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Conduct Of Monetary Policy

Conduct Of Monetary Policy

Media release 31 July 2002

Conduct of monetary policy

During the election campaign there was significant comment about monetary policy and speculation about what the Government should establish by way of an agreement with the new Reserve Bank Governor. Much of this comment focused on the relationship between the conduct of monetary policy and its impacts on a balanced growth strategy that would propel New Zealand into the top half of the OECD.

Business NZ has had the opportunity to carefully review recent developments, and to discuss the conduct of monetary policy with its membership and other interested parties. We have also reviewed the Australian experience and the conduct of its monetary policy. This statement sets out Business NZ's position.

Monetary policy's contribution to growth

The key, critical role of monetary policy is to underpin sustainable economic growth through the maintenance of price stability. Essentially, effective monetary policy enables the Government's other policy levers to work more efficiently and encourages the private sector to invest, spend, and save with confidence.

This is because price stability provides economic certainty and stability, encourages the efficient allocation of resources, results in lower interest rates, and provides a sound platform for businesses to invest with confidence. For individuals, price stability prevents arbitrary and inequitable redistributions of assets and incomes, it protects the 'real' value of their earnings and savings, and it provides confidence that their purchasing power is not being eroded.

Exchange rate volatility

New Zealand has a very high proportion of small exporters (only 1.6% of exporting firms annually export more than $25 million each), many of which find it difficult or impracticable to hedge and therefore find themselves exposed to occasionally large and sudden fluctuations in the currency. IMF statistics indicate that between 1989-2001 the New Zealand dollar was no more volatile than the Australian, Canadian, UK and US currencies, but there is much anecdotal evidence that periods of sudden appreciation in the New Zealand dollar have caused many smaller firms to cease exporting.

While we acknowledge that the relationship between changes in monetary conditions and movements in the exchange rate is often inconsistent with what would normally be expected, Business NZ urges the Reserve Bank to take greater notice of the effect exchange rate volatility has on the export sector when it implements monetary policy.

Danger of looser monetary policy

Business NZ considers loosening monetary policy on the grounds that 'a little bit more inflation would help economic growth' to be a dangerous proposition. Higher inflation would erode real wages and savings, would inevitably lead to higher interest rates and a higher cost of capital, and could cause severe economic distortions.

Increased inflation would further detract from New Zealand's already inadequate productivity growth and would actively work against the objective of lifting New Zealand's rate of sustainable economic growth to above 4%. In our view, the existing 0-3% inflation target should be maintained.

Additional objectives

Business NZ does not consider the Reserve Bank Act 1989 should be amended to provide the Bank with objectives additional to price stability. We believe that maintaining price stability is the best way the Reserve Bank could help New Zealand to achieve sustainable economic growth.

There is no evidence that monetary policy has adequate levers to directly influence objectives other than price stability unless the Reserve Bank were to be granted the authority to make policy, for example, on employment or social welfare matters.

More flexibility

Business NZ supports the recommendations of Professor Lars Svensson's Review of the Operation of Monetary Policy. Professor Svensson said that the Reserve Bank's conduct of monetary policy is "entirely consistent with best international practice".

While many of Professor Svensson's recommendations related to governance issues within the Reserve Bank, he suggested the Policy Targets Agreement should be amended to explicitly state that the Reserve Bank's inflation target should be medium-term.

Business New Zealand supports such an amendment. We believe that the current wording, which states that the "target shall be 12-monthly increases in the CPI of between 0-3%", could imply a short-term focus and encourage overly rapid and/or pronounced easing or tightening of monetary conditions.

Our view is that the target should continue to be stated as a 0-3% inflation range, rather than an explicit point target of 1.5%, as suggested by Professor Svensson. Instead, we believe the Reserve Bank should remain free to interpret a 'target point' as it sees fit. If a point target were to be explicitly written into the Policy Targets Agreement then we believe that a range for 'acceptable outcomes' would also be needed - this range would be 0-3%.

Although we support providing an explicit medium term focus, we note that over the past decade, inflation has averaged around 2%, and more recently nearer 3%. Therefore, the suggestion that the Reserve Bank has been fixated on inflexibly targeting the 0-2% or 0-3% mid-points (be they 1% or 1.5%) is simply not borne out by the experience. The financial markets have recognised this and expectations of future inflation have tended to average around 2%, although expectations are now beginning to nudge higher based on the more recent inflation record.

Appointment of the next Governor

It is critical that the next Governor of the Reserve Bank be a person who is suitably qualified and experienced and has a high level of credibility in the business community and financial markets. We would be most concerned if the next Governor is not perceived to have an explicit commitment to maintaining inflation within the 0-3% range.

Growth promoting policies

The conduct of monetary policy is just one ingredient in an overall recipe to improve New Zealand's rate of sustainable economic growth. Productivity is the key, but New Zealand's rate of productivity growth has consistently lagged behind the likes of Australia and the United States. This is the single biggest reason for New Zealand's decline in OECD rankings and our inability to date to make meaningful progress in reducing the growing gap to the richest countries.

The incoming Government must be committed to ensuring that all its economic, social, and environmental policies are focused on lifting New Zealand's productivity growth rate, and therefore the country's rate of sustainable economic growth. Unfortunately, on the evidence of the election campaign, political parties across the board inadequately aided public understanding that only growth could deliver the level and quality of social and environmental outcomes sought by New Zealanders.


In summary, Business NZ considers:

* No amendments to the Reserve Bank 1989 are required;

* The 0-3% inflation target should be retained;

* The Policy Targets Agreement should be amended to explicitly state that the 0-3% inflation target is to be a medium-term target; * The appointment to the position of Reserve Bank Governor must be a person who is suitably qualified and experienced and has a high level of credibility within the business community and financial markets; and * New Zealand's economic, social, and environmental policies must be consistent with increasing New Zealand's productivity and therefore its sustainable rate of economic growth.


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