Monetary policy framework to be stress tested

Data Flash (New Zealand) - Opinion

Monetary policy framework to be stress tested

RBNZ encounters an old truth: there is no free lunch

The NZ dollar reached historic lows last week. While US dollar strength is partly to blame, adverse economic fundamentals caused the NZ currency again to depreciate by more than other currencies. On a trade-weighted basis, the NZ dollar is trading 11% below its level a year ago and 28% below the cyclical peak in 1997.

The high current account deficit and low growth potential for the economy are at the top of the list of negative fundamentals. The disappointing performance of the economy with respect to developing stronger non-commodity export industries and markets is common to both problems. Given that those fundamentals are of a structural nature, a broad based strong recovery of the NZ dollar is unlikely in the foreseeable future. While ground may be recovered against the US dollar if US growth moderates, other currencies are likely to outperform the NZ dollar in such a scenario.

Considering the rising trend of New Zealand's external deficit over recent years, such structural currency adjustment was inevitable. As tends to be the case, imbalances are usually allowed to build for a considerable period of time, which causes the subsequent correction to be relatively abrupt and painful.

Given the magnitude of the NZ dollar depreciation, the shock to the domestic price level will put significant pressure on the monetary policy framework. It can be argued that the overvalued exchange rate during the 1990s helped to keep the price level and inflation artificially low, with the currency depreciation now causing a catch-up. That proves again that there is no free lunch anywhere - not even for monetary policy.

Disinflation policy contributed to the external sector problem in the first place

The forthcoming episode of adjusting to a higher domestic price level as a result of NZ dollar weakness can be seen as a left-over from the disinflation period of the 1990s.

The disinflation process commenced in the late 1980s and accelerated in the early 1990s, with the RBNZ surprised to reach the 0-2% inflation target band two years early in late 1991. However, given the 1991 recession, a strong cyclical influence was reflected in the inflation rate. When the economy recovered, the RBNZ had to rely on a continued strong NZD appreciation to keep inflation in the confines of the 0-2% target range. The appreciation was supported by high domestic interest rates.

Keeping inflation low with the help of an overvalued NZD contributed to the build-up of the current account deficit. Export growth slowed markedly and domestic producers faced increased competition from cheaper imports. The underlying trade surplus fell by around 3% of GDP between 1992 and 1997, due to a significant extent to the ongoing process of deteriorating international competitiveness. It can be argued that the RBNZ maintained low inflation at the expense of a worsening external disequilibrium.

Long-term disinflation process may not be finished yet

With the external imbalance now being viewed as unsustainable by foreign investors, the downward correction of the NZ dollar will force the economy to a higher price level. It is a major challenge for the RBNZ to ensure that the price level adjustment does not translate into ongoing higher inflation. However, given the magnitude of the currency shock, it is unlikely that second-round effects can be entirely avoided. In particular, wages are likely to respond to higher CPI inflation, thereby adding to cost pressure for businesses.

The economy is forecast to operate close to potential over coming years, which suggests that cyclical inflation pressure should be close to zero. Consequently, RBNZ action to counter second-round effects from the lower NZ dollar will amount to structural disinflation policy, i.e. policy that reduces the underlying trend rate of inflation in the economy. Such a scenario can be interpreted as a continuation of the process that was left unfinished in the 1990s: adjusting the economy to a long-term trend inflation rate of 1-2%, which is consistent with the specification of the 0-3% inflation target.

Consensus for tough inflation stance to be tested

According to the Policy Targets Agreement, the RBNZ has to prevent underlying inflation from exceeding 3%. Headline inflation is allowed to rise above 3%, if that is due to terms of trade shocks or government policy (e.g. increase in sales taxes). The question has been raised whether there should be a similar caveat for real exchange rate shocks. However, we consider this to be relevant primarily for the issue of accountability of the Governor of the RBNZ, with no material difference for policy making. Caveat or not, the commonsense response to a real exchange rate shock is for the RBNZ to ignore the first round inflation effect and to focus policy on potential second-round influences.

The RBNZ has stressed repeatedly that it will take the commonsense route and only respond to second round-effects. However, there is a potential downside to the Bank's communication of the issue. While it is entirely sensible to draw a clear distinction between first- and second-round effects, the RBNZ has not raised sufficient awareness of the fact that policy reactions may not be distinguishable in the same neat fashion. Given that monetary policy is effective only with considerable lags, acting against potential second-round effects may appear as fighting the first-round rise in inflation. With the market and the public largely focused on the near term and on currently weak domestic trading conditions, pre-emptive interest rate action later this year and early next year is likely to be viewed as inconsistent with the RBNZ's stated policy approach.

Political pressure on monetary policy likely to increase

Similar to the markets and the public, the Government is likely to expect the RBNZ to give prime consideration to the health of the economy during the process of adjustment to a higher price level. Given the RBNZ's recent writings about the flexibility of the framework and the tolerance towards wider inflation cycles, the period ahead will be seen as a test of how tolerant the RBNZ will be in practice.

The 16 August Monetary Policy Statement contained a surprisingly strong focus on current economic conditions. The aim of ensuring a medium-term return of the annual inflation rate to around 1.5% suggests that the RBNZ will, sooner than later, shift back to the medium term outlook for inflation. As a consequence, it is likely to revert to a more hawkish policy response. However, while the RBNZ will view an outlook of 2.5% inflation for several years as sufficient reason for further successive interest rate tightening, public or political support is likely to be absent. With supporters of the current Government likely to suffer most from the adjustment to higher prices, there is considerable risk that a further rise in interest rates will generate significant tension between the Government and the RBNZ. The next year is likely to show that a consensus for low inflation exists in New Zealand - but not for a trend rate as low as 1.5% if that means holding back the real economy.

Ulf Schoefisch, Chief Economist, New Zealand

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