by specifying one appropriate combination of interest rate and exchange rate, we are now simplifying that by adopting an index of monetary conditions - the Monetary Conditions Index, or MCI. In future we intend to use the MCI to indicate the overall firmness of the conditions which we seek, and to describe actual monetary conditions. We are confident that this further increase in the transparency of our signalling will assist financial markets, and the public more widely, to understand the intended stance of monetary policy.
As you will have seen from reading the Statement, the Bank now believes that the economy grew more slowly in the first two quarters of 1997 than we thought likely when we issued our March Economic Projections. Indicators for the March quarter in particular suggest that there was quite an abrupt slowing during the first three months of the year. Indeed, it is not inconceivable that the economy may even have contracted slightly in that quarter. Indicators for the June quarter, however, together with our own business contacts, suggest that the economy may have rebounded somewhat in that quarter, and we currently project that growth will strengthen in subsequent quarters. By the March 1998 quarter, we see GDP being 2.4 percent above that in the March 1997 quarter. This growth rate, being slightly below our assessment of the economy's long-term sustainable growth rate, is consistent with an easing in inflationary pressures on capacity in the economy.
Beyond that, we see growth accelerating to between 3.5 and four percent in each of the following two March years, in large part as a result of the significant fiscal stimulus currently planned for the year beginning 1 July 1998.
On the basis of this real economy outlook, signs that price effects from the recent exchange rate appreciation are finally coming through more strongly (as in the car market), and monetary conditions evolving as outlined, we are anticipating a decline in underlying inflation to about one percent in the year to March 1998. Inflation should then remain at around that level through the balance of 1998 and into 1999, before rising gradually to slightly above the middle of the target at the end of the period covered by the projection.
This pleasingly low inflation track, coming as it does after two years during which the Bank has had to grapple with inflation at, and at times marginally above, the top of our target range, should help in the task of convincing New Zealanders that low inflation really is now the norm, not some temporary aberration. As that is accepted, we would expect to see rates of credit growth, and real interest rates, move closer to those found in other low inflation countries.
But we are not deliberately attempting to push the inflation track below the middle of the range: the fact is that, once an inflation trend develops some momentum, it is neither sensible nor feasible to try to change it very quickly. It is perhaps worth recalling that, through almost all of 1996, the period most relevant to inflation outcomes in 1997 and the first part of 1998, we were in fact targeting inflation at the mid-point of our previous 0 to 2 percent range, or 1 percent.
Is this low inflation achieved only at the cost of doing severe damage to the real economy? If we are right that real economic growth will fall only marginally below our estimate of sustainable long-term growth over the next year, before accelerating to rates of growth somewhat higher than the economy's sustainable growth rate, then clearly low inflation does nothing to inhibit the economy's growth.
The matter can be put in another way. The New Zealand economy has been growing virtually without interruption since price stability was first achieved. The trough of the present cycle seems likely to involve growth of around two percent. And just as monetary policy aimed at price stability inevitably means that the Bank will be leaning against growth in demand which exceeds the economy's long-term potential to deliver, it also means that the Bank will be easing conditions as demand falls below long-term potential and inflationary pressures abate.
And this is where we are now: for the second time in six months, sanctioning an easing in monetary conditions. The inflation projection which I have outlined, and which is set out in more detail in the Statement, is based on monetary conditions being the equivalent of 100 basis points easier during the September quarter than the conditions we saw as appropriate in our March Economic Projections; or in terms of our new MCI, we judge that desired monetary conditions for the September quarter are around 825, in contrast to the 925 we saw as appropriate in March. This new level of desired monetary conditions is in fact very close to where actual monetary conditions have been in recent weeks. In other words, we are not seeking any further easing in actual monetary conditions.
There may be some scope for a further small easing in monetary conditions in the last quarter of 1997, but beyond that we see the need for monetary conditions to remain broadly stable in real (inflation-adjusted) terms. This maintenance of monetary conditions at a reasonably firm level relates to our expectation that the economy will have only minimal excess capacity available by mid-1998, when further tax cuts and increased government spending take effect.
I want to stress two things. First, as already indicated, our present judgement about the firmness of monetary conditions in quarters beyond September is inevitably highly conditional. For example, because we do not as a rule build in policy changes until these are firm commitments, we have assumed that there is no compulsory retirement savings scheme instituted next year. Clearly, however, if such a scheme were instituted, and if as a consequence the net fiscal stimulus was rather smaller than now assumed, monetary conditions would almost certainly need to be easier than now envisaged to keep the inflation rate in the middle part of the target range. Similarly, if the international economy evolved differently from the path now assumed, monetary conditions would need to be different than now projected. Again, if, contrary to our expectations, the domestic economy turned out to be much weaker than now projected, appropriate monetary conditions beyond the end of the year would be easier than now anticipated in order to keep inflation headed back to the middle part of the target range.
Secondly, although we have shown a projected track not only for monetary conditions in aggregate but also for both 90 day interest rates and the TWI, the projected tracks for interest rates and the exchange rate are purely illustrative. How the `mix' of conditions actually evolves will depend on the relationship between monetary conditions in New Zealand and monetary conditions abroad, and on the perceptions of hundreds of thousands of individuals, here and abroad, about the riskiness of investing in New Zealand dollar assets. For this reason the projected tracks for interest rates and the exchange rate are only one of a very large number of alternative `pairs', all of which would have a broadly similar impact on medium-term inflation in New Zealand.
Two more points about signalling
Two additional points should be made about our approach to signalling our view of the appropriate stance of monetary policy. First, as a general rule, we only make a comprehensive assessment of the inflation outlook on a quarterly basis. It follows that in normal circumstances we only make a comprehensive assessment of desired monetary conditions on a quarterly basis, and we will announce that when we release our quarterly inflation projections (generally June and December in Monetary Policy Statements and March and September in Economic Projections). We will in normal circumstances resist the temptation to change our view of projected inflation on receipt of every new piece of data. If, on a rare occasion, our view of desired conditions does change significantly between quarterly projections, we will announce that fact (unless we change our view in the days immediately preceding the release of a new quarterly projection) in the form of a statement released over all the relevant media simultaneously. We will not be giving nods and winks to the market, nor coded signals.
I realise, of course, that there is no way I can stop people trying to read between the lines and making guesses. After all, an essential role for market participants is to try to predict the future direction of monetary policy; profitable trading depends on doing that successfully. We try to make this task as easy as possible by making our projections public every three months, together with a substantial amount of the detail underlying those projections. At this stage, I believe we reveal more about the thinking which underlies our projections than does any other central bank in the world.
The second issue involves some uncertainty in the market about the extent to which we are willing to accept deviations between actual monetary conditions in the market and desired monetary conditions. In recent weeks in particular there has been a great deal of market commentary on the extent to which we might be willing to tolerate such deviations.
It is not a simple issue. On the one hand, it is clear that deviations from desired monetary conditions can be very large indeed without threatening either edge of our inflation target if those deviations are of relatively short duration. This suggests that the Bank should be relatively tolerant of quite large deviations from desired. On the other hand, large deviations, even for relatively short periods, may raise doubts - either about the Bank's determination to achieve the inflation goals we have been set or about the possibility that the Bank, in accepting those large deviations, may have changed its view of desired conditions. These doubts can create uncertainty, and that uncertainty has real costs, both short-term and long-term. We already allow monetary conditions to move within a range, without reaction from the Bank, which is at least as wide as that allowed in other developed countries.
I am reluctant to be too precise about how much deviation we are willing to accept and for how long. Much will depend on the circumstances in which the deviation occurs. We may, for example, be more tolerant of deviations which appear to arise out of sharp movements in overseas exchange rates, where local interest rates or exchange rates may take a brief period to adjust. We may be more tolerant of deviations during the weeks immediately preceding our next quarterly inflation projection, since it is at that time when our last comprehensive review of desired conditions is, by definition, getting most dated. We are likely to be less tolerant if monetary conditions change very rapidly, and appear to be building some momentum, without any obvious explanation in terms of overseas exchange rates or changed prospects for inflation.
As a very approximate guideline, we would expect actual monetary conditions to be within a range of plus or minus 50 MCI points from desired in the weeks immediately following a comprehensive inflation projection. As more data comes to hand over the ensuing three months, and as our last comprehensive inflation projection recedes into history, we may be rather more tolerant. But this is not, repeat not, a binding rule which the market can expect us to follow under all circumstances, and those expecting us to do so are likely to be disappointed.