New Zealand inflation targeting pioneer. In 1990, New Zealand became the first country to adopt formal inflation targeting.

Transcription

1 New Zealand inflaion argeing pioneer In 1990, New Zealand became he firs counry o adop formal inflaion argeing. Key feaures of inflaion argeing in New Zealand ƒ he governmen and he cenral bank agree on specific numerical arges for inflaion ƒ inflaion argeing was adoped only afer a successful disinflaion had been nearly compleed. ƒ he price index on which inflaion arges are based is designed o exclude he firs round effecs of supply shocks and hus measure underlying inflaion. ƒ he inflaion argeing regime is perhaps he mos nearly rule like of any counry ha has adoped inflaion argeing, bu i sill has allowed considerable flexibiliy. ƒ accounabiliy of he cenral bank is a key feaure of he inflaion argeing regime. Legally, he governor of he Reserve Bank may be dispensed if he inflaion arge is breached. ƒ he inflaion arge in New Zealand is saed as a range, raher han as a poin arge. ƒ he relaively narrow arge range and a one-year ime horizon for arges has resuled in 2 relaed problems ƒ a conrol problem ƒ and insrumen insabiliy problem 1

2 I. he adopion of inflaion argeing Inroduced in February 1 s I requires he Reserve Bank of New Zealand o formulae and implemen moneary policy direced o he economic objecive of achieving and mainaining sabiliy in he general level of prices. Requires he miniser of finance and he governor of he Reserve Bank o negoiae and make public he policy arges agreemen (PTA) ha ses ou specific arges by which moneary policy performance in relaion o is sauory objecive can be assessed during he period of he Governor s erm. Why was inflaion-argeing adoped? Poor economic performance: New Zealand experienced double-digi inflaion for mos of he period since he firs oil shock. Cumulaive inflaion beween 1974 and 1988 was 480%. Throughou he period, moneary policy faced muliple and varying objecives which were seldom clearly specified, and only rarely consisen wih achievemen of inflaion reducion. As a resul of his experience, inflaion expecaions were deeply enrenched in New Zealand sociey. Discussion of a change in moneary policy began in 1984 following he elecion. A consensus gradually emerged, boh in he governmen and in he Reserve Bank, abou he proper objecives of moneary policy as well as he insiuional framework needed o achieve hose objecives. A key elemen of his consensus was he need for increased focus on price sabiliy. 2

3 NEED FOR COMMITMENT AND CREDIBILITY The cenral bank feared ha once inflaion raes of around five percen had been achieved, people would anicipae an easing of moneary policy. New Zealand s policymakers realized ha some public commimen was necessary o pu a cap on inflaion expecaions. In addiion, aenion urned o possible insiuional arrangemens which would improve moneary policy credibiliy. I soon became apparen ha increased independence of he cenral bank would be necessary. The Bank has argued ha he coss of inflaion resul mainly from uncerainy abou fuure inflaion and ha o minimize ha uncerainy he cenral bank mus be charged wih and held responsible for achieving price sabiliy. Moneary policy mus be boh clearly formulaed and credible. Auonomy for he cenral bank was also argued o promoe credibiliy, ransparency, and accounabiliy. The cenral bank would cerainly be more credible if i were boh free o se he insrumens of policy and also held responsible solely for mainaining price sabiliy, wih no incenive o pursue oher goals. Muliple objecives end o reduce he ransparency of moneary policy and also, herefore, oo weaken he accounabiliy of boh he cenral bank and he governmen. Given muliple objecives, failure o achieve one objecive can oo easily be explained by reference o anoher objecive. 3

4 A he ime of he signing of he firs PTA (policy arges agreemen) in March 1990, he bank had already succeeded in bringing inflaion down from almos 17 percen a he beginning of 1985 o roughly 5%. Thus he decision o announce inflaion arges occurred afer mos of he disinflaion and is recessionary consequences had already aken place. The announcemen was imed less o promoe disinflaion hen o foresall a rise in inflaionary expecaions once moneary policy began o ease. II. The operaional framework Iniially he goal of price sabiliy was defined as an annual rae of inflaion beween 0 and 2%. This was an exremely ambiious goal given he narrowes of he range and he fac ha he cener of he range was so close o zero. The cenral bank iniially ried o downplay he likelihood of conrol problems, however such problems canno be avoided, and a he end of 1996 he band was widened from 0 2% o 0 3%. 4

5 Measuring Inflaion There has in some ambiguiy abou he choice of price index for defining he inflaion arge. Iniially he decision was o define he inflaion arge in erms of he headline CPI. Acceping a posiive average rae of inflaion reflecs ƒ index number problems ƒ he survey mehodology ƒ he difficuly of adjusing for new goods or for improvemens in qualiy The firs PTA admied ha he headline CPI is no an enirely suiable measure: I incorporaes prices and servicing coss of invesmen relaed expendiures -- increases in ineres raes shown direcly as increases in he cos of living. Policy ighening creaes an essenially spurious rise in measured inflaion. The opimal definiion of underlying inflaion depends on he srucure of he paricular economy in he ypes of economic shocks ha faces. The Reserve Bank has in pracice paid greaer aenion o is measure of underlying or core inflaion. The firs round effec of ineres rae changes on prices is auomaically excluded -- also, he bank makes addiional adjusmens ha feels are warraned. 5

6 The effecs of hese adjusmens are no inconsequenial: The headline and underlying inflaion series have diverged by as much as wo percenage poins and have occasionally moved in opposie direcions. Response o shocks discreionary policy and escape clauses The Bank can deviae from he arge under special siuaions: ƒ A movemen in ineres raes ha causes a significan divergence beween he change in he CPI and he change in he CPI excluding he ineres rae componens. This has been used frequenly because of he effecs of ineres rae changes on morgage and credi charges. ƒ significan changes in he erms of rade arising from an increase or decrease in eiher impor or expor prices. Used wice in 1990, 1991 and in 1994 oil price changes were excluded from he calculaion of underlying inflaion. ƒ an increased rae decrease in he rae of he goods and services ax. ƒ an increase in prices induced by facors such as a naural disaser or a major livesock epidemic. ƒ Changes in governmen or local auhoriy ax levies. 6

7 The use of adjusmens and arge definiion of inflaion is problemaic in ha i may reduce he ransparency and credibiliy of policy. Since ousiders canno reproduce he banks judgmenal esimaes of underlying inflaion, an imporan par of he policy decision process becomes obscured. Reasons for narrow focus on price sabiliy 1. moneary policy affecs inflaion only in he long run 2. because moneary policy is only one insrumen, i can deal wih only one goal a a ime. 3. muliple objecives allow policy o change in ways ha may appear arbirary hereby lowering credibiliy in raising inflaionary expecaions. 4. o require he Reserve Bank o corporae and governmen agencies objecives such as employmen sabilizaion would compromise is auonomy. 5. muliple objecives reduce ransparency and accounabiliy. 7

8 Complicaions due o he exchange rae Beginning and lae 1996 he Reserve Bank consruced and explained he use of a moneary condiions index (MCI) as a means o assess he overall sance of moneary policy. In New Zealand, he MCI is consruced as a 1:2 weighed average of he rade weighed exchange rae and he 90 day ineres-rae. This weighing reflecs he relaive impac of a move in exchange raes on inflaion versus a move in ineres raes 2% rise in exchange rae = 1% rise in ineres raes. The raio underscores how imporan he exchange rae is o he New Zealand economy oher counries which have creaed such indices have found ha i akes hree or four imes as much movemen and exchange raes o be equivalen o a 1% rise in ineres raes. In conras o Germany and Swizerland, New Zealand has never used money growh argeing as an inermediae sep o achieve heir inflaion goals: Empirical work has no been able o idenify any paricular money aggregae which demonsraed a sufficienly close relaionship wih nominal income growh and inflaion. In addiion o he MCI, he yield curve has also been imporan in he banks analyses. The yield curve is used as a means of assessing he sance of moneary policy, wih an invered yield curve signaling igher policy. 8

9 III. New Zealand moneary policy under inflaion argeing Three episodes since inflaion argeing was adoped ƒ March 1990 March 1992: a period of disinflaion and weak economic performance ƒ he second quarer of 1992 hrough he firs quarer of 1994: a period of recovery ƒ he years 1994 o 1997: a period of rising inflaion and ineres raes, coninued appreciaion of he exchange rae, susained GDP growh. During his period, he inflaion arge was breached wice briefly. We focus on he hird episode: The recurring opic afer early 1994 was he uncerainy abou he level of growh ha he economy could susain wihou inducing inflaion. Srucural reforms sared in 1985 liberalizaion of he economy and opening of he markes o inernaional compeiion, changes in he wage seing process were presumed o have made i more difficul for price and wage inflaion o develop. Togeher wih increased credibiliy of he moneary policy framework, he reforms migh permis higher noninflaionary growh in he economy. Esimaing he noninflaionary rae of growh proved o be difficul. 9

10 Throughou 1994, growh was paricularly srong in he consrucion secor. Hence, here was a difference beween he radeable and non-radeable secors. This caused problems for moneary policy. wha deermines he exchange rae? purchasing power pariy $ e 1$ = $ P 1H $ P 1H = ( P ) P 1$ $ e + 1 e = P P P P = ( 1+ π ) ( 1+ π ) As New Zealand s cenral bank increased ineres raes during 1994 o slow he economy, his caused he exchange rae o appreciae. This hur he exporing secor of he economy bu did lile o diminish he demand in he non-radeable secor. 10

11 In May 1995 inflaion breached he 2% ceiling he headline CPI rae rose even higher o 4.6%. This episode demonsraed he conrol problem inheren in moneary policy. When hisorically higher real ineres raes appeared o be insufficien o mainain inflaion wihin he arge range consisenly, he feasibiliy of he arge range was quesioned more widely. The sringen requiremens of inflaion conrol caused harm o he real economy, noably he expor secor. The ension is beween, on he one hand, choosing a arge range which effecively anchors inflaion expecaions a a low-level bu which is so narrow ha provokes excessive policy acivism and risks loss of credibiliy by being frequenly exceeded; and on he oher, a arge range which does a less effecive job of anchoring inflaion expecaions, bu which requires less policy acivism and proecs credibiliy by being rarely breached. Gov. Brash A he end of 1996, New Zealand s cenral bank agreed o widen he arge range o 0 3%. 11