Academic journal article The Reserve Bank of New Zealand Bulletin

The Crisis and Monetary Policy: What We Learned and Where We Are Going: An Address by Dr Alan Bollard to the Canterbury Employers' Chamber of Commerce Christchurch, 29 January 2010

Academic journal article The Reserve Bank of New Zealand Bulletin

The Crisis and Monetary Policy: What We Learned and Where We Are Going: An Address by Dr Alan Bollard to the Canterbury Employers' Chamber of Commerce Christchurch, 29 January 2010

Article excerpt

1 Introduction

Inflation targeting is a monetary policy framework that was developed in response to the high inflation and macroeconomic instability of the 1970s and 1980s. Twenty years ago, New Zealand was the first country to formally adopt key elements of this approach--such as an explicit inflation target and various accountability and monitoring structures--in the Reserve Bank Act 1989. The framework has been durable, even as we've continued to learn how the economy works and continued to adapt and refine the way we do monetary policy.

The past two decades have included one of the longest periods of growth that New Zealand has seen in decades, 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. This speech looks back over those two decades of inflation targeting to see what lessons we can draw from these experiences, as well as outlining some of the challenges ahead.

2 Assessing two decades of learning

The framework we put in place in 1989 and refined in the following two decades has now been adopted in its main features by over 20 countries. In looking back, I will focus on the New Zealand experience, but the main conclusions I draw are not unique to New Zealand. I will argue that 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. Other factors matter: neutral fiscal policies, monetary settings in the major global economies, and a stable financial system. It is in the interplay of the financial system and macroeconomic stability that most learning will need to be done in the coming years.

Price stability has been broadly achieved

In terms of what it was directly designed to achieve, namely price stability, inflation targeting has been a success. Consider the range of conditions under which inflation has been contained within a fairly narrow range. These include an early period of restructuring, a 'benign' period of rising global integration and rapid growth in information technology, where energy prices were low and the costs of a wide range of manufactured goods were falling rapidly; a challenging period of sharply rising commodity and asset prices in the past few years; and the extreme ructions of the global financial crisis. This can be seen from figure 1, which shows New Zealand CPI inflation since 1980, as well as a survey measure of 2-year-ahead inflation expectations. In particular, while inflation expectations crept up in the boom years, and fell back sharply in late 2008 as the financial crisis hit, they have remained well anchored across that time period.

[FIGURE 1 OMITTED]

Inflation targeting has supported, but not guaranteed, macroeconomic stability

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. …

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