Governor Don Brash's speaking notes to Parliament's Finance and Expenditure Committee on the August MPS, 4 Oct 2000
4 October 2000
It is almost exactly six months to the day since I last appeared before this Committee, and the prospects for the economy have changed quite considerably over that time.
Back in March, we thought it likely that the economy would slow from its rapid growth in the second half of 1999, but would continue to grow at a rate of 3 to 4 per cent per annum. We estimated that the surplus capacity which had been a feature of the economy over much of 1998 and 1999 had been largely drawn back into production, and indicated that, with the exchange rate at levels then regarded as "near historic lows", at around 54 on the trade-weighted index, it was appropriate that the Official Cash Rate move interest rates in a less stimulatory direction. This move was in line with the expectations of most commentators, and was fully priced into financial markets.
At the time of our May Monetary Policy Statement, there seemed to be clear evidence that general inflationary pressures were likely to increase over the next year or so unless there was some further firming in monetary conditions. The exchange rate remained around 54 on the trade-weighted index and seemed to be providing strong stimulus to the export sectors. The economies of our major trading partners similarly seemed to be buoyant. Both business and consumer confidence were high as at the end of April, when we were finalising the Statement; levels of capacity utilisation were similar to those in the mid-nineties; there were anecdotes of labour shortages coming in from many parts of the country; tourist arrivals were running at a rate some 18 per cent above the same month in 1999; and the latest official statistics indicated that there had been a strong 2.8 per cent increase in hours paid during the March quarter. Nevertheless, we thought that, with a relatively moderate increase in interest rates, and some then-projected appreciation in the exchange rate, inflation would continue not much above the mid-point of our target band. Again, the May increase in the Official Cash Rate was in line with the expectations of most commentators, and was fully priced into financial markets.
A great deal changed between the preparation of that May Statement and the preparation of our August Statement. To begin with, the near-term outlook for CPI inflation deteriorated markedly, with a sharp increase in the excise tax on cigarettes announced even before the May Statement was actually published, a sharp further increase in international oil prices, and a fall (instead of the assumed rise) in the exchange rate. The near-term growth outlook also deteriorated markedly. Reported business confidence fell very sharply during May and again in June, and consumer confidence with it. It became clear that the very strong contribution made to March quarter GDP by the construction sector was likely to be reversed in the June quarter, while weather factors were likely to lead to a downturn in output from some parts of the agricultural sector. Just prior to finalising the Official Cash Rate in August, we learnt that official data which had suggested a strong increase in hours paid during the March quarter had been in error, and that instead of a 2.8 per cent increase the corrected data suggested a very small fall in hours paid. Together, this information suggested that the economy had been significantly weaker by the end of the June quarter than anyone could reasonably have foreseen in March, or expected in May.
So at that point, in August, we projected that CPI inflation would reach the top of the 0 to 3 per cent target band by the end of this year, and that there would be a small fall in GDP in the June quarter and a rise of only some 0.5 per cent in the September quarter. The inflation spike to 3 per cent wouldn't last, but on the basis of still-strong growth in the economies of our trading partners, and an exchange rate around 51 on the trade-weighted index, we still felt that there would probably be a need for some further small increase in interest rates some time over the next few quarters to ensure that inflation gradually returned to nearer the middle of the target band.
But we acknowledged that there were two alternative scenarios which were quite plausible, and which would have very different implications for the future track of interest rates.
In one scenario, business confidence would bounce back strongly from what seemed to be an unreasonably large fall in the generally healthy circumstances; growth would pick up quite strongly; in this environment businesses would be successful in raising prices to recover the increased costs arising from the lower exchange rate and the increased price of petroleum products; wages and salaries would rise rather strongly; and there would be a need to increase interest rates quite significantly to keep underlying inflation under control.
In the other scenario, business confidence would remain weak (perhaps feeding on itself, perhaps reflecting an underlying malaise that was not yet obvious in the hard numbers); growth would remain similarly weak; businesses would be unable to raise their prices to restore profit margins squeezed by increased costs; there would be little ability to increase wages and salaries; and there could well be a need to reduce interest rates to prevent the emergence of a deflationary situation.
On balance, we decided, as we had when we reviewed the Official Cash Rate early in July, to make no change in the OCR.
I should note as an aside that, although we did not increase the Official Cash Rate in either July or August, we believe it was right to have increased the OCR in the earlier part of the year. There can be little doubt that, without those increases, the exchange rate would be even lower than it is at present, and CPI inflation pressures probably higher.
Where are we today? Well, the near-term outlook for inflation has deteriorated further over the last six weeks or so. International oil prices have been volatile, but have been higher than assumed when we prepared the August Statement. The exchange rate has fallen still further, and at around 47 on a trade-weighted basis is some 15 per cent lower than the level assumed for this time back in May, and even some 9 per cent lower than the level assumed in the August Statement. No doubt in large part as a result of these developments, the National Bank's survey of business opinion in September found that a net 70 per cent of businesses in the retail sector, and a net 60 per cent of those in the manufacturing sector, intend to increase their prices over the next three months. It now seems likely that CPI inflation for the year to December this year will well exceed 3 per cent.
The economy has also turned out to be even weaker than we had projected in August, with production GDP falling by 0.7 per cent in the June quarter, and some commentators expecting a further fall in GDP in the September quarter.
This morning, we announced that there would be no change in the Official Cash Rate as a result of our review of the outlook for medium-term inflation this week.
And the rationale for that decision is essentially that the medium term inflation outlook remains unclear. Although there will clearly be a sharp increase in CPI inflation in the near term, most of that increase is the direct result of factors which are not expected to have an impact on ongoing inflation, which is the proper focus of monetary policy. Indeed, abstracting from the direct effect on the CPI of the increase in cigarette taxes, international oil prices, and the sharp fall in the exchange rate, it seems at this stage likely that inflation will remain comfortably within the target range.
Further out, although the economies of our trading partners continue to be reasonably strong and the exchange rate is obviously providing strong support for activity in the export and import-competing sectors of the economy, business confidence remains at moderate levels and consumer confidence is marginally on the negative side of neutral. Credit growth is low, and house prices flat to falling somewhat. This is an environment in which price increases may cost businesses sales, and wage increases beyond productivity may cost employees their jobs. So there is a tension between a growing desire to recoup higher costs of living and of doing business on the one hand, and, on the other, an environment in which doing that is increasingly difficult.
So we have left the OCR unchanged again.
As before, this tension may be resolved in various ways. It is possible that business confidence will recover more strongly as the increased competitiveness of New Zealand production stimulates additional investment and further growth in employment. This might make it easier for businesses both to increase the wages and salaries they pay and at the same time rebuild profit margins by increasing prices. This would require the Bank to increase the Official Cash Rate in order to protect the hard-won gains of low inflation, and this is even more the case if the exchange rate remains at current low levels.
But it is also possible that there will be a reversal in the moderate recovery in business confidence, perhaps as a result of a sharper-than-expected slowdown in activity in our trading partners, or perhaps as a result of some totally unforeseen development. As we noted was a possibility in our August Statement, this might well lead to a greater risk of deflation than of inflation, and require a reduction in the Official Cash Rate.
There is a third scenario, and that is of a situation where confidence, and so economic growth, are low but where there is an aggressive push for higher prices and higher incomes, perhaps from those of us in the non-tradable sectors trying to insulate ourselves from the fall in real incomes implicit in the fall in the exchange rate and the rise in international oil prices. That situation would run the risk of creating low growth but relatively high inflation, often referred to as stagflation. A situation of that kind robs savers, savages those on fixed incomes, and enriches speculators. In that situation, the Bank would have to increase the Official Cash Rate to control inflation, even though, in the short term, that would further damage economic growth.
Given the continuing uncertainty, however, leaving the OCR stable at this point in time seemed our best course of action.