RBNZ comments to Parliament's Finance and Expenditure Committee

May 31 2000

Thank you, Chairman

Let me first offer apologies on behalf of Dr Brash. In my 5 years as Deputy Governor, this is only the second of these hearings he has missed. Dr Brash is currently in Europe for, amongst other events, the annual meetings of the BIS.

Let me also introduce my colleagues - Tim Ng, Manager Forecasting, and Andy Brookes, Manager of our Monetary Policy Implementation section.

I would like to start with a brief statement drawn from Chapter 1 of our document - largely to re-emphasise some key points which may have been lost in the noise during the 2 weeks since our Statement was first released. I will then touch on a couple of other issues of relevance.

Some key points from the May Statement:

We had strong growth over the second half of 1999. As a result, the level of GDP in the December quarter was 5.8 percent higher than it had been a year earlier. Indications are that growth has continued into 2000, albeit at a more subdued pace.
We estimate that over the past two years, the economy has grown to the point where demand is now exerting pressure on the economy's supply capacity and beginning to create inflationary pressures.

This conclusion is supported by a range of indicators, including high levels of capacity utilisation, anecdotes about the difficulty which employers are having in finding staff in some sectors and some signs of emerging domestic price pressures.

At the time we completed our forecasts, we pointed also to the high levels of confidence which businesses had about the prospect for their own sales and profitability.

The international economy remains strong, with the US and Australia maintaining high growth, Asia continuing its recovery, Europe looking more robust and signs that Japan may be emerging from its protracted recession.

Measures of inflation have begun to turn up, reinforcing our sense that demand is beginning to put pressure on capacity. We see those signs in pricing intentions data, inflationary expectations, and trend measures of inflation.

Since May 17 there has been some new data - with fairly mixed implications. Business confidence indicators have weakened noticeably, while building activity in the March quarter was stronger than expected and the latest producer price indices show clearly the impact of the lower exchange rate and higher oil and other commodity prices.

Additionally, there have been petrol price increases and increases in taxes on tobacco products, which will likely see a CPI outcome for the June quarter closer to 0.8 percent than the 0.3 percent we projected in our Statement. These tax and exchange rate related price increases, however, are ones we tend to "look through" - in other words, there is no necessary monetary policy reaction provided they do not spark a second round of more generalised inflationary pressures.

All these factors, together with upcoming data, will be taken into account as we make our assessments ahead of the next review of the OCR, which is scheduled for 5 July. It would be premature to speculate now on how things might look at that time. But it may be helpful if I outline the broader context within which we see monetary policy being shaped as we go forward.

From their low levels of 1999, interest rates have risen to a zone that we judge as broadly neutral. That is, we now see interest rates as neither stimulating nor constraining demand - acknowledging the normal bounds of uncertainty around such judgements.

The exchange rate, on the other hand, remains very low - indeed has become more so since the release of our Statement. At these levels, the exchange rate is unambiguously supportive of activity in the export and import-competing sectors. Overall then, we see monetary conditions as somewhat stimulatory or supportive of economic activity.

But this support will not be seen across the board. We can think of this as something of a Swiss cheese recovery - plenty of overall substance, but with holes scattered throughout.

We can expect to see the export sector - generally - enjoying robust profitability and expanding relatively quickly. In doing so it will provide a sound base for growth.

At the same time, we may well see the domestic economy, or parts of it, remaining fairly subdued. This will be particularly the case if householders' appetite for additional debt has finally waned - in the way we have suggested was possible in recent Statements.

One further comment on the exchange rate. At current levels, the exchange rate is clearly "cheap" by most of the conventional yardsticks. Certainly, in crude real - or inflation adjusted - terms, the TWI is at the edges of the levels reached in previous cycles over the past 30 years or so. Of course, the strength of the US dollar is an important part of the explanation for the weakness of the Kiwi and, indeed, other currencies of late. But it is hard to envisage that current exchange rate relativities will be maintained for any extended period and our projections assume some gentle appreciation over the next year or so.

While the weaker exchange rate helps underpin activity in the export sector, it has other implications too - particularly with respect to inflation. In common with a number of other inflation targeting countries, we have seen surprisingly little direct impact in local pricing from the decline in our exchange rate over the past couple of years.

That is unlikely to last. As already noted, we expect the direct price effects of the exchange rate decline will become more visible in our inflation measures over the next couple of quarters. Also noted earlier, there is no automatic monetary policy reaction to that development. It is already too late to adjust monetary policy to counter those direct price effects - even if we felt that necessary. The focus for our policy decisions is more medium term - on the impact that the lower exchange rate has on underlying demand pressures relative to the economy's capacity to meet those demands over the course of the next one to two years.

That is the broad context. As usual, the implementation of monetary policy from one review date to the next requires that we continue to gather data and assess prospects. While we lay out a future track for interest rates in each of these Statements, those forward tracks are highly conditional on subsequent developments turning out as anticipated. Such is rarely the case. As new information emerges, policy judgements need to be reassessed. We have ample scope to do that with four Monetary Policy Statements and four additional OCR reviews each year. Adjustments are made as new information suggests that is required.

Thank you Chairman. I am happy to take questions.

Murray Sherwin
Deputy Governor
Reserve Bank of New Zealand