Flexibility and the Limits to Inflation Targeting

By Bollard, Alan; Ng, Tim | The Reserve Bank of New Zealand Bulletin, September 2008 | Go to article overview

Flexibility and the Limits to Inflation Targeting


Bollard, Alan, Ng, Tim, The Reserve Bank of New Zealand Bulletin


This article reproduces the paper for a speech given by Governor Alan Bollard on 30 July 2008. We argue that New Zealand's flexible inflation-targeting framework serves the economy well, but one should not to ask too much of it. Inflation targeting is the best approach New Zealand and many other similar countries have yet found for monetary policy, among a limited number of viable alternatives. The fact remains that the New Zealand economy is subject to powerful forces, and monetary policy can only do so much to buffer the shocks. When shocks are persistent, as with oil and food prices currently, it is difficult to judge the appropriate response. Monetary policy needs to allow the initial price changes to occur, but be firm enough to ensure that generalised second-round inflation effects do not take hold. The clear medium-term objective of 1-3 percent inflation helps to anchor inflation expectations, and gives us more scope to accommodate short-term inflation shocks while ensuring that the price stability objective is not undermined in the process.

Introduction

The New Zealand economy, like many others around the world, is going through a tough time. The cost of living is rising and there is a risk of persistent inflation emerging. However, there is also a broad and quite rapid slowing under way in retail spending and the housing market. The extraordinarily large and persistent rise in international oil prices has made New Zealand poorer - it now costs us more to produce and to consume, and the economy needs to adjust to that. This is a difficult combination of influences not seen since the oil shocks of the 1970s.

On the positive side, food commodity prices are also generally going up and this has benefited our dairy sector in particular. There is some evidence that international meat prices are now on the move upwards also.

To add complication, financial markets and banking systems around the world remain very unsettled. Credit markets worldwide began malfunctioning following the US sub-prime crisis, and have not yet returned to normal. Risk aversion remains widespread. Indeed, some people think the credit situation will get worse before it gets better.

The New Zealand dollar exchange rate has fallen somewhat in response to these domestic and international pressures. On a trade-weighted basis, the exchange rate remains at high levels, but there are big differences in the level of the dollar against particular currencies. We are at historical highs against the US dollar and the Japanese yen, but well below average against the Australian dollar - and almost exactly historically 'normal' against the euro and the British pound.

These are strong influences, and they tug in many different directions. Through all this, the Reserve Bank's task of maintaining price stability is a difficult one. Many other central banks are facing similar challenges. In New Zealand, we are arguably starting from a relatively good position, in that interest rates have been at firm levels and restraining inflation pressure for some time, and have room to fall in response to the weakening economy and abatement of the inflation pressure. For some other countries, growth is set to weaken markedly while inflation concerns remain, but real interest rates are already low or negative.

In this speech, I would like to put current circumstances in the context of the internationally accepted inflation-targeting framework for monetary policy, as applied in New Zealand. I want to ask the question: although the framework has stood the test of time - almost 20 years and counting - is it up to the challenges we face now? I will start by affirming that price stability is the best contribution monetary policy can make to economic growth and prosperity. Overall macroeconomic stability, however, also depends on a sound overall government policy framework that does not itself contribute to economic fluctuations. …

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