## Mr Brash: Will the Reserve Bank choke the recovery?
Address by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the Auckl Regional Chamber of Commerce & Industry, Auckland, on 21 March 2000.
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## Introduction
Ladies and Gentlemen,
I was invited to give this address after a number of pretty aggressive attacks on the Reser monetary policy, and on me personally in the Auckland media in late January and early Februa the Bank increased the Official Cash Rate from 5 per cent to 5.25 per cent in the middle of
Who does Don Brash, an unelected bureaucrat whose name appeared on no ballot paper in the election, think he is, to be making such important decisions?
Why does Don Brash refuse to engage publicly with any of the media on the issue?
Why is New Zealand the only OECD country that 'persists in intervention to fuel another self recession' (this from the Auckland Chamber of Commerce itself, using the same words aft increase in the Official Cash Rate in January, and again after the further increase last wee
Wouldn't life be much better if we simply did away with such intervention, and allowed pure forces to determine interest rates?
Hasn't the Reserve Bank, and the way in which it has run monetary policy under the Reserv Act of 1989, caused New Zealand's huge balance of payments deficit, and won't pushing u Official Cash Rate simply make matters worse?
Why did the Bank increase the Official Cash Rate as the economy was just beginning to emerg the recession?
Surely it was inappropriate to tighten policy when the Government Statistician has sh inflation in the latest year was below the mid-point of the 0 to 3 per cent inflation target
Why does the Reserve Bank claim the right to be the sole judge of how fast the New Zealand e can grow?
Isn't it possible that New Zealand, like the United States and other developed countries, ca faster than before without inflation?
These and other questions poured forth - and this despite the fact that January's modest 25 basis points had already been fully priced into financial markets (as indeed last week's to the OCR had been also)!
## Some questions based on misunderstanding
I welcome the opportunity to respond to these questions this morning. Some of them raise i issues, though I think it is fair to say also that others simply reflect misunderstandings.
For example, and contrary to the view once expressed by former Prime Minister David Lange, t no sense in which Don Brash has huge or unfettered power. Parliament has made it clear Reserve Bank must use its ability to influence monetary conditions to maintain price Parliament has made it clear that what price stability means has to be the subject of agreement between the Government and the Bank's Governor. And of course, that agreement curr requires me to keep the CPI inflation rate between 0 and 3 per cent (with some qualificat Government has made it clear that that is what I have to deliver, and under the Reserve Ba
Government has the right to change that target, unilaterally if they wish to do so, provided t change is made public.
So any decisions which Don Brash makes are tightly constrained, are based on the best informat which my colleagues can gather, and are made to achieve an objective which Parliament has la down. In no sense am I an unconstrained bureaucrat.
The suggestion that I am reluctant to engage in debate with the media arose, I suspect, becau January we issued a press statement announcing and explaining the increase in the Official Cash but then declined to answer further media questions. It is always a difficult judgement about frequently the Bank should comment on monetary conditions 'on the record'. On that occasion, I f that had I given an interview to one journalist I would have had to give interviews to quite a and I was reluctant to run the risk of sending a multiplicity of messages which might have conf more than it enlightened. In general, however, we are more accessible to the media than any o central bank that I know of, and no central bank is more transparent about the rationale f decisions.
And have we been the only central bank in an OECD country to adjust monetary policy in a tighteni direction in recent times? Hardly. In the last six months, the central banks of Australia, Sweden, Switzerland, the United Kingdom, the United States and the European Monetary Union have all tightened monetary policy on several occasions. That in itself does not make it sensible fo tighten policy, of course, but at very least it makes it clear that what we have been doing is t what is happening in many parts of the world.
But why not let 'pure market forces' determine interest rates? As somebody who has a great deal confidence in market forces, it feels a bit strange to have to disagree with those who advocate market forces be the sole determinant of interest rates. Of course, market forces do determine i rates to a very large degree. Central banks really have a strong influence only on short-term rates. But why do we need central banks at all? This is not the place to give a comprehensive a to this question. 1 But it might be worth noting that, to the best of my knowledge, no country in t world currently operates without the services of a central bank. In other words, all countries t aware of have their own central bank, or effectively use the services of another country's centr (through using that other country's currency, or tying their own currency to that of some country). And all of those central banks intervene, as we do, by influencing short-term interest
What about the balance of payments? Surely, the Reserve Bank and its obsession with price stabi have been a major contributor to the large current account deficit which New Zealand has experien over the last decade? Well, actually no. New Zealand has had a current account deficit in every since 1974, through a range of monetary policy regimes. Indeed, the largest deficit experienced that 25 year period, relative to GDP, was in the mid-seventies, with another very large deficit mid-eighties.
I am myself absolutely persuaded that, even if the Reserve Bank Act were amended to make the Ban responsible for reducing the balance of payments deficit, monetary policy has no ability to pr any sustainable reduction in that deficit. Indeed, I do not even know whether reducing a cu account deficit would involve tightening monetary policy (which would push up the exchange rate b slow down domestic spending) or easing monetary policy (which would tend to push down the exchange rate but accelerate domestic spending).
But surely it was daft for the Reserve Bank to tighten policy just as the New Zealand economy emerging from a recession? Well, it might have been daft to do that if that is what we had done, course we did not. New Zealand experienced a brief, mild, recession in the first half of 19 significant part because of the impact of the Asian crisis and of a severe drought. But the ec
1 But see 'Monetary policy and the free-market economy', an address to the Auckland Manufacturers' Association, 22 February 1996.
started growing again in the third quarter of 1998, and despite a few wobbles has been gro increasing vigour since that time.
Most commentators believe that over calendar 1999 the economy grew by over 4 per cent, and in line with our own estimate. (We know that the economy grew by 3.1 per cent in the fi quarters of the year, and our Monetary Policy Statement published last week suggested that quarter GDP grew by a further 1 per cent. Many commentators are already suggesting that th cent estimate will prove to be too low.) It also seems very clear that as a result of that g amount of excess productive capacity which existed in the economy through much of 1998 and has now been largely, or perhaps completely, used up. A tightening of monetary policy over four months has been entirely appropriate.
So those are the questions and comments with which it is pretty easy to deal.
## More fundamental questions
But there are some fundamental questions which must be taken more seriously, questions ab relationship between inflation and growth which go to the heart of monetary policy decision How fast can the New Zealand economy grow without generating inflation? What does 1999 tel about the answer to that question? Let me try to answer those questions, while acknowledgin some areas we ourselves do not have answers. Before doing that, it may be helpful to something about the way we look at this issue.
This is best illustrated in a graph.
The straight line A/B represents the gradual growth in the economy's capacity to deliver goods services without inflation. If demand exceeds the line A/B, then prices will have a tendency to demand falls short of that line, then prices will have a tendency to fall. (I say 'have a tendenc and 'have a tendency to fall' because of course there are many other things which have an influ on prices, including changes in international prices, changes in government charging policy, ch in tariff policies, and similar factors.)
The slope of the line, in other words the trend rate of growth in the economy's capacity to sup largely driven by factors like the growth in the labour force, the quality of the education sys quality of management decision-making, the openness of the economy, the quality of the judic system, the quality of the industrial relations framework, and so on. Monetary policy can hel delivering price stability, because that helps people interpret relative price changes more eas they can do in the presence of high and variable inflation, and avoids the distortions whic interaction of inflation with the tax system often creates. But the main factors affecting tren are the other ones I have mentioned. Monetary policy helps at the margin by keeping prices stable
In practice, of course, A/B is not a straight line - it varies in response to a whole raft including things like changes in net migration.
Like the capacity to supply, demand also tends to fluctuate - in response to changes in intern conditions, in response to changes in public confidence, in response to changes in government po in response to the introduction of new inventions, in response to changes in wealth, in respons whole host of things - and yes, in response to changes in monetary policy.
The key point to note is that when demand falls short of the economy's capacity, as at points C it is possible for the economy to grow rapidly while at the same time inflation is low or f Conversely, when demand exceeds the economy's capacity, as at D, it is perfectly possible for economy to grow very slowly, or indeed even to shrink somewhat, while at the same time inflation rising. It seems to me that, conceptually at least, point C represents the state of the New economy in the early nineties (with very rapid growth but low inflation despite a big fall exchange rate); D represents the state of the economy in 1996 and 1997 (with growth slowing b inflation pushing up to and beyond the top of the then 0 to 2 per cent target range); and E rep where we have been over the last couple of years (with the economy first contracting briefly, growing quite strongly, but with inflation low or falling).
Seen in this light, we should perhaps not have been surprised that there was very little inflati second half of 1999, despite the fact that growth in that half of the year probably ran at an an rate of over 6 per cent; or that inflation in the year as a whole was just 1.3 per cent, despite the whole year of at least 4 per cent. As already mentioned, other factors influence the inflatio the short-term of course - things like international oil prices, changes in government pricing p and so on - but the trend inflation which is the proper focus of monetary policy is basically a of the relationship between demand and the economy's capacity to supply.
But of course this tells us nothing about how fast the New Zealand economy can grow withou generating inflation. What is that 'sustainable growth rate'? What, in other words, is the slope line A/B? Nobody, and certainly not the Reserve Bank, knows the answer to that question wit certainty. But because the answer to the question is so fundamental to our decisions about mone policy, we can not avoid making an estimate of that sustainable growth rate. We are forced to re judgement on the matter.
At the present time, we estimate that the sustainable growth rate of the New Zealand economy around 3 per cent per annum. Of course, the economy can grow faster than that for a time if it from a situation of excess capacity, as was the case in the early nineties and was the case in mi But when that excess capacity is used up, the economy needs to slow to about the sustainable gro rate or risk inflation beginning to pick up.
Some people worry that the Reserve Bank can do considerable damage to the economy by assuming too low a sustainable growth rate, by assuming, say, a 3 per cent growth rate where in reali economy could grow at 4 or 5 per cent if only the Bank would allow demand to expand more rapidly
But if the economy is really capable of growing at 5 per cent and the Bank runs monetary the assumption that it is only capable of growing at 3 per cent, then quite quickly deman below capacity to supply, there will be a strong tendency for prices to fall, and the infl pushed down towards the bottom of the 0 to 3 per cent target range. And since we take n through the bottom of the target as seriously as we take not going through the top, we ar ease monetary policy to let demand expand. In other words, we can't avoid making a judgement sustainable growth, and we can't get it wrong for too long before we are forced to adjust ou
Indeed, we had a rather higher estimate of the sustainable growth rate of the econom mid-nineties but revised it down as we found inflation consistently pushing up towards, a beyond, the top of the target range. Whenever any new piece of data comes out about infl GDP, we look again at whether our current estimate of sustainable growth is still reasonable
What about the 'new paradigm'? As discussed in our Monetary Policy Statement last week, there are those who believe that recent US experience, with rapid growth and low inflation, points some new ability for modern economies operating with the latest technology and in competiti producers from all over the world to grow more rapidly than previously believed without i Local optimists argue that New Zealand too could see more rapid growth with low inflation if Reserve Bank were not so cautious.
Others suggest that, even in the US, the conjunction of low inflation with rapid growth has large part the disinflationary impact of some one-off factors, such as the recent weaknes commodity prices, and the recent strength of the US dollar. They note that there is not yet evidence in New Zealand to suggest that there has been a significant increase in the tr productivity growth of the sort which might be required to justify a belief in the 'new p New Zealand.
As our Statement last week noted, we are not yet persuaded that there is evidence of any fund change in the relationship between growth and inflation in New Zealand. But we are open-min the issue, and will continue to examine the data for evidence of such a change. Indeed, a wh of the Statement was devoted to acknowledging that, while we have no doubt about the need to re the stimulus which monetary policy has been providing to the economy in recent times, there less certainty about how far monetary policy will need to tighten beyond the next few months
## Conclusion
And this is my main message to you today. All the evidence suggests that, after a very brie two years ago and growth of 3 to 4 per cent per annum since the middle of 1998, the excess p capacity in the economy is largely gone. (In other words, referring back to my graph, we ha point E and the demand line is very close indeed to the supply line.) It was appropriate th conditions were stimulatory while demand fell well short of capacity. If we are right that supply are now close to balance, however - and there is now a large body of official sta unofficial anecdotes supporting this view - it is high time that this stimulus was remov course that is what we have been seeking to do with the increases in the Official Cas November, January, and now in March. We project that we will need to continue this reduc stimulus, this easing back on the accelerator, over the next few months.
But will we need to step on the brakes, and if so, how hard? The answer, as so often in matters, is 'it depends'. Our Statement projects some need for monetary policy to become restrictiv to apply the brakes, over the next year or two. But at this stage this seems likely to in milder tightening in monetary conditions than has been the case historically.
One of the reasons for this belief is that New Zealanders now carry a lot more debt, relat incomes, than they did a decade ago. We are assuming a relatively moderate rate of gr household sector expenditure in the next few years as a result. In particular, we are assum rate at which new debt is taken on will slow down as compared with the nineties, and that i interest rates will have a bigger impact on consumption expenditure and even on new housethan in the nineties.
Of course, we could be wrong on this assumption, in either direction. There is not much evidence that increased debt levels have encouraged a slow-down in the rate at which consumption is growi so it is possible that demand arising from the household sector will be stronger than we now pr requiring firmer monetary conditions than we now project.
Conversely, debt levels may be such that even small increases in interest rates induce a slow-do consumption spending and in house-building, requiring monetary conditions to be rather easier t now projected.
Another important area of uncertainty is the exchange rate. At the present time, the New Zea dollar is close to its lowest level ever, on a trade-weighted basis. There are many reasons for t Zealand short-term interest rates have been lower than those in several other English-spea countries, providing little inducement to foreigners to invest in New Zealand dollar assets commodity prices of greatest relevance to New Zealand seem to be recovering rather more slowly th do some other commodity prices. There has been some nervousness about the political environment among investors both here and abroad. New Zealand has a large current account deficit, which lo likely to improve only slowly.
To the extent that the exchange rate is weak because of low commodity prices, we know that offset the stimulus of the low exchange rate is the disinflationary effect of weak export prices. This suggest no need for monetary policy to react.
On the other hand, to the extent that exchange rate weakness simply reflects other factors, such current account deficit or nervousness about the political environment, the Bank may well nee adjust monetary policy to avoid the total demand pressures on the New Zealand economy exceeding the country's capacity to supply. In this event, of course, interest rates may need to rise by m projected in our Statement last week, as I noted at that time.
But of one thing you can be absolutely certain. The Reserve Bank has absolutely not the sligh interest in choking off the recovery. All the evidence suggests that the economy has been gro with increasing vigour over the last couple of years, and most commentators expect it to cont growing at between 3 and 4 per cent per annum for at least the next couple of years. All the evi suggests that, in these circumstances, it is high time to ease off the accelerator and ponder wh touch the brakes.
As Ian Macfarlane, the Governor of the Reserve Bank of Australia, said recently, an alternative w describing the objective of a central bank committed to safe-guarding price stability is to say central bank wants to let the economy 'grow as fast as possible without breaking the infla objective, but no faster'. 2 That is exactly how I see the mission of the Reserve Bank of New Zealand.
Price stability is not an end in itself. Rather, it has always been the best contribution which policy can make to allowing the economy to grow at its maximum sustainable pace.
2 Speech by Mr Ian Macfarlane, Governor of the Reserve Bank of Australia, to the CEDA a nnual general meeting dinner, Melbourne, 28 November 1996.