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RBNZ response to questions from the FEC on MPS

Reserve Bank response to questions from the Finance and Expenditure Committee on May MPS 2002

27 May 2002

Mr Mark Peck
Finance and Expenditure Committee
House of Representatives
Parliament Buildings

Dear Mr Peck

Mr Kersey passed on a list of questions on which the Committee sought clarification. The questions and our answers are provided below. Please note that we have reordered and grouped some of the questions to avoid repetition.

How are you factoring in asset price growth (houses, land, farms) into your outlook for consumer price inflation?

Box 1 on pages 12-13 of the May Monetary Policy Statement provides the answer in relation to the housing market in particular, but many of its points are applicable to other asset markets.

Asset prices can play three roles in relation to consumer price inflation. They can be an indicator of CPI inflation - consistent with the tendency for all prices to move together when inflation occurs. They can be a symptom - since people tend to buy real assets as protection against inflation. Upward pressure on asset prices can thus reflect the emergence of an inflationary psychology. And they can contribute to general inflation developments - through their effect on actual or perceived wealth and the associated willingness and ability to borrow.

It is also sometimes the case that asset prices have no detectable relationship with consumer price inflation.

Compared with other assets, house prices are often more closely associated with general consumer price inflation, in part because of connections between house prices and components of the CPI (even though the price of existing houses is not itself included in the CPI).

At times of unusually large changes in asset prices we attempt to understand whether the change is related to general inflation pressures, and evaluate which role, if any, asset prices might be playing. That evaluation helps shape our forecasts of inflation pressure, but rarely in a big way. We do not judge asset price developments to be playing a big role in shaping inflation pressures at the moment.

What pressures are you seeing in the labour market re:wage growth and how do you see this feeding into consumer price inflation (i.e. higher sale prices or less profitability for firms as they absorb the wage costs)?

Several indicators (see figure 20 on page 15 and the surrounding discussion) suggest that the labour market is tighter than normal; our discussions with businesses provide the same message. However, wage growth remains moderate. Wage growth developments normally follow some time behind changes in labour market conditions. Given that our projection is for a modest tightening in labour market conditions (were monetary stimulus to remain in place), we believe it is too early to assess the meaning of recent moderation in the pace of wage growth.

If wage inflation were to accelerate, it would not automatically be the case that consumer price inflation would accelerate. Whether that happens would depend on whether employers put up the prices of the goods and services they produce, which in turn would depend on whether the higher wage costs were offset by an increase in productivity growth or something else, and on how easily firms could increase prices. In the latter regard, our projection is for market conditions to become increasingly accommodating of higher prices (again, if monetary stimulus were to remain in place).

Is the surge in migration into the country reducing or adding to medium-term inflation pressures (i.e. more demand immediately, but also more labour supply)?

We have moved more towards the view that the inflow is stimulating demand to a greater extent than it is adding to the economy's capacity to produce goods and services to meet that demand. This analysis draws mainly from the age and vocational composition of migration flows (in both directions), and supporting evidence from migrants' transfers and discussions with experts including providers of educational services. At the macro-economic level, various labour market indicators - including measures of skill shortages, vacancies and the unemployment rate - suggest that the `tight' labour market conditions evident over 2000 and 2001 have not been alleviated to any great extent recently. This is despite significant net inflows into the working age population over the last few quarters brought about by the migration surge.

This evaluation is relevant for inflation over the period that matters for monetary policy (the "medium term") but says nothing about the long-term consequences. In the long term, an increasing population through immigration may well be positive for the economy's growth capacity, to the extent it adds to the labour force, and to the extent that productivity is boosted by people arriving with new skills and capabilities.

Why is New Zealand only allowed to grow 3% per annum - as suggested by your potential output estimates, and how is monetary policy impacting on this potential output?

We would strongly dispute the notion that New Zealand is only "allowed" to grow at any particular rate. But to sustain any particular rate of growth over long periods of time, it needs to be the case that such a rate of growth doesn't persistently add to inflation or deflation. Whether any particular sustained rate of growth adds to inflation or deflation is determined by geography (in its broadest sense), by New Zealanders' choices, and by the rest of the world. It is not normally determined by monetary policy. Typically the only time that monetary policy has an impact on the non-inflationary trend growth rate is when monetary policy allows substantial and variable inflation to emerge. In such cases monetary policy harms growth potential, by confusing and distorting decision-making.

The question arises from our current estimate that a rate of growth of around 3% over the next few years would not put pressure on inflation, one way or the other.

That estimate does not constitute a limit beyond which the economy cannot grow. In fact, the economy is probably growing faster than that at the moment. It certainly grew faster than that in the year to March 2000 (at around 5%) and in the year to March 1994 (at around 7%).

Nor does the fact that we have that estimate create a self-fulfilling prophecy. To be sure, if growth continues to exceed our estimate of what can be sustained without inflation, we would tighten monetary policy, which in turn would slow the economy. But if we were wrong about our estimate, inflation would fall too far, too fast. Unexpectedly low inflation provides independent evidence that the economy can grow faster than we assumed without generating inflation pressure. (At the same time, unexpectedly high inflation provides independent evidence that the economy can't grow as fast as we assumed without generating inflation pressure.) In response to inflation moving lower, we would act to facilitate more activity so that the economy grows faster than our former estimate of potential.

The harm caused by a poor estimate of non-inflationary potential growth is to the stability of economic growth, rather than to its trend. It is true that a very bad mistake in estimation might make economic growth so unstable that harm would be done to the trend, again by confusing and distorting decision-making. But we do not believe that we are in such a danger. Indeed, economic growth has been relatively stable in recent years, relative to our history.

As to the question of why 3 per cent (currently) and not 2 per cent or 4 per cent, we readily acknowledge that this is one of the most difficult questions for economics to answer. It has to do with productivity growth, the determinants of which are poorly understood. Because of this, our practice is to observe past productivity growth, try to detect the trend, extrapolate that trend, and be prepared to adjust the estimated trend as more experience is added. We are careful to avoid mechanical approaches that presume an unchanging trend. We also pay close attention to other indicators of the degree of inflation pressure on the economy's resources. This exercise is difficult enough, but it pales into insignificance compared with the difficulty of building a forecast of productivity trends from theory.

Isn't there a real risk that the increase today will end up combining next year with the effect of export returns to have a significant dampening effect on economic growth? What is the effect of lower commodity prices (eg dairy) on your economic outlook? Given the high projected decline in dairy export receipts, why has the Bank revised export prices for the 2002 year upwards from -8¾ per cent to -6¼ per cent?

We fully expect that the withdrawal of stimulus associated with the OCR increase will combine next year with declining export returns to dampen economic growth. We have allowed for a fall of 5 per cent in total export returns, partly from lower commodity prices and partly from a higher exchange rate. But:

a 5 per cent fall is to be set against a 40 per cent rise over the last three years, leaving most of the recent gains intact to support spending, and
there are other supportive factors - such as still stimulatory monetary policy, the momentum of domestic consumption and investment spending, a recovering world economy, and a sharp increase in the population - that collectively are large enough to overwhelm the negative effect of lower export incomes.
Is there a risk that export incomes could drop by more than we have allowed, and alter the equation? Yes. One of the factors that could do that is a faster/larger exchange rate appreciation. We have already observed more exchange rate appreciation than we allowed for in the projections. But there are also risks on the other side.

As to why we revised the low point for overall export prices upwards in the May projection (compared with the March projection), the reasoning was given on page 22 of the Statement (first column). Prices of non-dairy commodities appear to have stabilised or firmed in world markets earlier than we expected in March. Meantime, the outlook for world prices for non-commodity exports (including services) looks better with consolidation of a recovery path for the world economy.

Where is "neutral" on the interest rate front?

As with related notions, such as the non-inflationary potential growth rate of the economy and the equilibrium exchange rate, the neutral interest rate is a useful mental construct to help the Bank's thinking process, but hard to pin down to any specific number. The basic idea is that interest rates will cycle around a long-term trend level as the economy cycles around its long-term trend growth rate. Very broadly speaking, when the economy is below trend, interest rates are brought down, which stimulates activity, and when the economy is above trend, interest rates are pushed up, slowing the pace of growth. This counter-cyclical movement of interest rates helps keep the economy on a steady course, and helps keep inflation within bounds. The level around which interest rates cycle is described as "neutral" in the sense that somewhere near that level, interest rates are neither obviously stimulatory nor contractionary.

We hesitate to be very definitive about numerical representations of neutral interest rates, given the difficulty in estimating an unobservable and changing concept. However, a reasonable range of estimates of the neutral real (i.e. inflation-adjusted) 90 day interest rate today would cover at least the range from 3 per cent to 4½ per cent. (The range is probably lower now than it would have been five years ago.)

To this number has to be added an estimate of typical inflation expectations for the period that matters for people's expenditure decisions. Given that inflation is currently a little under 3 per cent, that core inflation is probably around 2½ per cent, and the lowest inflation expectation survey number is a little under 2 percent, one might reasonably add between 2 and 3 per cent to the estimated real neutral interest rate.

In other words, a reasonable range for the neutral 90 day interest rate would cover at least the range from 5 per cent to 7½ per cent.

How do you factor in the future path of the exchange rate in terms of the interest rate decision? Noting that our interest rates are now well ahead of those offshore, what pressure do you see higher interest rates in New Zealand having on the New Zealand dollar?

As a standard matter, our projections assume that the exchange rate will return to around its long-term trend over a few years. We don't try to predict the pace of that return, but we do modify the standard assumption a little for the effect of interest rate differentials. So, given the interest rate path built into the May Statement projections, the exchange rate is now assumed to get to its trend faster than previously. In the course of doing so, exchange rate stimulus is withdrawn, in turn reducing the pace and extent to which interest rate stimulus needs to be withdrawn.

With New Zealand interest rates higher than foreign interest rates, and with expectations of exchange rate appreciation widespread, it may be the case that the exchange rate comes under more upward pressure than we have allowed for. We say that with some hesitation. Only last year, it was common for countries with relatively high and increasing interest rates to experience exchange rate depreciation. We cannot be at all sure that such a reaction won't return. Given that uncertainty, all we can reasonably do is adapt our policy settings as needed through time.

What readings do you have on consumer price inflation expectations?

There are various surveys of inflation expectations (see figure 5 on page 6 for a selection). One can also extract estimates of inflation expectations from interest rates for different maturities and other financial market prices. However, these indicators are unlikely accurately to represent the true expectations that wage and price setter act on. As a result, in general we look at broad movements across a variety of measures and take into account the probability that inflation outcomes, if sustained, will probably influence "true" expectations.

In this regard, various representations of core or sustained inflation are currently in the vicinity of 2½ per cent (see table 1 on page 16 and the accompanying discussion). Headline inflation is likely to be close to 3 per cent for the next couple of quarters - sufficiently close that a reading of over 3 percent is a material risk - before falling back towards the middle part of the inflation target band over the next 2 years.

What factors do you take into account when you balance short-term volatility with longer-term inflation goals i.e. fulfilling section 4c of the PTA?

Section 4c of PTA points to a concern about the volatility of the real economy. In thinking about the effect of monetary policy on the real economy's volatility, a balance has to be found between the two main alternatives.

If we try to reduce inflation too rapidly, an overly-aggressive increase in interest rates would slow economic growth to the point where subsequent disinflationary pressures would call for a sharp reversal of policy direction. Not only would interest rates and economic growth go through a large cycle, but so might inflation itself. It is likely that the exchange rate cycle would also be larger in this circumstance, but for reasons already noted, the connection between interest rates and the exchange rate is not very clear.

The damage that would be caused by an overly aggressive reaction is the reason why we are prepared to see inflation move to, and occasionally beyond, the edges of the inflation target range.

The other alternative involves reducing inflation too slowly. Once inflation gathers some momentum, it is harder to get it subsequently to fall. This was our experience in the mid-1990s. Moreover, once inflation has drifted up, new economic events that drive prices up would have a higher chance of pushing inflation above the target range, potentially causing a further upshift in inflation expectations. The harder it is to get inflation to fall, the larger the cost to the real economy when it does happen.

The risk of creating unnecessary instability in output, interest rates and the real exchange rate and so causing damage to the economy by letting inflation expectations drift to the edges of the band is the reason why we aim to nudge inflation back toward the middle of the target range. It is also the reason why we aim to do this over the years ahead, rather than rapidly.

In charting a course between these two alternatives we have taken the calculated risk that a slow return of inflation towards the middle of the inflation target range (see figure 3 on page 5) does not leave us too close to the second alternative.

Yours sincerely

Roderick M Carr
Acting Governor

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