Mr. Brash gives an address on 'Reserve Bank forecasting: should we feel Address by the Governor of the Reserve Bank of New Zealand, Mr. Donald T. Brash guilty?' The New Zealand Society of Actuaries inWaitangi on 21/10/98.
## Introduction
Thank you for the invitation to address you today. I last addressed the Soc April 1995 on why I was strongly in favour of the Government's issuing inflation-indexed Notwithstanding some concerns about the tax treatment of those bonds, and their inaccessi small investors, I believe that the issue of the bonds has been successful, and I am very Government proceeded to issue them.
Today, I want to talk on quite a different matter. You, as actuaries, spend your time assessing the viability of pension schemes, and in doing that you need t assumptions about the rate of inflation, the rate of return on investments, and a host of And of course sometimes your assumptions turn out to be wrong, because the one thing you be absolutely certain of is that the future will never turn out to be quite the same as will be.
Well, I have a great deal of sympathy for you. Like you, I as a central banker great deal of my time trying to make an assessment of the future. And like you, I rar absolutely right.
Recently, the Reserve Bank has been severely criticized by a number of peopl having misread the economy in recent months, and in particular for failing to head off quarters of negative growth which New Zealand experienced in the first half of this year. newspaper has gone so far as to suggest that our forecasting record is 'abysmal'. In recen the New Zealand dollar up sharply against the US dollar, we have also been criticized for this to happen. I believe the critics are wrong.
## The accuracy of Reserve Bank projections
The Reserve Bank devotes very considerable effort to its projections. We study wide range of data from New Zealand sources on production, prices, wages, money supply, credit, business and household confidence, and much more. We have developed a series of so indicator models, which help us to assess what is happening in the economy at the prese before we have the official GDP figures available to us. We have developed a sophisticated the whole economy to help us with medium-term forecasting, after looking carefully at t done in other similar countries, particularly in Canada and Scandinavia. Before each projection, a group of Reserve Bank staff fans out across the country and talks to upwa businesses and business organisations to get an up-to-the-minute impression of what a smal of - hopefully - representative firms are experiencing. We have, for example, talked companies and business organisations throughout the country in the last few weeks, in pre for our November Monetary Policy Statement. We get information from the non-executive Dire of the Bank itself, and from a large number of informal sources, such as letters, phone ca meetings which I myself have throughout the country. We talk to Statistics New Zealand to t an understanding of what lies behind some of the statistics. We talk to the producer board understanding of what is happening in the agricultural sector. As a result, we go into ea projection 'round' armed with a very great deal of information on the New Zealand economy.
We do not ourselves make forecasts of the international economy, but instead u monthly Consensus Forecasts, produced by Consensus Economics Inc. in London. These reflect assessment of a group of forecasters in each of the major countries to which New Zealand and historically the average of these forecasts has tended to outperform the forecasting p of any single forecaster. We certainly have no reason to believe that we could produ forecasts for our overseas markets than can the forecasters 'on the ground' in the concerned.
But despite all this effort, we often end up wishing, with the benefit of hind we had run monetary policy slightly differently. Unfortunately, it is inherent in the wa monetary policy works that at times we will wish we had done things a little different Because monetary policy has its effect on the real economy with a considerable lag, and it inflation with an even longer lag. To make matters worse, the lags are not even stable. T that to avoid making errors we would have to have perfect foresight, and of course I embarrassed to admit that we have nothing of the kind.
Indeed, the situation is even worse than that. Not only can we not see into t with perfect foresight, we do not even know precisely where the economy is at present. To we receive lots of anecdotes, and some of the data we analyse may only be a few weeks out But the most comprehensive measure of output in the economy, the estimate for Gross Dom Product, is not available for almost three months after the end of the quarter to which i then for the next year or so that figure is subject to revision, often to very substantial for example, the first estimate made by Statistics New Zealand for GDP in the March quarter indicated that the economy was growing at an annualised rate of some 1.5 per cent. A ye Statistics New Zealand estimated that the annualised growth rate for the March quarter of actually some 4.2 per cent. The policy implications of those two numbers are radically Cynics have suggested that God made economic forecasters to make weather forecasters look But at least weather forecasters can look out the window, and with reasonable accuracy kn the weather is at the present time. Economic forecasters do not have that advantage.
If monetary policy works well, it can help the economy adjust to the unfor shocks which will inevitably hit us from time to time, whether these be sudden changes i prices, sudden changes in import prices, or whatever. This should have a tendency to fluctuations in output to some extent. But it is quite unrealistic to expect that moneta eliminate the business cycle completely, and we have never claimed that we can do so. No how prescient the Reserve Bank had been, the sudden collapse of the Korean economy was al going to have a hugely negative impact on the New Zealand forestry industry, and on part New Zealand tourist industry. We should not, and do not, feel embarrassed about being un fully offset events such as that.
In years past, some economists, recognising the very great practical pro involved in forecasting over the period relevant to monetary policy, suggested that as a s economic forecasting central banks should simply concentrate on keeping some measure of m supply growing at a rate consistent with the inflation target. Alas, central banks aroun found that keeping money supply growing at a stable rate was not only very difficult to do but it also provided rather poor control over inflation. As a result, virtually all centra having abandoned such a monetarist approach to monetary policy, and even those central which continue to base policy on money supply numbers to some degree often find it neces depart from a strict adherence to those targets.
Other monetary policy 'rules' have been devised, the most famous of these per being that named after Professor John Taylor of Stanford University. The Taylor rule setting interest rates in response to deviations in the rate of inflation and the level their targeted levels.
But all of these rules involve a simple rule of thumb as a guide to policy in where the central bank must of necessity set policy for an economic situation which is months into the future, and therefore can not be foreseen with any certainty whatsoever. way the Reserve Bank could avoid the embarrassment of being wrong about the future at le often as being right would be to stop publishing our projections. Indeed, most central ba publish detailed projections for either the economy or for inflation. The Bank of Englan does the Swedish central bank. But the Reserve Bank of Australia does not, the Bank of Cana not, the Federal Reserve Board in the United States does not, and the Bundesbank does not. believe that publishing our projections is helpful to an understanding of what the Reser doing, but life would certainly be rather more comfortable for us if we did not.
What of the present situation? How seriously have we misread the situation? Th point to note I think is that the Bank's primary responsibility is to keep the inflation target which has been agreed with Government. That is the measure against which the Bank be held accountable. The inflation target was originally 0 to 2 per cent, but has been 0 since December 1996. We first entered that inflation target in 1991 and, with the except year to June 1995 (when we exceeded the target by 0.2 per cent, in part as a result of a increase in vegetable prices two months before the end of the year), and 1996 (when w slightly above the target throughout the year), the inflation rate has been within the throughout that period. For all of 1997 and for 1998 to date, we have not only been within but have been close to the middle of the target. At no point since first entering the t 1991 have we driven inflation below the bottom of the band, and indeed at no point has gone below the mid-point of the band which applied at the time. This hardly suggests an forecasting record, nor that the Bank has operated policy excessively firmly. On the overall, it suggests that the Reserve Bank has done its job well.
As an aside, I don't propose to comment in detail here on why we have had to policy rather tighter in New Zealand in recent years than has been necessary in Austra matter has been dealt with in a good article in the Bank's quarterly Bulletin not long a point is that we clearly experienced a conjunction of inflationary pressures, including increases in housing prices, in the mid-1990s, whereas Australia had a rather different ex inflationary pressures in the two countries converge, I have no doubt that in due course w that monetary conditions in the two countries will converge also. Indeed, that seems happened to a considerable extent in recent months.
But is it fair to suggest that the Bank was slow to ease policy in response to crisis, or to the drought? It is worth recalling that the present easing cycle began when Policy Statement was issued in December 1996. At that time, an easing, even the relatively one which we indicated was appropriate, seemed a fairly bold move. Inflation had been out top of the target band all year, the Government had announced a major increase in gove spending for the next three years, and a major reduction in income taxes, although defe year, was within the period relevant to monetary policy. Moreover, financial markets were m confident than we were that inflation was trending down, and kept monetary conditions tigh we felt was necessary almost constantly for more than the next four months. Nobody, i Zealand or elsewhere, was predicting the Asian crisis at that time, though it was at th
monetary conditions relevant to economic activity in the first part of 1998 were determined in New Zealand or elsewhere, was predicting the drought at that time.
Throughout 1997, the Reserve Bank continued to ease monetary condition gradually. During the first months of 1997, most of the easing took the form of lower int Through the balance of the year, the easing took the form of a lower exchange rate, wit rates somewhat firmer. But in interest-rate-equivalent terms, we sanctioned an easing 3 percentage points between December 1996 and 1997.
And how reasonable was the assessment in the Monetary Policy Statement we issu in December 1997? In October that year, the World Economic Outlook published by the I projected that world economic growth would continue at above 4 per cent per annum for the of the decade. This projection was made in the knowledge of the emerging problems in Asia, the expectation that relatively robust growth would continue in the United States and Euro weeks later, the South Korean economy was clearly in serious difficulty, but the mean November Consensus Forecasts projected that industrial production in Korea would grow by a 8 per cent in 1998. Industrial production in Japan was projected to grow at what seemed l modest 2 per cent this year. We were suspicious that perhaps the Consensus Forecasts w picking up the seriousness of the deterioration in the world situation. For the fir deliberately departed from our traditional use of the mean of the Consensus Forecasts, an used a pessimistic sub-set of those forecasts. We had a hunch that the situation could tu worse than these numbers suggested but, with the overwhelming majority of international for continuing to project strong growth in key markets such as Australia, the United States, a we stayed with that pessimistic sub-set.
Even though, with the wisdom of hindsight, it is clear that the growth we pr for the New Zealand economy in 1998 was too optimistic, that is not the same as sayi monetary policy itself was flawed. Every quarter, the Bank produces a new quarterly projec adjusts its position in the light of new data. Perhaps of even greater importance, the financial markets very considerable leeway to adjust monetary conditions in the light of between those quarterly projections. The real issue is not whether the Bank's projecti absolutely correct; they will never be. Rather the issue is whether the Bank allowed conditions to evolve appropriately in the light of new information, and I believe that we d
Over the 10 months since December 1997, the easing of monetary conditions h accelerated so that today monetary conditions are the equivalent of almost 10 percentag easier than they were in December 1997, and more than 9 percentage points easier than th projected to be now, back in December 1997. Of course, not all of that easing has been reduced interest rates: the exchange rate has fallen substantially also. But 90-day intere are at levels last seen in early 1994, and indeed, apart from that brief period in earl Zealand has not seen lower 90-day rates, or lower floating rate mortgages, since the v 1970s! Part of that easing has come about as the Bank has announced its new quarterly pr but most has occurred as the market has interpreted the new data to mean that inflationary are continuing to abate even more rapidly than the Bank's forecasts envisaged. And while from time to time sought to rein in the speed of the market easing, for the most par sanctioned it because we too could see that the emerging data justified easing beyond that when our projections were completed. Remember that when market conditions change and the B sanctions that change by its silence, the Bank has effectively taken an action. Each W morning at 9.00 a.m. when the Bank says nothing, that silence contains deliberate meaning the markets understand very well. In my business, silence does not mean abdication.
Certainly, both the March and June quarter GDP figures were weaker than we h envisaged when we did our projections. But it is inappropriate to compare our published pr completed six weeks or so prior to the publication of the GDP estimates, with the est market economists immediately prior to the release of those estimates if by that co something meaningful is implied. All of us revise our estimates as new pieces of the jigsa and the fact that we have been revising down our own internal estimates is amply illustra extent to which we have been willing to accept conditions very much weaker than envisaged projections.
The last few months illustrate the point rather well. In our August Monetary Statement, we estimated that the June quarter GDP figure would, when released, show that G contracted by 0.2 per cent. On that basis, we estimated that the economy would have a cer of unused capacity, resulting in weak inflation pressures. On that basis, we indicate appropriate level of monetary conditions, on the MCI, would be around zero during the fo three months. By 25 September, when Statistics New Zealand released their first estimate quarter GDP, it was clear that inflationary pressures were abating much more quickly than expected in early August as we completed the Monetary Policy Statement, that GDP had pro reduced by rather more than 0.2 per cent, and that easier monetary conditions would be app And in fact monetary conditions just prior to the release of the June quarter GDP num 25 September were not zero but -290. We issued a 'that's about far enough for the m statement on 7 October, by which time conditions had reached -370.
To repeat, the real issue is not whether our quarterly projections were cor rather whether those projections were reasonable in the light of the data available to us and whether our response in terms of sanctioning easier monetary conditions was appropriate data emerged. Certainly, monetary conditions have eased very substantially over the last 1 and, as we see it at the moment, that has been appropriate.
Do we feel in some sense 'guilty' that we did not ease earlier? Even looking ba decisions, which we took, seem reasonable in the light of the information available at th no, we don't feel 'guilty'. As President Harry Truman once said, 'Any schoolboy's hind better than the President's foresight'.
In summary, I have no doubt about the professional excellence of my staff, or the rigor they bring to our projections four times a year.
Inherent in the criticism, which has been made of the Bank in recent weeks, view that we have unnecessarily constrained the economy by failing to allow monetary condi evolve as the emerging data have suggested was warranted. If that's true, we will see in near to, or below, zero. Well, the latest annual inflation number was 1.7 per cent, mid-point of the inflation target agreed with the Government, and slightly above expectations. I don't know of too many commentators who are projecting inflation to go an close to zero over the next year or two.
Our projections are not an end in themselves; they are merely a guide to the as to how the Reserve Bank is thinking given current data. Nobody who is informed expects come precisely true, because the world is always changing. That's why we constantly all markets to adjust monetary conditions as new data emerge.
Why, then, all the criticism? Partly it is that people always want someone t when times are tough, and the Reserve Bank is an easy target for a cheap shot. Also, I th instinctively want certainty, even when it is not to be had. In that sense, the Reserv continue to disappoint those who want everything to be black-or-white for as long as t continues to be open and honest.
## What about the rising exchange rate?
The only other point I would like to touch on briefly relates to the strengthening of the New Zealand dollar over the last few weeks. Since 23 September, wh New Zealand dollar reached 0.492 against the US dollar, the kiwi has strengthened against dollar by nearly 9 per cent (as of late 19 October). This is pretty dramatic stuff, and th has clearly worried some exporters who fear it may be the beginning of a new period of exchange rate appreciation. Indeed, the Meat and Wool Economic Service of New Zealand estimated, presumably on the assumption that no forward exchange cover has been taken at exchange rates and that the appreciation is not soon reversed, that a 10 per cent rise in rate would see farmers' returns on lamb drop by 17 per cent, on beef by 14 per cent, and o 12 per cent.
I am bound to say that the present mix of monetary conditions is not one, makes me terribly enthusiastic. Given the propensity of us New Zealanders to borrow as cash-flow constraints allow I worry that at present levels interest rates have become undes I certainly don't see much evidence that, at these lower interest rates, New Zealander rushing to increase their savings in order to fund our on-going appetite for borrowing.
Even at the higher interest rates which prevailed earlier in the year - all highest real interest rates in the developed world - New Zealanders were enthusiastic borr reluctant savers, at least in fixed-interest form, suggesting that, whatever the arithmeti implied about real interest rates, most New Zealanders did not perceive interest rates as high in real terms. Certainly, our real interest rates are not out of line with those in s today.
In any case, I have long ago had to face the fact that central banks have ver ability to affect the mix of monetary conditions. To be sure, we could push up interest ra at the cost of putting still further upward pressure on the exchange rate. I know of no w the Reserve Bank can both reduce the exchange rate and increase interest rates. (Of course ease monetary policy further, thereby reducing both interest rates and, presumably, the rate, but the appropriate level of monetary conditions is something which we have to jud light of the overall inflationary pressures, or lack of them.)
What we do know is that international foreign exchange markets have been throu period of quite extraordinary turbulence in recent weeks. During one 24-hour period, the depreciated by 10 per cent against the Japanese yen in the biggest one-day movement exchange rate since most currencies were floated in 1973. Over a three-day period, the dol almost 20 per cent against the Japanese yen, again an unprecedented movement.
In fact, most of the apparent recent strength in the New Zealand dollar ha simply a reflection of the decline in the US dollar. Against the German mark we had 19 October, appreciated by less than 5 per cent; against the Australian dollar we were alm unchanged; and against the Japanese yen, we had depreciated by 8 per cent. The Trade-Wei
Index had appreciated by little more than 1 per cent (all comparisons with rates on 23 S Throughout this recent period of extreme turbulence in international financial markets, Zealand dollar has barely been outside a narrow range of 55 to 57 on the Trade-Weighted Ind
Moreover, it is also clear that the New Zealand dollar has fallen a very l since its peak in April 1997, at 69.1 on the TWI. There seems not the slightest ri approaching these levels again in the near future. Indeed, there is some evidence to sugg current 'bounce' in the New Zealand dollar has a great deal to do with turmoil among th funds in New York. Certainly, market gossip suggests that some of these funds have been sel of so-called short kiwi positions in recent weeks, causing upward pressure on the New dollar as a result. But before you rush to denounce these funds for putting upward press currency, keep in mind that they were instrumental in putting some downward pressure o currency in the process of establishing the short-kiwi positions which they now appear to unwinding. When these short positions have been closed out, the upward pressure on the c could well dissipate quite quickly.
Having said that, neither I nor anybody else I know has a dogmatic view abou appropriate, 'fair', or equilibrium exchange rate for the New Zealand dollar. My own guess is somewhat stronger than the present exchange rate. Certainly, on an inflation-adjusted long-term average trade-weighted exchange rate is a little higher than the present level. the exchange rate almost certainly overshot during the period of almost four years in wh appreciating, so it may overshoot 'on the other side'. Given New Zealand's large current deficit, and still-heavy dependence on world commodity markets, some further weakness i currency in the short-term would not be at all surprising.
One thing we know with confidence, and that is that if financial markets disinclined to continue investing in New Zealand in large amounts at current low inter either interest rates will rise somewhat or the exchange rate will fall somewhat. The Rese responsibility is to ensure that, whatever the mix of monetary conditions, we continue price stability.
## Conclusion
On 26 June this year, I gave a speech entitled, Monetary Policy in a Dang World. Though delivered about two hours after the release of the weak March quarter GDP num it was, of course, written several days before that release. In it, I warned that we could 'the most serious shock to hit the New Zealand economy since the oil shocks of the 1970s also said that the reforms of the last 15 years, including a monetary policy committed to on-going price stability, put us in a good position to weather the storm. Nothing that ha since 26 June has changed my mind, either about the seriousness of the shock or about our weather the storm.