Mr. Brash speaks on monetary policy in New Zealand Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald T. Brash, before the Auckland Chamber Commerce, in Auckland, on 20/4/98.
I very much appreciate this opportunity to address such an important Auck audience at this time. We all know that, on 18 March, the Reserve Bank announced a furthe of monetary policy, an easing which was rather larger than most people had been expecting then, the exchange rate has fallen and interest rates have risen (especially at the short e curve).
These developments have led to a great deal of puzzlement and some anger. W kind of easing is it which leads to an increase in interest rates? Hasn't Don Brash beco Rob Muldoon, interfering in the market and manipulating first this lever and then that initially focused on keeping inflation low but now, worried by the balance of payments pushing down the exchange rate to help reduce that deficit and pushing up interest rates Auckland house buyers? Why do we need the Reserve Bank interfering in financial markets now that we have a largely deregulated economy? Surely the easing was totally 'botched'?
This morning I want to answer those charges. (I will not be making any comment the current level of the MCI, or about what the Bank might or might not do about it.)
## Central banks are an 'intervention', but the RBNZ is not 'Muldoonist'
Let me begin by stating at the outset that central banks are an interventio economy. The Reserve Bank of New Zealand probably has less direct control over financial prices than any other central bank in the world - we haven't intervened in the foreign market for 13 years, for example, and don't fix any single interest rate - but I do no moment that we intervene to influence overall monetary conditions.
I do not want to be side-tracked into a long debate about the virtues of h central bank, beyond simply observing that for all practical purposes we either have our o bank, as the great majority of countries do, or we abandon our own currency and use the se some other central bank, such as Hong Kong and Argentina effectively do (they use the ser the US central bank of course). As long as we want to retain our own money, we need to monetary policy, and some institutional structure with which to implement that monetary pol
The key issue is what that institution, typically a central bank, should try with its powers. I presume that those who accuse us of having become 'Muldoonist' believe have given up our single-minded pursuit of price stability and have instead started using policy to achieve other objectives, perhaps trying to help to reduce the balance of payment trying to deflate property prices. Some people have of course welcomed this 'more pr approach'. I don't think even our worst critics have accused us of manipulating monetary political purposes, which of course was one of the accusations levelled against Rob Muldoon
So let me say it again: monetary policy has been exclusively focused on deli low inflation in accordance with the target agreed with Government (initially 0 to 2 per 0 to 3 per cent) since at least the time I was appointed Governor, now almost 10 ye Monetary policy remains focused exclusively on that objective. Indeed, any other focus monetary policy would be inconsistent with the legislation under which the Reserve Bank o passed without dissent in 1989.
But it is important to recall that price stability was not chosen as the sing of monetary policy because Parliament thought that other objectives were unimportant. Ra the late eighties it had become increasingly recognised here and abroad that the best c
which monetary policy could make to those other objectives - social justice, growth in emp growth in output - was to deliver predictably stable prices. And indeed, this point is no quite explicitly in the wording of the Policy Targets Agreement between the Treasurer and m
Monetary policy aimed at stable prices assists social justice by avoiding the capricious transfers of income and wealth which are the inevitable result of inflation .
Monetary policy aimed at stable prices assists growth in output and jobs by h the price system, which is at the heart of the market economy, work more effectively.
And monetary policy aimed at stable prices assists the economy by helping to s business cycles. Ah, you say, he admits it: the Reserve Bank is using monetary policy smooth the business cycle. No, I am not saying that at all. What I am saying is that whe policy is aimed at delivering stable prices it has the ancillary benefit that the business cycle may be smoothed to some degree also. Why? Because the situations where inflationary pressur increasing are by their nature usually situations where demand in the economy is running the economy's long-term capacity to supply, so that monetary policy aimed at restraini inflationary pressures inevitably tends to dampen down booms. And conversely, those si where demand falls short of the economy's long-term capacity to supply are usually situatio inflationary pressures are falling towards zero, so that monetary policy aimed at preventi falling below zero (as required by my agreement with the Treasurer) inevitably tends to mitigate those downturns.
In determining the stance of monetary policy, we are inevitably trying to asse future inflation pressures will be. That means we are always trying to assess how demand will evolve relative to the economy's ability to supply. Are we primarily trying to smoo cycles? No, we are trying to maintain consistently low inflation within the target we h with Government, but one of the corollaries, one of the ancillary benefits, is that, if w the business cycle will be somewhat moderated also - less vigorous booms and less reces busts. As one of America's leading monetary policy economists, Larry Ball of Johns Hopkins University, has recently argued, even if you were mainly concerned to smooth outpu employment cycles, focusing monetary policy on delivering predictably low inflation would most sensible way of running monetary policy.
So let's make this abundantly clear. The Reserve Bank has not had some so road-to-Damascus experience. We have not decided that inflation matters less and that we 'go for growth'. We have not decided to fix the current account. We have not decided t farmers back in the black. And we have certainly not, as columnist Chris Trotter put it, 'the National Government's political needs'. The easing process that is now underway is a intrinsic to, and an inevitable result of, the monetary policy framework that has New Zealand since the passage of the 1989 Reserve Bank Act. More precisely, it is the i result of an inflation target which has an upper and a lower limit. Recent events are t 'business as usual'.
## Recent changes in interest rates and the exchange rate
But, you ask, hasn't the Reserve Bank just deliberately knocked down the exch rate and increased interest rates? Doesn't that suggest that the Bank has taken its eye stability ball, and is now trying to manipulate conditions in order to reduce the balance deficit? That is certainly a widespread perception, but it is totally wrong.
For a very long time, the Bank has argued that, while we can tighten monetary or we can ease monetary policy, we can not control the way in which these policy adjustmen monetary conditions. Put another way, the mix of monetary conditions is determined by the
decisions and perceptions of countless thousands of individuals, borrowers and savers, bo New Zealand and overseas.
Let me illustrate that point first by looking not at the events of the last fe months but rather at the period during which monetary policy was being tightened to h emerging inflationary pressures from early 1994. Graph 1 shows how overall monetary cond tightened from the beginning of 1994 through to late 1996. In 1994, that tightening took both an increase in interest rates and an increase in the exchange rate, as shown in Gr through 1995 and 1996, as exporters and those competing with imports know only too well, i rates fluctuated through quite a narrow band while the exchange rate continued to increase Indeed, at times the overall firming of conditions took the form of an actual fall in i more than offset, in terms of the effect on inflationary pressures, by a strong increase in rate.
## GRAPH 1
Nominal Monetary Conditions Index January 1994 - April 1998
## GRAPH 2
TWI & 90 Day Bank Bill Rate January 1994 - December 1996
Were overall monetary conditions firming through that period, even though int rates were stable and sometimes falling? In my view they were, and I suspect that most and those competing with imports are in full agreement.
Was the situation ideal? In my view it was not. From our point of view in the bank, it meant that interest rates stayed too low to restrain the very strong growth in bor occurred through that period, which in turn meant that there was insufficient disinflation on those domestic sectors of the economy which were the source of so much of the inflation years. Conversely, the strong increase in the exchange rate was putting more an disinflationary pressure on those sectors of the economy in competition with the rest of even though inflation in those sectors was very low. I occasionally expressed my unhappin that particular mix of monetary conditions, but I recognised that I was not able to change
Over the last year or so of course the process has been substantially revers Bank has been progressively willing to ease overall monetary conditions, and the exten easing since the end of 1996 is also shown in Graph 1. But as can be seen in Graph 3, easing, indeed more than all of the easing , has taken the form of a fall in the exchange rate, offs part by some increase in interest rates.
Is this new mix of monetary conditions surprising? Not really, given the wide perception that New Zealand's balance of payments deficit has reached a high level and g still-strong demand by New Zealanders to borrow. In other words, our strong demand to borr our reluctance to save require us to attract the savings of foreigners. Since those forei seen an increasing risk that the New Zealand dollar might depreciate, we have had to pay i interest rates to offset that perceived risk of currency depreciation.
## GRAPH 3
TWI & 90 Day Bank Bill Rate January 1997 - April 1998
Is the new mix of monetary conditions in some sense undesirable? I am sure i seem so to many indebted companies and households. On the other hand, I am equally confide there are a great number of people in the export sector, and in companies competing with who are absolutely delighted by the change in the mix of monetary conditions. So also people who derive income from their savings. Predictably, most of them are not issui statements expressing their delight, so the overall impression created is that the whol miserable about the change.
In my own view, the change in the mix of monetary conditions which we have se over the last year or so has been a positive development for the economy's medium development. It should certainly assist in reducing the currently large balance of payme Having said that, however, the balance of payments is not an objective of monetary poli that's just as well because, as I have noted already, monetary policy has no ability to mix of monetary conditions.
But didn't the Reserve Bank deliberately change the mix, by projecting a we exchange rate and higher interest rates in its quarterly inflation projections? Certa project an easing in overall monetary conditions over the next year or so and, because w make some assumption about how that easing will be reflected in interest rates and the exch in order to complete our inflation projection, we did indicate that we expected that easin form of a somewhat reduced exchange rate and broadly unchanged interest rates (at least 1998). But we have routinely disclosed the interest and exchange rate assumptions underl inflation projections, and financial markets have understood that these are not assumptions necessarily expect to see realised, let alone assumptions which we can in some way enf financial markets. In December 1997, for example, we projected that the exchange rate w remain broadly unchanged at 64.2 on the Trade-Weighted Index and the 90 day interest rate stay at around 7.6 per cent through the first half of 1998. Well before our March projections were published, the exchange rate had fallen well below 64.2 and interest rates had ris 7.6 per cent. Neither in December 1997 nor in March 1998 were our assumptions about the interest and exchange rates intended to direct financial markets to particular outcomes.
But hasn't the Reserve Bank's easing been 'botched' in some way? Has there r been an easing at all? On those questions I have not the slightest doubt.
One can debate whether the Bank's Monetary Conditions Index is correct calibrated, whether a 2 per cent fall in the exchange rate is equivalent to a 100 basis po in 90 day interest rates. One can debate whether the Bank's Trade-Weighted Index co measures movements in the New Zealand dollar. One can debate whether the 90-day interest correctly measures movements in New Zealand interest rates. And I am familiar with all debate. (We dealt with several of these issues in the March 1998 Economic Projections, and in my speaking notes for journalists in releasing that document.) But if we accept, as I beli that in a small, open economy monetary policy works to affect the real economy and, in t inflation through both interest rates and the exchange rate, then I don't have the slightest d overall monetary conditions have eased in New Zealand in recent months, and indeed have ea quite considerably. That easing has taken the form of a sharp fall in the exchange rate been partly offset by an increase in short-term interest rates (the increase in longer-term has been much more moderate).
I have often conceded that the MCI is not a perfect measure of monetary condi We will continue to seek ways to improve it. But as a rule-of-thumb to guide financia between quarterly projections it has proven enormously useful. It has assisted us thro major rebalancing of monetary conditions at a time of great turbulence in financial internationally, with an absolute minimum of drama. Yes, interest rates have gone up, but balance of payments deficit - or in other words, our huge appetite for borrowing and our aversion to saving - that should not be a matter for surprise or regret. If as a nation enthusiastic about borrowing or more enthusiastic about saving, we can expect interest decline to the levels which would seem to be justified by our low inflation.
In conclusion, I think it is important that we all look at recent events o Right now, the New Zealand economy is having to adapt to a complex set of circumsta including an increase in government expenditure, a reduction in taxation, a changing housin and, coming rapidly over the horizon, the negative implications of the Asian financial c what we see is adjustment to these new circumstances, taking place within existing st without great drama. Monetary policy, with its single focus on price stability and transparency, has reacted as it must, smoothly and objectively. The markets too are dea changed circumstances and creating a context within which New Zealand can be more internati competitive. This is 'business as usual'.