Monetary Policy Statement for August 1998
Speaking notes for briefing journalists on the release of the August 1998 MPS
Good morning. This morning we are releasing our 19th Monetary Policy Statement.
Overall assessment and level of conditions
Since the release of our last Monetary Policy Statement in May, the outlook for the economy has weakened considerably, and inflation pressures seem likely to be more subdued than we then anticipated. As a result, the Bank has been willing to sanction a very large easing in monetary conditions over the last quarter.
Clearly, in current circumstances we find ourselves making important judgements based on very uncertain prospects. The international environment has evolved rapidly over the last year, and will probably continue to be quite unstable for some time yet. At the same time, we must be conscious that we have eased monetary conditions very considerably, and the full impact of that has still to emerge.
On balance, we have decided to go with a level of zero on the MCI for the December quarter. This is about where monetary conditions currently are, of course, so no further adjustment is called for with today's announcement.
Developments since the May Monetary Policy Statement
When we released our May Monetary Policy Statement, it was obvious that the economy had been slowing sharply for several months. It is now apparent that GDP actually fell somewhat in the March quarter, and almost certainly fell further in the June quarter. This means that the economy was probably in a mild recession in the first half. At this stage, we project that GDP will grow by about 0.8 percent during the second half of 1998, but this too is markedly less than the 1.7 percent growth we had expected for the second half when we did our projections back in May.
Firm monetary policy in 1996 provides some of the explanation for the slow-down in the real economy. At that time, the Bank was trying to reduce the inflationary pressures which had pushed underlying inflation above two percent, the top of the target to which we were committed until December of that year.
But what turned a projected slow-down into an actual fall in GDP was the combined impact of the Asian crisis and a prolonged drought along the eastern coasts of both Islands. Neither of these factors could have been foreseen back in late 1996, when the monetary conditions which affected the real economy in the first half of this year were being determined.
As recently as October 1997, the International Monetary Fund projected, in its World Economic Outlook, that world growth would continue at over 4 percent per annum for the foreseeable future. In November, when we were preparing our December Monetary Policy Statement, the mean of the Consensus Forecasts for the 14 countries which constitute our main export markets was that GDP in those countries would grow by 3.4 percent in 1998 (weighted on the basis of New Zealand's exports). Last month, as we were preparing the projections for this August Statement, the mean of the Consensus Forecasts was that GDP in the same 14 countries would in aggregate grow by only 1.2 percent.
The main factor in this deterioration has been the very much weaker state of the Japanese economy than projected late last year, though the very weak condition of South Korea and some of the other countries of East Asia, and the slow-down in both the United States and Australia, have also been relevant. The sluggish state of demand in external markets has had a dramatic effect on the foreign-currency prices of many of our major commodity exports, and in some cases has also sharply curtailed export volumes.
At the end of June, I suggested that the Asian crisis could well constitute the most adverse shock to hit the New Zealand economy since the oil shocks of the `seventies. So far, I have had no reason to change that view.
To make matters worse, the drought turned out to be more severe and more prolonged than we (and indeed most other people) had expected in the second half of 1997. This had a marked effect on GDP in the March quarter, and indeed will have an adverse impact on the economy for many months yet, as farmers struggle to rejuvenate their pastures and rebuild their herds.
In the second half of 1998, we see a more gradual pick up in growth than previously projected. Several of our major markets remain in recession and seem likely to remain sluggish for some time. At home, residential property prices look somewhat weaker than we had projected in May and this, together with an increase in unemployment, suggests that consumer demand will grow rather more slowly than previously projected.
But going into 1999, we still see quite a strong pick-up, with growth averaging a little over four percent in each of the years to March 2000 and March 2001. This expectation is based on a number of factors, of which the main ones are:
- First, the sharp fall in the real exchange rate which has taken place over the last 16 months has greatly improved the competitiveness of New Zealand producers, and assisted them in penetrating new export markets.
- Second, the balance sheets of New Zealand banks and corporates are in very much better shape than they were in the early `nineties, and this should assist the economy to respond to the lower exchange rate.
- Third, we are projecting that external demand for our exports will be a little stronger next year than this, as East Asian economies stop contracting, steady but slightly slower growth continues in Australia and the US, and Euroland growth picks up further.
- Fourth, we are projecting a moderate increase in investment next year, partly on the basis of our business contacts' suggesting that new investment is currently being deferred rather than cancelled and partly on the basis of anticipated public sector investment in infrastructure, health and education.
Already there are signs that both business sector and consumer confidence have improved rather sharply over recent weeks. While GDP growth of one percent per quarter sounds implausibly optimistic at this stage, it is worth recalling that GDP grew by at least 1.5 percent per quarter in each of the first three quarters of 1993, as New Zealand emerged from the recession of the early `nineties.
Outlook for inflation, and implications for monetary conditions
Because growth has been appreciably slower than expected three months ago, it seems clear that there is more spare capacity in the economy now than we expected back in May. This is reflected in the output gap (graph 13), which is expected to be both larger and more long-lasting than previously projected.
As a result of this excess capacity, and weak international prices for both our imports and our exports, inflationary pressures seem likely to remain weak for some time. Measured inflation is being further restrained by some sector-specific developments (such as new entrants into petrol retailing and electricity distribution, and intense competitive pressures in the telecommunications market), and by policy measures such as the removal of restrictions on parallel importing.
In 1999, we see some increase in measured inflation as the direct effects of recent exchange rate depreciation finally come through to some extent, but at this stage our best estimate is that CPIX inflation will remain between one and two percent per annum over the period covered by our projection.
There are some risks to that inflation outlook. Already, some measures of inflation (such as the weighted median) suggest that inflation may actually be somewhat higher than suggested by the CPIX, while expectations of inflation in the household sector remain much higher than measured inflation. There is a risk that we may be under-estimating the potential for prices to be pushed up by the exchange rate depreciation. Clearly the Bank will need to be mindful of these risks, and to monitor new information carefully as it comes to hand.
Our projection is based on a markedly easier track for monetary conditions than we thought was appropriate three months ago. As already mentioned, we now believe that monetary conditions of around zero on our Monetary Conditions Index are appropriate for the December quarter (we had projected 275 for the December quarter in our May Statement).
Beyond that, we see scope for some further easing, with the MCI levelling off at around -225 in the second half 1999, before firming gradually in 2000. But as always, our forward track for monetary conditions is highly conditional, and will be reviewed in the light of emerging data. We have no desire to over-do the easing: that would only require a more vigorous tightening further out, to the detriment of everybody.
As has often happened in the past, financial markets have reached very much the same conclusion as the Bank has, so that monetary conditions in recent days have been very close to the level suggested in today's Statement. This confirms our view that the better informed financial markets are about our likely reactions to new information, the greater the probability that monetary conditions will evolve in a way consistent with our policy objectives.
Looking ahead, there are plenty of uncertainties.
For example, future revisions of the March quarter GDP number may well show that output fell by rather less than the preliminary figure suggested and that, as a result, the output gap is smaller than now seems possible. Confidence may continue picking up more strongly than now expected, perhaps as a result of the sharp fall in interest rates recently. In that event, importers and retailers may well try to pass on to consumers to a greater extent than now expected the increased New Zealand dollar prices they have been paying as a result of the depreciation in the exchange rate.
On the other hand, the international environment could turn out to be even weaker than now projected, with further difficulties in Asia, and possibly sharper slow-downs in the United States and Australia, perhaps triggered by an apparently-overdue correction in US equity prices. Domestically, consumer spending could be eroded by house prices falling by more than the five percent we have assumed they will fall (in real terms) over 1998.
From a policy point of view, it is quite a tricky call. Our sense is that the world economic situation is fragile. It is rare for such a large part of the world economy to be in sharp contraction, with a quick return to robust growth not just around the corner. At the same time, some important economies, including the world's largest, are at the tail end of a long period of growth, and are showing some of the signs of imminent correction. If these economies continue to grow, weakness in Asian and other emerging economies will be buffered. If not, a major world recession is possible.
On what scenario should we base policy? Section 7 contains a scenario in which world growth is assumed to be much slower, and it shows, not surprisingly, that in that event we should be engineering significantly easier monetary conditions. But it is by no means certain that a much slower world economy is the most probable outcome, and we also have to be mindful of the risks of higher inflation that I have already mentioned.
Given all the uncertainty, our view is that the Bank will need to continue to adopt a flexible approach to allowing the financial markets latitude to adjust. This flexibility has been well illustrated since the May Statement.
Flexibility in the level of monetary conditions
It may be helpful at this point to make a few comments about the Monetary Conditions Index.
The MCI was developed as a very broad guide as to how much, all other things remaining equal, short-term interest rates need to change in order to keep overall monetary conditions constant if the exchange rate changes. Of course, seldom do all other things remain equal. Movements in the MCI thus always need to be interpreted in the context of everything else that is happening that has the potential to influence inflation pressures in the period ahead.
When in June 1997 we first began projecting the monetary conditions which would be required to deliver inflation close to the middle of our target band (in contrast to projecting the inflation rate which would result from given assumptions about monetary conditions), we provided markets with a rough indication of how we expected actual monetary conditions to behave relative to those specified in our projections as being consistent with the inflation objective.
In broad terms, and with considerable qualification that bears re-reading, we indicated that ".....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."
With that in mind, how should the markets interpret the development of the MCI over the past quarter, and what does the last quarter say about the Bank's likely behaviour in the future?
The last quarter can best be viewed as unusual. Only a few weeks after the release of the May Statement, it became clear from the flow of emerging data that there was justification for a weaker MCI track than had been outlined in that document. The renewed weakness in Asia, the depreciation of the yen and the Australian dollar, and the evidence of greater-than-expected weakness in the domestic economy (especially the first quarter GDP result) all pointed in the direction of weaker inflationary pressures. As that new data emerged, financial markets generally adjusted smoothly in the direction of a lower MCI. In that situation, there was little case for a Reserve Bank response.
Have we become more tolerant of deviations from the specified MCI? As I have noted, the last quarter provided sound reasons for substantially greater deviation from `desired' than we have seen, or have been prepared to accept, in the past. But deviations of the scale seen between May and August cannot be assumed to recur. If they do, they will need to be similarly justified by the flow of new information.
The Bank has, however, attempted to become less immediately responsive to market developments. The move to limit responses to the once-weekly window was a deliberate step in that direction. In making our weekly assessments, we are explicitly considering the duration as well as the extent of any deviations of the MCI from that announced, in the light of new information regarding the inflation outlook. As the quarter proceeds, we also pay some attention to the projected level of the MCI announced for the subsequent quarter.