Inflation Targeting:The New Zealand experience

Banco Central do Brasil11 August 2006

Grant SpencerAssistant Governor

Reserve Bank of New Zealand

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

Inflation targeting has been good for New Zealand

• Lower and more stable inflation

• Higher and more stable output

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Ann % Ann %

Inflation

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

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Ann % Ann %

Inflation

Post price stability(1992 – 2006)

Average inflation = 2.2%Standard deviation = 0.7%

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

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Ann % Ann %

Annual GDP Growth

Post price stability(1992 – 2006)

Average GDP Growth = 3.4%Standard deviation = 2.0%

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Ann % Ann %

Annual GDP Growth

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

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

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

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

Institutional structure of IT in NZ

Minister of Finance

Board of Directors

Governor

Reserve Bank

•Policy Targets Agreement

•5 yr funding agreement

•Board reports on Bank performance

•Board monitors Bank performance

Public/markets

Parliament

•Qtrly Monetary Policy statements

•Annual report•Committee hearings

•Monetary policy decision maker

200620042002200019981996199419921990

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8

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Ann % Ann %

Inflation

200620042002200019981996199419921990

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7

6

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4

3

2

1

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8

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6

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Ann % Ann %

Inflation

Evolution of the PTA

200620042002200019981996199419921990

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Ann % Ann %

Inflation

• 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

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

Issue 1

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USD NZD

Nominal USD oil price (LHS)

Real oil price, 2006 New Zealand Dollars (RHS)

Monetary policy looks through supply shock but expectations influenced by headline inflation

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Ann % Ann %

Inflation

Inflation Expectations

Issue 1

2007200520032001199919971995

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% %

Target range

Central projectionProjection

CPI inflationCPI inflation expected to be

outside target range for 8 qtrs

Issue 2Current policy Issues in NZ: 2. What do we mean by “on average over the medium term”

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

Issue 2

• A more explicit definition of the medium term may be necessary to enderpin policy credibility

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

4

5

6

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8

9

1999 2000 2001 2002 2003 2004 2005 2006

Percent

Official Cash Rate (OCR)

Effective mortgage rate

+225 basis points

+95 basis points

Issue 3

Policy has been aimed at moderating housing and domestic demand pressures

Issue 3

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Ann % Ann %

Private Consumption

House price inflation

But borrowers have moved increasingly to fixed rate borrowing, funded offshore

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120

1999 2000 2001 2002 2003 2004 2005 2006

Floating Fixed

NZ$ billion

Issue 3

But borrowers have moved increasingly to fixed rate borrowing, funded offshore

0

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100

120

1999 2000 2001 2002 2003 2004 2005 2006

Floating Fixed

NZ$ billion

Issue 3

At the same time, higher short rates have put pressure on the exchange rate

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% Index

90 day rate spread(NZ-US)

TWI (RHS)

Issue 3

At the same time, higher short rates have put pressure on the exchange rate

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% Index

90 day rate spread(NZ-US)

TWI (RHS)

Issue 3

Causing demand to be spilled into imports, worsening the balance of payments

Issue 3

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% of GDP NZ$bill

Current Account Deficit (LHS)

Outstanding NZ dollar bondsissued offshore (RHS)

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

Issue 3

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?

End

Monetary policy has poor leverage when it is out of synch with global interest rates

Easy Tight

Easy

Tight

O’seas policy

NZ policy

Predominant effect of NZ policy change

• Int rate• Ex rate

• Int rate

• Int rate • Ex rate

Policies in synch

Issue 3

Role of the exchange rate in monetary policy has changed markedly over the 20 years since the float

Evolution of monetary policy regime

•Disinflation period•Uncertain inflation expectations and real interest rate

•Initial float period

•Mgmt of interest and exch rate•Reducing pass through

•Inflation targeting through OCR and Qgap•Medium term target

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index

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20%

Crawling Peg

Exchange Rate Comfort Zone

Check List OCR

Direct Controls

<------------- Floating Exchange Rate ------------>

TWI

inflation (right scale)

MCI

6

7

8

9

10

1999 2000 2001 2002 2003 2004 2005 2006

Percent

Two year fixed mortgage rate

Fixed rates have been more attractive than floating mortgage rates

Fixed rates have been more attractive than floating mortgage rates

6

7

8

9

10

1999 2000 2001 2002 2003 2004 2005 2006

Percent

Floating mortgage

rate

Two year fixed mortgage rate

Fiscal performance has improved markedly

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% of GDP % points

Fiscal Balance (LHS)

NZ-US 10yr Bond Spread(RHS)

Commodity prices are an important driver of exchange rate cycles

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Index Index

Commodity Prices (LHS)

Trade Weighted Index (RHS)

Exchange rate cycles are led by the housing cycle

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Ann % Index

House Price Inflation (LHS)

Trade Weighted Index (RHS)

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)