RBNZ's Bollard defends inflation targeting; rejects ANZAC dollar; welcomes property tax reforms (Update 4)

Reserve Bank Governor Alan Bollard has defended the bank's performance through the financial crisis and its use of inflation targeting as its main monetary policy tool, but has said he welcomes reforms to taxation of property to rebalance the economy. Bollard responded in detail to critics, including Opposition Leader Phil Goff, in a speech to the Canterbury Employers' Chamber of Commerce in Christchurch. (Update 4 includes links to Economic Weather Report video) See an Economic Weather Report on Bollard's speech here on our video page. Watch video on Youtube here. Bollard said inflation targeting had stabilised inflation since its introduction with the Reserve Bank Act of 1989, although there remained other macroeconomic imbalances that needed to be addressed with tax reforms to the property investment sector.

Supplementary tools such as the Reserve Bank's recently introduced prudential liquidity policy could also help act as an automatic stabiliser for the economy that reduces the necessary hikes in the Official Cash Rate during an upturn, Bollard said. Bollard also rejected suggestions that New Zealand adopt a currency union with Australia or use a Singaporean-style policy to control the currency and capital flows, arguing they could have worsened any imbalances. He said inflation targeting had worked to stabilise inflation, but some other imbalances remained. "Inflation targeting has done well on the price stability front, and has given central banks a lot of flexibility in helping steer the economy through turbulent waters. However, in itself, it has not guaranteed balanced growth or macroeconomic stability," Bollard said. He went on to say:

In taming inflation expectations, the inflation targeting framework has removed a major source of economic volatility. It has also allowed for active macroeconomic stabilisation in a broader sense. Most notably, once the global financial crisis hit, we were able to respond with significant policy easing swiftly, cutting the OCR by more than 5 percentage points and providing banks with emergency liquidity at rates consistent with the OCR, at a time when the international wholesale funding markets were severely impaired. We were able to provide this degree of support because the inflation targeting framework allowed for a flexible response, and inflation expectations were well anchored. However, the extent of the financial crisis makes it clear that inflation targeting monetary policy has not been sufficient to guarantee comprehensive macroeconomic stability. Recall the decade or so from the second half of the 1990s to the late 2000s that many commentators called the "˜Great Moderation' or the "˜Goldilocks' economy, when many economies experienced an extraordinarily long stretch of unbroken strong growth. Even then, we continued to see large movements in commodity prices, house prices, interest rates, and exchange rates. There were also significant shifts in the composition of growth, from the traded to the non-traded sector, and big increases in household and external indebtedness. Some of these changes were structural, such as the rise in the global demand for agricultural and other commodities from the late 1990s onward, or the surge in migration to New Zealand in the early 2000s. Some of the price movements were beneficial in helping the New Zealand economy adjust to those changing conditions. But we also saw growing economic imbalances, and the commodity and asset price rises in the years leading up to the financial crisis were among the hardest challenges faced by central banks over the past 20 years.

The Reserve Bank had also been able to 'look through' a quadrupling of the oil price in US dollar terms.

The rise in house prices posed an even greater challenge. When any asset price rises sharply in the context of subdued overall inflation, monetary policy needs to decide whether to raise interest rates now "“ even though inflation pressures are subdued "“ to prevent potential asset bubbles that might have deleterious consequences later. In New Zealand, while we do not "˜target' house prices, we have been able to identify a clear link between the housing market and broader household spending, and have therefore always monitored the housing market as an important indicator for the inflation outlook. However, in an environment of low perceived risk, willing capital markets, and widespread expectations of capital gains, short-term interest rates turned out to have only limited leverage over housing activity. The difficulty was exacerbated by a tax system which favoured investment in housing, and by expansionary monetary and exchange rate policies in the major global economies which fuelled a global carry trade. Thus the NZ dollar appreciated while mortgage rates remained relatively low until quite late in the piece

Bollard went on to reject the idea of an ANZAC dollar, saying it would have caused more imbalances and reduced New Zealand's flexibility.

The NZ dollar has fallen by over 10 percent against the AU dollar since 2006, a period in which Australia experienced an unprecedented minerals boom and very strong growth. If our currency had been pegged to the AU dollar, New Zealand's exchange rate to the rest of the world would have been higher, interest rates would have risen three times already, and our recession would probably have been deeper. The argument is even stronger for other currencies, such as the US dollar. Australia and New Zealand are not the same, but we are far more similar to each other than to Europe or the US. If our currency had been pegged to the US dollar over the past decade, interest rates would have been lower for longer in 2003 and 2004, exacerbating the housing boom (figure 3). Some of the challenges of a currency union can now be seen in Euro area economies such as Ireland, Greece and Spain, where monetary policy settings have been unable to lean against unsustainable domestic booms, or against the deep recessions that followed.

A Singaporean system was also not suitable for New Zealand, he said.

Singapore's monetary policy regime is sometimes pointed to as an alternative to inflation targeting that has maintained stability in the currency while achieving a track record of low and stable inflation. Over the past two years, of course, this has not been the case, with inflation approaching 8 percent in 2008 and prices falling in 2009. Over a longer period, it does appear that Singapore has generally managed to guide its exchange rate to keep inflation stable. But a range of special factors made this possible "“ Singapore's extraordinarily high trade ratio, its large stock of domestic savings and foreign exchange reserves, and a range of supplementary stabilisation instruments and capital controls. In particular, in New Zealand, with its much larger non-traded sector, a Singaporean regime might potentially have required greater swings in the exchange rate than we actually saw to achieve similar inflation outcomes.

Bollard then went on to encourage the government to remove fiscal stimulus and reform taxation to help him on the monetary policy front.

Achieving both low inflation and balanced growth is considerably easier in an environment of fiscal discipline, and where the tax system is neutral with respect to households' and firms' investment decisions. In this respect, a failure to gradually remove the recent fiscal stimulus would put added pressure on monetary policy over the coming period. We are also hopeful that the recently released report of the Tax Working Group will lead to a more efficient and even-handed tax system. Tax policy is complex and needs to meet multiple objectives. Our concerns are to minimise tax-fuelled property investment and consumption that might detract from more balanced savings and growth.

Bollard then addressed the issue of supplementary monetary policy tools, including either measures to force banks to have stable funding (prudential liquidity) or to force them to put aside more capital for property lending. The Reserve Bank has opted for a prudential liquidity policy (Core Funding Ratio) and is reluctant to go down the capital controls route, he said.

At this stage, we believe that the new liquidity policy and in particular the Core Funding Ratio could usefully contribute to the monetary policy task by limiting the banks' ability to fuel credit growth using cheap and plentiful short-term wholesale funding during boom periods, as was the case from 2003 to 2007. In this respect, the Core Funding Ratio could potentially act as an automatic stabiliser and reduce the required hikes in the OCR during economic upturns. The role for a macro-oriented minimum capital requirement in promoting macro-financial stability (as opposed to individual bank resilience), and also assisting monetary policy, is less clear. The relationship between capital requirements and loan pricing is highly uncertain, particularly as the large lenders in New Zealand (as elsewhere) target capital holdings well in excess of current regulatory minima. At best, these instruments could supplement the role of the OCR, but will not fundamentally alter it. Ideally, they would change the mix of monetary conditions and take some pressure off the exchange rate. Overall monetary conditions would still need to be set appropriately to keep inflation stable.

Here is the full press release with the speech below. We will update this speech with more detail and reaction through the afternoon.

Monetary policy worked well in crisis New Zealand's inflation targeting monetary policy has proven flexible, durable and successful, but economic growth requires more than this, Reserve Bank Governor Alan Bollard said today. New Zealand was the first country to formally target inflation. This was in response to the high inflation and macroeconomic instability of the 1970s and 1980s, Dr Bollard said in a speech delivered to the Canterbury Employers' Chamber of Commerce in Christchurch. "It has now been tested through a long period of growth, as well as droughts, migration shocks, terms of trade changes, an Asian crisis, a dot-com boom and bust, and, most recently, the worst global economic and financial crisis seen in generations. "In terms of what it was directly designed to achieve, namely price stability, inflation targeting has been a relative success." Alternative monetary policy frameworks would not have provided the same flexibility to navigate through the crisis, and may in fact have made it harder to maintain price stability while avoiding unnecessary volatility in the wider economy. "Our flexibility meant that, once the global financial crisis hit, we could respond swiftly, cutting the OCR by more than 5 percentage points and providing banks with emergency liquidity, when international wholesale funding markets were gridlocked." Dr Bollard said that inflation targeting works best in conditions where global economic conditions are stable, domestic fiscal and tax policies are neutral, and the financial system is stable. "We know that our job will in part depend on policy choices made by the major global players as they exit from current stimulatory policy settings. Central bankers around the world are balancing the need to provide ongoing support for a very fragile recovery against the risk of keeping monetary and fiscal conditions too easy for too long. "In New Zealand, successful removal of the recent fiscal stimulus would ease pressure on monetary policy. We are also hopeful that the recently released report of the Tax Working Group will lead to a more even-handed tax system when it comes to investment and consumption decisions." He said the key international lesson from the crisis was that financial instability can cause problems for the real economy. Authorities were now working out ways to strengthen and improve the prudential supervision of financial institutions. "In New Zealand, the financial system is a lot simpler than in other parts of the OECD, and has not seen the same types of excesses. Nevertheless, we are taking steps to make our banks and finance companies more resilient to financial system shocks. "In implementing the Basel II capital framework, we have ensured that banks' assessment of risk is based on a "˜through-the-cycle' approach rather than just on the most recent period of growth. We have also put in place a new prudential liquidity policy for banks to make the system less vulnerable to a drying up of international funding markets, such as we saw in late 2008 and early 2009." Dr Bollard said that, as a small, flexible and full-service central bank, the Reserve Bank is in a good position to be at the forefront of progress in integrated macro-financial policy design. He concluded that, at best, new policy instruments could supplement the role of the OCR, but will not fundamentally alter it. "Ideally, such instruments might change the mix of monetary conditions and take some pressure off the exchange rate. Overall monetary conditions will still need to be set appropriately to keep inflation stable."

My view I agree with the Governor's comments. I'm no huge fan of an Anzac currency union or Singaporean style currency and capital controls. The more I see of Europe and Asia, the more I think a freely floating currency is a great automatic stabiliser. Greece, Spain and Ireland would kill for our currency regime right now. We also don't have the savings, the trade-flows or the currency reserves to support a Singaporean style system. I'm no huge fan of Singapore. I lived there for over a year. It's a one family autocracy that runs a workforce that is too scared of the first family (Lee Kuan Yew and his offspring) to be truly creative. You can run a currency regime in a culture like that. I don't think it would work here. I also agree with Bollard that tax reform for the property sector is necessary to rebalance the economy. Hopefully the Tax Working Group's proposals, which are politically and fiscally neutral enough to go through, are adopted in the May budget. He's right too about the government needing to withdraw stimulus, although I don't think that should be used as an excuse for not raising the Official Cash Rate from its record low of 2.5% sooner rather than later. I sort of wish he didn't bother commenting on it, as much because it makes clear the separation. I won't comment on yours if you don't comment on mine. Mucking around on both sides of the fence muddies the waters. I also like the Governor's comments on other tools. The Reserve Bank's prudential liquidity policy is a sensible (and trend-setting) move to dampen the prospect of another credit boom in housing. It is a handy supplementary tool, but is no replacement for moving interest rates to control the economy. It essentially forces the banks to raise more money for longer terms and more money domestically to avoid being stung by a freeze on international markets. The upside is that it increases the banks' funding costs, forcing them into a defacto tightening of monetary policy, but also allowing them to avoid an explosion in rates if markets were to implode again (which is still a real possibility I reckon). The one area where I differ with the Governor is on capital controls for banks. He's right that it would be difficult to use as a monetary policy-style lever, but I still think the capital requirements for housing and farming lending are too low. They may yet rise courtesy of the changes being driven through by the Basle Committee. That would be a good thing. Your view? I welcome your comments and insights below. Here is the full speech from Bollard: RBNZ's Bollard talks on monetary policy