Data Flash (New Zealand)
What lessons can the Government learn from the last monetary policy cycle?
Friday December 17
The Treasurer, Dr Michael Cullen, has signed a new Policy Targets Agreement with the RBNZ. The agreement now includes
the following statement: "In pursuing its price stability objective, the bank.shall seek to avoid unnecessary
instability in output, interest rates and the exchange rate."
According to Dr Cullen, the "renegotiation sought by the Government reflected a concern not to repeat the experience of
the mid-1990s, when the export sector was placed under immense pressure by a sharp increase in the value of the dollar."
Hopefully the Government does not interpret the change as meaning the RBNZ needs to be less pre-emptive in offsetting
inflation pressures than in the past. The lesson from the mid-1990s is that the Bank needs to be more pre-emptive not
less. A failure to tighten monetary policy (or ease for that matter) early enough will leave the Bank having to make
efforts to catch up. This will tend to add to instability, not reduce it.
* The lesson from the previous monetary policy cycle
The above chart reveals that in the first half of the 1990s, the RBNZ did not begin to tighten monetary policy in any
meaningful sense until well after the economy had begun to strengthen. Indeed, the tightening lagged the turning point
in the economy by more than 2 years.
As the RBNZ has itself admitted, the failure to move early contributed to the unsustainable growth rate reached in the
1994 and 1995 period. In turn, this contributed to the degree of tightening that was eventually needed to bring
inflation under control.
While some may ask what the problem was given that underlying inflation remained under 3% over this period, the
non-tradable component of underlying inflation reached 4.9% in the year to June 1996. If the exchange rate had not
appreciated considerably over this period, New Zealand's inflation performance would have been much worse. This may have
had a marked impact on the credibility of the RBNZ and NZ's long-term inflation performance. In turn, we believe this
would be negative for NZ's long-term economic performance.
Interestingly, the above chart suggests the RBNZ may already be somewhat "behind the curve". If the graph was updated to
include the December 1999 quarter (for which capacity use data is not yet available), then we would most likely find a
further tightening in capacity and an easing in monetary conditions. Of course, if the RBNZ's supposition that the NZ
economy is now less inflation prone than in the early part of the decade is correct this may not be of any great
concern. However, the strength of the economy (to be confirmed in next week's GDP figures), already tight capacity and
rising inflation pressures (as evident in a number of surveys) suggests only one direction for interest rates over the
next 12 months.
* Will there be for tension between the Government and the RBNZ?
It is not entirely clear what the Government expects the RBNZ to do in light of the change to the Policy Targets
No doubt the RBNZ believes it already conducts monetary policy in a manner consistent with the additional words. This
does not mean, however, that swings in the value of the NZ dollar or interest rates will not be substantial. Indeed,
depending on the strength of the economic cycle, large swings in these variables may be needed to prevent "unnecessary
instability in output".
This could be a source of tension between the Government and the RBNZ if this proves to be the case over the next year
Another source of tension could be the timing of the RBNZ's actions. As noted above, the monetary policy lesson to draw
from the mid- 1990s is not to move too late. By acting in a pre-emptive manner and looking to smooth the peaks and
troughs of the business cycle somewhat, the Bank is likely to lessen the peaks and troughs in monetary policy settings.
The problem, as always, is that the question of when to move and by how much can be a subject of considerable debate.
Monetary policy operates on the basis of forecasts that, by their very nature, are subject to a large degree of
In addition, the lags involved in monetary policy mean that being pre-emptive requires moving before inflation has
actually begun to rise to any significant degree. In the 1992/93 period, inflation (CPI- ex credit) was actually
falling. However, in hindsight, the RBNZ should probably have begun tightening during this period.
Dr Cullen is an open admirer of the RBA's approach to setting monetary policy, arguing the RBNZ should move closer to
the RBA's style. In this regard, it is interesting to note how the RBA approaches the uncertainty inherent in monetary
policy. The RBA has argued that central banks should seek to avoid "the big mistake". Thus, late last year when the big
mistake looked like underestimating the impact of Asia the RBA chose to ease. Similarly, late this year the RBA
concluded the big mistake would be to underestimate the strength of the Australian economy - so the Bank tightened.
The lesson from the mid-1990s would seem to be that the big mistake for the RBNZ is to wait too long before tightening.
With growth looking robust, the costs of reversing this are likely to be greater than those of tightening too soon.
This conclusion should not be interpreted as advocating that the RBNZ move the cash rate higher at the time of the
January review. We see very few circumstances in which the RBNZ should move other than after a full review of the
economic and inflation outlook.
However, it does mean that any pressure from Government to delay a tightening would be a mistake. Of course, the RBNZ is
very unlikely to respond to such pressure and will tighten if the inflation outlook warrants it (and we think it will).
It will be very interesting to see how the various elements that make up the Government cope as interest rates head
Hopefully, there will an understanding of why the Bank is acting in this manner. Reported comments from an Alliance
Cabinet minister that the Government should wash its hands of the "monetarist experiment" suggest this hope is
misplaced. While such comments will have little impact on actual policy settings, they suggest the degree of policy
"noise" could be quite high over the next 12 months. This may do more to add unnecessary volatility to interest rates
and the exchange rate than any actions by the RBNZ.
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