RBNZ's Wheeler looks at success of inflation targeting after 25 years; restates that NZ$ unjustifiably high; says Macro-Prudential policy needed to prevent asset booms

By Bernard Hickey

Reserve Bank Governor Graeme Wheeler has reassessed New Zealand's pioneering inflation targeting regime on its 25th anniversary, saying it had delivered price stability without damaging New Zealand's long term growth rate.

In a wide-ranging speech to an International Journal of Central Banking conference in Wellington, Wheeler said however that monetary policy was unable in the long run to lift economic performance or change the real exchange rate on its own. He said New Zealand and other small open economies that were integrated into global capital markets faced a series of challenges because very easy monetary policies elsewhere were fuelling asset price booms.

This meant the Reserve Bank may have to use Macro-Prudential policies such as its high LVR speed limit to prevent asset booms and complement monetary policy, Wheeler said.

He also repeated the Reserve Bank's comments at repeated points this year that the New Zealand dollar was "unjustifiably and unsustainably high."

The Reserve Bank intervened in August to sell the New Zealand dollar lower, but did not follow up with further intervention in September or October, generating some criticism from business groups that it prematurely tightened monetary policy and had not done enough to drag the currency back towards its justifiably or sustainable levels.

'Inflation targeting worked'

Wheeler began his speech with an assessment of the economy's growth and inflation record since the introduction of inflation targeting under then Governor Don Brash after the introduction of the Reserve Bank Act in 1989.

Wheeler said inflation targeting had delivered price stability without reducing New Zealand's long term growth rate.

"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, annual inflation and real GDP growth have averaged 2.3 and 2.6 percent respectively and there has been a marked decline in inflation variability," he said.

Wheeler said the bank continued to view inflation targeting was the most important contribution monetary policy could make to promoting efficiency and the long-run growth of incomes, output, and employment.

"Price stability preserves the purchasing power of the currency and enables producers and consumers to plan with greater certainty for longer periods, including by responding to relative price changes that would otherwise be obscured during times of high inflation," Wheeler said.

"Price stability also reduces the inflation risk premium in interest rates, facilitates long-term borrowing, lending and contracting, and reduces the need for speculative investments designed to protect against inflation risks," he said.

'Can't effect exchange rate'

Wheeler said the exchange rate remained an important monetary policy transmission mechanism and was often stronger and less predictable than the bank would like.

"In recent years, New Zealand and many other economies have experienced an appreciation in their real effective exchange rate, driven in part by spillovers from the stimulative monetary policies pursued by the major central banks," Wheeler said. Later in the speech he noted that central banks had undertaken US$7 trillion of Quantitative Easing (often described by others as money printing) since the GFC and QE was expected to be bigger in 2015 than in any year since 2011.

"Despite a recent decline in the nominal rate, the high level of New Zealand’s real effective exchange rate remains unjustified and unsustainable," he said.

"While we recognise the pressures associated with exchange rate overshooting, there is little the Bank can do to sustainably alleviate an overvalued real exchange rate, whether through monetary policy actions or the choice of exchange rate regime."

Wheeler said New Zealand had tried various exchange rate regimes over the past 40 years, including a fixed rate, crawling peg, and the current floating rate. The choice of regime had little impact on the medium term level of the real effective exchange rate, he said.

"Instead, the appropriate policy response often lies elsewhere – for example, through measures to improve domestic saving, boost competitiveness, and raise the growth rate of potential output," he said.

'We can't change much on our own in the long run'

Wheeler said monetary policy could not substitute for structural adjustments or deliver long term social equity or distributional outcomes. He referred to the housing market in particular.

"By influencing mortgage rates and the demand for credit, monetary policy can affect the demand for housing and thereby help ease imbalances in the market while housing supply is increased. But monetary policy cannot free up more land constrained by zoning regulations, address procedural and pricing issues around planning consents, or raise productivity in the construction sector," Wheeler said.

Wheeler made a point of explaining how the bank used a Governing Committee to make monetary policy decisions, even though he retained a casting vote on the committee and had the formal and final say in any decisions.

"The decision to establish a Governing Committee follows similar moves by the Bank of Canada, which also has a single decision maker model for monetary policy under its legislation," he said, although he noted there was no evidence that having a single decision maker made the bank's performance weaker or more volatile than other banks with committees making decisions.

'Preventing asset booms'

Wheeler then went on to discuss the emergence of Macro-Prudential policy such as the bank's high LVR speed limit. He repeated the bank's view that the limit had the same effect on house price inflation, credit growth and the 'wealth effects' on inflation as a 25-50 basis point hike in the Official Cash Rate.

"The introduction of LVR restrictions moderated excesses in the housing market, thereby enabling the Bank to delay tightening interest rates, and reducing the incentive for further capital inflows into the New Zealand dollar in search of higher returns," he said.

"The impact of LVRs will weaken over time and they will be eased when housing pressures moderate and the Bank is confident that there will not be a resurgence in house price inflation," he said, noting the bank could not prevent or control housing cycles.

"It can only hope to influence the demand for mortgage lending and the availability of credit, and buy time for the housing supply to increase. In the end, the challenge of rising house prices needs to be met through increases in housing supply," he said.

"But, this often requires other issues to be addressed such as the approval procedures around land use decisions and building consents, and other matters such as the tax treatment of savings, the taxation of investment in real estate, and ways to increase productivity and reduce costs in the building sector."

'Integrated capital markets'

Wheeler then went on to discuss how integrated capital markets had meant central banks in open economies could not have much impact on long term interest rates in the long run.

"Empirical studies show changes in long-term interest rates are highly correlated across countries. This means that central banks operating in floating exchange rate regimes, particularly in smaller countries, are significantly constrained in their ability to run independent monetary policies," he said.

"They can influence short-term rates but cannot set their own long-term rates. Instead, international investor activity has a greater influence over long-term rate," he said.

"We see this at present. The Reserve Bank raised short-term rates during the period March to July 2014 but longer-term mortgage rates have fallen as a result of the decline in long rates in the major economies. This means that macro-prudential policies may need to be called on to help prevent asset price booms and complement monetary policy."

Wheeler ended his speech by saying there remained much to be explored around the interaction of monetary and Macro-Prudential policies.

"Particularly important in this regard will be considerations as to how best to coordinate monetary policy and macro-prudential policy decisions when economic and financial cycles are out of sync and the policies are not complementary," he said.

'Better than we were in 1991'

The current global and domestic challenges reminded central banks what can and can't be achieved with monetary policy.

"For example, monetary policy is relatively powerless to offset the spillovers that global economic and policy developments can impose on our exchange rate and commodity export prices," he said.

"But, monetary policy can complement structural and fiscal policies in supporting the economy’s flexibility and adaptability, and help counter short-term economic fluctuations. Moreover, recent financial sector reforms, including the new macro-prudential policy framework, have given the Bank additional tools for containing systemic risks and promoting macroeconomic stability," he said.

"There is still much to learn in this area, including in the interactions between prudential and monetary policies, but the Reserve Bank is now much better equipped to help build a stronger and more resilient economy than we were prior to 1991."