Inflation targeting in New Zealand, 1988-2000
Inflation targeting in New Zealand, 1988-2000
an address by Dr Donald T Brash Governor, Reserve Bank of New Zealand
to the to the Trans-Tasman Business Circle Melbourne, Australia 9 February 2000
Introduction
It is now almost exactly two years since I addressed a luncheon hosted by the Trans-Tasman Business Circle in Melbourne, and it gives me great pleasure to be back here again.
Today, I want to talk about New Zealand's experience of having an inflation-targeting central bank, and to make a few remarks comparing our own approach to inflation targeting with that in Australia.
Twelve years ago, Roger Douglas made it clear to the Reserve Bank of New Zealand, in early April 1988, that we should get inflation down to a range of 0 to 2 per cent per annum, and keep it there. And it is just 10 years last week since legislation came into effect making the achievement and maintenance of price stability the single focus of monetary policy, and giving the Reserve Bank operational independence to achieve that objective.
I believe that that singular focus on achieving and maintaining price stability, on targeting monetary policy at a very low rate of measured inflation as agreed between the Minister of Finance and the Governor of the Bank, has served New Zealand well.
As can be seen in Graph 1, New Zealand's inflation performance through the seventies and eighties was not only high in absolute terms, it was also high relative to that in most other developed countries. Australia's own inflation performance during those decades was not particularly brilliant; New Zealand's was markedly inferior.
Since the introduction of
inflation targeting in early 1988, New Zealand's inflation
performance has moved from being among the worst in the
developed world to being around the middle of the pack. We
have not, it should be noted, driven our inflation rate
markedly below the average in the developed world, but we
are certainly now clearly in the mainstream of low-inflation
countries. Comparing New Zealand with Australia, as is done
in Graph 2, it can be seen that, after many years in which
our inflation rate was markedly higher than that in
Australia, the last decade has seen inflation in New Zealand
running at a rate very similar to that in
Australia. Yes, inflation has fallen throughout the
developed world in the last decade but, as indicated,
inflation in New Zealand not only fell in absolute terms, it
fell relative to inflation in other developed countries.
Inflationary expectations also fell markedly between the
eighties and the nineties, with 10 year bond rates falling
from 17 to 18 per cent in the mid-eighties, some 1000 basis
points above US government bonds of similar maturity, to
around 7.5 per cent today, less than 100 basis points above
US government bonds. For much of the last decade the yield
on 10 year New Zealand bonds has been lower than that on
Australian bonds of similar maturity. There seems little
doubt that the inflation targeting regime played a
substantial part in this achievement through focusing the
attention of the central bank and the government, and
through assisting the public to understand what was being
aimed at. The impact of low inflation on growth? But
even those who concede that New Zealand's performance in
keeping inflation low and stable has been good often argue
that the cost of achieving this, in terms of economic growth
and employment foregone, has been too high, and that perhaps
something more moderate, or "less obsessive" in the words of
some of our critics, would have been more desirable. There
is not much doubt that the process of reducing inflation
from around 15 per cent per annum in the mid-eighties to
below 2 per cent in 1991 had an adverse impact on growth and
employment during that period. I have often acknowledged
that point, and indeed I know of no central banker who would
claim with any confidence that inflation can be reduced from
a high level to a low level without at least some,
temporary, impact on growth and employment. The reasons for
this are now widely understood and relate to the way in
which a policy to reduce inflation interacts with
expectations that inflation will continue at its previous
pace. But shortly after inflation was first reduced to the
0 to 2 per cent target in 1991, the economy began to grow
again and unemployment began to fall. In the six years to
1997, real GDP growth averaged 3.5 per cent. This was slower
than the 4 per cent growth achieved by Australia over that
period, but fractionally higher than growth in the United
States, and clearly faster than the growth achieved in Japan
and most of continental Europe. Unemployment fell from a
peak of close to 11 per cent in early 1992 to 6 per cent in
1996, and has been consistently somewhat lower than that in
Australia since 1992. Throughout that six year period at
least, growth in real GDP was clearly superior to New
Zealand's trend growth in the seventies and eighties. But
it is also fair to acknowledge that growth over the six
years to 1997, while falling not far short in total of that
in Australia, was significantly more uneven than in
Australia. For a whole variety of reasons, including the
fact that the Reserve Bank perhaps allowed monetary
conditions to remain very easy for too long in 1993, New
Zealand accelerated out of its early-nineties recession much
faster than Australia, and growth in real GDP peaked at a
clearly unsustainable 7.1 per cent in the year to September
1993. It was not long before demand exceeded the economy's
capacity to supply without inflation, and throughout the
mid-nineties monetary policy in New Zealand had to lean hard
to restrain those inflationary pressures. Throughout 1995
and 1996, policy was tight, with high real interest rates
and a rising real exchange rate, and despite that fact
inflation remained slightly above the agreed 2 per cent
limit throughout 1996. Towards the very end of 1996, we felt
reasonably confident that we could project a period of
positive but below-trend growth coming up which would get
inflation back within our target, and began a gradual easing
of policy even though, in the year to December 1996,
inflation was 2.4 per cent. At much the same time, we were
given additional room to manoeuvre when the newly-elected
Coalition Government proposed an amendment to the inflation
target, from 0 to 2 per cent to 0 to 3 per cent. What we
expected to happen then was a gradual decline in inflation
as the economy continued to grow moderately. In the event,
of course, six months later the Asian crisis began and six
months later still the country was in the midst of its most
severe drought for many years. Inflation did decline
gradually, and was between 1.5 and 2.0 per cent throughout
most of 1997 and 1998. On that score, the performance was
good. But because neither we nor anybody else I have met
accurately predicted either the Asian crisis or the drought,
our growth projection was wrong. Instead of below-trend but
positive growth in 1998 we actually had a mild two-quarter
recession, with real GDP shrinking by a total of 1.6 per
cent in the first two quarters of the year. This induced
a very considerable degree of national pessimism in New
Zealand. How could we have got it so wrong, especially when
Australia continued to motor on strongly, despite the Asian
crisis? Was it poor monetary policy in New Zealand, and
perhaps specifically the introduction of a Monetary
Conditions Index (MCI) "with bands" in June 1997, which was
to blame? I don't propose to give a comprehensive answer
to these questions here, but in my own view the main reason
for the difference in performance between the two economies
in 1998 was that Australia was at a quite different stage in
its business cycle than New Zealand was when the Asian
crisis struck, perhaps because we in New Zealand were a bit
too slow to tighten monetary policy in 1993-94.1 And drought
had a relatively much larger impact on the New Zealand
economy than was the case in Australia. While the path which
short-term interest rates took in the year following the
introduction of the MCI "with bands" in June 1997 may well
have delayed the pick-up in activity somewhat, it seems
unlikely to have been the major factor responsible for a
recession which started just six months after that approach
was adopted. In any event, the New Zealand economy has
been growing again since the middle of 1998, the result in
large part of a strong recovery in the world economy and
very relaxed monetary conditions. After shrinking by 1.6 per
cent in the first half of 1998, it grew by 1.3 per cent in
the second half, to make a very slight contraction for the
year as a whole, while during the first nine months of 1999
the economy grew by 3.1 per cent. With most commentators now
expecting growth for the full year to be around 4 per cent,
it seems very likely that growth in the New Zealand economy
will have been quite respectable for the decade as a whole,
compared with our history and compared with the growth in
many other developed countries over the same period. It is
not obvious that maintaining low inflation (as distinct from
achieving low inflation) has incurred any cost whatsoever in
terms of growth foregone, and some modest growth "dividend"
from low inflation seems at least plausible. But why, some
New Zealanders and even some Australians ask, has New
Zealand not grown quite as strongly as Australia? New
Zealand's trend growth rate has been lower than that in
Australia for a number of decades. The gap was quite large
in the sixties, seventies, and eighties and was actually
somewhat narrower in the nineties. But in a sense the
strange thing is not that our two growth rates are slightly
different but that so many people expect them to be the
same. In reality, there are a great many quite
fundamental differences between the two countries, so a
different growth rate should be no surprise at all. Yes, our
two countries both export commodities, but the mix of those
commodities is quite different; New Zealand exports almost
no minerals and is a net importer of oil. Yes, we both have
governments which take a lively interest in the health,
education, and income level of our peoples, but the extent
of that support, relative to GDP, is markedly different in
our two countries. It is as logical to expect average growth
in New Zealand to be the same as average growth in Australia
as it is to expect growth in Tasmania to match that in
Queensland. New Zealand is neither Tasmania nor Queensland.
Nor does it precisely replicate the characteristics of the
Australian economy as a whole. This is neither "good" nor
"bad". It just means that New Zealand is different in some
respects. Lessons What have we learnt about inflation
targeting and monetary policy over the last decade or so? At
least four things I think. First, I think we have seen
further evidence of what theory and international experience
have been saying for a good many years now, namely that
monetary policy makes its best contribution to economic
growth and employment by keeping inflation low and stable.
New Zealand had high inflation in the seventies and
eighties, relative to other developed countries, and very
poor growth. In the nineties, our inflation rate was typical
of the low inflation achieved by most other developed
countries, and our growth rate was somewhat better than it
had been in the seventies and eighties, and indeed better
relative to growth in many other developed countries. There
were no doubt many reasons for that better growth, including
the far-reaching policy changes which had an adverse initial
impact on growth in the late eighties and early nineties.
But, as I have noted, at very least it seems reasonable to
conclude that monetary policy aimed at maintaining very low
inflation had no adverse impact on trend growth, and pretty
reasonable to conclude that, at the margin, low inflation
actually helped the economy grow in a more sustainable way.
That said, it is also clear that no amount of good
inflation policy can convert a slow-growth economy to a
fast-growth economy. As I said in a speech just 10 days ago
in Christchurch, the speed at which an economy can grow in
the longer term depends on a whole range of factors -
quality of the labour force, quality of management, openness
of the economy to the world economy, quality of government
policy, geography, and so on. Bad monetary policy can damage
the economy; good monetary policy avoids that
damage. Secondly, I think we can say with confidence that
a credible institutional framework is helpful in encouraging
desirable behavioural changes in the central bank, in
government, in financial markets, and in the public. To be
sure, what ultimately matters for behaviour is a record, a
history. No amount of political promises, and no amount of
institutional tinkering, will convince people that low
inflation will be an enduring feature of the economic
landscape if what they have actually seen over decades is
promises regularly broken and the value of their money
constantly shrinking. But the combination of a single
focus on price stability; an explicit and numerical
definition of the inflation target; the operational
independence of the Bank (coupled with an explicit
understanding that the Governor could be dismissed for
"inadequate performance" under the inflation target); and
the requirement for a transparent accounting to Parliament
and the public of central bank actions, all these together
played a part in convincing people that this time the
Government was serious about reducing inflation and keeping
it down. Without wishing to overstate the point, I believe
this played some part - small perhaps, but nevertheless
useful - in reducing inflationary expectations in financial
markets (I have already mentioned the effect on bond
yields), in pricing behaviour, and in wage settlements.
Indeed, in 1990, soon after the legislation mandating price
stability was passed, the head of the Council of Trade
Unions actively campaigned for moderate wage increases,
recognising the serious implications for unemployment of
high wage settlements in an environment where the Government
was committed to having the central bank reduce the
inflation rate. At least as important as the effect of the
inflation target on financial markets and the public was its
effect on the central bank and the Government. Perhaps for
the first time, the central bank had a clear and unambiguous
mandate. Whatever individuals might think about the relative
merits of a 1 per cent inflation target as compared with,
say, a 3 per cent target, the inflation target had been
agreed formally and in writing between Government and
Governor. The only debate possible around the implementation
of monetary policy was about how best to achieve that
target, and that certainly helped to focus our
deliberations. The Government also recognised that, having
nailed its colours to a particular inflation mast, the
extent to which monetary policy had to be tightened in order
to deliver that was, to some degree at least, a function of
the stance of its own fiscal policy. Easier fiscal policy
was likely to lead to tighter monetary policy in any given
set of circumstances, and vice versa. This relationship was
most clearly seen in the early nineties, when an easing of
fiscal policy in 1990 was followed by a tightening of
monetary policy, and when a tightening of fiscal policy in
1991 was followed by an easing of monetary policy. In late
1995, the then Government promised to reduce income tax
rates in 1996 subject to a number of prior conditions, one
of which was an assessment from the Reserve Bank about the
extent to which monetary policy would need to be tightened.
I think it is fair to suggest that one of several factors
which led New Zealand from a very persistent series of
fiscal deficits to a succession of surpluses from 1993/94 to
the present was an awareness on the part of the Government,
and sectors particularly sensitive to the impact of monetary
policy, of this relationship between fiscal and monetary
policy. Thirdly, I think we have seen confirmation that
monetary policy is a poor instrument with which to target a
balance of payments deficit. New Zealand has had a current
account balance of payments deficit in every year since
1974. Sometimes that deficit has been modest in size; at
other times it has been very large. But it has been
persistent through all kinds of monetary policy, and
certainly long pre-dated the inflation targeting regime.
During the mid-nineties, the Reserve Bank was blamed for
causing an increase in the deficit by tightening monetary
policy, with a resultant strong appreciation in the exchange
rate and pressure on the export sectors of the economy.
During the late nineties, some have suggested that
excessively easy monetary policy has caused a deterioration
in the current account position through the strong stimulus
provided to the domestic economy (and therefore demand for
imports), despite the fact that the exchange rate has been
close to its lowest levels in history throughout most of the
last two years. I am among those economists who want to
believe in the view that, with a floating exchange rate,
policy-makers can afford to be relatively relaxed about a
current account deficit as long as it arises from private
sector decisions (and not a public sector deficit), a view
variously associated with the names of Max Corden, John
Pitchford and Milton Friedman. But whether or not I should
be concerned about the current account deficit - and in New
Zealand it is currently pushing 8 per cent of GDP, even
higher than the already fairly high Australian deficit - I
am quite persuaded that monetary policy can't reliably
reduce the deficit. If monetary policy is tightened,
domestic demand is reduced and with it the demand for
imports and for goods which could be exported. This helps to
reduce the deficit. But the firmer monetary policy also
tends to push up the exchange rate, and this tends to slow
the growth of exports and encourage the growth of imports.
Conversely, when monetary policy is eased, domestic demand
is stimulated and with it the demand for imports and for
goods which could be exported. This tends to increase the
deficit. On the other hand, the easier monetary policy also
tends to lead to a depreciation in the exchange rate, and
this tends to encourage the growth of exports and to
discourage the growth of imports. So even if monetary
policy were not mandated to focus on keeping inflation low
and stable, and even if I thought that reducing New
Zealand's balance of payments deficit was the most important
policy priority, I would argue strongly that monetary policy
cannot be an effective instrument with which to deal with a
balance of payments deficit. And fourthly, we are feeling
our way towards a better understanding of the possible
trade-off between the variability of inflation and the
variability of output. Theory associated with John Taylor of
Stanford University suggests that, if a central bank
attempts to constrain inflation into too narrow a channel,
the economy may be pushed towards a boom-bust cycle. This
sounds entirely plausible, and work which some of my own
staff have done points in the same direction. The theory
also sounds suspiciously like a basis on which to compare
the recent track records in New Zealand and Australia. But I
doubt that the trade-off is quite as straightforward as
might seem on the surface, or any more "exploitable" than
the infamous Phillips curve. Let me illustrate. Since we
began inflation targeting in New Zealand, inflation has
become dramatically more stable than previously. But output
cycles have also been smaller than previously, not larger.
The same is true for several other countries, including
Australia. And many people, including John Taylor himself,
attribute a large part of the remarkable record of steady
growth in the US recently to a monetary policy that has more
successfully kept inflation under control. What, then, is
the policy prescription from this trade-off? It seems to be
to focus monetary policy on price stability, but not to the
"nth degree". The problem is that we don't know what "n" is
in this context: where is the cross-over point from an
appropriate to an inappropriate degree of stability, and how
does it vary with circumstances? We can, I think, be
confident that, once inflation expectations have fully
adjusted, and have become well anchored, it may be feasible
to reduce the variability of output slightly by being
willing to tolerate a little more variability in inflation.
But the cross-over point, between appropriate and
inappropriate price stability, will change with
expectations. Looking forward New Zealand now has a
monetary policy framework which looks pretty robust - an
inflation target of appropriate width, an explicit
recognition that there will be supply shocks and other
events which will (and should be expected to) drive
inflation outside the agreed band, and appropriate
directives to the Bank to operate policy in a transparent
and sustainable manner while avoiding, to the extent
feasible, unnecessary variability in output, interest rates,
and the exchange rate. We have an unambiguous mandate that
monetary policy should focus on delivering medium-term price
stability, and a wide, though not by any means unanimous,
acceptance of that being done through an operationally
independent but accountable central bank. For our part,
the Bank has shifted its focus to the important issues
affecting medium-term inflation rather than the issues which
have more temporary impact, such as the direct price effects
of exchange rate movements, with an acceptance of the fact
that this may mean somewhat more variability in short-term
inflation outcomes. While this shift in part reflects a
better understanding on our part of the factors which drive
medium-term inflation, it is also a dividend from the more
firmly anchored inflation expectations of recent years. In
all important respects, the inflation targeting frameworks
in Australia and New Zealand are now very similar. Both
countries are now clearly and explicitly "inflation
targeters". Both countries run policy by setting a
short-term interest rate. Both countries forecast and react
to expected future inflation. And the central banks of both
countries take flak from all sides whenever monetary policy
is tightened! There are a few differences, but in most
cases these are more apparent than real. For example,
Australia's use of a "2 to 3 per cent on average over the
cycle" target, while expressed differently, is quite similar
to the approach now adopted in New Zealand with a 0 to 3 per
cent per annum target, with not too much concern over
temporary breaches of the bottom or the top of this range.
There are a few differences in the area of transparency,
in that we publish more detailed information about how we
see the present and the future. But we recognise that there
are both positives and negatives about this. As we
discovered last month - when we increased our Official Cash
Rate by 25 basis points less than two hours before the
Government Statistician announced that inflation in the
December quarter had been well below the estimate we had
published in November - a high degree of transparency can at
times be not only very uncomfortable but also damaging to
the credibility of the central bank. Given that forecasting
errors of this kind will happen from time to time, the
benefits of increased transparency in terms of market
understanding of what the central bank is doing have to be
weighed against the inevitable costs in terms of
credibility. Unfortunately, we have not yet been very
successful in getting across the idea that our accuracy in
estimating current and recently-past inflation is actually
rather less important in judging our performance than
whether we keep trend inflation within target most of the
time or not. And that involves picking the big swings in the
economy accurately most of the time, not picking the precise
magnitude of last quarter's inflation or GDP figure. The
reality is that recently-past inflation is only marginally
relevant to how policy should be set to deal with
inflationary pressures one to two years ahead. Given the
lags, it is not too surprising that inflation in the second
half of 1999 was pretty low - demand had fallen short of
capacity for the previous 18 months. But equally it is not
surprising that the Reserve Bank should see a need to move
conditions to a more neutral stance fairly quickly given the
speed with which demand has been expanding in the last few
quarters. Even following last month's increase in the
Official Cash Rate, most observers believe that monetary
policy remains "below neutral" and is thus providing
continuing stimulus to the economy. Far from "choking off
the recovery" therefore, as some have suggested, we are
simply easing back on the throttle somewhat in an endeavour
to moderate, and thus prolong, the period of growth. But
it is obviously a bit difficult for some observers to
reconcile that gradual easing back on the throttle with the
low figures for recently-past inflation. In the same way, it
may have been a bit difficult for some observers to
understand why we began to ease monetary policy in December
1996, even though inflation was above the top of the then 0
to 2 per cent inflation target (though I did not hear too
many people protesting that easing at the time!). Monetary
policy has to be forward-looking, and it was because of that
that we increased the Official Cash Rate in November last
year, and increased it again last month. Our November
Monetary Policy Statement foreshadowed the need to gradually
continue to increase the Official Cash Rate during this
year, though of course it goes without saying that the
extent to which that will prove necessary remains under
literally constant review by my colleagues and me. I was
somewhat relieved to deduce that Mr Ian Macfarlane, Governor
of the Reserve Bank of Australia, occasionally faces
somewhat similar misunderstanding of what he is doing. In a
speech to Business Economists in Sydney on 11 November last,
he noted that "Some interpretations of (Australia's flexible
inflation targeting framework) imply that the Bank is not
supposed to contemplate any rise in interest rates until the
upper end of the target is threatened. This is equivalent to
saying that the most expansionary setting reached during the
downward phase of the interest rate cycle should be
maintained until such time as a move to a clearly
restrictive setting is required, and only then should a move
be made. (That virtually guarantees that such moves will be
large.) It is as though policy has to operate only with
settings of maximum "go", and heavy braking."2 Precisely.
As Mr Macfarlane went on to say, the policy "instrument does
not remain at its most extreme setting once that is no
longer needed. As the outlook changes, and as the balance of
risks shifts, it is appropriate also for the policy
instrument to shift." Indeed, it is particularly
important if we in New Zealand are to take seriously our new
mandate to seek to avoid unnecessary instability in output,
interest rates and the exchange rate that we move to adjust
policy in a timely fashion. The appreciation of New
Zealand's real exchange rate in the mid-nineties was not in
fact out of line with real exchange rate appreciations
experienced during the nineties by a number of other much
larger countries with floating exchange rates, such as the
United States and the United Kingdom. It was very much
smaller than the real exchange rate appreciation experienced
by Japan during the nineties. These countries approach
monetary policy in various ways, and their experience makes
me reluctant to promise that we in New Zealand will
necessarily be able to avoid big exchange rate appreciations
in the future. But we certainly intend to try, and we
recognise that big appreciations of the kind we experienced
from early 1993 (when the New Zealand dollar was almost
certainly below its long-term equilibrium) to early 1997
(when it was almost certainly above its long-term
equilibrium) make life very difficult for the export and
import-competing sectors. It is our current assessment
that the best way of reducing the risk of a repetition of
that kind of experience is to ensure that monetary policy
avoids a situation where inflationary pressures build up too
big a head of steam, with the consequence that policy has to
be tightened aggressively for a prolonged period. Far from
being inconsistent with the new clause in my agreement with
the Minister of Finance, as some have suggested, our
decision to increase the Official Cash Rate last month was
absolutely consistent with that clause. Finally, let me
acknowledge that the practice of monetary policy is more art
than science, with a huge amount of uncertainty surrounding
all decisions. In making a decision on policy affecting
inflation in two years time, the central banker does not
clearly know how the economy works now (even though he may
have a hazy idea of how it worked in the past), does not
know what unpredictable events (droughts, share-market
collapses, Asian crises, etc) lie within the next two years
and, despite all efforts to gather information from formal
and informal sources, has only a very vague notion of where
the economy is at the time the decision has to be made. As
Dr Mervyn King, Deputy Governor of the Bank of England,
remarked in a speech in August last year.3 "Perhaps one
of the strongest arguments for delegating decisions on
interest rates to an independent central bank is that,
whereas democratically elected politicians do not often
receive praise when they say "I don't know", those words
should be ever present on the tongues of central
bankers." To the extent that our rhetoric has not always
reflected that reality, we will certainly strive to do
better!
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--- 1.See Brook, Anne-Marie (1998), "A quick look over
the neighbour's fence: New Zealand and Australia compared",
Reserve Bank of New Zealand Bulletin, 61(1). 2.Macfarlane,
I J (1999), "Notes for a talk to Australian Business
Economists", Sydney,
http://www.rba.gov.au/speech/sp_gov_111199.html. 3.King,
Mervyn (1999), "Challenges for Monetary Policy: new and
old", Bank of England Quarterly Bulletin, 39(4).
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