Monetary Policy Statement for November 1998
Speaking notes for briefing journalists on the release of the November 1998 MPS
Good morning, and welcome to the release of our 20th Monetary Policy Statement.
Overall assessment and level of conditions
Since the release of our last Monetary Policy Statement in August, the economic outlook has deteriorated both internationally and in New Zealand. We now project weaker growth and more subdued inflation pressure than we projected in the August Statement, with the outlook now similar to the `weaker world' scenario illustrated in that Statement.
The Bank has viewed the easing in monetary conditions since August as broadly consistent with this decline in inflation pressure, and has not sought either to impede or to accelerate it to any great degree. Based on the projections in this Statement, we see an MCI of around minus 400 as appropriate for the March 1999 quarter. This is 250 MCI points easier than we projected for that quarter back in August and about 150 points easier than market conditions yesterday, but only a little easier than where conditions have been over recent weeks.
Uncertainty about world economic prospects continues to cloud the assessment of the outlook for New Zealand. Since August, the idea that a serious global recession may be possible has gained currency. While some positive developments have emerged internationally over recent weeks, with an easing of monetary policy in a number of countries and some encouraging signs that Japan may be moving to deal with the problems in its banking sector, at this stage we are not yet inclined to take these glimmers of light for the world economy as the beginning of a bright new day. Moreover, the extent of unused capacity in the New Zealand economy suggests that there is considerable scope for growth before the re-emergence of significant inflationary pressure.
At the same time, with circumstances able to change rapidly, caution seems warranted. Monetary conditions are now at quite a stimulatory level, and their full effects will take some time to come through in the economy. Given all these circumstances, we project monetary conditions to remain roughly stable for some time. However, if events unfold in a manner different to that now projected, we will of course adapt our policy stance as necessary.
The outlook for growth and inflation
To elaborate on our view, it is clear that the economy went into recession in the first half of this year: even with modest growth resuming in the second half, it is our current assessment that GDP for the whole of calendar 1998 will be 1.5 percent down on 1997.
To some extent the slowdown in the New Zealand economy over recent quarters was the result of firm monetary policy in late 1996 and early 1997, at a time when inflation was pushing the top of our inflation target and the Asian crisis was not even a distant cloud on the horizon. Coming on top of this slowdown, the sharp contraction in some of New Zealand's major trading partners and the drought have together taken a considerable toll on domestic activity. The agricultural sector and other export sectors have been hit the hardest, of course, but the general climate of uncertainty and economic weakness has dampened activity in other areas of the economy too. Looking ahead, we expect that it will be early 1999 before quarterly growth rates of GDP begin to gather strength.
We now project GDP growth to reach 3.4 percent for the year to March 2000, and 4.0 percent for the year to March 2001. (In August, we expected 4.0 percent and 4.7 percent respectively.) Compared to the last economic recovery, in 1991-92, the projected recovery will be quite modest. There are various reasons for this judgement, and two in particular. First, the international environment is projected to remain relatively weak for some time, providing less impetus to exports than was the case in 1991. Second, household sector debt levels are now very much higher, relative to household sector income, than they were in the early nineties, which suggests that growth in consumption expenditure will be less vigorous than it was in the earlier recovery.
We devote Chapter 2 of the Statement to a fuller discussion of the differences between the projected recovery and the recovery from the 1991 recession. It is sufficient to note at this point that one of the major drivers of the projected recovery is stimulatory monetary conditions. In the previous recovery, by contrast, robust growth in household expenditure funded by a sustained rise in borrowing, high rates of growth in business investment following restructuring of the business sector, and a relatively buoyant world economy played large roles.
The weakening of demand has led to the emergence of substantial spare productive capacity. Although GDP growth is projected to pick up to above-trend rates over the projection period, we do not anticipate this excess capacity to be fully absorbed until a little beyond the end of the projection period. This persistent excess capacity will continue to place downward pressure on inflation through the projection period.
We project CPIX inflation to remain at around its current levels until the middle of next year, as further pass-through effects from the recent substantial fall in the exchange rate come through in tradeables inflation. CPIX inflation is then projected to fall slightly to just below the mid-point of the inflation target. I should acknowledge that we have projected CPIX inflation below the mid-point of the target in the past, and it has not occurred yet! We shall see.
It's worth emphasising, as we have many times before, that our inflation and growth projections depend on our projected path for monetary conditions. In turn, our assessment of the appropriate path of monetary conditions is driven by the outlook for inflationary pressure, which is the product of many factors.
If things occur to change the outlook for inflationary pressure, we will project a different monetary conditions path, consistent with our aim of keeping inflation close to the midpoint of the target range. This means that, in general, the inflation projection will not vary a lot from quarter to quarter. What will change rather more is the level and path of monetary conditions, which acts to offset the effects of unexpected events on overall inflationary pressure.
As discussed at length in our August Statement, dealing with unexpected developments is inherent in the formulation of monetary policy. And as already noted, the major uncertainty as we look ahead now concerns how the world economy will evolve.
Since August, the financial difficulties that began in East Asia have spread to Russia and Latin America. Aversion to risk on the part of international investors has become pronounced, and this has led to often-violent movements in the prices of currencies, bonds, and shares.
In the last few weeks, there have been some positive developments internationally. Several central banks, including the US Federal Reserve, have reduced their interest rates, alleviating to some degree concerns about a `credit crunch' becoming a reality in global markets. (A `credit crunch', of course, is the situation in which credit becomes prohibitively expensive, or simply unavailable.) Meanwhile, the Japanese authorities have taken steps to help resolve the debt problems of their banks.
Although financial markets in New Zealand have remained relatively calm, relative to offshore markets, while these events unfolded, they have been caught up to some degree nevertheless. In particular, the volatility of offshore markets has had an impact on the way the mix of domestic monetary conditions has evolved as the overall level of conditions has progressively eased.
Investors who had previously positioned their investments in the expectation that the New Zealand dollar would fall in value have been reducing the size of those positions, by buying New Zealand dollars. This has meant that the recent easing in monetary conditions has come about principally through lower interest rates, rather than through a lower exchange rate. Indeed, New Zealand 90 day interest rates have fallen by around 200 basis points over the last three months, while the TWI exchange rate has remained relatively stable.
Although there are tentative signs that October may have seen the worst of the global financial market volatility, it's unlikely that the recent erratic behaviour of financial markets has ended. The mix of monetary conditions which we have assumed for New Zealand over the next few years is, as always, a relatively mechanical result of some simple relationships between projected domestic and international interest rates. On this occasion, we have assumed a relatively flat profile for both 90 day rates and the TWI.
What actually happens to the mix, however, will depend on several things, including investors' assessments of the risk of holding New Zealand dollar assets, and movements in interest rates here and abroad. Assessments of risk may well be affected by developments in the current account. In August, we projected a reasonably rapid fall in the current account deficit over the next couple of years. Our present projections have the already-high deficit remaining high for rather longer, as a result of the further deterioration in the world economy. But as I have observed many times before, these things that affect the mix of interest rates and the exchange rate are outside our control, and we do not try to influence that mix. What we can influence is the level of monetary conditions, and we will seek to keep the level of conditions appropriate to ensure that inflation is under control whatever the mix.
Events occur and circumstances change quickly and without warning. In setting monetary policy in such an environment, we continue to believe that there are substantial benefits in informing the public about how we see the economic outlook (notwithstanding the fact that we would save ourselves some embarrassment at times if we did not!). As well, we continue to believe that there are advantages in allowing financial markets considerable scope to adjust monetary conditions as events unfold. The flow of emerging news is continuous, whereas formal projections by the Bank are made only once a quarter.
In releasing our August Statement, I mentioned that we had, over the previous three months, sanctioned rather more divergence between actual monetary conditions and the level indicated as appropriate in May than had been our custom previously. I suggested that that degree of divergence was likely to be unusual, and was the result of the very considerable deterioration in the world economy over that three month period.
The same comment can be made about the most recent three months. The global economy has suffered some rather major shocks, and that has caused a general downgrading of the outlook for world growth next year. In late September, it was revealed that the New Zealand economy had contracted in the June quarter. These developments in turn led both the Reserve Bank and financial markets to see less inflationary pressure in New Zealand in the years ahead, and as a consequence to see easier monetary conditions as being appropriate.
The reality is that we are still in unusual circumstances, where the chance of large unforeseen developments hitting the economy remains high. Under these conditions, I am not inclined to specify an appropriate range within which monetary conditions should move over the next three months. Nor am I saying of course that we will sanction monetary conditions at any level. Our response to developments will depend on our assessment of the implications for the inflation outlook, which at the moment calls for monetary conditions to be somewhat easier than has been the case in recent days.