There has been much talk in political circles about the increasing strength of the NZ$ is and its affect on New Zealand’s current account deficit. Labour, NZ First, and the Greens have all being calling for a change to the monetary policy framework – less of a focus on inflation and more on the exchange rate. Brian Fallow of the NZ Herald referred to it as a King Canute-like to imagine in such times that the New Zealand monetary policy settings, or the framework in which the central bank operates, make a difference to the NZ dollar. Cutting the Official Cash Rate (OCR) in a bid to lower the value of the NZ$, making exports cheaper and imports more expensive, would be something that markets would see through and expect to be reversed, and could prove counter productive. Those who say that the main focus of the RBNZ should still be inflation believe that policy be directed to variables that we have some control of i.e. supply-side policies geared to improving New Zealand’s productivity and competitiveness in global markets.
What does determine the value of the NZ$
The NZ$ is deteremined a whole range of variables at different times of the growth cycle in New Zealand and in overseas markets.
* Interest rate differentials – hot money – money which is borrowed at cheap rates overseas and then invested in a currency that has relatively higher interest rates.
* Commodity prices – primary products (priced in US$) – with higher prices this means more US$ have to be converted into NZ$ which increases the value of the NZ$
* Quantitative Easing by economies – US now has implemented QE3
* Risk mentality in financial markets – when the major markets are bouyant they regain their eagerness for more risk and invest in currencies like the NZ$
* International events – with the ease of moving money globally events such as wars, oil prices, exchange rates policies of larger nations lead to more unstability in foreign exchange
* NZ$ appreciates against the AUS$ to news that the Australian economy is stronger than previously anticipated and vice-versa.
However, as Brian Fallow pointed out, the exchange rate is not just about exports and imports but the gap between investment and saving. The more we rely on importing the savings of foreigners, the more demand there is for NZ$’s the stronger it becomes.
With Dr Alan Bollard coming to the end of his second 5 year term as Reserve Bank Governor, there will be a little uncertainty as to the monetary policy outlook under Graeme Wheeler the governor-designate until a new policy targets agreement is finalised in the next few months. Grant Cleland from the Parliamentary Library produced a neat summary of the policy targets agreement since the signing of the Reserve Bank Act in 1989.
Under section 9 of the Reserve Bank Act 1989, before the appointment or reappointment of a Reserve Bank Governor, an agreement setting out specific policy targets has to be signed between the Treasurer and the Reserve Bank Governor. There have been nine Policy Target Agreements signed to date. The first PTA was signed in March 1990 between the Minister of Finance, Hon David Caygill and the Reserve Bank Governor, Dr Don Brash. It set the policy target of achieving an annual inflation rate of 0 – 2 percent by the year ended December 1992.
The following table shows the policy targets agreements signed to date, the signatories, and the inflation policy target within each of them. In December 1996, the policy target for annual inflation changed to a 0 – 3 percent inflation target band. In September 2002, this inflation target band was amended to an inflation target band of 1 – 3 percent on average over the medium term.
The latest Policy Target Agreement was signed in December 2008. It was similar to the previous PTA signed in May 2007, but included a change to the Government’s economic objectives as part of the Price stability section of the agreement. The wording for this section from the last two PTAs are shown below:
May 2007 Policy Targets Agreement – “The objective of the Government’s economic policy is to promote sustainable and balanced economic development in order to create full employment, higher real incomes and a more equitable distribution of incomes. Price stability plays an important part in supporting the achievement of wider economic and social objectives”.
December 2008 Policy Targets Agreement – “The Government’s economic objective is to promote a growing, open and competitive economy as the best means of delivering permanently higher incomes and living standards for New Zealanders. Price stability plays an important part in supporting this objective”.
If you are teaching monetary policy in any course the graphic below shows a significant expansionary monetary policy. Remember in New Zealand the RBNZ changes interest rates to influence the level of economic activity in order to achieve price stability. Note the following:
• Implementation of monetary policy is one of the roles of the RBNZ
• The Reserve Bank Act established “price stability” as the main objective of the RBNZ. The RBNZ is therefore responsible for achieving “price stability”
• “Price stability” is defined in the PTA (Policy Target Agreement) as keeping inflation between 1 to 3% (measured by the percentage change in CPI)
In order to stimulate the economy the ECB cut benchmark interest rates to 0.75%. Chinese authorities cut one year yuan lending rate to 6% (still has ammunition left). The Bank of England reduced rates to 0.5%. This is in the hope that businesses will use the cheaper sources of credit to invest in their business and therefore create jobs. Lower rates would also ease the burden of those on floating interest rates.
The recent CPI figures published by the Dept of Statistics in Wellington show that there was a 1% in the CPI from the June 2011 quarter to the June 2012 – the lowest annual rise since 1999. This is at the bottom of the Policy Target Agreement which stipulates that the CPI should be kept between 1-3%. The question now is whether annual headline CPI inflation can avoid dipping below the bottom of the 1.0% and whether the threat of deflation is a serious concern?
Deflation – why is it a concern?
In the short-term a period of deflation can help the economy. Falling prices mean that consumers can buy more with their income and rising purchasing power would provide a boost to confidence and could assist the economy by increased growth.
However a longer period of deflation can be very damaging to an economy for two reasons:
1. Expecting prices to be lower in the future consumers put off purchasing goods and services in the expectation that they will get lower. This leads to a contraction of demand and ultimately lower growth. Japan in the 1990’s is a good example of this – see graph below.
2. A more dangerous scenario is debt deflation. As prices fall the real value (nominal – CPI) of debt increases – just as it decreases if prices are rising.
The increase in debt that people have taken on over the last 5 years makes this latter point very worrying. However, commentators have suggested that deflation shouldn’t become a problem in NZ.
Supply side policies have the objective of raising the economy’s supply potential and in conjunction with fiscal policy can improve productivity and boost overall supply. It mainly takes the form of tax incentives, investment opportunities, and training of the labour force. It also focuses on reducing the cost burden on businesses.
The BNZ Markets Outlook produced a very interesting article on supply-side issues in the NZ economy. The graph below shows the gap between the capacity of the NZ economy against the aggregate demand. Where the line is 0 – supply = demand and there is no output gap. Above the line there is excess demand and below excess supply.
Interesting that between 2004-2007 the slowing levels of growth reflected the lack ability to increase supply into the market – approaching the inelastic part of the aggregate supply curve. This was in contrast to the official view which led us to believe that demand was slowing. With the pressure on supply, prices started to rise as did wage inflation.
The RBNZ, around 2005/06, was projecting the economy to open up some spare capacity by 2007/08. The economy actually moved into a state of greater excess demand. The difference was like failing to forecast a 4% pick-up in GDP growth.
A recent Westpac publication looked at the apparent confusion in New Zealand concerning interest rates. The Reserve Bank of NZ stated that interest rates will remain at an expansionary level till maybe the end of the year. With this in mind the RNBZ are assuming that there is spare capacity in the economy in that this expansionary monetary policy will not threaten the 1-3% inflation target. The graph below shows 3 scenarios over this year:
1. Status Quo – inflation and growth remained subdued in the NZ economy. The Christchurch rebuilding doesn’t generate any inflationary pressure and little GDP growth.
2. RBNZ – as above their is growth in the economy but spare capacity nullifies any inflationary pressure.
3. Bank Economists – a lot suggest that stronger GDP will cause inflationary pressure
Inflation figures, whether increasing or subdued, will have a significant influence on interest rates. Some analyst have said that the Official Cash Rate (OCR) will remain low for this year i.e. expansionary. But with the Christchurch rebuild there are indications that their will be a tightening early next year. However is an increase in the OCR from 2.5% – 3% a tightening? It really depends on what the neutral OCR rate is – 4%?
Today Alan Bollard, Governor of the Reserve Bank of New Zealand, unsurprisingly kept the Official Cash Rate at 2.5%. One area of concern in today’s statement was the NZ dollar – the RBNZ would prefer to see it a lower levels (see notes below on advantages and disadvantages of a strong dollar). Therefore the future direction of NZ dollar will be critical to interest rate decisions. The bank did suggest that they would hold off on rises with the sustained strength of the NZ dollar.
The Output Gap
The output gap refers to the difference between potential GDP and actual GDP or actual output. According to the BNZ the Treasury produced three estimates of the output gap using various filtering techniques. They were all close to zero, with one slightly abovevand two slightly below. If this is where the true output gap currently sits, it means there is little spare capacity in the economy. So, any reasonable growth is likely to lead to inflationary pressure before too long. It could yet turn out that the RBNZ does not have that much time up its sleeve, before medium term inflation pressures emerge. That though, is likely to be a story for later in the year.
Advantages of a Strong Dollar
• A high NZ$ leads to lower import prices – this boosts the real living standards of consumers at least in the short run – for example an increase in the real purchasing power of NZ residents when traveling overseas
• When the NZ$ is strong, it is cheaper to import raw materials, components and capital inputs – good news for businesses that rely on imported components or who are wishing to increase their investment of new technology from overseas countries. A fall in import prices has the effect of causing an outward shift in the short run aggregate supply curve
• A strong exchange rate helps to control inflation because domestic producers face stiffer international competition from cheaper imports and will look to cut their costs accordingly. Cheaper prices of imported foodstuffs and beverages will also have a negative effect on the rate of consumer price inflation.
Disadvantages of a Strong Dollar
• Cheaper imports leads to rising import penetration and a larger trade deficit e.g. the increasing deficit in goods in the NZ balance of payments in 2001
• Exporters lose price competitiveness and market share – this can damage profits and employment in some sectors. Manufacturing industry suffered a steep recession in 2001 partly because of the continued strength of the NZ$, leading to many job losses and a sharp contraction in real capital investment spending and the lowest profit margins in manufacturing industry for over a decade
• If exports fall, this has a negative impact on economic growth. Some regions of the economy are affected by this more than others. The rural areas are affected by a strong dollar in that our produce becomes more expensive to overseas buyers.
Bernard Hickey wrote a very valid piece in the New Zealand Herald yesterday. The gist of his writing focuses on the RBNZ and the fact that it should be following other central banks in printing money – quantitative easing. In the 1930’s the RBNZ did inject money into the economy and this helped pull NZ out of the Great Depression.
Most people see the dangers of quantitive easing in the hyperinflation that may follow such an expansion of the money supply. However, if you look at Japan in the 1990’s (the lost decade) interest rates remained at near 0% and the printing of more money didn’t create inflation. Furthermore if you look at more recent examples you see the following:
US Federal Reserve, Bank of Japan, Bank of England, Peoples’ Bank of China, and the European Central Bank have printed a combined US10 trillion in the last 4 years and spent it on bonds, cash injections into banking systems. This normally happens when central banks run out of ammunition to stimulate growth – i.e. low interest rates and they enter a liquidity trap scenario. The graph below shows a liquidity trap. Increases or decreases in the supply of money at an interest rate of X do not affect interest rates, as all wealth-holders believe interest rates have reached the floor. All increases in money supply are simply taken up in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Hence, monetary policy in this situation is ineffective.
Bernard Hickey suggests that it would be much better if the government borrowed from the RBNZ rather than foreign banks and pension funds. Also to print money to fund the deficit which in turn will reduce the value of the NZ$ and therefore make exports more competitive. Click here to view the full article.
Alan Bollard has decided not to stand for another term when his current 5 year term expires on 25th September. Bollard was appointed in 2002 and has been at the helm of the RBNZ during the boom years up to 2007 and the subsequent financial crisis that followed.
It has been hinted that this will be a good time to introduce changes with regard the policy target agreement (currently 1-3%) and decision making within the Monetary Policy Committee. The OCR decision could be made by a voting committee rather than solely being the domain of the Governor. Also to introduce more prudent measures on the non-banking and insurance sectors.
Speculation on potential candidates to replace Dr Bollard include, internally; Deputy Governor and Head of Financial Stability, Grant Spencer; Assistant Governor and Head of Economics, Dr John McDermott. Possible external candidates include: Adrian Orr, a former Deputy Governor of the Reserve Bank, and current Chief Executive of the New Zealand Superannuation Fund; Rod Carr, a former Deputy Governor and acting Governor of the RBNZ, currently Vice Chancellor of Canterbury University; Murray Sherwin, also a former Deputy Governor of the RBNZ, and currently Chair of the Productivity Commission.
In a presentation in Christchurch last week, Bollard identified rising interest rates and the Canterbury rebuild as weighing on future monetary policy reviews, as rising bank funding costs push up retail rates independent of movements in the official cash rate. However, one can say that he has done a great job as Governor in very trying times.
The inflation figures issued yesterday took many economists by surprise. For quarter 4 2011 the CPI was -0.3% (+0.4% was the pick by most analysts) whilst the annual CPI figures was +1.8% (+2.6% was the pick). One reason for this fall relates to the 2010 GST hike dropping out of the annual calculations. According to the BNZ there are other factors that are influencing the CPI:
1. International commodity prices – have been at historically low levels and have had the impact of reducing local food prices.
2. Strong NZ$ – cheaper imports especially for things like clothes, furniture etc.
3. Lower telecommincation prices – As Statistics New Zealand noted, “the fall in telecommunication services reflects lower Internet charges, due to increased data caps and lower prices for broadband plans, cheaper international calling rates from landlines, and lower cellphone service charges.”
4. Insurance – Insurance prices rose 0.7% in Q4, to be up 4.5% over the year. This was less than expected. Dwelling insurance has increased 17.5% over the
year. There will be no doubt higher prices in insurance prices in Q1 and Q2 2012, as the 1 February 2012 tripling in the EQC levy feeds into the CPI figures.
All this implies that despite inflation looking well-contained at present, we still harbour inflationary concerns looking into next year and beyond, as forecast growth pushes beyond what looks like a relatively low speed limit at present. Inflation is likely to become a problem at relative low rates of economic growth. This might all seem too far away to worry about at present, especially with today’s drop in headline prices and with so much to watch and consider internationally. But such things are well worth keeping an eye on and weighing up against other developments. Just like any self-respecting, forward-looking, central bank would do.
From the BNZ Economy Watch