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Monetary policy in New Zealand: the OCR and other policy approaches

Aaron Drew, Reserve Bank of New ZealandPresentation to High School Economics Teachers Massey University

16 November 2007

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Overview

1. Conventional view of monetary policy and how it works through the economy.

2. New Zealand’s economic performance over recent years.

3. Summary of RBNZ (and other) work on supplementary policy approaches.

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Key background papersThe RBNZ has published 3 key reports in 2006/7 broadly related to

macroeconomic policy in New Zealand

• Supplementary Stabilisation Instruments

http://www.treasury.govt.nz/ssip/

• Testing stabilisation policy limits in a small open economy: Proceedings of a macroeconomic policy forum

http://www.rbnz.govt.nz/research/workshops/12jun06/2837468.html

• RBNZ submission to the FEC Inquiry into the Future Monetary Policy Framework

http://www.rbnz.govt.nz/monpol/about/3074316.html

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Some conventional views…

• Monetary policy can only influence the general level of prices in the long run - though substantive evidence that moderate to high inflation impairs long run growth performances.

• The RBNZ’s pioneering “inflation targeting” approach is widely regarded as international best-practice and has been adopted in many countries.

• An independent monetary policy can not control the “mix” of monetary conditions in an economy with free international capital flows (aka the impossible trinity!)

• Pursuit of a single objective (the inflation target) is best accomplished by sole use of a single instrument (e.g. in New Zealand’s case the OCR).

Last point is an ongoing source of debate in New Zealand and, to a lesser extent, abroad.

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The Transmission Mechanism

• Describes how a change in the OCR affects economic activity and inflation.

• The mechanism is not mechanical – linkages are subject to uncertainty over timing and impacts and are likely to differ over the course of the business cycle.

• There is also evidence that the mechanism has altered in New Zealand (and elsewhere) over the past decade or so; particularly with regards exchange-rate pass-through.

• But NO evidence that the mechanism has made the conduct of monetary policy in New Zealand ineffective.

Reference: http://www.rbnz.govt.nz/research/bulletin/2007_2011/2007jun70_2drewsethi.pdf

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Figure 1. The Transmission Mechanism of New Zealand Monetary Policy

0 21 3 4 5 6 7 8 9

OCR ↑

Time in quarters

Inflation ↓

Wholesaleshort-term rate ↑

Exchange rate ↑

Wholesalelong-term rate ↑

Bond and equity prices ↓

Deposit rates ↑

Effective mortgage rates ↑

House prices ↓

Floating mortgage and Variable loan

rates ↓

Savings ↑

Household Consumption ↓

Tradables Inflation ↓

Exports ↓

Output ↓

Inflation expectations↓

Business Investment and Activity ↓

Employment and wages ↓

Imports ↑

Non-tradables Inflation ↓

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Macroeconomic backdrop

• Despite unprecedented period of economic growth “imbalances” in the growth pattern and persistent inflationary pressure have lead to questioning whether…

• …in the “new world economic order” of open borders, integrating financial markets, low inflation, flexible exchange rates, new centres of high growth, etc…

• ….New Zealand’s macro-economic policy frameworks and policy settings are adequate.

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Growth recovery since early 1990s has been impressive

• NZ’s early 1990s growth recovery is now well documented.

• Recovery from the 1998/99 recession has continued this impressive growth into the new millennium

• Professor Robert Shiller (summary of latest Penn World Tables)….….

” China isn’t the only success story. Other big winners in terms of real per capita GDP between 2000 and 2004 are

Lithuania (up 48%), Romania (up 41%),

Estonia (up 40%), Chile (up 33%),

Hungary (up 32%), Greece (up 31%),

New Zealand (up 28%), Australia (up 25%), Korea (up 23%), Ireland (up 23%), ….”

• http://www.project-syndicate.org/commentary/shiller42

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Expansion since 1997 is longest on record

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But macroeconomic adjustment processes

(or “imbalances”) have looked threatening

• Strong domestic demand growth fuelled by rising house prices and household incomes

• Sustained by foreign funding of lending (e.g.Uridashi bonds)

• More recently fiscal policy and rising commodity prices have added to demand pressures

• Pushing inflation and expectations beyond target band

• And appreciating the exchange rate

• Process has put pressure on the tradable goods sector, particularly non-commodity exporters.

• “Imbalances” manifest in a very large current account deficit, very low levels of housing savings, strong non-tradables inflation….

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2008200620042002200019981996

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-4

-6

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-10

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-4

-6

-8

-10

% %Current account balance

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2008200620042002200019981996

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4

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0

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% %

Non-tradables

Tradables

CPI

Inflation breakdown

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20062002199819941990

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% %

Net Exports

Domestic spending

GDP

GDP growth breakdown

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Have we had too much of “The Good Life”?

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Policy questions

The fundamental question (Do these “imbalances” pose a risk to New Zealand’s continuing prosperity?) can be broken down into (at least!) 7 other questions:

• Has global financial integration reduced the potency of domestic monetary policy?

• Does the exchange rate “move too much” and does it damage long-run growth?• Is the current account deficit “too big” and is NZ at risk of a “sudden stop”?• What is the role of the housing market?• Should fiscal policy do more to assist monetary policy over the cycle?• Is there a cyclical role for prudential policies? • Do structural policies (e.g. features of the tax system and certain regulations)

amplify the cycle, “imbalances” and housing demand?

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Has monetary policy lost potency?

• International financial integration has enabled greater access to international credit

• Including for example Uridashi bonds where the foreign lender carries the exchange

rate risk.

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Global financial integration

• Has seemingly caused domestic interest rates to be more tightly linked to ‘world’ rates, particularly longer-term rates.

• Reducing the margin between NZ and international long-run interest rates,

• and…

Source: BIS

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..causing

…greater separation between domestic short and long rates

…and

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inducing (mortgage) borrowers ….

…. to move out along the yield curve

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Around 2004-2006 reducing effectiveness of increases in the OCR

• Raising of OCR affects longer-term rates, but impact was mitigated by low world rates and low bank lending margins…

• weakening the leverage of the OCR over effective borrowing rates.

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But this phase has now past and policy is starting to gain traction….

20072005200320011999

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6

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% %

OCR

Effective mortgage rate

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But this phase has now past and policy is starting to gain traction….

2007200219971992

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Annual % 000s per month

House sales (RHS)

QV houseprice inflation

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Advice of “international experts”

• “No obvious missing instrument that would deliver a home run.”

• In this new world of open borders, integrated financial markets, low inflation, flexible exchange rates, new centres of high growth, still widespread support for the macroeconomic institutional arrangements.

• In considering what could be adjusted to reduce imbalances, always a risk “such adjustment could come at the risk of losing what NZ presently has.”

• Maybe marginal improvements to be had in monetary and fiscal policy, but greatest gains likely from improved structural (micro) policy settings.

http://www.rbnz.govt.nz/research/workshops/12jun06/2837468.html

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Desirable properties of a monetary policy instrument…

• Inside lags (recognition and approval) and outside lags (implementation and affect) are as short as possible.

• Linkage from the instrument to output and inflation are fairly well understood.

• Impacts are broad-based.

• Impacts are difficult to avoid.

• Usage of the instrument enjoys wide political support.

• The central bank has full instrument independence.

NO alternative instruments identified so far seems to fulfil the criteria above as well as the OCR

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The RBNZ’s recommendations to the FEC inquiry included…

• Encouraging further work by the relevant agencies to ensure that housing land supply and the development of new subdivisions is not unduly restricted by regulatory or administrative constraints.

• Reviewing the taxation of investment income and the tax treatment of the financing of the purchase of investment assets. This should include examining the possibility of modifications to the existing provisions that allow any losses on investment activities to be fully offset against a taxpayer’s other income at that taxpayer’s marginal tax rate (“ring-fencing”).

• Encouraging the development of a framework under which higher thresholds are in place before substantial increases in government spending (or tax reductions), especially those financed from unexpected revenue gains, occur at times when demand pressures in the economy are intense.

• Recommending the allocation of additional resources to improve the overall range, quality, and timeliness of New Zealand’s macroeconomic statistics.

http://www.rbnz.govt.nz/monpol/about/3075586.pdf