Monetary and fiscal policy and their impact on exporters
Over the last few weeks, there have been a number of concerns expressed about the way in which monetary policy is being conducted in New Zealand: accusations of inconsistency and `flip-flopping' have been made, and one commentator has suggested that Bank staff could with advantage take a course in writing plain English. Even more substantively, a great deal of concern has been expressed about whether the way in which the Bank seeks to keep inflation under control is in fact doing more harm to the economy than any possible good that might flow from low inflation.
It won't surprise anybody when I say that I do not agree with those who accuse us of inconsistency and `flip-flopping'. Nor do I agree with those who claim that the manner in which the Bank implements monetary policy is doing more harm than good. But I do have some real concerns about some aspects of the present situation, and today I want to share some of those with you.
The recent past
But first let me talk about the recent past. On 15 October, it was announced that underlying inflation for the September quarter had come in at 0.3 percent, much lower than the 0.7 percent that we had expected as recently as mid-September. This was clearly good news, but was it the `conclusive evidence' of the abatement of inflationary pressures which the Bank had said it was waiting for before sanctioning an easing in overall monetary conditions? Financial markets appeared to think so, and short term interest rates started falling quite rapidly, along with the exchange rate.
Our analysis indicated otherwise. The inflation result for the September quarter was almost exactly in line with our forecast, except for a single sub-component within the index, that relating to house construction costs. The model we use to forecast house construction costs had suggested that, if historical relationships remained relevant, house construction costs should rise by a little over 4 percent for the quarter. That seemed a little too high to us, so we had included an increase of only 3.4 percent in our forecast. In the event, they rose by only 0.1 percent. Either historical relationships had broken down entirely, rendering our model useless, or this was an aberrant number. Given the very good performance of our model over history, and the plausibility of the connections that it makes between house prices and the sale price of newly-constructed homes, we thought it quite likely to be an aberrant result.
Accordingly, we issued a statement to that effect on 16 October (attached). The statement said that the September inflation outcome was good news, but it was `only one number', with most of the deviation from forecast being in a single area, construction costs. We indicated that `at this stage any further easing in monetary conditions would be inappropriate'. At the time, 90 day bank bill rates were at 9.4 percent and the exchange rate, measured by the trade-weighted index (TWI), was at 66.5.
Note that the statement made absolutely no reference to interest rates as such, or indeed to the exchange rate. It simply said that at that stage `any further easing in monetary conditions would be inappropriate'.
Within a few trading days, the exchange rate had appreciated sharply, with the TWI at almost 68, and 90 day interest rates only a little changed, at 9.3 percent. The combination constituted quite a significant firming in overall monetary conditions, indeed to the extent that it was our judgment that, if these conditions were sustained, inflation could have been driven below the bottom of the 0 to 2 percent target range during the second half of 1997.
Accordingly, we issued our second statement, dated 24 October (attached). This was a longer statement, making it clear that the `marked tightening in overall monetary conditions' which had occurred over the preceding days had left conditions `a little firmer than needed for the task of keeping inflation inside the target range'.
What happened over those few days to swing conditions around from easing too quickly, to being too tight? There are two things that are relevant.
First, although there had been no specific mention of interest rates in the first statement, it appears that many in financial markets interpreted the statement as implying that the Bank would be quite unwilling to see 90 day interest rates fall much below 9.5 percent. With such an apparent commitment to preventing interest rates from falling, the New Zealand dollar seemed a one-way bet, and the exchange rate rose strongly.
For some considerable time now we have made it explicit that we fully accept that both interest rates and the exchange rate affect inflation, and that for this reason we can be more or less comfortable with a range of interest rate/exchange rate combinations. But it seems that we still have considerable work to do to remind people of that fact.
Many market participants fully understand this, of course, and indeed a number of people have published their own estimates of what combinations of interest rates and exchange rate produce equivalent effect on inflation; in the jargon, their own estimates of the Monetary Conditions Index.
At some stage, we may publish our own Monetary Conditions Index. To date we have been reluctant to do so, partly because the state of our knowledge does not allow any very firm judgements to be reached about the precise nature of the relationship, partly because we suspect that the relationship may be quite unstable over the course of the cycle, and partly because, though Monetary Conditions Indices are often referred to as if they were simply a two dimensional relationship between, say, 90 day interest rates and some measure of the exchange rate, we suspect that in fact the relationship is very much more complex, and should include what is happening to interest rates further down the yield curve, what is happening to particular bilateral exchange rates, and so on.
But in the meantime, it is certainly important to remember that the Bank is looking at both interest rates and the exchange rate in making its assessment of the appropriateness of monetary conditions.
(There may also be a need for the Bank to look again at its own signalling techniques. To date, and with only rare exceptions, we seem to have been able to convey our view of monetary conditions very effectively through our quarterly inflation forecasts and comments made in conjunction with the publication of these. We have not found it necessary to make many additional comments about monetary conditions or to take other specific actions. Indeed, it is worth recalling that, with the exception of the two statements made last month, we have not found it necessary to express an opinion on monetary conditions other than in the context of our quarterly inflation forecasts since early November last year, while we have not had reason to take a specific action to firm or ease conditions since July of last year. Far from talking a lot to the market, we have for some time been largely silent about monetary conditions.
I believe that this implementation framework, relying primarily on the release of detailed inflation forecasts each quarter, has served New Zealand well. But it is not perfect - we can easily communicate to the market that we want monetary conditions tighter, or easier, but the present approach is less well suited to telling the market how much tighter, or how much easier. This has not seemed a major problem to date, since most market participants seemed to understand the framework well. But with more and more of the participants in the New Zealand market being overseas institutions, familiar with a more traditional, directive, approach to monetary policy implementation, where the central bank directly and regularly changes one particular interest rate, the potential for confusion and misunderstanding has grown. After our 24 October statement, for example, with 90 day bill rates trading at 9.05 percent, one foreign investor in the New Zealand market asked me why we had reduced 90 day rates by 25 basis points, and not taken them down to an even 9.00 percent, and seemed genuinely puzzled that the Bank had neither set the `new' 90 day rate nor determined the precise movement in such rates.)
Capital inflow and the mix of monetary conditions
But a second factor was also relevant, and that was the dramatic increase in capital inflows which New Zealand has experienced in recent months: taken in conjunction with the impression that the Bank would not allow interest rates to fall, this produced a strong increase in the exchange rate.
It is about this capital inflow, its causes and its effects, that I want to talk for the balance of the time available.
The first point to note about the capital inflow is that it illustrates once again that central banks can not control the mix of monetary conditions. In other words, central banks can tighten monetary conditions or they can ease monetary conditions, but they can not determine whether a tightening takes the form of increased interest rates with a stable exchange rate or of stable interest rates with an increased exchange rate, or of some combination of both. Likewise, central banks can ease monetary conditions, but can not determine whether that easing takes the form of lower interest rates with a stable exchange rate, of stable interest rates and a lower exchange rate, or of some combination of both. That mix is ultimately determined by the opinions and judgements of countless thousands of individuals, locally and overseas. In New Zealand's case, those individuals reach their decisions on the basis of views about both New Zealand and the rest of the world.
Those who doubt that and who suggest that lowering interest rates would `obviously' lead to a reduced exchange rate, need look no further than the experience of the last few weeks: following our 24 October statement, both interest rates and the exchange rate fell briefly, but within a week, with interest rates down by some 40 basis points, the TWI was back to a level slightly above that at which our statement had been issued. Both in New Zealand and overseas there are plenty of examples of exchange rates rising while interest rates are stable or falling (New Zealand in 1993 or Japan in 1995, for example), and plenty of examples of the reverse. The suggestion that the Reserve Bank could, if only it were not so stubborn, shift the mix of monetary conditions to one more beneficial to, say, the export sector is, alas, wishful thinking.
The second point to note about the inflow is that, at its present level, it is an important issue for the incoming Government to be aware of. In October alone, it is estimated that foreign investment in New Zealand dollar interest-bearing securities amounted to some $2 billion, and the flow is continuing strongly into November, often in the form of so-called Euro-kiwi or Samurai bond issues which tap investment funds from many thousands of retail investors in Europe and Japan.
As you are acutely aware, monetary policy has been working to restrain the inflationary pressures created by an economy trying to grow at or above its sustainable growth rate for the last two or three years. Much of the inflationary pressure has shown up in the domestic economy, with housing and the associated construction costs being a prominent factor - in part because of a strong surge in inward migration. At the same time, much of the force of monetary policy has been felt by those involved in international trade, some of whom have been hit from three directions simultaneously: higher interest rates, higher exchange rates, and weaker international prices for their particular products.
There is little doubt that a different distribution of gain and pain would have been preferable for the sake of the long-term health of the economy. Owners of Auckland property and of businesses providing services to the domestic economy (large city restaurant owners, for example) have typically been doing relatively well. Although they have been paying higher interest rates, they apparently feel that those interest rates are not all that high - or at very least, interest rates have not been high enough to deter a very strong growth in private sector borrowing. Household sector borrowing has been increasing at a rate of some 15 percent per annum over most of the last three years. Nor have interest rates been high enough to encourage saving in the form of term fixed-interest investments. The reality seems to be that many New Zealanders appear to look at current interest rates and compare them with either the much higher rates of the eighties, or with the recently-rapid increases in property prices, and find themselves overwhelmingly tempted to borrow more.
And, at the same time that interest rates have been too low to deter rapid increases in borrowing, the exchange rate has appreciated significantly - of that there is no doubt. Since the beginning of 1994, when monetary policy first began to lean against emerging inflationary pressures, the New Zealand dollar has appreciated by some 12 percent against the Australian dollar, 14 percent against sterling, 26 percent against the US dollar, and 27 percent against the Japanese yen. On a TWI basis, the New Zealand dollar has appreciated by nearly 19 percent since the beginning of 1994. And for three important and interrelated reasons, there has been more exchange rate appreciation than there might otherwise have been.
To begin with, New Zealand's economy has been out of phase with the economies of our major trading partners. Over the last few years, we became rather more overheated than did our trading partners, and we have taken rather longer to cool down to a moderate non-inflationary growth rate. As a result, while we have had to keep interest rates up, the Australian, American, Japanese, Canadian, and European central banks have been reducing interest rates or holding them at low levels. Our interest rates, especially for short terms, are in real or inflation-adjusted terms now well above those in comparable countries. The resulting interest rate differential between New Zealand and overseas has led to upward pressure on the exchange rate.
Secondly, the surge in inward migration that occurred over the last two years has been quite unusual in modern New Zealand experience. That surge has put particular pressure on the housing market, where constraints on short-term supply are significant. Although the skills and energy that are brought to New Zealand by these recent arrivals will be a very important contributor to our future performance, the additional short term pressures on demand have been noticeable. Higher interest rates have been required as a result, which in turn has meant more exchange rate appreciation.
Thirdly, fiscal policy has recently contributed to the need for rather tighter monetary conditions than might otherwise be the case. This is true notwithstanding the fact that New Zealand's performance in converting a very large fiscal deficit in the mid-eighties to a fiscal surplus was a truly remarkable achievement - New Zealand had substantially the largest fiscal surplus of any OECD country in the 1995/96 year - and that government continues to run a fiscal surplus. The tax reductions and expenditure increases announced in recent months amount to a substantial turnaround in the fiscal position, which has moved from a strongly rising surplus to a rather smaller one over quite a short period of time. And the extent of the turnaround, at some 4 percent of GDP over two years, represents a significant reduction in fiscal policy's braking action on the economy.
Let me be clear that when consulted by the Government in November 1995 during the planning for the 1996 tax cuts, the Bank indicated that the fiscal impulse should be able to be absorbed without excessive additional pressure on monetary policy. Subsequent events, observable only in retrospect, have altered circumstances. The New Zealand economy, buoyed by strong employment growth, by immigration and by high levels of business confidence, has proved very much more resilient during 1996 than anyone had expected in late 1995.
The net result has been that fiscal policy has reduced its braking action on the domestic economy at a time when the economy remains somewhat overstretched, and has thereby required monetary conditions to be firmer than otherwise. The extent to which the New Zealand economic cycle is out of phase with the rest of the world has thereby been exacerbated.
Fiscal issues are exacerbating the present situation in another way - not because of what any Government has done but rather because of the perception of what might be done. At the present time, there is a widespread public perception, evidently shared by the financial market, that the process of coalition-building is likely to result in a net additional fiscal stimulus - more government spending as political parties seek to accommodate the promises made by potential coalition partners. Until it is clear to what extent, if any, there will be additional fiscal stimulus, it is not surprising that the market reflects the general expectation that fiscal policy will be more expansive and that, as a result, delivering any low inflation target will require very firm monetary conditions.
These three interrelated influences - New Zealand being out of phase with the rest of the world, the pressure from migration flows and the turnaround in the fiscal situation - together have meant large interest rate differentials. And then an additional factor is added. At the present time, New Zealand enjoys a very high reputation for the economic reforms of the last few years. The world has seen a good record on inflation, a good record on growth (by the standards of most developed countries), an extraordinary move from large fiscal deficit to large fiscal surplus, and a reduction in unemployment without parallel in the OECD in a very long time. We are described in glowing terms in financial media all over the world. In that environment, it is hardly surprising that institutional investors seeking a place to invest their funds look at New Zealand as one possibility. And when they do, they see interest rates which, though too low to be ideal for our own domestic circumstances, look very attractive indeed in comparison to the rates available to them at home. In addition, they note that, in recent years, the New Zealand dollar has appreciated strongly. Under all the circumstances, it is hardly surprising that money pours in.
The problem is that these capital inflows - which in other circumstances might be very welcome - exacerbate the unfortunate distribution of gain and pain. The exchange rate is pushed higher, and interest rates are pushed lower. As our statement on 24 October noted, the further appreciation of the exchange rate places an even greater proportion of the burden on the export sector. At the same time, the lower interest rates take some of the disinflationary pressure off the domestic economy, and the housing market in particular. We concluded, reluctantly, that `in order to keep overall monetary conditions consistent with maintaining price stability, it appears that we will have to accept rather less interest rate pressure than might be ideal, and rather more exchange rate pressure than might be ideal.' That statement remains valid.
What solutions are available?
What is to be done? If things are not ideal, surely there are means of improving the situation?
Let me first draw an important distinction between temporary and more lasting forces at work in the economy. If the underlying factors leading to the capital inflow were of lasting relevance, then even though the inflow might cause transitional problems, it would nonetheless be welcome overall. Thus, for example, if the strong performance of the domestic economy in recent years were mostly associated with some lasting improvement in growth capacity of that sector, then a strong inflow of capital would be welcome as a means of funding expansion. That damage would be done to the weakest parts of the export sector by the associated rise in the exchange rate would, from the perspective of the economy as a whole, be simply part and parcel of resources shifting to where the rate of return was highest. In principle, this would be no different from what happens when, for example, the return on producing dairy products shifts in lasting fashion above the return on producing beef. Those invested in beef production find their assets and prospects declining in value, which hurts the individuals involved but helps move resources away from beef production towards dairy production.
To the best of my judgment, however, the situation we are facing at present is mostly a product of temporary forces, not lasting ones. Two of the three factors that I have mentioned - New Zealand being out of phase with the rest of the world and the pressure from migration flows - will come to an end, sooner or later. And on the assumption of current policy, the fiscal surplus will also start increasing again after 1997/98. Our September Projections indicate that inflation pressures in New Zealand will ease over the next year sufficiently to allow some easing in monetary policy. At some stage in the not-too-distant future, inflation pressures in our major trading partners will build to the point where their interest rates begin to rise, thereby reducing the interest rate differential from the other side. With both happening simultaneously - as may well be the case - we might well see the rate of reduction of New Zealand interest rates being held back by higher world interest rates, but a correspondingly larger decline in the exchange rate as monetary conditions overall eased.
It is worth noting that migration flows are already waning. In the year to March 1995, net long-term permanent immigration amounted to a little over 14,000 people, and in the year to March 1996 to almost 20,000. The Bank is projecting that number to fall to some 11,000 in the year to March 1997. By the end of 1997/98, moreover, assuming that no significant new fiscal initiatives come out of the coalition-building process, the fiscal surplus should start increasing again.
While our current Projections see an increase in export growth over the next few years, there are risks. In particular, continued rapid strengthening in the exchange rate would considerably weaken export growth. In view of this risk, it is worth considering whether we have policy measures available that might help reduce the scale of the problem, and reduce the risk.
First port of call for many will undoubtedly be a temporary relaxation of monetary policy. Tolerating more inflation might result in a lower exchange rate but, of course, as all our history proves, that provides only very temporary relief for exporters: it is not too long before the higher domestic inflation catches up with the temporary benefit conferred by the lower exchange rate. In current circumstances, where the domestic economy is already pushing up close to its capacity limits, that loss of the temporary benefit arising from a lower exchange rate might happen very quickly. And, perhaps more importantly over the longer haul, allowing a temporary relaxation of the inflation target now would only increase pressure to do the same thing again in the future, something that would get built into inflation expectations to the detriment of all. Fiddling with medium term policy in response to temporary problems is almost always unwise.
Other people, recognizing the risks of simply tolerating `just a little more inflation', will look for other solutions. Perhaps the situation could be helped, it is suggested, by defining the target inflation rate to exclude some of the more volatile (and recently fast-increasing) components of the inflation index, such as housing. Or perhaps there could be some kind of direct intervention to try to change the mix of monetary conditions, perhaps by sharply increasing the risk-weighting applying to lending to the housing market to make such lending much less attractive to banks. But few of these suggestions have any merit at all. There is good reason to doubt whether the Government Statistician should be including the price of new housing in the CPI, but even removing that component of the index would not diminish the reality that, over the last few years, the price of the housing services which New Zealanders buy has gone up, and one way or another that should be reflected in the measure of inflation which the Bank targets. And the risk-weighting applying to bank lending on housing is an internationally-agreed ratio which realistically reflects the low risk of lending on the security of residential mortgages.
Clearly, one direct way of reducing the risk inherent in the present situation would be to ensure that further fiscal stimulus is not added in the process of coalition-forming. Coalition partners may indeed need to consider deferring some part of the tax cuts already announced if there is to be any net increase in government expenditure.
There is obviously a huge problem for political leaders in this situation, since the public tends to assume that, so long as there is a fiscal surplus, the Government can quite prudently spend it, and indeed should do so. The public is right, viewed from a longer term perspective, but timing matters. The impact of the net change in the fiscal position, and the relationship to monetary conditions, is little understood. It is vitally important for the farming industry, and indeed for the sake of all exporters and all competing against imports, that this issue is better understood quickly.
A more realistic understanding on the part of foreign investors of the risks of investing in New Zealand dollar assets would also help. Unfortunately, it seems to have become accepted popular wisdom, both here and abroad, that investing in New Zealand dollar assets has become a virtually riskless exercise. Popular commentators imply that, just because the New Zealand dollar has been rising strongly over much of the last four years, that trend will continue indefinitely. That is clearly nonsense and, in the circumstances, damaging nonsense. To be sure, the New Zealand dollar has risen sharply against the yen over the last year or so, from around 55 yen to around 80 yen today. But immediately after the devaluation of July 1984 the New Zealand dollar bought 121 yen. Many people forget that, on a TWI basis, the New Zealand dollar depreciated by more than 10 percent in 1988, and again in 1991. It is quite easy to imagine a scenario where, with domestic demand pressures easing in New Zealand, with the risk of further fiscal stimulus eliminated and inflation comfortably heading back into the target range, interest rates in New Zealand would be heading lower just as interest rates are rising abroad: a depreciation of a similar magnitude could easily occur again.
Indeed, and this is my final point, the scenario I have just painted, where New Zealand's inflation pressures weaken and our interest rates come back more into line with world interest rates - helped by a supportive fiscal stance - is the ideal one. If such a scenario does not eventuate, my fear is that one of two bad outcomes might eventuate.
One bad outcome would have the return to price stability being associated with a considerable and unhealthy crunch to the export sector. To be sure, the exchange rate would eventually drop sharply - perhaps in response to a sharp rise in the current account deficit - but by then serious damage might have been done (and the suddenness of the adjustment would itself create further damage).
Alternatively, we might see a future Government, concerned to alleviate the pressure on the export sector, adopt what might euphemistically be described as `unconventional' measures. Whether those measures involved acceptance of `temporarily' higher inflation or specific regulatory or tax-related measures, the longer-run consequences would be just as unhealthy.
It must be hoped that international investors recognize that there is an exchange rate risk from both of these outcomes, and therefore help ensure that neither eventuate.
Statement issued on the 16 October 1996
No scope for further easing at this stage
David Archer, Chief Manager of the Reserve Bank's Financial Markets Department, said today that at this stage any further easing in monetary conditions would be inappropriate.
"Yesterday's inflation outcome was markedly lower than we and other forecasters had expected. That is good news. However it is only one number, and most of the deviation from forecast occured in a single area (construction costs). The implications of this result for the future inflation outlook will have to be assessed in the light of all the other emerging indicators before we could be comfortable with considering a major easing in policy. In the normal course of events that review will take place as we prepare our projections leading up to the December Monetary Policy Statement, to be released on 17 December."
Reserve Bank of New Zealand
16 October 1996
Statement issued on 24 October 1996
David Archer, Chief Manager of the Reserve Bank's Financial Markets Department, today indicated that monetary conditions have become a little firmer than needed for the task of keeping inflation inside the target range.
"The sharp exchange rate appreciation that we have seen in recent days has been accompanied by a relatively small drop in interest rates, leading to a marked tightening in overall monetary conditions", Mr Archer said. He explained that while the Bank had expressed concern about too rapid an easing in monetary conditions following the surprisingly low inflation result for the September quarter, it could see no particular policy requirement for monetary conditions to have firmed as much as has occurred in recent days.
"The issue for monetary policy is that, as the exchange rate rises, somewhat lower interest rates are needed to keep the impact of overall monetary conditions on inflation broadly the same. But those lower interest rates also take some of the disinflationary pressure off the housing market. Rapidly rising prices in the housing sector have been one of the main factors behind our recent surge in inflation," Mr Archer said. "However, preventing interest rates falling a little also means that upward pressure on the exchange rate would remain. The end result would be too much overall monetary policy tightness, with an even greater proportion of the pressure coming onto the export sector."
"Unfortunately, in order to keep overall monetary conditions consistent with maintaining price stability, it appears that we will have to accept rather less interest rate pressure than might be ideal, and rather more exchange rate pressure than might be ideal."
Reserve Bank of New Zealand
24 October 1996