An address to the Canterbury Employers Chamber of Commerce
Governor of the Reserve Bank of New Zealand
Mr Chairman, I appreciate this opportunity to address the members of the Canterbury Chamber again at the beginning of a new year.
This is the third occasion on which I have addressed the Chamber on the last Friday of January, and in thinking about what I wanted to say on this occasion I re-read what I said on the earlier occasions. It was a somewhat sobering experience.
In January 1994, two years ago, with 90 day interest rates below 5 percent, with 10 year bond rates below 6 percent, and with the exchange rate, measured on a trade-weighted basis, around 57, I felt it necessary to explain why the Reserve Bank was not willing to use monetary policy to encourage economic growth and employment. This was a response to those who felt that our single-minded preoccupation with the control of inflation was inhibiting growth.
In January 1995, I felt it necessary to defend the substantial tightening of monetary conditions which had occurred during 1994, a tightening which had taken 90 day interest rates to 9.3 percent this time last year, 10 year bond rates to 8.6 percent, and the exchange rate, again on a trade-weighted basis, to over 60. The Bank was being attacked for this substantial tightening in a situation where underlying inflation had increased only slightly, from 1.3 percent for the 1993 calendar year to 1.5 percent for the 1994 calendar year.
In other words, I was reminded in preparing for this address that being attacked for holding monetary conditions too tight is the normal situation for a central banker, almost irrespective of monetary conditions, while the number of those calling for tighter policy at any given moment can normally be counted on the fingers of one hand (with enough spare fingers to manipulate chopsticks).
Well, looking back over the inflation results of the last 12 months it is clear, as we have said several times now, that, despite the substantial tightening of monetary conditions during 1994, and despite the maintenance of firm monetary conditions during 1995, we tightened policy insufficiently during 1994, and possibly maintained conditions insufficiently firm during 1995. There is no other way of explaining the fact that underlying inflation reached 2.2 percent in the year to June 1995 (its highest level since underlying inflation first entered the required 0 to 2 percent range in 1991), and remained at 2.0 percent in the years to both September and December.
Today, I want to make just five points.
First, given the inevitable uncertainties in economic forecasting and the fact that monetary policy has its effect on inflation only after a considerable lag, there is always a risk that underlying inflation will breach the 0 to 2 percent range which the Minister has set for the Bank. That risk is inevitable. What is important, I believe, is not that the range is never under any circumstances breached but rather that the Bank is constantly aiming to deliver inflation outcomes within that range, and that all New Zealanders know and understand that fact, and act in that confidence.
Secondly, while there is always a risk of a breach, the risk can be reduced if the Bank is always striving to deliver forecast underlying inflation in the middle part of the range in six to 18 months' time. Does that mean we should be targeting 1.0 percent at all times, as some critics have argued? I don't personally have a quarrel with the basic thrust of that view, but suspect that there is a rather spurious accuracy conveyed by suggesting that we should at all times be targeting 1.0 percent. Given the lags and given the uncertainties, if underlying inflation can be kept within the 0 to 2 percent range most of the time it is a considerable achievement, and compares well with inflation performance in most other countries and at most other times in our recent history. But we best ensure that result by operating policy so that forecast underlying inflation is in the middle part of the range, and that is certainly clear.
Thirdly, for this reason, we are determined to operate policy so that monetary conditions reduce inflation well below the top of the target range as quickly as possible.
What does that mean? In our December Monetary Policy Statement, we projected inflation over the next two and a half years on the basis of an assumed set of monetary conditions. Those assumptions involved 90 day interest rates remaining at around 8.5 percent over the forecast period, and the exchange rate, measured on a trade-weighted basis, appreciating at a rate equal to the difference between the centre of our inflation target range and the forecast of inflation in our trading partners, or by 1.7 percent per annum. That forecast gave us underlying inflation moving very slowly away from the top of the target range, and bottoming out at 1.3 percent in about one year's time.
After the event, such an outcome might well be regarded by many as acceptable, but looking forward, with all the uncertainties in forecasting, that was not an outlook which could make us terribly comfortable. That was all the more so in a situation where some observers were publicly asserting that we really do not have a 0 to 2 percent target at all, and seem happy to have underlying inflation constantly nearer the top of the range than the bottom. This notion is expressed in more popular form when people ask me `why do you target 2 percent inflation?'
So when the Statement was issued we made it clear that the monetary conditions on which the projections were based were really the minimum we could afford to tolerate under present circumstances; that we would operate policy to ensure that conditions were not easier than those assumed; and would not be at all uncomfortable if conditions were somewhat firmer. If conditions were in fact somewhat firmer than assumed, that would deliver an inflation track which was usefully lower than that projected. That in turn would enable us quickly to re-establish confidence that the Bank is determined to deliver underlying inflation well within the range specified by Government.
But won't that involve maintaining interest rates at levels which are, in inflation-adjusted terms, already among the highest in the world? This is a question I am often asked. Indeed, I am probably asked this question more often than any other. My short answer is that interest rates are at present levels largely because, whatever the arithmetic shows, most New Zealanders do not see current interest rates as particularly high, whatever they protest to an enquiring television journalist. If they did see present interest rates as high, total bank lending would not have been almost 12 percent higher, nor bank lending to the household sector more than 14 percent percent higher, in November 1995 than in November 1994. Only when New Zealanders regard present interest rates as quite high, so that borrowers are a little more reluctant to borrow and savers are a little more eager to save, will interest rates begin to track down again. That will be one important by-product of consolidating confidence in the Bank's absolute commitment to low inflation.
Fourthly, while no country has yet found a substitute for a sound monetary policy if inflation is to be kept tightly under control, it is also clear that many other policies can assist monetary policy. I mentioned when I spoke to you last year that, in New Zealand, we have been fortunate that there have been many other policies which have assisted monetary policy - a gradual reduction in tariff protection, for example, a rising fiscal surplus, more flexible labour market arrangements, liberalisation and deregulation of many previously-regulated and inflexible industries, perhaps especially in sectors such as transport, telecommunications, and banking. Monetary policy could certainly have delivered low inflation even in the absence of such policies, but only at much greater social and economic cost - in other words, much slower economic growth and much slower growth in employment.
As we look forward over the next year or two, it will be important that we leave no stone unturned to find and implement policies which can assist monetary policy to keep prices stable while avoiding an unreasonably high proportion of pressure being borne by exposed sectors such as agriculture and manufacturing. Without such additional policies, the exposed sectors face continued considerable pressure from firm monetary conditions. With such additional policies, there will still be pressure, but it should be rather less.
What other policies might be contemplated? As you know, several other major groups, including Federated Farmers, the Manufacturers Federation, the Tourism Industry Association and the Forest Owners Association are already actively engaged in a search for such policies to suggest to Government. We have had discussions with some of these groups, and would be keen to see additional policies implemented if they can make a useful contribution both to inflation control in the short-term and to the growth potential of the economy in the long-term as well.
Further reduction in tariffs is one obvious candidate for consideration, though given the bipartisan agreement on further tariff reduction which is already in place it seems unlikely that anything more can sensibly be attempted there.
The design details of the proposed tax cuts may be relevant to this issue. The Bank's inflation projections are based on 75 percent of the tax cuts being spent and 25 percent saved, with little net impact on people's willingness to work. Clearly, if the tax cuts can be designed to encourage people to save rather more than 25 percent, or can encourage additional people into the workforce, both of these would assist in keeping inflation under control.
This is certainly not the place to attempt a comprehensive review of policies which might be implemented to assist monetary policy in keeping inflation under control, while moderating the pressure on the export and import-competing sectors. I simply make the point that, while a sound monetary policy is fundamental, other policies can help and the Bank is keen to see all of these other possibilities carefully considered.
Finally, in looking to the future, it is important to be realistic about New Zealand's economic prospects - which means avoiding both excessive optimism and excessive pessimism.
I suspect that excessive optimism has been our recent problem. With real growth of 5 to 6 percent for two years in a row, many people began to think that we had in some way found the secret of growing at East Asian `tiger' rates, perhaps forgetting that such growth was possible only because, when it began, there were very considerable resources of both people and capital equipment standing idle and able to be drawn back into productive employment. Over the last four years, for example, numbers employed rose by 187,000, or 13 percent, a rate of growth significantly faster than the growth of the population. That was possible in large part because the proportion of the workforce who were unemployed fell from nearly 11 percent to close to 6 percent. Whatever the view about what the non-inflationary level of unemployment is (and we have no fixed view on this in the Bank), it is by definition impossible to reduce the unemployment rate by 5 percent every four years indefinitely. Increasingly, therefore, real growth potential will be limited by the extent to which additional people can be drawn into the labour force (either from increased participation rates or from immigration), and more importantly by the extent to which we can improve productivity.
The scope for continuing to increase productivity is, in principle, much better now than it was 10 years ago. Companies in all parts of the economy, and indeed the public sector also, are much more attuned to market demands than previously, much more likely to be allocating investment on the basis of real needs free from inflationary distortions, much more aware of the need to invest in staff training, much more aware of the need for quality and service. But we are still a society where for more than two generations we have been sent signals which discourage savings, signals which discourage the acquisition of skills, signals which discourage earning a living by competing on the international market, and signals which encourage looking to government for solutions to all problems. It will take some time before we develop the passion for education and training felt by, for example, the Singaporeans, or for that matter their national commitment to saving.
But it is equally important to avoid excessive pessimism and, as published statistics this year progressively reveal that the economy slowed down quite sharply last year, I suspect that that is the greater risk. It will be important not to forget how far we have travelled over the last decade - from being one of the most heavily regulated societies this side of the old Iron Curtain to one of the freest; from being a country where government spent $1.28 for every $1 taken in tax to a country where government is now in its third consecutive year of fiscal surplus; from being a country with steadily rising government debt to one where the ratio of government debt to GDP should soon fall below 30 percent, with the net foreign currency debt of government very probably being entirely extinguished within a year; from being a country where economic growth was often the product of temporary fiscal and monetary stimulus to being one where growth has been driven very largely by investment activity; from being a country where waiting months or years for a telephone connection was regarded as normal to one where waiting days is unusual; from being a country where growth was consistently lower than the developed country average to one where growth at the very top of that range looks very probable.
A monetary policy delivering predictably low inflation has been only one small part of this remarkable success story. But it has been a part of that story. We remain convinced that consolidating the emerging confidence that New Zealanders now have that price stability will endure is the best contribution we can make to continued success.