Inflation Targeting: The New Zealand experience

1. Inflation Targeting:The New Zealand experience Banco Central do Brasil 11 August 2006 Grant Spencer Assistant Governor Reserve Bank of New Zealand

2. Contents • History of IT in NZ • Characteristics of the NZ approach • Evolution of IT in NZ • Current issues • Impact of oil shock • Defining medium term inflation objective • Influence of global interest rates • Points for discussion

3. Inflation targeting has been good for New Zealand • Lower and more stable inflation • Higher and more stable output

4. Pre-inflation targeting (1975 – 1990)Average inflation = 12.4%Standard deviation = 4.6%

5. Post price stability(1992 – 2006)Average inflation = 2.2%Standard deviation = 0.7%

6. Pre-inflation targeting(1975 – 1990)Average GDP Growth = 1.5%Standard deviation = 2.8%

7. Post price stability(1992 – 2006)Average GDP Growth = 3.4%Standard deviation = 2.0%

8. But Inflation targeting was part of a wider economic reform program in the late 1980s – early 1990s • Inflation targeting – Reserve Bank Act (1989) • Financial sector liberalisation (1984-1985) • Fiscal reform – Fiscal Responsibility Act (1994) • Reform of broader public sector management – State Sector Act(1988), State Owned Enterprises Act(1986) • Labour market reform – Employment Contracts Act (1991) • Privatisation of state trading enterprises – eg Telecoms, Energy • Trade liberalisation

9. Key influences behind IT in NZ • Broader public sector reforms in late 1980’s were consistent with giving RBNZ a single clear objective – and accountability • Financial liberalisation and the float of the NZ dollar in the mid 1980’s gave the Bank the ability to run an effective market based monetary policy • Monetary theory (Monetarism, the NRH, Rational Expectations) pointed to inflation as the appropriate single objective for monetary policy • Money and credit aggregates had proven ineffective as intermediate targets for monetary policy

10. Institutional characteristics of the NZ approach • Standard characteristics • An independent Central Bank (Reserve Bank Act 1989) • 5 year term for Governor • 5 year funding agreement with Government • Explicit inflation target • Price stability the legislated goal for Monetary Policy • Inflation target specified in contract between Minister and Governor (PTA) • Accountability structures • Board monitors performance of Governor - continuous • Parliament – annual report and quarterly reviews of policy statements • Markets and public – quarterly policy statements

11. Institutional characteristics of the NZ approach • Non standard characteristics • Single decision maker – the Governor • Advice from internal advisory group of governors and senior staff – not the Board • Role of Board is purely monitoring • Can recommend dismissal of governor for non-performance • High level of forecast disclosure • Detailed quarterly forecasts including interest and exchange rate forecasts

12. Institutional structure of IT in NZ Board of Directors Minister of Finance • Board reports on Bank performance • Policy Targets Agreement • 5 yr funding agreement • Board monitors Bank performance Governor • Monetary policy decision maker Reserve Bank Parliament Public/ markets • Annual report • Committee hearings • Qtrly Monetary Policy statements

13. Evolution of the PTA • Strict IT • Target 0% - 2% • Caveats for shocks • Short policy horizon • Policy emphasis on exch rate rather interest rates • Flexible IT • Target 0% - 3% • No explicit caveats • Policy emphasis shifting from exch rate to interest rate • Target 1% - 3% • On average over medium term • Avoid unnecessary volatility in output, exch rate, int rate

14. Issue 1 Current policy Issues in NZ: 1. How to contain the second round effects of the oil shock?

15. Issue 1 Monetary policy looks through supply shock but expectations influenced by headline inflation

16. Issue 2 Current policy Issues in NZ: 2. What do we mean by “on average over the medium term” CPI inflation expected to be outside target range for 8 qtrs CPI inflation

17. Issue 2 Achieving the target “on average over the medium term” can be defined in various ways: • For example: • Three year forward moving average of CPI inflation projections • Three year backward or centered moving average of actual and projected CPI inflation • Being comfortably within the target zone in the second half of a three year ahead horizon • A more explicit definition of the medium term may be necessary to enderpin policy credibility

18. Issue 3 Current policy Issues in NZ: 3. The impact of recent OCR increases has been weakened by low global interest rates

19. Issue 3 Policy has been aimed at moderating housing and domestic demand pressures

20. Issue 3 But borrowers have moved increasingly to fixed rate borrowing, funded offshore

21. Issue 3 But borrowers have moved increasingly to fixed rate borrowing, funded offshore

22. Issue 3 At the same time, higher short rates have put pressure on the exchange rate

23. Issue 3 At the same time, higher short rates have put pressure on the exchange rate

24. Issue 3 Causing demand to be spilled into imports, worsening the balance of payments

25. Issue 3 This issue has led to a search for supplementary stabilisation instruments • Examples: • Changes to the tax system that might moderate the amplitude of housing cycles • Structural policies aimed at improving supply responses in housing booms • Enhancements to the banking supervision framework to reduce any amplifier effect of bank lending on the housing cycle • Other discretionary cyclical stabilisation instruments

26. Points for discussion • Are institutional arrangements working properly? • Decision making • Formal monitoring structures • Policy transparency and effective market monitoring • How to minimise the impact of the current oil shock on inflation expectations? • How to maximise policy credibility under a flexible IT regime? • How to manage policy when the domestic cycle is out of synch with the global cycle?

27. End

28. Policies in synch Predominant effect of NZ policy change O’seas policy Issue 3 • Int rate • Ex rate • Int rate Tight Easy • Ex rate • Int rate NZ policy Easy Tight Monetary policy has poor leverage when it is out of synch with global interest rates

29. Role of the exchange rate in monetary policy has changed markedly over the 20 years since the float Evolution of monetary policy regime • Initial float period • Disinflation period • Uncertain inflation expectations and real interest rate • Mgmt of interest and exch rate • Reducing pass through • Inflation targeting through OCR and Qgap • Medium term target

30. Fixed rates have been more attractive than floating mortgage rates

31. Fixed rates have been more attractive than floating mortgage rates

32. Fiscal performance has improved markedly

33. Commodity prices are an important driver of exchange rate cycles

34. Exchange rate cycles are led by the housing cycle

35. Preconditions for IT "it is sometimes suggested that inflation targeting … requires a sophisticated inflation forecasting ability in the central bank, or a sophisticated financial system, or a sophisticated measure of inflation… But when New Zealand began inflation targeting in the eighties, we had none of those things...“ (Don Brash, Governor 1988-2002)