Monetary Policy Statement for March 1998
Speaking notes for briefing journalists on the release of the March 1998 MPS
Economic circumstances have changed since December
Since we finalised our most recent Monetary Policy Statement in early December, it is our judgement that economic circumstances have changed quite significantly.
To be sure, since December the domestic economy has evolved more or less in line with our earlier expectations. In particular, inflation outcomes have been broadly in line with those we expected in December and we currently expect that output growth over the December 1997 and March 1998 quarters will also have been in line with our earlier view. But there have been three significant changes from what we had previously expected.
First, the exchange rate has fallen considerably more than projected.
Secondly, and perhaps most importantly, the outlook for world growth has been revised down substantially, largely because of developments related to the East Asian crisis. In these projections, we have again adopted a pessimistic view about world growth prospects. Although there are some positive signs emanating from East Asia - especially from Thailand and Korea - events in Indonesia are quite volatile, and Japan may be headed into outright recession. As a result, since December most observers have substantially lowered their estimates of growth in East Asia. Although prospects look solid for the US, Australia, and Europe, these prospects are not sufficient to offset the negative implications for New Zealand of lower Asian growth. As a consequence, we now believe that export growth will be substantially weaker than projected in December.
Thirdly, and no doubt in part related to the weaker international environment and media coverage of that, both consumer and business confidence have weakened significantly in recent months. This is likely to restrain domestic expenditure by more than we expected in early December. In addition, more subdued housing prices seem likely to alter households' views of their wealth, providing a further dampening influence on spending.
Overall, weaker export growth and weaker domestic demand tend to reduce output growth in the year to March 1999. This implies that aggregate supply will exceed aggregate demand by more than we had thought likely in December, and for a rather longer time.
Implications for inflation and monetary conditions
The implication of these changes - a lower exchange rate and weaker domestic and external demand than we had projected in December - is a slightly higher inflation track in the next two years but appreciably lower domestic inflationary pressures over most of the period covered by these projections.
As a result, we have lowered our assessment of desired monetary conditions for the June quarter from the 650 we projected in the December Monetary Policy Statement to 500, with a further easing in monetary conditions conditionally projected through the beginning of the year 2000. (I will come back to what I mean by `conditionally' in a moment.)
Why, it might be asked, are we projecting such an easing given that the inflation track will be slightly higher than we projected in December? The reason is that, at this point, tighter monetary conditions would do little to prevent the near-term rise in inflation that we are projecting. Instead, taking a forward-looking approach, a loosening of monetary conditions now is warranted to offset the expected disinflationary consequences of the weaker profile for demand. Thus, today's easing, and the conditional easings projected for coming quarters, should serve to keep the inflation rate near the mid-point of the 0 to three per cent target range in the years to March 2000 and 2001.
Implications for the real economy
If things evolve in the way we now project, growth in GDP in the year to March 1999 (annual average) will be 2.8 per cent, that in the year to March 2000 will be 4.2 per cent, and that in the year to March 2001 will be 2.7 per cent. This means that we are now projecting slightly lower growth in the year to March 1999 than we were in December (2.8 per cent instead of 3.0 per cent) but slightly stronger growth in the year to March 2000 (4.2 per cent instead of 3.9 per cent). Over the two years starting 1 April this year, therefore, the difference is negligible. (We did not previously project a GDP growth figure for the year to March 2001.)
Again if things evolve in the way we now project, we see government's operating balance as a share of GDP being slightly stronger than we did in December, with the balance of payments current account deficit being fractionally higher in the years to March 1998 and March 1999 but rather lower than previously projected in the following years.
At first sight it may appear that there is an inconsistency between the significant monetary policy easing envisaged in these Projections on the one hand and the slightly higher inflation outcomes and relatively robust economic growth on the other. But in fact there is no inconsistency.
In the absence of the monetary policy easing projected, economic growth would be considerably weaker than now projected for the years 2000 and 2001, and as a consequence inflation would be heading well below the middle part of the 0 to three per cent inflation target. In fact, what we see in this situation is an illustration of how monetary policy exclusively focused on delivering price stability has the important ancillary benefit of smoothing business cycles also. While this inevitably means that we lean against a rapid expansion of demand when it looks likely that this will increase inflation, we also ease policy when this can be done without rekindling inflation, and this is particularly true if it looks as if inflation will head below the bottom of the 0 to 3 per cent inflation target we have been set by Government.
Risks and uncertainties
You will have seen that, as usual, we have devoted a section of the document to a discussion of the risks and uncertainties in the projection. There are two risks which need to be particularly noted.
First, although the exchange rate has depreciated since the December Monetary Policy Statement, and that should ultimately help to improve our external position, the current account deficit is still expected to remain quite high over the projection period. While these Projections represent our best judgement about the likely course of the economy, financial market participants might take a different view. In particular, if concerns about the current account deficit increased, the currency might prove to be weaker than we are expecting. If so, interest rates would need to be higher than we are now projecting to stem the inflationary consequences. As we note in the Projections, under some circumstances overall monetary conditions might need to remain tighter than now envisaged.
Secondly, it is possible that the outlook for demand could turn out to be different than we envisage. In this regard, a principal risk is the Asian crisis. The affected economies will begin to recover at some point, but when that will occur is still quite unclear. On the other hand, it is possible that growth in Europe and the US could provide a bigger offset to weak Asian demand than now expected.
The Bank will be watching these developments closely. And in that connection I need to stress that the track of future monetary conditions now projected is highly conditional. That has always been true, but it is particularly important to stress the point in a situation where the projected track shows quite a marked further change in monetary conditions. Because of the uncertainty involved, financial markets should understand that the Bank will resist vigorously any tendency to anticipate the easing now projected for the period beyond the June 1998 quarter.
We will not, of course, expect monetary conditions to be right on 500 on the Monetary Conditions Index at all times, any more than we have insisted on such a close correspondence between actual and desired monetary conditions in the past.
As I have indicated previously, our tolerance of deviations from the Bank's desired conditions will depend on the circumstances in which the deviation occurs. For example, we may be more willing to accept deviations which occur due to sharp adjustments in overseas exchange rates, where local interest rates and exchange rates take time to adjust. We are likely to be less complacent if monetary conditions change rapidly, and appear to be building some momentum, without any obvious developments which suggest that the future inflation track will be markedly different from that previously projected.
As a very approximate guide, we would expect actual monetary conditions to be within a range of plus or minus 50 MCI points from desired in the period immediately following a comprehensive inflation projection. As data comes to hand which may alter the inflation projection, and as our last comprehensive inflation projection recedes into history, we may well be more comfortable with a greater divergence between actual conditions and that now announced as desired.
Having said that, it is important to remember that we periodically reset the desired level of monetary conditions taking into account all new information, as well as changes in our views about what that information means for future inflation. Only in quite exceptional circumstances would we formally reset `desired' monetary conditions other than in the context of that comprehensive quarterly review, but we may well, as indicated, become more tolerant of deviations of actual conditions from desired as new information suggests that that is warranted.
Criticisms of the Monetary Conditions Index
There have been two criticisms of the Monetary Conditions Index in recent months to which I would like to respond.
The first is that, because the Bank's measure of the New Zealand dollar exchange rate, the TWI, includes no Asian currencies except the Japanese yen, the exchange rate component of the MCI significantly overstates the recent fall in the New Zealand dollar and therefore overstates the extent to which monetary conditions have eased in recent months. It is certainly true that the Bank's TWI does not include any of the currencies against which the New Zealand dollar has appreciated very sharply recently, but it does not follow that the TWI seriously overstates the extent to which the New Zealand dollar's recent depreciation affects New Zealand inflation, which is, of course, our only concern. Box 3, which starts on page 23, tries to deal with that issue. The key point is that we still believe that the TWI is a reasonable approximation of the extent to which movements in the New Zealand dollar affect our inflation rate.
Moreover, even if the fall in the TWI slightly overstates the impact which recent exchange rate movements are likely to have on our inflation rate, it is quite likely that there is an offsetting overstatement arising from the way in which interest rates are measured in the MCI. At the present time, we factor in the influence of interest rates on the inflation rate by including the 90 day interest rate in our MCI. But in the last year or two there has been a very strong increase in bank lending which is priced not off the 90 day interest rate but off interest rates further down the yield curve. Partly because of recent very strong capital inflow in the form of Eurokiwi bond issues, these longer-term interest rates have tended to be significantly lower than 90 day interest rates. What is relevant for my argument is that, in recent months, the 90 day interest rate has increased quite strongly and that has been incorporated into the calculation of our MCI. Had we been using a longer-term interest rate - perhaps a one year or three year interest rate, for example - the effect would have been to show a significantly greater easing in monetary conditions than that shown by the MCI as presently constructed.
Of course, this simply illustrates something which we have always recognised: the MCI is not perfect. It does not take account of a host of relevant financial market prices, including longer-term interest rates, share market prices, and forward exchange rates. But then we have never suggested for a moment that it is perfect, and I suspect that we will continue to fine-tune it in the years ahead. Criticism from market commentators will be helpful in that regard. One of the reasons for allowing actual monetary conditions to diverge from `desired' is precisely this uncertainty about the precise weights to be given to different components of monetary conditions. But the MCI has the important benefit that it forces financial markets and the Reserve Bank to consider the impact of both interest rates and the exchange rate when assessing the influence of monetary policy on inflation, and we have no intention of abandoning it. When we prepare our quarterly inflation projections, we do not use the MCI as such, but rather look at each of the various factors which have a bearing on inflation over the policy-relevant period. The MCI is useful therefore primarily as a guide to financial markets between these quarterly projections; comparing the absolute level of monetary conditions as measured by the MCI over a long period of time has little meaning.
The second criticism of the MCI tends to come not so much from New Zealand financial market commentators as from the local business community and from overseas funds managers. How, it is sometimes asked, can you claim that monetary policy is easing when 90 day interest rates are high or rising? Or more simply, given reduced inflationary pressures, why isn't the Reserve Bank easing monetary policy?
My response to that criticism is that the Bank has been sanctioning a gradual easing of monetary policy for more than a year. One can debate, of course, whether we should have been easing more aggressively, though there is little evidence in the inflation outcomes so far that a more aggressive easing would have been warranted. But overall monetary conditions have been steadily easing, with a substantial fall in the exchange rate (some 10 per cent from its peak on a TWI basis, some 18 per cent against the US dollar) offset by some increase in short-term interest rates. The fall in the exchange rate will, in our judgement, provide more stimulus to the economy, and thus more upwards pressure on inflation, than the rise in short-term interest rates will dampen demand and inflationary pressures. In other words, in our judgement the overall impact of monetary policy over the last year has been to stimulate aggregate demand and thus to offset the disinflationary forces which are outlined in the Projections.
Given the slowing but still-strong domestic demand for credit, and the size of the balance of payments deficit, it is neither a source of surprise nor dismay that recent easing in monetary conditions has taken the form of a lower exchange rate and higher interest rates. No doubt as the demand for credit slows further, and the balance of payments deficit shrinks, the mix of monetary conditions will change again.
The last issue of Economic Projections
I mentioned in December that we were proposing to modify the timetable for issuing Monetary Policy Statements and Economic Projections from 1998, with our next Monetary Policy Statement published in mid-May (instead of late June, as in recent years), our next Economic Projections published in mid-August (instead of in September), and our final Monetary Policy Statement for the year published in mid-November (instead of in December). This change was essentially related to the timing of some key data releases by the Government Statistician.
We have now decided to discontinue publishing a document entitled Economic Projections. In other words, this March 1998 edition will be the last.
Instead, we propose to call all major published analyses of the inflation outlook Monetary Policy Statements. The Reserve Bank Act requires us to publish such Statements at least every six months, and in fact we will usually issue them at approximately quarterly intervals. It may be that there will be some variation in the content of the Statements from time to time, with some devoting more emphasis to some issues than others, but there will be no significant change in the frequency with which we comment on the inflation outlook.
We are making this change partly to reduce public and media confusion (until now we have effectively published inflation projections each quarter but only issued Monetary Policy Statements six-monthly) and partly to reflect the fact that the two documents have evolved over time to the point where they are, from the point of view of financial markets, of equal importance as statements of the Bank's view.
Reserve Bank of New Zealand