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Reflections on 25 years of inflation targeting

Date 1 December 2014

Reflections on 25 years of inflation targeting

Inflation targeting has delivered price stability without reducing long-term growth, and remains the appropriate focus for monetary policy, Reserve Bank Governor Graeme Wheeler said today.

In a speech prepared for a joint Reserve Bank/International Journal of Central Banking conference marking 25 years of inflation targeting, Mr Wheeler took stock of the Bank’s experience with inflation targeting since the passage of the Reserve Bank of New Zealand Act.

“Price stability has brought many benefits. It enables people to plan and contract with greater certainty for longer periods. It reduces the inflation risk premium in interest rates and the need for speculative inflation hedges, and it reduces the insidious toll that inflation exacts on the more vulnerable and less financially sophisticated,” Mr Wheeler said.

“In the 20 years before the Act, annual real GDP growth averaged 2.2 percent while annual inflation was volatile around an average of 11.4 percent. Since 1990, real GDP growth and annual inflation have averaged 2.6 and 2.3 percent respectively, and there has been a marked decline in inflation variability.”

Mr Wheeler said the Reserve Bank is a ‘flexible inflation targeter’.

“We seek to anchor inflation expectations close to the price stability objective while retaining discretion to respond to inflation and output shocks in a flexible manner.”

This flexible, medium-term approach to policy was drawn on at the outset of the Global Financial Crisis when the Bank lowered the Official Cash Rate by almost 6 percentage points in 2008-2009, even though headline inflation was initially well above target. This policy stance was able to cushion the impact of the crisis.

In order to do its job effectively, Monetary Policy needs to be supported by prudent fiscal policy and sound structural adjustment policies. Monetary policy can affect the demand for housing and help ease imbalances in the housing market while supply is increased. But it cannot free up more land constrained by zoning regulations, address procedural and pricing issues around planning consents, offset tax policies in the housing sector, or raise productivity in the construction sector.

The Reserve Bank has multiple checks and balances to monitor its performance and hold the Governor accountable, including a Board and regular Parliamentary hearings. It was ranked second out of 120 central banks in a recent international survey on transparency. Last year, the Bank established a Governing Committee, comprising the four governors, that considers all major monetary and financial policy decisions under the Bank’s responsibilities.

Beyond monetary policy, Mr Wheeler said that the Global Financial Crisis had highlighted the need for sound prudential policies, and led to the emergence of macro-prudential policies to reduce risks to financial stability and the economy from growing imbalances in asset markets.

Looking to the future, Mr Wheeler said that formulating and implementing monetary policy continues to pose many challenges. These relate to the difficulties of fully understanding economic linkages, and forming the judgements needed in assessing policy change, in light of the significance of cross-border financial flows, and their impact on exchange rates and long term interest rates.

He said that central banks operating in floating exchange rate regimes, particularly in smaller countries, are significantly constrained in their ability to run independent monetary policies. They can influence short-term rates but cannot set their own long-term rates.

“This means that macro-prudential policies may need to be called on to help prevent asset price booms and complement monetary policy. But there is still much to be explored around the interaction of monetary and macro-prudential policies, the costs and benefits of such interventions, and the circumstances where such policy initiatives are likely to be successful.”

Read the speech: Reflections on 25 years of inflation targeting


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