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New Zealand’s monetary and exchange-rate policy
In international comparison†
Klaus Schmidt-Hebbel ††, Central Bank of Chile
Overview
rate policy, and the need for developing counter-cyclical
New Zealand’s recent business cycle has been driven by
fiscal and financial policy tools to deal with large exchange-
exceptional international conditions, reflected in high world
rate swings and current account imbalances.
growth and favourable terms of trade, and a booming
domestic housing market. While domestic demand is
currently cooling off, the persistence of a large current
1
account deficit and a real exchange-rate that is still on the
New Zealand’s recent business cycle has been driven by
appreciated side, raise questions about the sustainability and
favourable world growth and external terms of trade, as
downside risks of New Zealand’s current and prospective
well as a strong domestic housing boom. However, GDP
conditions. This paper analyses monetary and exchange-rate
growth has been declining from 4.4% in 2004 to 2.4%
policy in New Zealand from the perspective of comparison
in 2005 and a projected rate of 1.7% in 2006, implying
with various control groups comprised of advanced
a narrowing output gap (Figure 1).1 The housing boom
economies. Trends, cyclical behaviour, and correlations of
has been evidenced by strong construction activity, strong
key macroeconomic variables and a comparative assessment
growth in housing permits, and massive capital gains in the
of New Zealand’s overall macroeconomic policy framework
housing market (Figure 2). Construction and the housing
provide a necessary starting point. Evidence on transmission,
market have also started to cool off since 2005, although
efficiency, and independence of monetary policy reveal
house prices are still high.
important similarities and differences between New Zealand
and comparator countries. Drawing from the international
evidence about exchange-rate misalignments and their
implications for growth allows estimating exchange-rate
Introduction
Figure 1
GDP growth and output gap in New Zealand,
1986q1-2005q4
%
misalignment in New Zealand and making inferences about
%
15
15
its potential growth effects. Reviewing the international
10
10
5
5
0
0
-5
-5
evidence on the role of the exchange-rate in the conduct of
monetary policy and the effectiveness of forex interventions
leads to inferences about RBNZ’s monetary and exchange†
††
I thank Paul Baines, Mark Blackmore, Alan Bollard, Philip
Borkin, Robert Buckle, Peter Bushnell, Andrew Coleman,
David Drage, Kelly Eckhold, Hugh Fletcher, Jane Frances,
Andrew Gawith, Khoon Goh, Arthur Grimes, David
Hargreaves, Bernard Hodgetts, John Janssen, Brent Layton,
John McDermott, Anella Munro, Brendan O’Donovan, Michael
Reddell, Rishab Sethi, Murray Sherwin, Grant Spencer, and
Simon Tyler for insightful discussion and/or data provision,
as well as Louise Abolins for kind support, during my April
visit in Wellington. I also thank Alan Bollard, Robert Buckle,
Willem Buiter, Aaron Drew, John Edwards, Stephen Grenville,
Pierre Siklos, Grant Spencer, and other participants for their
valuable comments on the first draft of this paper presented at
the “Macroeconomic Policy Forum” organized by the Reserve
Bank of New Zealand and The Treasury in Wellington on June
12, 2006. I thank Marcelo Ochoa for outstanding research
assistance and discussion. The views presented herein do not
necessarily reflect those of the Reserve Bank of New Zealand,
the Treasury of New Zealand or the Central Bank of Chile. All
remaining errors are mine.
Central Bank of Chile. Email: [email protected]
Testing stabilisation policy limits in a small open economy
-10
Annual GDP growth
Output gap
-15
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003
-10
-15
Source: Statistics New Zealand
Reserve Bank of New Zealand
1
Reserve Bank of New Zealand (2006)
83
Figure 2
Figure 4
House prices, house permits, and GDP growth
Nominal bilateral exchange-rate and real
in residential construction in New Zealand,
effective exchange-rate in New Zealand,
1986q1-2005q4
1986q1-2006q1
Index
200
%
14
US$/NZ$
0.8
180
12
0.7
160
10
0.7
140
8
120
6
100
4
80
2
60
0
40
20
House prices (2000=100)
House permits (2000=100)
GDP growth in residential construction (RHS)
-2
-4
0
-6
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
Source: Statistics New Zealand
Bank lending, particularly the boom in mortgage lending, has
been significantly financed by foreign lending in domestic
currency, the counterpart of a large current account deficit.
While the terms of trade attained in 2004-2005 their
highest levels in two decades, the current account deficit
widened continuously to reach 8.8% of GDP in 2005, one
of the highest external imbalances observed among OECD
Nominal exchange rate US$/NZ
Real Effective Exchange Rate (2000=100) (RHS)
Index
150
140
130
0.6
120
0.6
110
0.5
0.5
100
0.4
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
90
Source:
Reserve Bank of New Zealand
It is hard to blame macroeconomic policies for the domestic
spending boom. The fiscal stance has continuously improved
since the introduction of the Fiscal Responsibility Act in
1994, as reflected by public sector surpluses, a reduction
in government debt ratios, and very low (even negative)
implicit country risk spreads over US Treasury bonds.
Monetary policy, guided by the world’s first inflationtargeting framework implemented by the Reserve Bank of
countries (Figure 3). The large excess of domestic spending
New Zealand (RBNZ), has been successful in keeping inflation
over income was reflected in a strong appreciation of the
low and stable during the last 15 years (Figure 5). Monetary
New Zealand dollar that peaked in late 2005, with a partial
policy is consistent with international best practice in flexible
reversion taking place since early 2006 (Figure 4).
inflation targeting, providing some weight to its counter-
Figure 3
cyclical stabilisation role. Rising inflationary pressures have
Terms of trade and current account balance in
led the RBNZ to raise its monetary policy rate since 2003,
attaining a level of 7.25% at the time of writing.
New Zealand, 1986q1-2005q4
Index
115
%
0
-1
110
-2
105
-3
-4
100
-5
95
90
85
-6
-7
Terms of trade (2000=100)
Current Account (% of GDP) (RHS)
-8
-9
-10
80
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
Source: Statistics New Zealand
84
Reserve Bank of New Zealand and The Treasury
Figure 5
•
What is the monetary policy transmission process in
CPI inflation and monetary policy interest rate
New Zealand and its efficiency compared to other
in New Zealand, 1986q1-2006q1
countries? What is the extent of exchange-rate
%
20
18
monetary policy transmission to financial markets,
18
16
14
devaluation and oil-price pass-through to inflation;
%
20
Short-term interest rate
Annual inflation rate
16
output, and inflation; inflation target accuracy; and
14
monetary policy efficiency reflected in inflation and
12
12
10
10
8
8
6
6
4
4
is the influence of foreign interest rates on domestic
2
2
rates in New Zealand relative to other countries?
0
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
0
output volatility?
•
•
What is the world evidence on the costs of real
exchange-rate volatility and misalignments? Which are
Source: Statistics New Zealand
Reserve Bank of New Zealand
the fundamentals that drive the medium-term behaviour
The exchange-rate has been a key absorber of foreign and
of the real exchange-rate in the world? Is there evidence
domestic shocks, in a framework of a flexible, cleanly-
of past and present real exchange-rate misalignment in
floating exchange-rate regime adopted consistently during
New Zealand, and will misalignment have implications
the last 20 years. While the RBNZ announced in 2005 a
for economic growth?
framework for possible exchange-rate interventions, it has
not apparently intervened to date. The banking sector is well
Is monetary policy in New Zealand independent? What
•
What is the best approach to achieve domestic price
regulated and supervised, and commercial bank soundness
stability, while avoiding cyclical extremes in the
indicators remain healthy.
exchange-rate? How should the secondary concern of
Yet the mix of a large current account deficit (projected by
the OECD at 9.1% of GDP for 2006) and a real exchangerate that is still on the appreciated side of its historical
distribution, largely driven by the housing boom, raise
major questions about the sustainability and downside risks
exchange-rate stability or competitiveness be addressed
by a flexible exchange-rate targeting central bank?
Which counter-cyclical fiscal and financial policy tools
could be developed to deal with persistent exchangerate swings and current-account imbalances?
of New Zealand’s current business-cycle conditions. This, in
I address these questions by comparing New Zealand’s
turn, leads to questions about appropriate policy measures
macroeconomic and policy performance to that of relevant
to correct current imbalances and strengthen the economy’s
groups of comparator countries. I do this by providing
structure to avoid future repeats of the recent experience.
descriptive evidence and empirical results for behavioural
Among these questions are:
relations for New Zealand and two alternative comparator
•
How do New Zealand’s macroeconomic performance
and business cycles compare to advanced open
economies during the last two decades? What about the
trend behaviour, cyclical performance, and correlations
of key macroeconomic variables in New Zealand?
•
country groups. The first set (termed CCG1) is comprised of
the world’s 19 inflation-targeting (IT) countries; the second
group (termed CCG2) is a subset of the former, comprised of
5 small advanced ITers that are, at least in part, commodityexporting countries: Australia, Canada, Norway, Sweden,
and Chile.
How does New Zealand’s overall mix of monetary, fiscal,
external, and structural policy framework compare to
those of other advanced countries? Are there areas for
potential policy improvement?
Testing stabilisation policy limits in a small open economy
85
Section 2 documents trends and business-cycle conditions
2
Macroeconomic performance
and business cycles
of key macroeconomic variables in New Zealand and
compares them to those in country group CCG2. Section
How do New Zealand’s macroeconomic performance and
3 summarizes the distinctive features of New Zealand’s
business cycles compare to the five countries grouped in
overall macroeconomic policy mix in comparison to those
CCG2 during the last two decades? I address this question
of the CCG2 country group, pointing out a few areas of
by focusing on the trend behaviour, cyclical performance,
potential improvement. Section 4 provides an international
and correlations of key macroeconomic variables in
comparison of New Zealand’s monetary policy transmission
New Zealand, compared to those in CCG2 countries. I start
and efficiency, focusing on four dimensions: the extent
by reporting the mean, volatility, and cyclical features of
of exchange-rate and oil price pass-through to inflation;
each quarterly series spanning 1986-2005. To characterize
monetary policy transmission to financial markets, output,
the cycle I follow Harding and Pagan’s (2002) method of
and inflation; inflation target accuracy; and monetary policy
describing the cyclical nature of the selected variables. They
efficiency reflected in inflation and output volatility. Section
adopt a two-step procedure. First, they identify the turning
5 assesses if there is scope for an independent monetary
points in a series, which marks the periods of cyclical
policy in New Zealand and comparator countries that are
expansions and contractions.2 Then, given the turning
closely integrated into world financial markets. There I
points, they compute three cyclical features: cycle duration,
report simple correlation coefficients between domestic
cycle amplitude, and cumulative change.
and foreign short-term interest rates and impulse response
dynamics of domestic short-term rates in response to
foreign rate shocks.
Subsequently I report two measures of co-movement
between different series: simple correlation coefficients and
the degree of concordance index proposed by Harding and
Section 6 starts reviewing the world evidence on the costs
Pagan (2006). The latter index captures the co-movement
of real exchange-rate volatility and misalignments. Then I
between two variables during their phases over the cycle.3
review international evidence on the fundamentals that
drive the medium-term behaviour of real exchange-rates and
provide evidence on the behaviour of New Zealand’s real
exchange-rate. This allows identifying evidence of past and
present real exchange-rate misalignment in New Zealand
and, drawing from the world evidence, possible implications
for economic growth.
Figure 6 depicts the raw data. Table 1 summarizes simple
statistics for each series and country, while Table 2 provides
information about the three cyclical features. Correlations
and degree of concordance indexes are reported in Table 3.
Next I discuss selectively New Zealand’s cyclical behaviour
and how it compares to the other five countries.
Section 7 starts by reviewing the literature and international
evidence on the role of the exchange-rate in the conduct
of monetary policy. Then I review the international practice
and evidence about interventions and their effectiveness.
In the light of the latter reviews, and the findings about
New Zealand’s monetary and exchange-rate policy reported
in preceding sections, I draw policy lessons for New Zealand
at the end of this section, identifying possible fiscal and
financial-policy instruments to deal better with exchangerate misalignments and current-account imbalances.
Section 8 concludes with a brief summary of the paper’s
main findings and policy implications.
86
2
3
A contractionary phase is defined as a peak-to-trough period
and an expansionary phase as a trough-to-peak period.
If two variables are perfectly pro-cyclical then the index is
unity, while a value of zero marks reflects exact countercyclicality.
Reserve Bank of New Zealand and The Treasury
Figure 6
Selected indicators in New Zealand and CCG2 countries, 1986-2005
Testing stabilisation policy limits in a small open economy
87
Figure 6
Selected indicators in New Zealand and CCG2 countries, 1986-2005 (cont.)
88
Reserve Bank of New Zealand and The Treasury
Figure 6
Selected indicators in New Zealand and CCG2 countries, 1986-2005 (cont.)
Testing stabilisation policy limits in a small open economy
89
Figure 6
Selected Indicators in New Zealand and CCG2 countries, 1986-2005 (cont.)
90
Reserve Bank of New Zealand and The Treasury
Table 1
Selected indicators in New Zealand and CCG countries, 1986-2005
New Zealand
Australia
Canada
Chile
Norway
Sweden
Mean
-4.61
-4.65
-1.09
-2.14
5.19
2.39
Std. Dev.
1.69
1.16
2.35
2.07
6.50
3.17
101.70
105.39
98.92
125.22
74.78
103.02
5.71
9.50
5.39
27.09
18.14
6.02
Mean
1.34
0.95
0.76
0.89
1.55
-0.14
Std. Dev.
4.58
6.73
4.44
18.14
14.39
3.71
Mean
119.64
111.21
102.93
91.16
96.10
105.40
Std. Dev.
12.02
9.71
7.05
8.86
14.49
10.62
Mean
1.33
0.06
-0.01
-0.72
2.14
-0.86
Std. Dev.
8.37
8.32
5.36
7.14
4.57
6.77
Mean
2.51
3.29
2.78
5.82
2.73
2.12
Std. Dev.
3.36
1.62
1.97
3.46
1.78
1.97
Mean
-0.17
-0.04
0.00
-0.05
0.02
0.01
Std. Dev.
2.25
1.11
1.33
1.99
1.02
1.31
Mean
3.98
3.96
0.47
0.97
3.09
3.28
Std. Dev.
6.24
6.97
4.73
1.80
10.04
7.48
Current Account (% of GDP)
Terms of Trade
Mean
Std. Dev.
Terms of Trade (annual % change)
Real Effective Exchange-rate
Real Effective Exchange-rate (annual % change)
GDP growth (annual, %)
Output gap
Real House Prices (annual % change)
House Permits (annual % change)
Mean
0.42
-0.12
6.38
-
0.82
0.29
Std. Dev.
18.62
20.57
19.68
-
17.74
42.40
Mean
2.45
3.66
2.23
5.22
1.05
3.84
Std. Dev.
10.78
7.93
5.48
8.31
5.30
5.10
Real GDP in residential construction
(annual % change)
Private investment in housing (annual % change)
Mean
4.09
4.10
3.38
-
2.74
7.37
Std. Dev.
13.46
13.07
9.34
-
12.14
9.48
Mean
1.16
1.37
1.15
1.79
0.64
0.44
Std. Dev.
0.45
0.30
0.13
0.15
0.18
0.20
Population Growth (annual % change)
Note:
Definitions and sources of the data are provided in Annex A.
Testing stabilisation policy limits in a small open economy
91
Before focusing on the comparative descriptions for the
Australia’s and Norway’s, similar to Canada’s and Chile’s,
two decades spanning from 1986 through 2005, a word
and much smaller than Sweden’s.
of caution on this sample period is in order. New Zealand
adopted major structural and macroeconomic reforms
from the late 1980s through the early 1990s, which were
associated with transition costs. Hence the full 19862005 period comprises an earlier sub-period (1986-1993)
of higher inflation and lower growth (and larger output
and inflation volatility) and a second sub-period (19942005) of improved macroeconomic stability. The latter
Regarding expansions, New Zealand’s mean duration
is 12.33 quarters, which is similar to Canada’s but much
shorter than recoveries observed in the other CCG2
countries. The mean amplitude of the recovery is 5.7%
of GDP in New Zealand, much below the output increase
observed elsewhere. New Zealand’s cumulative output gain
during expansionary phases is 64.02% on average, well
below the other countries’ output gain, except Canada’s.
fact is highlighted in section 4 below on New Zealand’s
improvement in inflation and output volatility. However, the
following international comparison in this section spans the
full two-decade period. The subsequent figures depicting
New Zealand’s full 1986-2005 performance suggest a
structural break toward lower inflation and output volatility
in the early 1990s. However, no volatility decline is apparent
in housing market-related variables, the current account
balance, and the real exchange-rate.
Figure 7 depicts the three cyclical features during downturns
and recoveries in New Zealand and the average cyclical
features for four of the CCG2 countries: Australia, Canada,
Norway, and Sweden.4 In comparison to the 4-country
average, New Zealand’s output contractions are shorter
but exhibit a larger output decline. While contractions
last about 2.25 quarters and exhibit a mean amplitude of
-1.56% in New Zealand, the average duration in the four
CCG2 countries is 5.75 quarters with a mean amplitude of
-1.32%. New Zealand’s output loss is smaller than the loss
GDP growth and business cycles
of output experienced by the CCG2 country group, which
New Zealand’s annual GDP growth averaged 2.5% between
presents a cumulative output loss of 3.87% on average.
1986 and 2005, a figure that is close to average growth in
Similarly, New Zealand’s expansions are shorter and exhibit
Australia, Canada, Norway, and Sweden (2.7%) but lower
a smaller output gain than the average in the four CCG2
than Chile’s 5.8% (Table 1). However output volatility is
countries, where expansions last about 20 quarters, with
much higher in New Zealand than in CCG2 countries apart
a mean amplitude of 13.1%, and a mean output gain of
from perhaps Chile, as shown by the standard deviation of
189.65%.
annual GDP growth and the output gap. As suggested by
Next I briefly discuss the business-cycle features of other
Figures 1 and 6, New Zealand’s higher 1986-2005 output
macroeconomic variables, focusing only on the comparative
volatility reflects its large GDP swings during the earlier
indicators depicted in Figure 6.
1986-1993 reform period, as discussed above.
New Zealand’s business-cycle features reveal that output
contractions last on average 2.25 quarters while expansions
reach a mean duration of 12.33 quarters. New Zealand’s
mean contraction duration is similar to Norway’s and Chile’s
and is slightly shorter than Australia’s and Canada’s. The
mean amplitude (or depth) of New Zealand’s contractions
is 1.56% of GDP, similar to Canada’s and Chile’s, somewhat
deeper than Australia’s and Norway’s, but much shallower
than Sweden’s. New Zealand’s cumulative output loss in
contractionary phases is 2.04% of GDP, again larger than
92
Housing market
Real house prices have increased in New Zealand at an
average annual growth rate of 3.98%, similar to the figures
observed in Australia (3.96%), Norway (3.09%), and
Sweden (3.28%). However, the trend rise in house prices
in New Zealand has not been associated with a significant
4
Chile is excluded because it is an outlier in the CCG2 group
in many of its cyclical features. Simple averages of individual
country statistics are computed from the statistics of the other
countries.
Reserve Bank of New Zealand and The Treasury
Figure 7
Cyclical features of selected variables in New Zealand and four industrial countries, 1986-2005
New Zealand
Four CCG2 average
New Zealand
Four CCG2 average
New Zealand
Four CCG2 average
New Zealand
Four CCG2 average
New Zealand
Four CCG2 average
New Zealand
Four CCG2 average
New Zealand
Four CCG2 average
New Zealand
Four CCG2 average
Source: Authors calculations
Testing stabilisation policy limits in a small open economy
93
Table 2
Cyclical features of selected indicators in New Zealand and CCG2 countries, 1986-2005
New Zealand
Australia
Canada
Chile
Norway
Sweden
7.25
7.40
6.00
7.20
4.33
5.50
Current Account (% of GDP)
Peak-to-trough
Mean duration (quarters)
Mean amplitude (percentage points)
-2.61
-2.58
-1.27
-3.64
-2.87
-0.99
Cumulation (%)
-9.33
-12.72
-4.31
-14.74
-7.47
-4.18
Mean duration (quarters)
5.50
7.60
6.33
5.60
7.00
6.67
Mean amplitude (percentage points)
2.10
2.50
2.03
4.18
6.01
2.21
Cumulation (%)
6.61
10.40
9.43
12.11
32.81
10.22
5.60
5.80
9.67
4.50
4.86
3.60
Trough-to-peak
Terms of Trade
Peak-to-trough
Mean duration (quarters)
Mean amplitude (%)
-2.93
-4.06
-4.30
-10.69
-6.41
-1.57
Cumulation (%)
-8.47
-12.25
-29.06
-29.10
-16.39
-3.56
Mean duration (quarters)
6.40
5.50
18.00
3.86
4.29
5.80
Mean amplitude (%)
3.24
3.84
7.64
9.20
8.78
1.66
Cumulation (%)
10.54
14.11
57.30
27.32
25.46
5.72
7.50
6.00
6.50
4.17
8.25
5.00
Trough-to-peak
Real Effective Exchange-rate
Peak-to-trough
Mean duration (quarters)
Mean amplitude (%)
-7.47
-5.17
-3.91
-4.57
-2.72
-4.92
Cumulation (%)
-28.9
-18.53
-16.27
-10.83
-12.74
-14.06
Mean duration (quarters)
6.75
6.00
5.50
6.67
9.00
5.86
Mean amplitude (%)
6.31
6.45
4.42
5.27
6.64
3.43
Cumulation (%)
33.06
24.43
20.92
31.84
30.12
10.31
2.25
4.00
4.00
2.50
3.00
12.00
Mean amplitude (%)
-1.56
-0.54
-1.49
-1.50
-0.72
-2.52
Cumulation (%)
-2.04
-1.28
-2.22
-1.95
-1.46
-10.52
12.33
16.00
13.00
31.00
54.00
-
Trough-to-peak
Real GDP
Peak-to-trough
Mean duration (quarters)
Trough-to-peak
Mean duration (quarters)
Mean amplitude (%)
Cumulation (%)
94
5.70
7.07
5.52
26.70
19.50
-
64.02
64.05
46.17
458.73
536.99
-
Reserve Bank of New Zealand and The Treasury
Table 2
Cyclical features of selected indicators in New Zealand and CCG2 countries, 1986-2005 (cont.)
New Zealand
Australia
Canada
Chile
Norway
Sweden
Real house prices
Peak-to-trough
Mean duration (quarters)
4.33
4.50
21.50
7.00
12.00
7.00
Mean amplitude (%)
-1.37
-2.43
-6.37
-0.87
-14.47
-5.66
Cumulation (%)
-2.91
-6.73
-91.40
-3.73
-161.48
-25.84
Mean duration (quarters)
14.0
12.75
2.00
3.50
38.00
15.50
Mean amplitude (%)
10.48
10.70
0.37
0.62
32.86
11.16
Cumulation (%)
108.45
80.06
0.37
1.33
681.33
138.14
Mean duration (quarters)
6.00
6.33
3.83
-
6.80
3.33
Mean amplitude (%)
-15.27
-20.78
-10.57
-
-16.83
-28.40
Cumulation (%)
-52.80
-67.73
-30.11
-
-62.32
-59.21
Mean duration (quarters)
7.80
11.75
8.00
-
6.20
7.17
Mean amplitude (%)
18.07
20.33
16.33
-
15.26
23.14
Cumulation (%)
78.68
134.88
72.00
-
66.29
109.04
Mean duration (quarters)
4.80
4.33
7.00
2.80
5.83
3.00
Mean amplitude (%)
-7.96
-6.69
-4.27
-4.22
-3.52
-2.93
Cumulation (%)
-26.17
-17.86
-27.95
-7.73
-12.78
-5.92
Mean duration (quarters)
9.00
14.00
9.00
8.80
6.17
11.00
Mean amplitude (%)
11.53
11.03
5.63
10.36
3.88
8.64
Cumulation (%)
72.26
89.98
35.54
41.80
19.86
41.68
Mean duration (quarters)
3.40
6.33
4.40
-
9.75
-
Mean amplitude (%)
-10.86
-12.48
-5.74
-
-10.36
-
Cumulation (%)
-18.35
-37.90
-13.49
-
-104.74
-
Mean duration (quarters)
10.80
12.25
5.75
-
8.33
-
Mean amplitude (%)
15.80
18.34
4.85
-
13.33
-
Cumulation (%)
118.78
123.55
17.68
-
44.39
-
Trough-to-peak
House permits
Peak-to-trough
Trough-to-peak
Real GDP construction
Peak-to-trough
Trough-to-peak
Private Investment in housing
Peak-to-trough
Trough-to-peak
Note:
quarterly data for 1986q1 - 2005q4. The table reports the mean duration, amplitude, and cumulative changes for each cyclical
phase, i.e., from peak to trough and from trough to peak. Calculations methods and definitions follow Harding and Pagan (2002).
Testing stabilisation policy limits in a small open economy
95
increase in house permits; house permits have risen by an
Australia’s, but its standard deviation of population growth
average annual rate of 0.42%, lower than the growth in
is 50% larger than Australia’s and more than three times
house permits in the four-country group (1.84%).5 House
Canada’s.
prices and house permits are, on average, less volatile in
New Zealand than in the CCG2 country group.
On the cyclical features of residential construction, the results
show that during the expansionary phase of New Zealand’s
As depicted in Figure 7, house price cycles in New Zealand
construction activity, lasting about 9 quarters, construction
and the four CCG2 comparison countries are characterized
output rises on average by 11.53% per annum. In the
by short-lived phases of contraction and prolonged periods
subsequent contraction phase, which lasts 4.80 quarters,
of expansion. The mean duration of contraction phases in
output in this sector plunges by 7.96%, translating into a
New Zealand is about 4 quarters, while in CGG2 countries
cumulative construction output loss of 26.71%. This loss
it reaches 11.25 quarters, on average. In the contraction
is larger in New Zealand than in the four CCG2 countries,
phase, the fall in real house prices has been 1.37% per
where the mean amplitude reaches -4.35%, and the
annum in New Zealand, much smaller than that observed
cumulative output loss is equal to 16.13%, on average.
in CCG2 countries (7.23%). Real house price booms last
approximately 14 quarters and prices increase on average
by 10% in New Zealand. In CCG2 countries, periods of
expansion exhibit a mean duration of 17.06 quarters and
price gains of 13.77% per annum. In general, this pattern
of larger increases in expansion periods and smaller dips in
contraction phases is consistent with the larger trend rise of
New Zealand’s expansions of real private housing investment
last almost twice as long as those in the four CCG2 countries
and reflect an amplitude that is almost twice as large as
that in the comparator country group. Residential housing
contraction phases last about 3.4 quarters in New Zealand
(shorter than in the four CCG2 countries) and lead to a decline
in investment of 10.86%, similar to the CCG2 average.
real house prices in New Zealand. However, New Zealand’s
house price trend, volatility, and cycles are very similar to
Australia’s, during both booms and busts.
The timing and shape of the most recent expansionary cycle
(the 2001-2005 housing boom) has been very similar in
New Zealand, Australia, and Canada (Figure 8). Starting in
New Zealand’s residential construction activity has increased
in real terms at an average pace of 2.45% during 1986-2005,
while in the four CCG2 countries construction has risen by
2.7% per year. A similar variable is real private investment
2001-2002, the ratio of private housing investment to GDP
rose by approximately one percentage point in the three
countries until 2004, with some cooling off taking place in
2005.
in housing, which in New Zealand has grown by an average
4.1% per year, also slightly below the rate of growth of
Figure 8
private housing investment in four CCG2 countries (4.4%).
Private residential investment to GDP ratio in
In contrast, New Zealand exhibits the highest volatility in
New Zealand, Australia, Canada, and Norway,
real residential construction activity and real private housing
1970-2005 (% of GDP)
investment among the five countries, a likely reflection of
10
9
New Zealand’s larger population and immigration swings.
8
In fact, New Zealand’s average population growth, at
7
1.16% per year, is identical to Canada’s and slightly below
6
5
4
3
2
1
Aus tra lia
C anada
N ew Zealand
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
0
Cross-country comparisons for housing permits should be
taken with caution due to methodological differences in data
definition and collection.
1970
5
N orway
Source: RBNZ and OECD Economic Outlook database
96
Reserve Bank of New Zealand and The Treasury
Terms of trade
current account deficit (by 1.93 percentage points) and larger
New Zealand’s terms of trade have risen by 1.34% per year
reductions (3.19 percentage points) than New Zealand.
during the last two decades. This is slightly above average
annual growth of terms of trade in the CCG2 group (0.8%).
New Zealand’s terms of trade are among the least volatile
of the six-country group, with the second lowest standard
deviation, after Canada’s.
Real effective exchange-rate
New Zealand has experienced a trend appreciation of its
real effective exchange-rate (REER) during the last two
decades, at an average pace of 1.33% per year, which is
New Zealand’s terms of trade decline 5.6 quarters on
average during a cyclical downturn while the mean duration
of the recovery phase is 6.4 quarters. Both periods are
shorter in New Zealand than in the four CCG2 country
significantly larger than the very slight average appreciation
experienced by the CCG2 country group (0.12% per year).6
New Zealand’s REER has been more volatile than the average
volatility of REERs in the CCG2 group.
group on average.
The mean duration of depreciation phases of the REER (peakThe mean amplitude of New Zealand’s terms of trade
recoveries is larger than that of downturns, which is
consistent with the trend gain in the terms of trade
during 1986-2005. The mean amplitude and cumulative
movements during contractions and expansions are
also smaller in New Zealand than in the CCG2 group on
average, a reflection of New Zealand’s lower terms of trade
volatility.
Current account balance
During the last two decades New Zealand’s current account
balance has remained negative at an average deficit level
of 4.61 per cent of GDP. This Figure is similar to Australia’s
average current account deficit (4.65% of GDP) over the
same period. Although New Zealand’s current account
deficit is large compared to the CCG2 group, its variability
is smaller.
to-trough) is 7.50 quarters in New Zealand and the mean
appreciation phase (trough-to-peak) lasts 6.75 quarters.
The mean amplitude of the REER shows that during periods
of depreciation the REER falls by 7.47%, while the REER
rises by 6.31% during episodes of appreciation. In contrast,
REER appreciation and depreciation periods are slightly
shorter and less intense in the average CCG2 country than
in New Zealand.
Correlations and the degree of concordance
Table 3, overleaf, reports two measures of co-movement
between different pairs of the selected macroeconomic
indicators for New Zealand and the simple averages of the
two co-movement measures for the four-country CCG2
group, for 1986-2005. The lower diagonal reports the
simple correlation coefficient between the corresponding
variables and its p-value. The upper diagonal reports the
Regarding the cyclical features of New Zealand’s current
account deficit, its expansionary phase, from current account
degree of concordance index developed by Harding and
Pagan (2006).
balance peak to trough, lasts 7.3 quarters. It’s narrowing
from trough to peak is shorter (5.5 quarters). In contrast,
CCG2 countries exhibit shorter periods of a widening current
account deficit (5.81 quarters) and longer periods of a
narrowing current account deficit (6.9 quarters).
Not surprisingly, the output gap and real GDP growth are
positively correlated: both in New Zealand and in the CCG2
country group, they show a positive correlation coefficient
of around 0.50. Periods of high growth are identified by
periods of an increasing gap between actual and potential
During periods of current account deficit widening,
New Zealand’s current account deficit to GDP ratio rises by
2.6 percentage points, while during the opposite periods
of narrowing, the deficit declines by 2.1 percentage points.
The CCG2 country group exhibits a smaller widening of the
Testing stabilisation policy limits in a small open economy
6
This trend real exchange-rate appreciation is largely
specific to the 1986-2005 sample period, which starts at an
exceptionally depreciated value and ends at an exceptionally
appreciated level (see Figure 6 and further discussion in
Section 6).
97
Table 3
Correlations and degree of concordance of selected indicators in New Zealand and CCG2
countries, 1986-2005
(Four CCG2 countries)
Current
account
TOT
RER
Output gap
GDP
Real House
House
GDP
Prices
permits
construction
Current account
1.00
0.54
0.52
0.56
0.55
0.47
0.51
0.48
TOT
0.06
1.00
0.61
0.53
0.56
0.55
0.58
0.59
RER
-0.20
0.54
1.00
0.48
0.52
0.61
0.57
0.57
Output gap
-0.06
0.18
0.11
1.00
0.68
0.58
0.57
0.63
GDP
0.20
-0.05
-0.32
0.50
1.00
0.71
0.68
0.75
Real House Prices
0.22
0.05
-0.10
0.41
0.49
1.00
0.71
0.69
House permits
0.29
0.02
-0.03
0.16
0.34
0.53
1.00
0.68
GDP construction
0.20
-0.04
-0.27
0.40
0.43
0.50
0.38
1.00
TOT
RER
Output gap
GDP
Real House
House
GDP
Prices
permits
construction
(New Zealand)
Current
account
Current account
1.00
0.60
0.35
0.46
0.40
0.28
0.41
0.24
TOT
0.20
1.00
0.40
0.36
0.55
0.50
0.41
0.45
RER
-0.19
0.25
1.00
0.64
0.65
0.80
0.66
0.76
0.09
0.02
1.00
0.69
0.64
0.65
0.68
1.00
0.73
0.64
0.67
1.00
0.71
0.80
1.00
0.68
1.00
0.08
Output gap
GDP
Real House Prices
House permits
GDP construction
Note:
98
-0.13
0.34
0.47
0.24
0.00
0.00
0.09
-0.33
0.11
0.65
0.42
0.00
0.32
0.00
-0.17
0.36
0.57
0.52
0.48
0.12
0.00
0.00
0.00
0.00
0.29
0.17
0.04
0.33
0.46
0.43
0.01
0.13
0.75
0.00
0.00
0.00
-0.27
0.06
0.09
0.39
0.74
0.56
0.58
0.03
0.63
0.45
0.00
0.00
0.00
0.00
quarterly data for 1986q1 - 2005q4. The lower diagonal cells represent bivariate correlation coefficients and, in the case of
New Zealand, p-values are reported under each coefficient. The upper diagonal cells represent the degree of concordance index,
which captures the co-movement between variables during their phases over the cycle. When two variables are exactly procyclical the index takes a value of 1, and when they are exactly counter-cyclical the index takes value of 0. Values close to 0.5
represent no relation. The method is based on Harding and Pagan (2006).
Reserve Bank of New Zealand and The Treasury
output. This result is also supported by the index of
countries, these two variables are positively related, with an
concordance between the output gap and GDP. Housing
average correlation coefficient of 0.54.
market variables are typically pro-cyclical. In New Zealand,
the index of concordance between real GDP and real house
prices is 0.73, while the correlation between the output gap
and real house prices is positive and significant (0.65). House
permits and real activity in residential construction exhibit
similar figures. In the four CCG2 countries, on average,
house prices and real activity in residential construction are
pro-cyclical with an average index of concordance around
0.7 and a positive correlation with the output gap of around
0.4.
Real house prices and residential construction activity
There is no evidence of a significant correlation between
real GDP and the current account balance in either
New Zealand or the CCG2 group. In contrast, New Zealand
exhibits a negative correlation between the REER and the
current account balance, i.e., appreciations are related to
current account deficits. The index of concordance between
the latter variables is 0.35 and the correlation coefficient
is negative and significant. The negative co-movement
between the REER and the current account balance is also
observed in the CGG2 countries, exhibiting a negative
correlation of -0.20.
are negatively related to the current account balance
in New Zealand, with an index of concordance of 0.28
and 0.24, respectively. Correlations between the current
account and housing variables are also negative but only
significant for residential construction activity (-0.27).
Negative correlations are not observed in the average CCG2
country, where the index of concordance suggests no
apparent relationship.
3
Overall macroeconomic
policy mix
Table 4, overleaf, summarizes distinctive features of
New Zealand’s overall macroeconomic policy mix in
comparison to those of the CCG2 country group. It
is apparent that there is little country variation in the
Real house prices and real activity in residential construction
fundamental features of the monetary policy regime
are strongly positively related to the REER, with an index of
(they are all inflation targeters), the exchange-rate regime
concordance equal to 0.80 and 0.76, respectively. However,
(floating), fiscal soundness, domestic financial policy, and
only the correlation coefficient between real house prices
external financial policy (absence of any capital controls).
and the REER is significant (0.57). This evidence is not
limited to the case of New Zealand – it is quite similar in the
average CCG2 country.
However, there are several policy differences between
New Zealand and comparator countries that should be
noted. On one hand, New Zealand’s monetary policy
New Zealand’s terms of trade show a positive correlation
horizon is more imprecise than that in many inflation-
with the output gap (0.33) but the index of concordance
targeting comparator countries. New Zealand’s policy
is not conclusive about the pro-cyclical nature of the terms
aims at attaining inflation at target levels “over the
of trade (0.55). In contrast, the CCG2 countries present
medium term”, in contrast to the more specific horizons
a smaller correlation coefficient between terms of trade
defined by most other central banks. On the other hand,
and the output gap (0.18). New Zealand’s current account
deviations from medium-term target ranges are required
balance shows a mild positive correlation with the terms
to be corrected by appropriate policy and communication
of trade, with an index of concordance of 0.60 and a
actions in New Zealand – an exemption clause stipulated
correlation coefficient that is small but significant at 0.18.
in New Zealand’s current Policy Target Agreement (Reserve
The index of concordance between the terms of trade and
Bank of New Zealand 2002) that reflects in this dimension
the REER is 0.40 in New Zealand, while the correlation
a stricter framework than those in most inflation-targeting
between is small but positive and significant (0.25). In CCG2
countries, where exemption clauses tend to be absent. Yet
New Zealand’s monetary policy credibility and effectiveness
Testing stabilisation policy limits in a small open economy
99
Table 4
Monetary, fiscal, external, and financial policies in New Zealand and CCG2, circa mid-2006
New Zealand
Australia
Canada
Monetary regime
Inflation targeting
Inflation targeting
Inflation target indicator
CPI annual percent change Headline CPI annual
percentage change
CPI annual percent change
Inflation target
1-3 %
2-3 %
1-3%
Target horizon
On average over the
medium term
Average over the business
cycle
Through to the end of
2006 6-8 quarter horizon
Operational target:
Inflation forecast
Publication/indication of
future interest rate path:
Yes
No
No
Exemption clause
When certain shocks
cause actual inflation to
be outside the mediumterm target range,
the RBNZ shall take
corrective policy actions
in a transparent and
accountable manner
None
None
Monetary policy
Inflation targeting
Exchange rate policy
Floating ER
Yes
Under normal conditions
Yes
Interventions
None
Infrequent and under
exceptional circumstances
Under specific
circumstances
Intervention framework
Explicitly announced
None
Explicitly announced
Fiscal policy
Policy stance
Sustainable
Sustainable
Sustainable
Explicitly counter-cyclical
No
Yes
No
Intertemporal saving
No
No
No
Prudential regulation
Strong
Strong
Strong
Banking-sector strength
Large
Large
Large
Financial policy
External financing policy
100
Capital controls
None
None
None
Currency composition of
Public/external debt
Mostly domestic-currency
debt, net foreign-currency
debt is kept close to zero
Foreign
Foreign
Reserve Bank of New Zealand and The Treasury
Table 4
Monetary, fiscal, external, and financial policies in New Zealand and CCG2, circa mid-2006
(contd.)
Chile
Norway
Sweden
Monetary regime
Inflation targeting
Inflation targeting
Inflation targeting
Inflation target indicator
CPI annual percent
change
CPI annual percent
change
CPI annual percent
change
Inflation target
3% plus minus 1%
2.50%
2% plus minus 1%
Target horizon
12-24 months (mostly:
24 months)
Over the medium term,
usually I to 3 years
2 years horizon
Operational target:
Inflation forecast
Exemption clause
None
None
Justified in grounds
of consideration to
developments in the real
economy
Role of exchange rate in MP
In as much affects
inflation (and output)
None
Takes into consideration
exchange rate as other
asset prices
Floating ER
Under normal conditions
Yes
Under normal conditions
Interventions
Under exceptional
conditions
Under exceptional
circumstances
Yes, not clear under what
conditions
Intervention framework
Explicitly announced
at start of intervention
period
Monetary policy
Inflation forecast
Exchange rate policy
In the local foreignexchange market
Fiscal policy
Policy stance
Sustainable
Sustainable
Sustainable
Explicitly counter-cyclical
Yes
Yes
Yes
Intertemporal saving
No
Yes
Yes
Prudential regulation
Strong
Strong
Strong
Banking-sector strength
Large
Large
Large
Capital controls
None
None
None
Currency composition of Public/
external debt
Foreign
Foreign
Foreign
Financial policy
External financing policy
Sources: Central bank websites and author’s assessment
Testing stabilisation policy limits in a small open economy
101
could be strengthened by announcing a more specific time
pass-through from exchange-rate shocks in IT countries,
frame for the policy horizon.
like New Zealand, than in non-inflation targeting (NIT)
Second, like the Bank of Canada and the Central Bank of
Chile, the RBNZ has made public an explicit exchange-market
intervention scheme, in contrast to most other (intervening)
central banks in the world. And the RBNZ’s intervention
scheme spells out the conditions that would trigger a forex
intervention in a more detailed and transparent way than
countries. In particular, I will measure response of inflation
to exchange-rate and oil-price shocks in New Zealand and
three relevant country groups, selected by their monetary
regime and/or a specific period:
(i) New Zealand, 1989-1997,
(ii) New Zealand, 1998-2005,
other central banks.
(iii) ITers after the adoption of IT (excluding New Zealand),
Finally, New Zealand does not have in place an explicit
counter-cyclical fiscal policy, in contrast to Chile, Sweden,
(iv) Industrial ITers after the adoption of IT (excluding
New Zealand), and
and Norway. A strong, explicit counter-cyclical policy
framework could have an important stabilizing influence on
the exchange-rate and the current account balance (among
other key macro variables), as argued in section 7 below.
(v) NITers, 1998-2004.
Following Mishkin and Schmidt-Hebbel (2005), I estimate
the response for each group by estimating panel vector
autoregressive (Panel VAR) models, based on quarterly
data.7 The VAR system includes the following six variables
4
Monetary policy transmission
and efficiency
In this section I assess New Zealand’s relative monetary
policy transmission and efficiency across four dimensions.
First, I measure the extent of exchange-rate and oil price
pass-through to inflation. Second, I identify monetary policy
transmission to financial markets, output, and inflation.
Third, I provide an international comparison of inflation
target accuracy as a partial way of assessing monetary policy
efficiency. Finally, this section focuses on overall monetary
policy efficiency, reporting how New Zealand has reduced
inflation and output volatility over time and in comparison
to other inflation-targeting countries.
ranked by exogeneity: international oil price changes,
international interest rates, the output gap, annual inflation,
domestic interest rates, and the nominal exchange-rate.
Since the model yields similar impulse response functions
using two or more lags, for reasons of parsimony a lag
order of two was selected. To control for possible fixed
effects (correlated with the regressors due to lags of the
dependent variable) I use forward mean-differencing
(Helmert procedure) to remove the mean of all the future
observations available for each country. Lagged regressors
are used as instruments and coefficients are estimated by
General Method of Moments (GMM). Finally, the dynamic
responses to innovations in the system are identified using
the Choleski decomposition of the variance-covariance
matrix of residuals and their confidence intervals are
Exchange-rate and oil price pass-through
constructed by bootstrap methods.8 9
,
in New Zealand, CCG1 countries, and non-
Next I compare the dynamic response to shocks for
inflation targeting countries
New Zealand and the corresponding country groups. I
One way to assess monetary policy efficiency is by comparing
the effect of exchange-rate shocks and oil price shocks
7
Except for New Zealand in (i) and (ii), for which I estimate a
simple country VAR model with the same variable ordering,
frequency, time span, and estimation method.
8
See Holtz-Eakin et al., 1988; Love and Zicchino, 2002; and
Miniane and Rogers, 2003, for applied studies using Panel
VAR estimation.
Confidence intervals for responses of groups i) and ii) are also
estimated by bootstrap.
on inflation in New Zealand and relevant country control
groups. If IT improves the credibility of monetary policy
and helps to anchor inflation expectations, inflation would
9
respond less to oil price shocks and there would be a weaker
102
Reserve Bank of New Zealand and The Treasury
Figure 9
Dynamic response of headline inflation to an exchange-rate shock in New Zealand and CCGs
(7 quarters)
New Zealand vs ITERS and NON-ITers
New Zealand before 1997
New Zealand (1998-2005)
Difference
0.30
0.30
0.30
0.20
0.20
0.20
0.10
0.10
0.10
0.00
0.00
0.00
-0.10
-0.10
-0.10
-0.20
-0.20
-0.20
-0.30
-0.30
-0.30
-0.40
-0.40
-0.40
-0.50
-0.50
-0.50
0
1
2
3
4
5
0
6
New Zealand (1998-2005)
1
2
3
4
5
0
6
ITers after start of IT
0.30
0.30
0.30
0.20
0.20
0.20
0.10
0.10
0.10
0.00
0.00
0.00
-0.10
-0.10
-0.10
-0.20
-0.20
-0.20
-0.30
-0.30
-0.30
-0.40
-0.40
-0.40
-0.50
0
1
2
3
4
5
0
New Zealand (1998-2005)
1
2
3
4
5
6
Industrial ITers after start of IT
0.30
0.30
0.20
0.20
0.10
0.10
0.00
0.00
-0.10
-0.10
-0.20
-0.20
-0.30
-0.30
-0.40
-0.40
-0.50
1
2
3
4
5
6
0
1
2
3
0.00
-0.10
-0.20
-0.30
-0.40
1
2
3
4
5
-0.50
6
0.20
0.10
0.10
0.10
0.00
0.00
0.00
-0.10
-0.10
-0.10
-0.20
-0.20
-0.20
-0.30
-0.30
-0.30
-0.40
-0.40
-0.40
-0.50
-0.50
6
4
5
6
Difference
0.30
5
6
0.10
0.20
4
5
3
0.20
3
4
2
0.20
Non-ITers (1998-2005)
2
6
1
0.30
1
5
0
0.30
0
4
0.30
0
New Zealand (1998-2005)
3
Difference
-0.50
0
2
-0.50
-0.50
6
1
Difference
-0.50
0
1
2
3
4
5
6
0
1
2
3
4
5
6
report significant differences (statistically different from
Figures 9 and 11 depict the dynamic response of inflation
zero) between the response in New Zealand before and
to an exchange-rate shock (an exchange-rate appreciation)
after 1998 (group i vs. group ii), in New Zealand after 1998
and an oil price shock, respectively. Each row of three small
and after the adoption of IT in ITers (group ii vs. group iii), in
Figures focuses on a comparison between two particular
New Zealand after 1998 and after adoption of IT in industrial
sample groups. For instance, the second row of Figure 9
ITers (group iii vs. group iv), and in both New Zealand and
depicts the response of New Zealand in 1998-2005 (first
NITers after 1998 (group ii vs. group v).
column) to the response of ITers after adopting IT (second
Note that the assumption of independence between
my samples might be not appropriate. Hence I also use
bootstrap methods to construct confidence intervals for
differences in impulse-response functions instead of simply
taking their differences.10
column). The corresponding difference in response, and its
confidence interval, are depicted in the third column. Figures
10 and 12 focus on New Zealand alone, contrasting the
differences between dynamic pass-through of an exchangerate shock (Figure 10) and an oil-price shock (Figure 12) to
headline inflation and tradable-goods inflation.
The response of New Zealand’s headline inflation to an
10
If we were simply to assume sample independence, the
corresponding confidence intervals for differences would be
narrower.
Testing stabilisation policy limits in a small open economy
exchange-rate shock is not significantly different from
103
Figure 10
Dynamic response of headline inflation and tradables inflation to an exchange-rate shock in
New Zealand, 1989-1997 and 1998-2005 (7 quarters)
Headline inflation (1989-1997)
Tradables inflation (1989-1997)
0.3
0.3
0.2
0.2
0.1
0.1
0.0
0.0
0
1
2
3
4
5
6
-0.1
0
1
2
3
4
5
6
-0.1
-0.2
-0.2
-0.3
-0.3
-0.4
-0.4
-0.5
-0.5
Headline inflation (1998-2005)
Tradables inflation (1998-2005)
0.3
0.3
0.2
0.2
0.1
0.1
0.0
0.0
1
0
1
2
3
4
5
6
2
3
4
5
6
7
-0.1
-0.1
-0.2
-0.2
-0.3
-0.4
-0.3
-0.4
-0.5
-0.5
zero in the early 1989-1997 period (Figure 9). In contrast,
due to lower credibility of monetary policy, in emerging
during the recent 1998-2005 period, headline inflation
economies. Among NITers the pass-through impulse
responds significantly and negatively to an exchange-rate
response is not significantly different from zero. The
appreciation from the second to the fifth quarter after the
differences in inflation responses between all IT countries
shock. The pass-through coefficient attains a maximum
and New Zealand are negative and statistically significant
value close to 0.15 in the third quarter, an estimate that is
from zero; pass-through coefficients are significantly larger
in line with Hampton’s (2002) estimate of a pass-through
in quarters 1 through 5 in all ITers, on average, than in
of 0.15 within 12 months. The differences in pass-through
New Zealand. However, the difference between industrial
estimates between the second and the first period (depicted
ITers’ pass-through and New Zealand’s is not significantly
in the last column of the first row of Figure 9) are small and
different from zero, except in quarter 1, when it is larger
only significant for quarters 2 and 3.
among industrial ITers. Finally, the pass-through coefficient
The inflation response in comparator groups is negative and
significant in the group of all ITers and among industrial-
is significantly larger in quarters 1 and 2 in New Zealand
than among NITers.
country ITers as well. However the pass-through effect is
Transmission of an exchange-rate shock to inflation may
much larger and takes longer among all ITers (comprising
change considerably if we consider inflation of tradable
both emerging-economy and industrial country inflation
goods. Figure 10 depicts the responses of headline inflation
targeters) than among industrial-country ITers alone. This
and tradables inflation to an exchange-rate for New Zealand
reflects the larger role of exchange-rate shocks, possibly
in both sample periods. Both headline and tradables
104
Reserve Bank of New Zealand and The Treasury
Figure 11
Dynamic response of headline inflation to an oil-price shock in New Zealand and CCGs
(7 quarters)
New Zealand vs ITERS and NON-ITers
New Zealand before 1997
New Zealand (1998-2005)
Difference
1.0
1.0
0.03
0.8
0.8
0.02
0.6
0.6
0.4
0.4
0.01
0.00
0.2
0.2
-0.01
0.0
0.0
-0.02
-0.2
-0.2
-0.4
-0.4
-0.03
-0.6
-0.6
0
1
2
3
4
5
0
6
New Zealand (1998-2005)
1
2
3
4
5
6
-0.04
0
ITers after start of IT
1.0
0.6
0.8
0.8
0.4
0.6
0.6
0.2
0.4
0.4
0.2
0.2
0.0
0.0
-0.2
-0.2
-0.4
-0.4
1
2
3
4
5
New Zealand (1998-2005)
1.0
0.8
0.8
0.6
0.6
0.4
0.4
0.2
0.2
0.0
0.0
-0.2
-0.2
-0.4
-0.4
-0.6
-0.6
0
1
2
3
4
5
1
2
3
4
5
0.8
0.8
0.6
0.6
0.4
0.4
0.2
0.2
0.0
0.0
-0.2
-0.2
-0.4
-0.4
1
2
3
4
5
1
2
6
3
5
6
4
5
6
4
5
6
Difference
0.6
0.4
0.2
0.0
-0.2
-0.4
-0.6
1
2
3
4
5
6
0
1
2
0
1
2
3
4
5
3
Difference
-0.6
-0.6
0
0
6
Non-ITers (1998-2005)
1.0
4
-0.8
New Zealand before 1997
1.0
6
-0.6
0
6
5
-0.4
Industrial ITers after start of IT
1.0
4
0.0
0
6
3
-0.2
-0.6
-0.6
2
Difference
1.0
0
1
6
1.0
0.8
0.6
0.4
0.2
0.0
-0.2
-0.4
-0.6
-0.8
0
1
2
3
inflation are not affected significantly by an exchange-rate
The response of New Zealand’s headline inflation to an
shock in quarters 1 through 6 after an exchange-rate shock
international oil-price shock is positive and significant during
in the earlier period. This result changes radically in the
the first quarter in the 1989-1997 sample (Figure 11). During
second period, when both measures of inflation respond
the 1998-2005 period, the inflation effect of an oil-price
significantly to the exchange-rate shock. Not surprisingly,
hike is similar in magnitude (close to 0.25) but slightly more
the pass-through to tradables inflation is much larger and
persistent, extending from quarters 0 through 1. However,
somewhat quicker than pass-through for headline inflation.
the inflation effect is significantly but just slightly larger in
The maximum pass-through coefficient for tradables is
the first period in comparison to the second period – and
0.31, slightly more than twice the maximum pass-through
that occurs only in quarter 1).
estimate for headline inflation, both attained in quarter 3.
Testing stabilisation policy limits in a small open economy
105
Figure 12
Dynamic response of headline inflation and tradables inflation to an oil-price shock in
New Zealand, 1989-1997 and 1998-2005 (7 quarters)
Headline inflation 1989-1997
Tradables Inflation 1989-1997
1.0
1.0
0.8
0.8
0.6
0.6
0.4
0.4
0.2
0.2
0.0
0.0
1
2
3
4
5
6
7
0
-0.2
-0.2
-0.4
-0.4
-0.6
-0.6
Headline inflation 1998-2005
1
2
3
4
5
6
Tradables Inflation 1998-2005
1.0
1.0
0.8
0.8
0.6
0.6
0.4
0.4
0.2
0.2
0.0
0.0
1
2
3
4
5
6
7
1
2
3
4
5
6
7
-0.2
-0.2
-0.4
-0.4
-0.6
-0.6
The oil shock impact on inflation is also positive and
the 1989-1997 period, the effect is on average larger and
significant in the three country groups considered here: all
more persistent during 1998-2005. Now significant effects
ITers, industrial ITers, and NITers. In the group of all ITers,
are measured during quarters 0 through 3 after the oil
the oil price effect on inflation is quick, short-lived (from
shock, with a coefficient that peaks close to 0.60 at quarter
quarters 0 to 1), relatively small (close to 0.20), and is
1 and averages 0.52 during the four quarters.
very similar to New Zealand’s. However, among industrialcountry ITers the oil price to inflation response is more
persistent (extending from quarters 0 through 4) although
of a similar small size. A similar persistence and size of the
oil-price effect on headline inflation is observed among
NITers but here the oil shock to inflation coefficient peaks at
0.35 at quarter 3. Most interesting, no statistical differences
in response coefficients from oil shocks to headline inflation
are detected between New Zealand 1998-2005 and any of
the three country groups.
Like in the case of the exchange-rate shock, the effect of an
I conclude that exchange-rate pass-through to headline
inflation is significant but relatively small in New Zealand.
It is close to a maximum pass-through coefficient of
0.15 during 1998-2005, a likely result of well-anchored
inflation expectations. The dynamic impulse response
pattern in New Zealand is very similar to that observed in a
representative industrial country under inflation targeting.
Pass-through to tradable goods inflation is much larger and
somewhat quicker than pass-through to headline inflation
in New Zealand, which also accords with international
experience.
oil price shock on inflation is much larger and protracted for
tradables than for headline inflation in New Zealand (Figure
12), as elsewhere. While a large and significant effect of an
oil-price hike on tradables inflation is already apparent in
106
Reserve Bank of New Zealand and The Treasury
The dynamic response of headline inflation to an oilprice hike is also relatively small in New Zealand, close to
a maximum oil-price pass-through coefficient of 0.25 in
1998-2005, again a likely reflection of a credible monetary
policy and stable inflation expectations. The size and
dynamics of the oil-price to headline inflation response
in New Zealand is statistically not different from those
observed in all comparator country groups, both with
and without inflation targeting. New Zealand’s tradables
inflation is much more and more persistently affected by an
oil shock than headline inflation, a result also in line with the
international evidence.
Vector
yt includes the nine following variables: US Federal
*
Funds rate ( it ), US output gap
( yt* ) , US headline inflation
( π t ), domestic output gap ( yt ) , deviation of domestic
*
headline inflation from the inflation target
(π t − π tT ) ,
domestic short-term interest rate (it ) , money deviation
from trend ( mt ), (log) exchange-rate
(et ) , and long-term
interest rate ( Rt ). I assume that the US Federal Funds rate
does not respond to any domestic variable but only to
changes in the US output gap or inflation. This specification
is similar to the VAR models by Eichenbaum and Evans
(1995), Grilli and Roubini (1995, 1996), and more recently
by Scholl and Uhlig (2005).11
To identify the structural policy shocks, I follow Sims (1980)
Monetary policy transmission in New Zealand
in assuming recursive identification using the Choleski
and CCG2
decomposition of the reduced-from residuals. Based
Now I turn to assessing the effects of monetary policy
on previous work, I assume that the US output gap and
innovations in New Zealand, in comparison to the evidence
inflation are contemporaneously exogenous to the US
on the monetary transmission mechanism in the CGG2
monetary policy instrument, and this is also the case for the
country group. For this purpose I use a standard country
domestic economy. Therefore, the variables are ordered,
VAR model of the literature developed for identifying
starting with the most exogenous, as follows:
monetary policy shocks (e.g., Christiano et al. 1996, Evans
yt , (π t − π tT ) , it , mt , et , and Rt .
and Marshall 1998, and Kim 2001). I will focus on the
dynamic effects of monetary policy shocks on short-term
interest rates, long-term interest rates, the exchange-rate,
real output, and inflation.
Let yt be a vector containing a set of macroeconomic
variables at time t, and let Rt denote a long-term bond
yield. Following Marshall and Evans (1998), I assume that
the economy is described by the following system of
equations:
a b   yt   A( L) B( L)   yt −1   ety 
(1) 
+ R 

  = 

 c 1   Rt   C ( L) D( L)   Rt −1   et 
where a is a square matrix with ones on the diagonal, b is
a scalar, c is a row vector, A(L) is a matrix polynomial in the
lag operator L, C(L) is a row vector polynomial, B(L) and
y
R
D(L) are scalar polynomials, and the process (et et ) is a
vector of structural disturbances, serially uncorrelated with
variance
Λ . I assume that B( L) = 0 and b = 0 , implying
that neither contemporaneous nor lagged values of the
bond yield enter the other system equations.
Testing stabilisation policy limits in a small open economy
yt*, π t* , it* ,
Figure 13 reports quarterly impulse responses to a
contractionary monetary policy shock (a 25 basis point
rise in the short-term interest rate), with 95% confidence
intervals over six years. The first column shows the results
for New Zealand for the 1990-2005 period, while the
second column restricts observations to the 1998-2005
period. There is a trade-off between the larger sample size
of the 1990-2005 sample, on one hand, and the larger
sample homogeneity and higher relevance for today’s policy
of the shorter 1998-2005 sample. Weighting more heavily
the larger sample size, I tend to favour the results from
the full sample and therefore conduct the cross-country
comparison below on the basis of the 1990-2005 sample,
too. Therefore the subsequent columns in Figure 13 depict
the individual impulse responses for the five comparator
countries, based on 1990-2005 data.
11
For robustness I have also estimated alternative VAR country
models, allowing for the lags of the long-term interest rate to
feed back into the system, as in Bernanke, Gertler and Watson
(1997). However, the country impulse responses derived
from the latter alternative specification are not qualitatively
different from those reported below.
107
Figure 13
Dynamic response to a monetary policy shock in New Zealand, 1990-2005 and 1998-2005 and in
CCG2, 1990-2005 (25 quarters)
New Zealand 1990-2005
New Zealand post-1997
0.4
0.35
0.30
0.3
0.25
Short-term
interest rate
0.20
0.2
0.15
0.10
0.1
0.05
0.0
0.00
-0.05
0
1
2
3
4
5
0
6
1
2
3
4
5
6
-0.1
-0.10
-0.15
-0.2
0.15
0.08
0.06
0.10
0.04
Long-term
interest rate
0.05
0.02
0.00
0.00
0
1
2
3
4
5
-0.02
6
-0.05
0
1
2
3
4
5
6
0
1
2
3
4
5
6
0
1
2
3
4
5
6
0
1
2
3
4
5
6
-0.04
-0.06
-0.10
-0.08
-0.15
-0.10
0.02
0.02
0.02
0.02
Nominal
exchange
rate (US$/
Local Curr.)
0.01
0.01
0.01
0.01
0.00
0.00
0
1
2
3
4
5
-0.01
6
-0.01
Inflation
deviation
from target
-0.01
-0.01
-0.02
0.20
0.40
0.15
0.30
0.10
0.20
0.05
0.10
0.00
0.00
0
1
2
3
4
5
6
-0.05
-0.10
-0.10
-0.20
-0.15
-0.30
0.06
0.15
0.04
0.10
0.02
0.00
Output
gap
-0.02
0
1
2
3
4
5
0.05
6
0.00
-0.04
-0.06
-0.05
-0.08
-0.10
-0.10
-0.12
-0.15
-0.14
-0.16
-0.20
Years
108
Reserve Bank of New Zealand and The Treasury
Figure 13
Dynamic response to a monetary policy shock in New Zealand, 1990-2005 and 1998-2005 and in
CCG2, 1990-2005 (25 quarters) (cont.)
Australia
Canada
0.35
0.4
0.30
0.3
0.25
Short-term
interest rate
0.20
0.2
0.15
0.10
0.1
0.05
0.0
0.00
-0.05
0
1
2
3
4
5
6
0
1
2
3
4
5
6
0
1
2
3
4
5
6
-0.1
-0.10
-0.15
-0.2
0.25
0.3
0.20
0.3
0.2
0.15
Long-term
0.10
interest rate
0.05
0.2
0.1
0.1
0.00
0
1
2
3
4
5
6
-0.05
-0.10
-0.1
-0.15
-0.2
0.03
0.010
0.03
0.008
0.006
0.02
Nominal
exchange
rate (US$/
Local Curr.)
0.0
-0.1
0.004
0.02
0.002
0.01
0.000
0.01
0
1
2
3
4
5
6
0
1
2
3
4
5
6
0
1
2
3
4
5
6
-0.002
0.00
0
1
2
3
4
5
6
-0.004
-0.01
-0.006
0.15
0.100
0.10
0.050
0.05
Inflation
deviation
from target
0.000
0.00
0
1
2
3
4
5
6
-0.05
-0.050
-0.10
-0.100
-0.15
-0.150
-0.20
-0.25
-0.200
0.06
0.060
0.040
0.04
0.020
0.02
Output
gap
0.000
0.00
0
1
2
3
4
5
6
-0.020
-0.040
-0.02
-0.060
-0.04
-0.080
-0.06
-0.100
-0.08
-0.120
-0.10
-0.140
Years
Testing stabilisation policy limits in a small open economy
109
Figure 13
Dynamic response to a monetary policy shock in New Zealand, 1990-2005 and 1998-2005 and in
CCG2, 1990-2005 (25 quarters) (cont.)
Norway
Sweden
Short-term interest rate
0.30
0.35
0.30
0.3
0.25
0.25
0.2
0.20
0.20
0.15
0.1
0.15
0.10
0.10
0.0
0
0.05
1
2
3
4
5
6
-0.1
0.00
-0.05
Chile
0.4
0.35
0
1
2
3
4
5
6
0.00
-0.05
-0.2
-0.3
-0.10
-0.4
-0.20
0.12
0.2
0.10
Long-term interest rate
2
3
4
5
6
0
1
2
3
4
5
6
0.08
0.1
0.08
0.06
0.06
0.04
0.0
0
0.04
0.02
1
2
3
4
5
6
-0.1
0.02
0.00
-0.02
0.00
0
1
2
3
4
5
6
-0.04
-0.2
-0.04
-0.06
-0.3
-0.06
-0.08
-0.08
-0.4
0.010
Nominal exchange
rate (US$/Local Curr.)
1
-0.15
-0.15
-0.02
0
-0.10
0.10
Inflation deviation
from target
0.05
0.008
-0.10
0.03
0.010
0.02
0.008
0.006
0.02
0.006
0.004
0.01
0.004
0.01
0.002
0.00
0.002
0.000
-0.01
0.000
0
1
2
3
4
5
6
-0.002
0
1
2
3
4
5
6
-0.002
-0.01
-0.008
-0.004
-0.02
-0.010
0.140
0.20
0.150
0.120
0.15
0.100
0.100
0.10
0.080
0.05
0.060
0.00
-0.05
0.020
-0.10
0
1
2
3
4
5
6
3
4
5
6
0
1
2
3
4
5
6
0
1
2
3
4
5
6
0.000
0
1
2
3
4
5
6
-0.050
-0.100
-0.150
-0.200
-0.20
-0.040
-0.25
-0.250
-0.060
-0.30
-0.300
0.020
2
0.050
-0.15
0.000
-0.020
1
-0.006
-0.02
0.040
0
-0.004
0.15
0.150
0.10
0.100
0.05
0.050
0.000
Output gap
0
1
2
3
4
5
6
0.00
-0.020
-0.05
-0.040
-0.060
-0.080
-0.100
0.000
0
1
2
3
4
5
6
-0.050
-0.10
-0.100
-0.15
-0.150
-0.20
-0.200
-0.25
-0.250
-0.30
-0.300
Years
110
Reserve Bank of New Zealand and The Treasury
Figure 14
Dynamic response to a monetary policy shock in New Zealand, 1990-2005 and 1998-2005,
alternative VAR model (25 quarters)
New Zealand 1990-2005
Short-term
interest rate
New Zealand 1998-2005
0.50
0.4
0.40
0.3
0.30
0.2
0.20
0.1
0.10
0.0
0.00
-0.1
0
0
1
2
3
4
5
1
2
3
4
5
6
6
-0.10
-0.2
-0.20
-0.3
0.15
0.20
0.15
0.10
0.10
Inflation
deviation
from target
0.05
0.05
0.00
0.00
0
1
2
3
4
5
6
0
1
2
3
4
5
6
0
1
2
3
4
5
6
-0.05
-0.05
-0.10
-0.10
-0.15
0.15
0.15
0.10
0.10
Output
gap
0.05
0.05
0.00
0.00
0
1
2
3
4
5
-0.05
6
-0.05
-0.10
-0.10
-0.15
-0.15
-0.20
-0.20
-0.25
-0.25
Years
Let’s start by focusing on the results for New Zealand from
more than offsets a temporary positive response of inflation
both samples. Short-term interest-rate dynamics are similar
(a price puzzle) in the first quarter after the interest rate
in both periods, although they adjust somewhat more
hike. The output gap shrinks in response to the interest
quickly since 1998, possibly suggesting more monetary
hike. While the negative output effect is persistent but not
policy activism. Long-term interest rates respond significantly
significant in the full sample, it is negative and significant
on impact and, in the case of the full sample results, also
during quarters 2 through 4 in the 1998-2005 sample, with
in the first period after the short-term rate increase. While
subsequent oscillatory dynamics.
the exchange-rate appreciates in response to the short-term
rate increase, the appreciation is small and not significantly
different from zero.
In order to check robustness of the latter results on
monetary transmission in New Zealand, I estimate for both
sample periods an alternative, smaller VAR model. Included
A significant negative inflation response in quarters 4
variables comprise the international price of oil, domestic
through 9 to the monetary contraction is found for the full
output gap, deviation of domestic headline inflation from
sample. This significant and persistent reduction in inflation
Testing stabilisation policy limits in a small open economy
111
the inflation target, domestic short-term interest rate, and
from zero in New Zealand. Inflation declines significantly in
the nominal exchange-rate. The impulse responses for both
New Zealand in the second year after the monetary shock,
sample periods are reported in Figure 14. In comparison to
similar to what is observed in two comparator countries and
the results based on the original VAR, reported in Figure
opposed to the non-significant inflation response in the
13, these new results strengthen the evidence on monetary
other three countries. The output gap responds negatively
policy transmission in New Zealand, in particular for the full
and persistently (and significantly under an alternative VAR
1990-2005 sample. The negative and significant response
specification) in New Zealand, like in most other comparator
of inflation to the monetary policy contraction extends now
countries.
from quarters 5 through 9 and the negative output gap
response is now significant during a long period, extending
from quarters 5 through 13.
Now I turn to comparing monetary transmission in
New Zealand to the other five countries, returning to the
larger VAR specification and the corresponding country
Table 5
Mean absolute deviations of annual inflation
rates from inflation targets in 21 inflation
targeting countries, since start of inflation
targeting
Mean absolute deviation
impulse responses depicted in Figure 13. A short-term
Country
interest rate hike has a positive, significant, and persistent
effect on long-term rates in Australia, Canada, and Norway.
from target
percentage
as % of
points
target
However, in Sweden and Chile the response on long-term
Australia
1.20
47.89
Brazil
4.07
94.91
Canada
0.93
38.91
Chile
1.29
20.53
rates. Like in New Zealand, no significant exchange-rate
Colombia
1.25
13 .46
appreciation is identified in Australia, Canada, and Chile.
Czech Republic
2.03
51.56
However, for Norway and Sweden I find some evidence
Hungary
2.25
56.55
rates is not significantly different from zero. New Zealand’s
case is closer to the first group, showing a positive and
significant but more short-lived effect on long-term
of a temporary significant exchange-rate appreciation in
response to the monetary contraction.
Iceland
1.62
54.66
Israel
2.43
58.01
Korea
1.02
28.34
Like in New Zealand but somewhat more persistently,
Mexico
1.26
24.95
an interest rate rise reduces inflation significantly from
New Zealand
0.94
55.98
quarters 4-5 onwards in Australia and Sweden. However,
Norway
1.25
50.15
Peru
1.68
29.52
no significant effects on inflation are found for Canada,
Phillipines
1.68
32.73
Poland
2.27
44.68
Canada, exhibit a negative, significant, and persistent
South Africa
2.82
62.73
dynamic response of the output gap to an interest rate
Sweden
1.12
56.01
hike.
Switzerland
0.40
39.85
Thailand
0.63
35.80
United Kingdom
0.89
36.07
Average
1.57
44.44
exc/. New Zealand
1.60
43.87
Norway, and Chile. Finally, all comparator countries, except
From this evidence I conclude that monetary policy
transmission in New Zealand is broadly comparable
to, and at least as strong as, that observed in the CCG2
country group. Like in three of the five CCG2 countries,
but exhibiting less persistence, long-term rates respond
Source: Mishkin and Schmidt-Hebbel (2005)
Note:
Sample periods depend on the IT regime starting date.
New Zealand data are for 1990q1-2005q4.
to short-term rates in New Zealand. Like in four of the five
countries, the exchange-rate appreciation in response to
a short-term interest rate rise is not significantly different
112
Reserve Bank of New Zealand and The Treasury
Inflation targeting accuracy
Figure 15
Here I compare the accuracy of New Zealand in hitting
Mean absolute deviations of annual inflation
its official inflation target with the IT accuracy observed
rates from inflation targets in 21 inflation
in a sample of 20 ITers. Following Albagli and Schmidt-
targeting countries, since start of inflation
Hebbel (2005), I report the size, frequency, intensity, and
targeting
persistence of actual inflation deviations from inflation
targets, computing (i) the mean absolute deviations of
%
%
2.0
2.0
1.8
New Zealand
CCG2 *
Others **
1.8
inflation rates from target levels, (ii) the frequency of
1.6
deviations, (iii) the mean duration of deviations, and (iv)
1.4
1.4
the mean amplitude of deviations. Tables 5-7 summarize
1.2
1.2
1.0
1.0
0.8
0.8
quarterly data from the quarter at which the IT regime was
0.6
0.6
started in the corresponding country until the last quarter of
0.4
0.4
0.2
0.2
the latter statistics for New Zealand and the 20 ITers, using
2004, except for New Zealand which contains information
from the first quarter of 1990 through the fourth quarter
of 2005.12
0.0
0.0
1990-1997
Note:
New Zealand exhibits a mean absolute deviation of actual
annual inflation rates from its official inflation target of
0.94 percentage points, which is lower than the average
result for other IT countries and higher only to the absolute
1.6
1998-2004
The data for New Zealand considers data from 1990q1 to
2005q4.
* The sample includes Australia, Canada, Chile and
Sweden for the 1990-1997 period and adds Norway for
1998-2004.
** The sample includes Israel, Peru and the United
Kingdom for the 1990-1997 period. The 1998¬2004
period includes 20 inflation targeters.
inflation deviations observed in Canada (0.93), England
(0.89), Switzerland (0.4), and Thailand (0.63). When
Regarding asymmetry in inflation deviations, New Zealand
comparing New Zealand’s IT accuracy across the earlier and
exhibits a large share of episodes when inflation rates
the more recent sample periods, we note that its accuracy
exceed target mid-points (78.6% of time; Table 6, overleaf).
has improved between 1990-1997 and 1998-2005; the
Regarding large deviations, defined as those exceeding 1
average absolute inflation deviation has declined from 0.96
percentage point in absolute value, New Zealand has
percentage points to 0.79 percentage points (see Figure 15).
experienced large deviations 52.4% of the time, most of
New Zealand has also outperformed the average country
which were positive inflation deviations (48.8%). The
in comparator group CCG2, as well as the average country
experience of New Zealand is similar to that of many IT
in the complementary group of other (non-CCG2) ITers in
countries, which on average experience large deviation
both periods.
from targets 52.7% of the time. But, as opposed to
New Zealand, large deviations are symmetric in an average
IT country; both positive and negative large deviations are
observed 26% of the time.
New Zealand has improved its accuracy in hitting its inflation
12
A few inflation-targeting countries – and some countries
during part of their IT experience – have used inflation
measures other than headline CPI inflation, most frequently
core inflation measures. Among the latter is New Zealand,
which used a core inflation measure for its inflation target
until the late 1990s, when it switched to the headline inflation
measure. While I am aware of the latter exceptions, I compute
inflation targeting accuracy measures in this section (and
inflation deviation measures in other sections of this paper)
using headline CPI inflation for all countries, to maintain
comparability across countries and over time.
Testing stabilisation policy limits in a small open economy
target over time.13 The frequency of large deviations has
declined from 43.8% in 1990-1997 to 31.3% in 19982005. This has left New Zealand in a better position than
the average IT country (Figure 16, p 116).
13
As discussed in the preceding footnote, part of this
improvement in New Zealand may reflect a somewhat distorted
measure of the absolute inflation target deviation before 1999,
when the official target was based on a core inflation measure,
not headline CPI inflation.
113
Table 6
Frequency of deviations of annual inflation rates from inflation targets in 21 inflation targeting
countries, since start of inflation targeting
Country
Australia
Frequency of time
Frequency of time
Fraction of time
above the target below the target
1 p.p. above the target p.p. below the target
(% of time)
(% of time)
1p.p above or
below
the target
52.4%
47.6%
21.4%
21.4%
42.9%
Brazil
87.5%
12.5%
70.8%
12.5%
83.3%
Canada
42.9%
57.1%
12.5%
26.8%
39.3%
Chile
62.5%
37.5%
32.1%
14.3%
46.4%
Colombia
58.3%
41.7%
12.5%
20.8%
333%
Czech Republic
39.3%
60.7%
28.6%
35.7%
64.3%
Hungary
93.8%
6.3%
75.0%
0.0%
75.0%
Iceland
62.5%
37.5%
43.8%
0.0%
43.8%
Israel
50.0%
50.0%
36.5%
40.4%
76.9%
Korea
46.4%
53.6%
10.7%
32.1 %
42.9%
Mexico
75.0%
25.0%
37.5%
12.5%
50.0%
New Zealand
78.6%
21.4%
48.8%
3.6%
52.4%
Norway
25.0%
75.0%
18.8%
50.0%
68.8%
Peru
47.7%
52.3%
20.5%
29.5%
50.0%
Phillipines
25.0%
75.0%
12.5%
56.3%
68.8%
Poland
46.4%
53.6%
35.7%
42.9%
78.6%
South Africa
65.0%
35.0%
50.0%
30.0%
80.0%
Sweden
25.0%
75.0%
0.0%
47.5%
47.5%
Switzerland
50.0%
50.0%
0.0%
0.0%
0.0%
Thailand
40.0%
60.0%
10.0%
15.0%
25.0%
United Kingdom
173%
82.7%
3.8%
32.7%
36.5%
Average
51.9%
48.1%
27.7%
25.0%
52.6%
excl. New Zealand
50.6%
49.4%
26.6%
26.0%
52.7%
Source: Mishkin and Schmidt-Hebbel (2005)
Note:
Periods depend on the IT regime starting date. Data on New Zealand calculated for the 1990q 1-2005q4 period.
114
Reserve Bank of New Zealand and The Treasury
Table 7
Features of deviations of annual inflation rates from inflation targets in 21 inflation targeting
countries, since start of inflation targeting
Mean duration of deviations
Country
above the target
below the target
(in quarters)
Amplitude of deviations
Amplitude of deviations
above the target below the target above the target
(percentage points)
below
the target
(as % of target)
Australia
5.50
5.00
1.25
-1.14
50.1.
-45.5
Brazil
21.00
3.00
4.03
-4.31
100.8
-53.9
Canada
3.43
5.33
0.79
-1.03
33.1
-43.2
Chile
5.00
3.00
1.51
.0.91
17.8
-25.1
Colombia
2.80
2.50
0.72
-1.99
12.7
-14.6
Czech Republic
3.67
8.50
2.44
-1.76
52.6
-50.9
Hungary
7.50
1.00
2.40
-0.06
60.2
-1.2
Iceland
5.00
6.00
2.33
-0.43
77.2
-17.0
Israel
5.20
5.20
2.41
-2.45
49.8
-66.3
Korea
6.50
7.50
0.63
-1.35
21.0
-34.7
Mexico
4.50
2.00
1.35
-0.99
29.3
-11.8
New Zealand
13.20
4.50
1.06
-0.62
67.7
-23.3
Norway
2.00
6.00
1.09
-1.31
43.6
-52.3
Peru
3.50
4.60
2.06
-1.34
23.1
-35.3
Phillipines
2.00
12.00
1.39
-1.78
30.9
-33.4
Poland
4.33
7.50
2.17
-2.36
39.6
-49.1
South Africa
6.50
2.33
2.95
-2.59
65.6
-57.5
Sweden
3.33
10.00
0.54
-1.31
27.0
-65.7
Switzerland
3.33
5.00
0.32
-0.47
32.4
-47.3
Thailand
1.60
2.40
0.69
-0.58
39.6
-33.2
United Kingdom
3.00
14.33
0.88
.0.89
35.3
-36.2
Average
5.38
5.60
1.57
-1.41
43.31
-37.97
excl. New Zealand
4.98
5.66
1.60
-1.45
42.09
-38.71
Source: Mishkin and Schmidt-Hebbel (2005)
Note:
Periods depend on the IT regime starting date. Data on New Zealand calculated for the 1990q 1-2005q4 period.
Testing stabilisation policy limits in a small open economy
115
Figure 16
approach adopted here involves estimating an inflation
Frequency of deviations of annual inflation
and output variability efficiency frontier in order to derive
rates from inflation targets in 21 inflation
measures of economic performance and monetary policy
targeting countries, since start of inflation
efficiency. The performance of monetary policy can be
targeting
assessed using the inflation and output variability tradeoff
%
%
60
60
an efficiency frontier that is known as the Taylor Curve
New Zealand
CCG2 *
Others **
50
faced by the policy maker. This tradeoff allows constructing
50
(Taylor 1979). The inflation-output variability frontier is
understood by considering an economy that is hit by two
40
40
30
30
20
20
move output and inflation in opposite directions, forcing
10
10
the monetary authority to face a tradeoff between inflation
0
0
types of disturbances: aggregate demand and aggregate
supply shocks. As is well known, aggregate supply shocks
1990-1997
Note:
1998-2004
The data for New Zealand considers data from 1990q1 to
2005q4.
* The sample includes Australia, Canada, Chile and
Sweden for the 1990-1997 period and adds Norway for
1998-2004.
** The sample includes Israel, Peru and the United
Kingdom for the 1990-1997 period. The 1998¬2004
period includes 20 inflation targeters.
and output variability. Therefore, the position of the
efficiency frontier depends on the intensity of aggregate
supply shocks: the smaller are such shocks, the closer is the
frontier to the origin (Figure 17).
Figure 17
Monetary policy efficiency frontier and
observed performance
Additional features of inflation deviations from targets
are reported in Table 7, including duration of deviations
above or below targets and the amplitude of deviations.
In New Zealand above-target inflation deviations exhibit
an average duration of 13.2 quarters while below-target
deviations last on average 4.5 quarters. Positive deviations
are also larger than negative deviations: above-target
deviations were on average 1.06 percentage points,
while below-target deviations were on average only 0.62 percentage points. The mean duration of abovetarget deviations in New Zealand is almost three times
larger than in the average IT country but the mean size of
deviations is smaller both above and below inflation target
in New Zealand, in comparison to the average ITer.
The efficiency frontier is also an indicator of the degree
of optimality of monetary policy. When monetary policy
is sub-optimal, the economy exhibits large output and
inflation volatility and is positioned at a significant distance
from the frontier. Shifts toward the efficiency frontier
are an indication of improved monetary policy efficiency.
These features of the efficiency frontier allow constructing
Inflation and output volatility and monetary
measures of economic and monetary policy performance
policy efficiency
in order to examine the contribution of policy efficiency
macroeconomic
and variability of shocks to the observed differences in
performance is by focusing on the stability of inflation
macroeconomic performance between different samples
and output. Following Cecchetti and Krause (2001)
of New Zealand over time and across different country
and Cecchetti, Flores-Lagunes, and Krause (2004), the
groups.
An
116
effective
way
of
measuring
Reserve Bank of New Zealand and The Treasury
Table 8 reports three estimated comparative measures of
between 1990-1997 and 1998-2005. In the most recent
economic performance for each pair of comparisons. L
period, New Zealand also exhibits lower levels of volatility
is a measure of an economy’s performance, in terms of
than different groups of IT countries. One possible
output and inflation variability. A high value of L reflects a
explanation is that New Zealand is currently hit by smaller
poorer performance of the country or set of countries; E
shocks than in the past. Alternatively, the Reserve Bank of
measures the monetary policy efficiency, determining how
New Zealand may be more efficient in implementing policies
close actual performance is to the one under optimal policy
to meet its inflation and stabilisation objectives.
(i.e., the distance to the efficiency frontier). Hence the
smaller is the value of E, the closer monetary performance
is to optimal policy; and S gauges the variability of supply
shocks. The smaller is the variability of the disturbances
that hit the economy, the smaller is this measure.14 Table
8 also decomposes the gains in performance into a gain
in efficiency, ∆ E , reflected by getting closer to the
efficiency frontier, and a smaller variability of shocks hitting
the economy, ∆ S , reflected by a shift of the efficiency
frontier. Figures 18-22 depict actual performance points
and efficiency frontiers consistent with E , for each pair of
comparisons performed.
In the spirit of Mishkin and Schmidt-Hebbel (2005), in this
section I compute performance measures in order to identify
the contribution of different monetary policy strategies to
the observed differences in macroeconomic performance
between New Zealand’s experience before and after 1997. I
disentangle the contribution of changes in monetary policy
efficiency and supply shocks to the observed differences
in macroeconomic performance between New Zealand
post-1997 and four different country groups; ITers after IT
adoption, industrial ITers after IT adoption, non inflation
targeters (NIT) post-1997, and the CCG2 sub-sample of
ITers.15
Figure 18 shows that New Zealand has featured a significant
reduction in the volatility of inflation and the output gap
Table 8
Monetary policy performance and policy efficiency changes in New Zealand and CCG1 countries
Group 1
NZ before 1997
L1
E1
S1
Group 2
L2
E2
S2
L2-L 1
E2-E1
S2-S1
1.383
0.985
0.398
NZ after 1997
0.684
0.304
0.380
-0.699
-0.681
-0.018
71.2
28.8
44.4
55.6
97.4
2.6
4.727
2.204
2.523
NZ after 1997
0.684
0.304
0.380
-4.043
-1.900
-2.142
46.6
53.4
44.4
55.6
47.0
53.0
1.697
0.829
0.867
NZ after 1997
0.684
0.304
0.380
-1.013
-0.525
-0.487
48.9
51.1
44.4
55.6
51.9
48.1
0.938
1.261
0.304
0.380
-0.635
-0.881
38.6
61.4
44.4
55.6
41.9
58.1
0.268
0.303
0.304
0.380
0.035
0.077
47.0
53.0
44.4
55.6
31.3
68.7
(as % of L)
ITers after IT
(as % of L)
Industrial ITers
(as % of L)
CCG2 IT countries
2.199
(as % of L)
NITers after 1997
14
0.571
NZ after 1997
NZ after 1997
Mishkin and Schmidt-Hebbel (2005) provide a detailed
description of the methodology used in this section.
Testing stabilisation policy limits in a small open economy
0.684
0.684
15
-1.515
0.113
This group of countries includes Australia, Canada, Chile,
Norway and New Zealand.
117
Figure 18
Figure 19
Estimated efficiency frontiers and observed
Estimated efficiency frontiers and observed
performances: New Zealand before and after
performance points: New Zealand after 1997
1997
and ITers
Output variability
4.0
Output variability
8.0
3.5
NZ pre-1997
observed point
3.0
6.0
2.5
5.0
2.0
1.5
1.0
ITers after IT efficiency frontier
7.0
NZ post-1997
efficiency
frontier
NZ pre-1997
efficiency frontier
NZ post-1997
efficiency frontier
4.0
ITers after IT observed
point
3.0
NZ post-97
observed point
NZ post-1997
observed point
2.0
0.5
1.0
0.0
0.0
0.2
0.4
0.6
Inflation variability
0.8
1.0
0.0
0.0
1.0
2.0
3.0
Inflation variability
4.0
5.0
6.0
Figure 20
Figure 18 depicts New Zealand’s monetary policy efficiency
Estimated efficiency frontiers and observed
frontier before and after 1997 and the first two rows of
performance points: New Zealand after 1997
Table 8 report the estimated measures of performance.
and industrial ITers
Macroeconomic performance between these periods
Output variability
5.0
has improved, as the volatility of inflation and output has
4.5
declined significantly. This is reflected in an improvement in
3.5
the performance measure L and a negative value of L2 - L1.
2.5
Before 1997, the distance to the efficiency frontier explained
1.5
71.2% of actual macroeconomic performance (E2 - E1 =
0.681) while the variability of shocks explained 28.8% of
performance (S2 - S1 = -0.018). In contrast, during the post-
4.0
NZ post-1997 efficiency
frontier
Industrial ITers efficiency
frontier
3.0
2.0
1.0
NZ post-1997
observed point
Industrial ITers observed
point
0.5
0.0
0.0
0.5
1.0
1.5
2.0
Inflation variability
Note: Industrial ITers sample include Australia, Canada, Iceland, Norway,
Switzerland and England
1997 period New Zealand has been much closer to the
efficiency frontier, reflecting an improvement of monetary
The second and third comparisons are between New Zealand
policy efficiency. The gain in efficiency explains 97.4%
post-1997 and two sets of IT countries: first, all countries
of the improved performance while the decline in shock
(less New Zealand) after their implementation of IT and,
volatility explains only 2.6%.
second, only industrial ITers after their implementation of IT.
New Zealand exhibits actual performance levels, efficiency
frontier positions, and policy efficiency levels that are better
than those of all ITers (Figure 19). The superior performance
of New Zealand is equally explained by enhanced policy
efficiency (47%) and smaller shocks (53%). A similar result
is obtained when comparing New Zealand to industrial
ITers (Figure 20). Even though their performance points
and efficiency frontiers are closer to New Zealand’s,
New Zealand also outperforms industrial ITers in efficiency
(by -0.525, equivalent to a 51.9% contribution) as well as
the magnitude of shocks (by -0.487, equivalent to a 48.1%
contribution).
118
Reserve Bank of New Zealand and The Treasury
5
Figure 21
Estimated efficiency frontiers and observed
scope for an independent
performance points: New Zealand after 1997
monetary policy
and NITers
Is there scope for an independent monetary policy in small
Output variability
4.5
open economies that are closely integrated into world
4.0
financial markets? I address this question for New Zealand in
3.5
3.0
international comparison from three different perspectives.
2.5
NITers post-1997
observed point
2.0
1.5
1.0
Role of global markets and
NITers post-1997
efficiency frontier
First, I report simple correlation coefficients between the
NZ post-1997
observed point
domestic short-term interest rate and the US Federal Funds.
NZ pre-1997
efficiency frontier
0.5
0.0
0.0
0.1
0.2
0.3
Note: NIters sample includes OECD NIters.
0.4
0.5
Inflation
variability
Then I compare impulse response dynamics of domestic
0.6
0.7
short-term rates to the foreign rate for New Zealand and
comparator country groups, from the VAR models developed
Figure 22
in Section 4. Finally, I complement the latter results by
Estimated efficiency frontiers and observed
computing the dynamic impulse response of domestic to
performance points: New Zealand after 1997
foreign rates from the country VAR models developed for
New Zealand and the five CCG2 countries in Section 4.
and CCG2 ITers
Output variability
5.0
CCG2 ITers after IT
efficiency frontier
4.5
4.0
3.5
NZ post-1997
efficiency frontier
How correlated are interest rates in New Zealand with
3.0
2.5
2.0
CCG2 ITers after IT
observed point
1.5
1.0
0.5
0.0
Independence of monetary policy
NZ post-1997
observed point
0.0
0.5
1.0
1.5
2.0
2.5
Inflation variability
Note: CCS2 countries include Australia, Canada, Chile, Norway and Sweden
international interest rates? In this section I start by reporting
simple correlation coefficients to assess the extent to which
the short-term interest rate is linked to the international
rate, namely the US Federal Funds rate. I provide evidence
of change in this coefficient over recent years and contrast
the evidence for New Zealand with the experience of
Figures 21 and 22 depict the results of comparing
New Zealand post-1997 to the control group of 13
successful industrial NITers and the restricted set of
CCG2 ITers. The results show that New Zealand exhibits a
performance that is inferior to that of the NITers (L2 - L1
= 0.11). However, most of this difference in performance
is explained by smaller shocks in industrial NITers (S1 - S2
= 0.08, equivalent to a contribution of 68.7%), while the
difference in monetary policy efficiency is smaller (E2 - E1
= 0.03, equivalent to a contribution of 31.3%). In contrast,
New Zealand post-1997 presents a better performance than
the CCG2 country group, but this difference is mainly due to
comparator country group CCG2.
Figure 23
Moving correlation coefficients between the
New Zealand short-term interest rate and the
US Federal Funds rate, 1997-2005
1
0. 8
0. 6
0. 4
0. 2
0
-0. 2
-0. 4
smaller shocks (51.9 %).
F E D rate
Note:
Testing stabilisation policy limits in a small open economy
F E D rate (adj. ex c hange rate ex p.)
Correlation coefficient calculations are based on sevenyear moving windows.
119
Table 9 reports interest rate correlation coefficients for
expectations until 2002, when they start rising quickly to
New Zealand and the five countries in the CCG2 group.
levels around 0.40.
New Zealand presents a high level of connection between
the domestic short-term interest rate and the US Fed Funds
rate, with a large and significant correlation coefficient
close to 0.7 for the full 1990-2005 sample. However, when
splitting the full sample in two, a massive reduction in New
Zealand’s interest rate correlation is observed over time: the
corresponding coefficient drops from 0.93 in 1990-1997 to
0.30 (only significant at 10% confidence level) in the most
recent 8 years spanned between 1998 and 2005.
Figure 23 depicts the evolution of the correlation coefficient
in New Zealand using a seven-year moving window. Again
there is strong evidence of a massive reduction in domesticforeign interest rate correlation that took place in the late
1990s, to current levels close to 0.40.
Considering exchange-rate depreciation expectations I
examine evidence of uncovered interest-rate arbitrage
by focusing on the correlation between the short-term
domestic interest rate and the foreign rate augmented
by exchange-rate devaluation expectations. During the
first sub-period, the high correlation between domestic
and unadjusted foreign rates vanishes once we consider
devaluation expectations (Table 9). In contrast, for the
more recent 1998-2005 period, I still obtain a positive and
significant correlation coefficient of 0.41. Similar results
are obtained for moving-window correlation coefficients:
they are close to zero when adjusting for devaluation
Figure 24
Correlation coefficient between domestic
short-term interest rates and the US Federal
Funds rate in New Zealand and CCG2,
1990-2005
%
1.0
1990-2005
1998-2005
0.9
1990-1997
%
1.0
0.9
0.8
0.8
0.7
0.7
0.6
0.6
0.5
0.5
0.4
0.4
0.3
0.3
0.2
0.2
0.1
0.1
0.0
0.0
New
Zealand
Australia
Canada
Chile
Norway
Sweden
The positive association between domestic and foreign
interest rates is confirmed for the CCG2 country group
(Table 9 and Figure 24). The average correlation coefficient
for the five countries and the full 1990-2005 sample is 0.62
and declines to 0.38 for the uncovered arbitrage relation.
However, in contrast to New Zealand, most countries exhibit
an increasing association between their domestic interest
rate and the external interest rate. However there is large
country heterogeneity in the relation between domestic
and foreign rates (unadjusted and adjusted for devaluation
expectations) and their changes over time.
Transmission of international interest rate
shocks (1)
As a result of enhanced credibility and lower pass-through
from exchange-rate shocks to inflation, we expect more
independence of central banks in their conduct of monetary
policy. In this subsection I assess the response of domestic
short-run interest rates to shocks in international short-run
interest rates, adopting the method applied in Section 4
above.
Figure 25, overleaf, depicts the dynamic response of the
domestic interest rate to an international interest rate shock,
comparing the response for New Zealand over two different
120
Reserve Bank of New Zealand and The Treasury
Table 9
Correlation coefficients between domestic short-term interest rates and the US Federal Funds
rate in New Zealand and CCG2, 1990-2005
New Zealand
FED interest rate
1990-2005
0.70
0.16
(0.00)***
(0.22)
0.93
0.00
(0.00)***
(0.99)
0.30
0.41
(0.099)*
(0.02)**
0.66
0.22
(0.00)***
(0.09)*
0.84
0.03
(0.00)***
(0.89)
1990-1997
1998-2005
Australia
1990-2005
1990-1997
1998-2005
Canada
1990-2005
1990-1997
1998-2005
Chile
1990-2005
1990-1997
1998-2005
Norway
1990-2005
1990-1997
1998-2005
No CHART supplied
Sweden
1990-2005
1990-1997
1998-2005
Note:
FED interest rate (adj. exchange-rate
Time period
depreciation expectations )
0.46
0.58
(0.01)***
(0.00)***
0.76
0.42
(0.00)***
(0.09)*
0.70
-0.27
(0.00)***
(0.14)*
0.93
0.84
(0.00)***
(0.00)***
0.79
0.67
(0.00)***
(0.09)*
0.59
0.33
(0.00)***
(0.07)*
0.83
0.80
(0.00)***
(0.00)***
0.41
0.26
(0.00)***
(0.05)**
0.16
0.19
(0.39)
(0.29)
0.43
0.16
(0.01)**
(0.42)
0.47
0.31
(0.00)***
(0.02)**
0.24
0.30
(0.19)
(0.10)*
0.36
-0.03
(0.04)**
(0.88)
The source of data for exchange-rate depreciation expectations for New Zealand is the RBNZ, while for all other countries we
calculated expectations from estimations based on AR(1) processes.
p-values are reported in parenthesis.
* Significant at 10%, ** Significant at 5%, *** Significant at 1%.
Testing stabilisation policy limits in a small open economy
121
time periods, and the more recent period in New Zealand to
changes of international interest rates. As in the preceding
the group response of all ITers, industrial-country ITers, and
sub-section, the foreign interest rate is the US Federal Funds
NITers – as I did in Section 4 for other impulse responses.
rate.
The response of short-term rates in New Zealand to an
Recall that the VAR model is comprised by nine variables: US
international short-term interest rate shock is positive and
Federal Funds rate ( it ), US output gap ( yt* ) , US inflation
significant in the first quarters after the shock, both in the
*
( π t ), domestic output gap ( yt ) , domestic deviation of
*
earlier 1989-1997 and the more recent 1998-2005 periods.
inflation from the inflation target (π t − π tT ) , domestic
However, the magnitude and persistence of New Zealand’s
short-term interest rate (it ) , money deviation from trend
response is smaller in the more recent period, and the
(mt ) , (log) exchange-rate (et ) , and long-term interest rate
difference is significant from the third quarter onwards.
( Rt ) . I assume that the federal funds rate responds only to
This suggests that monetary policy independence has
changes in the US output gap and inflation, and we also
strengthened in New Zealand during the last decade.
assume that neither contemporaneous nor lagged values of
In the two country groups comprised by all ITers and
the long-term interest rate enter the other equations in the
industrial-country ITers, the response of the short-run
system.16
domestic interest rate to an international interest-rate shock
Figure 26, overleaf, reports the impulse responses to a
is also positive but its magnitude and significance rise over
US monetary policy shock, with 95% confidence intervals
time. This time pattern is strikingly different than the more
over six years. The US monetary shocks are defined by a
front-loaded response of short-term rates in New Zealand.
Federal Funds rate hike of by 25 basis points on impact,
While at short lags the interest rate response in New Zealand
followed by the sample-specific dynamics of US monetary
is larger, at longer lags the response in other IT countries
policy observed in the data. The first two columns contain
increases while it declines toward zero at longer lags in
the results for New Zealand using two different samples:
New Zealand. The last column of Figure 25 confirms the
the 1990-2005 period and the post-1997 experience.17 The
significance of these differences between New Zealand and
impulse responses in the five other countries during 1990-
other ITers.
2005 are presented in the subsequent columns.18
By contrast, the interest-rate response to international rate
In New Zealand, a higher foreign interest rate is followed
shocks is smaller and less significant in NITers than in ITers.
by an increase in both short-term and long-term domestic
Therefore the differences with New Zealand’s time pattern
interest rates. The rise in both rates is significant for about
are even more significant.
a year, and from then on the short-term interest rate rapidly
I conclude that New Zealand’s monetary independence
declines while the long-term interest rate decreases at a
has strengthened since the late 1990s and is similar to that
slower pace. Looking at the post-1997 results, we still find
observed in other inflation-targeting countries.
that an international interest rate shock leads to higher
domestic interest rates. However, the response is short-lived
and significant only during the first two quarters. From an
Transmission of international interest rate
international perspective, the response of the short-term
shocks (2)
and long-term interest rates in New Zealand is similar to
I complement the latter evidence by applying the same
the responses found in Australia and Canada. Norway, on
VAR model developed and used in Section 4 to assess the
evidence on the transmission mechanism of a shock in the
16
external interest rate in New Zealand and the CCG2 group.
17
Here I am particularly interested in the dynamic response
of the domestic interest rate and the exchange-rate to
122
18
Annex B describes he country data definitions and sources of
variables used in VAR estimations.
Due to the small number of observations for this period, we
should be careful in interpreting these results.
For robustness I also considered here alternative VAR
specifications, which, like in section 4, did not yield
significantly different results.
Reserve Bank of New Zealand and The Treasury
Figure 25
Dynamic response of domestic interest rate to an international interest rate shock in
New Zealand, 1990-2005 and 1998-2005, and in CCG2, 1990-2005 (25 quarters)
New Zealand vs ITERS and NON-ITers
New Zealand before 1997
New Zealand (1998-2005)
%
%
1.5
1.5
1.0
1.0
0.5
1.5
Difference
%
%
%
%
1.5
1.5
1.5
1.0
1.0
1.0
1.0
0.5
0.5
0.5
0.5
0.5
0.0
0.0
0.0
0.0
0.0
0.0
-0.5
-0.5
-0.5
-0.5
-0.5
-0.5
-1.0
-1.0
-1.0
-1.0
-1.0
1
2
3
4
5
6
1
7
New Zealand (1998-2005)
2
3
4
5
6
7
-1.0
1
2
3
ITers after start of IT
%
%
4
5
6
7
Difference
%
%
%
%
1.5
1.5
1.5
1.0
1.0
1.0
1.0
0.5
0.5
0.5
0.5
0.5
0.0
0.0
0.0
0.0
0.0
0.0
-0.5
-0.5
-0.5
-0.5
-0.5
-0.5
-1.0
-1.0
-1.0
-1.0
1.5
1.5
1.0
1.0
0.5
1.5
-1.0
1
2
3
4
5
6
1
7
2
3
4
5
6
-1.0
7
1
2
Industrial ITers after start of IT
New Zealand (1998-2005)
%
%
%
3
4
5
6
7
Difference
%
%
%
1.5
1.5
1.5
1.5
1.5
1.0
1.0
1.0
1.0
1.0
1.0
0.5
0.5
0.5
0.5
0.5
0.5
0.0
0.0
0.0
0.0
0.0
0.0
-0.5
-0.5
-0.5
-0.5
-0.5
-0.5
-1.0
-1.0
-1.0
-1.0
1.5
-1.0
1
2
3
4
5
6
1
7
New Zealand before (1998-2005)
%
2
3
4
5
6
-1.0
7
1
2
Non-ITers (1998-2005)
%
1.5
1.5
1.0
1.0
0.5
3
4
5
6
7
Difference
%
%
%
%
1.5
1.5
1.0
1.0
1.0
1.0
0.5
0.5
0.5
0.5
0.5
0.0
0.0
0.0
0.0
0.0
0.0
-0.5
-0.5
-0.5
-0.5
-0.5
-0.5
-1.0
-1.0
-1.0
-1.0
1.5
-1.0
1
2
3
4
5
6
7
1
2
3
4
5
6
7
1.5
-1.0
1
2
3
4
5
6
7
the other hand, presents a delayed response while Chile’s
depreciation. Looking at the post-1997 sample, we find
increase in the short-term interest rate is significant for at
that the currency depreciates only during the first year;
least two years but the response of long-term interest rates
thereafter the exchange-rate starts appreciating. A similar
in not significant.
pattern is also found in Australia, Canada and Norway, but
The fourth row in Figure 26 shows the impulse response
of the nominal exchange-rate to a US monetary policy
contraction. The results show that the bilateral USNew Zealand nominal exchange-rate depreciates until
only Australia presents similar magnitude of changes in the
exchange-rate, while the rest of the countries experience
smaller swings in the exchange-rate. Our results suggest
that there is evidence of delayed overshooting similar to the
approximately the second year and then starts a path of
Testing stabilisation policy limits in a small open economy
123
Figure 26
Dynamic response to an international interest rate shock in New Zealand and CCG2, 6 years
New Zealand 1990-2005
New Zealand 1998-2005
%
Foreign
interest rate
%
0.7
0.7
0.6
0.6
0.5
0.5
0.4
0.4
0.3
0.3
0.2
0.2
0.1
0.1
0.0
0.0
-0.1
-0.1
-0.2
-0.2
-0.3
-0.3
0
1
2
3
4
interest rate
0.4
0.3
0.3
0.2
0.2
0.1
0.1
0.0
0.0
-0.1
-0.1
-0.2
-0.2
interest rate
3
4
0.0
-0.1
-0.1
-0.2
-0.2
-0.3
1
2
3
4
5
6
%
%
0.3
0.2
0.2
0.1
0.1
0.0
0.0
-0.1
-0.1
-0.2
-0.2
0
%
1
2
3
4
6
5
%
%
0.20
0.20
0.25
0.25
0.15
0.15
0.20
0.20
0.10
0.10
0.05
0.05
0.15
0.15
0.00
0.00
-0.05
-0.05
-0.10
-0.10
-0.15
-0.15
0.10
0.10
0.05
0.05
0.00
0.00
-0.05
-0.05
-0.20
-0.20
-0.10
-0.10
-0.25
-0.25
1
2
3
4
5
6
%
0
%
1
2
3
4
5
6
%
%
0.02
0.03
0.03
0.01
0.01
0.02
0.02
0.02
0.00
0.00
0.01
0.01
-0.01
-0.01
0.00
0.00
-0.02
-0.02
-0.01
-0.01
-0.03
-0.03
-0.02
-0.02
-0.04
-0.04
-0.03
-0.03
-0.05
-0.04
-0.05
0
1
2
3
4
5
6
%
0.30
0.25
0.25
0.20
0.20
0.15
0.15
0.10
0.10
0.05
0.05
0.00
0.00
-0.05
-0.05
-0.10
-0.10
-0.15
-0.15
1
2
3
4
5
1
2
3
4
5
6
%
0.35
0.30
0
-0.04
0
%
0.35
Inflation
deviation
from target
0.1
0.0
6
5
%
0
Nominal
exchange
rate (US$/
Local Curr.)
0.2
0.1
0.30
0.30
Long-term
2
0.2
0.3
-0.3
-0.3
1
0.3
0
0.4
0
0.4
0.3
-0.3
%
%
Short-term
0.4
6
5
%
%
%
0.8
0.8
0.6
0.6
0.4
0.4
0.2
0.2
0.0
0.0
-0.2
-0.2
-0.4
-0.4
-0.6
-0.6
0
6
1
2
3
4
5
6
Years
124
Reserve Bank of New Zealand and The Treasury
Figure 26
Dynamic response to an international interest rate shock in New Zealand and CCG2, 6 years
(cont.)
Australia
Canada
%
%
0.30
0.30
0.25
0.25
0.25
0.25
0.20
0.20
0.20
0.20
0.15
0.15
0.15
0.15
0.10
0.10
0.05
0.05
0.10
0.10
0.05
0.05
0.00
0.00
0.00
0.00
-0.05
-0.05
-0.10
-0.10
-0.05
-0.05
-0.15
-0.15
-0.10
-0.10
-0.20
-0.20
-0.15
1
2
3
4
5
%
3
4
5
6
%
%
0.4
0.4
0.15
0.15
0.3
0.3
0.10
0.10
0.2
0.2
0.05
0.05
0.1
0.1
0.00
0.00
0.0
0.0
-0.05
-0.05
-0.1
-0.1
-0.10
-0.10
-0.2
-0.2
-0.15
-0.15
-0.3
1
2
3
4
5
-0.3
6
%
0
%
1
2
3
4
6
5
%
%
0.30
0.25
0.25
0.25
0.20
0.20
0.20
0.20
0.15
0.15
0.15
0.15
0.10
0.10
0.10
0.10
0.05
0.05
0.00
0.00
-0.05
-0.05
-0.10
0.05
0.05
0.00
0.00
-0.05
-0.05
-0.10
-0.10
-0.10
-0.15
-0.15
-0.15
0
1
2
3
4
5
%
0.02
0.02
0.01
0.01
0.00
0.00
-0.01
-0.01
-0.02
-0.02
-0.03
-0.03
-0.04
-0.04
-0.05
-0.05
-0.06
1
2
3
4
5
-0.15
2
3
4
5
6
%
%
0.01
0.00
0.00
-0.01
-0.01
-0.02
-0.02
0
6
%
%
1
0.01
-0.06
0
0.25
0
6
%
1
2
3
4
5
6
%
%
0.3
0.6
0.3
0.5
0.5
0.2
0.2
0.4
0.4
0.1
0.1
0.3
0.3
0.2
0.2
0.6
Inflation
deviation
from target
2
0.20
0.30
Nominal
exchange
rate (US$/
Local Curr.)
1
0.20
0
Long-term
interest
rate
-0.15
0
6
%
interest rate
0.35
0.35
0.30
0
Short-term
%
0.35
0.30
0.35
Foreign
interest rate
%
0.1
0.1
0.0
0.0
-0.1
-0.1
0.0
0.0
-0.2
-0.2
-0.1
-0.1
-0.3
-0.3
-0.2
-0.2
-0.4
0
1
2
3
4
5
-0.4
0
6
1
2
3
4
5
6
Years
Testing stabilisation policy limits in a small open economy
125
Figure 26
Dynamic response to an international interest rate shock in New Zealand and CCG2, 6 years
(cont.)
Norway
Sweden
%
%
Foreign interest rate
Short-term interest rate
%
0.35
0.35
0.35
0.30
0.30
0.30
0.30
0.25
0.25
0.25
0.25
0.25
0.25
0.20
0.20
0.20
0.20
0.20
0.20
0.15
0.15
0.15
0.15
0.15
0.15
0.10
0.10
0.10
0.10
0.10
0.10
0.05
0.05
0.05
0.05
0.05
0.05
0.00
0.00
0.00
0.00
0.00
0.00
-0.05
-0.05
-0.05
-0.05
-0.05
-0.05
-0.10
-0.10
-0.10
-0.10
-0.10
-0.10
-0.15
-0.15
-0.15
0.5
1
2
3
4
5
6
0
0.5
0.4
1
2
3
4
5
0
%
0.4
1
2
3
4
5
6
%
%
0.4
0.4
0.3
0.3
0.3
0.3
0.2
0.2
0.2
0.2
0.1
0.1
0.1
0.1
0.0
0.0
0.0
0.0
0.4
0.3
-0.15
6
%
%
%
0.4
0.3
0.2
0.2
0.1
0.1
-0.1
-0.1
-0.1
-0.1
0.0
0.0
-0.2
-0.2
-0.2
-0.2
-0.1
-0.1
-0.3
-0.3
-0.3
0
1
2
3
4
5
%
Long-term interest rate
%
0.35
0.30
0
0
6
%
1
2
3
4
5
-0.3
6
%
0
%
1
2
3
4
5
6
%
%
0.4
0.25
0.3
0.3
0.20
0.20
0.04
0.2
0.2
0.15
0.15
0.02
0.02
0.1
0.1
0.10
0.10
0.08
0.08
0.4
0.06
0.06
0.04
0.25
0.00
0.00
0.0
0.0
0.05
0.05
-0.02
-0.02
-0.1
-0.1
0.00
0.00
-0.04
-0.04
-0.2
-0.2
-0.05
-0.05
-0.06
-0.3
-0.3
-0.10
-0.06
0
1
2
3
4
5
0
6
%
Nominal exchange
rate (US$/Local Curr.)
%
%
0.35
0.30
0.35
1
2
3
4
5
%
%
-0.10
6
0
%
1
2
3
4
5
6
%
%
0.02
0.02
0.02
0.02
0.02
0.01
0.01
0.01
0.01
0.01
0.01
0.00
0.00
0.00
0.00
0.00
0.00
-0.01
-0.01
-0.01
-0.01
-0.01
-0.01
-0.02
-0.02
-0.02
-0.02
-0.02
0
1
2
3
4
5
6
0
%
%
Inflation deviation
from target
Chile
1
2
3
4
5
%
%
%
%
1.2
1.0
0.3
0.2
0.2
0.8
0.8
0.1
0.6
0.6
0.0
0.4
0.4
0.2
0.2
0.0
0.0
-0.4
-0.2
-0.2
-0.5
-0.4
0.0
0.0
0.1
-0.1
-0.1
0.0
-0.2
-0.2
-0.1
-0.1
-0.2
-0.2
-0.3
-0.3
-0.3
-0.3
-0.4
-0.4
-0.4
-0.5
-0.5
-0.5
6
0.5
0
1
2
3
4
5
6
-0.4
0
1
2
3
4
5
Years
126
6
0.3
0.1
5
5
1.0
0.1
4
4
0.4
0.2
3
3
0.4
0.2
2
2
1.2
0.3
1
1
0.5
0.3
0
-0.02
0
6
0.02
Reserve Bank of New Zealand and The Treasury
6
results found in Scholl and Uhlig (2005) and Eichenbaum
this view. More recently, Demers (1991) and Franke (1991)
and Evans (1995).
show that the uncertainty about the state of the demand
due to price uncertainty caused by exchange-rate risk
depresses output trade volumes, even in the case of risk-
6
Real exchange-rate volatility
and misalignment
What is the world evidence on the costs of real exchange-rate
volatility and misalignment? Which are the fundamentals that
drive the medium-term behaviour of the RER in the world?
Is there evidence of past and present RER misalignment in
New Zealand – and would it have implications for economic
growth?
neutral firms.
The basic models base their findings on the assumption
of absence of hedging instruments that would allow
ameliorating exposure to exchange-rate risk. Viaene and
de Vries (1992) formally include a mature forward market,
concluding that increased levels of exchange-rate volatility
may act to the detriment or benefit of trade flows depending
on the net currency position of that country. Canzoneri et
al. (1984), De Grauwe (1992), and Gros (1987) relax the
assumption that firms cannot alter factor inputs to adjust
World evidence on the costs of real exchange-
optimally in response to exchange-rate shifts, concluding
rate volatility and misalignment
that increased exchange-rate variability could create profit
Exchange-rate volatility, trade, and welfare
opportunities and rise average investment and output,
The post–Bretton Woods floating exchange-rate period has
as firms adjust to take advantage of high prices and to
been characterized by volatile and largely unpredictable
minimize the impact of low prices.
exchange-rate movements. Moreover, the liberalization
Most theoretical modelling of exchange-rate volatility
of capital flows accompanied by the huge increase in
and trade has taken a partial equilibrium perspective by
cross-border financial transactions has contributed to
focusing on firm decisions. Kumar (1992) develops a two-
exacerbated fluctuations in exchange-rates over the last two
country general equilibrium model to explore the effects
decades. Such unpredictability can be costly, both directly
of exchange-rate volatility on trade. The author argues that
and through the potential for associated exchange-rate
higher exchange-rate volatility lowers technological change
misalignments. On the other hand, the growth of financial
and international trade. This comes as the result of resource
hedging instruments and the rising share of international
reallocation to non-export oriented sectors that are not
transactions undertaken by multinational firms may suggest
exposed to exchange-rate risk.
that the impact and costs of exchange-rate volatility are
now lower than, say, some decades ago. The theoretical as
well as the empirical literature has addressed this ambiguity
by exploring if the major changes in the world economy
over the past decades have operated to reduce or increase
the extent to which international trade is adversely affected
by fluctuations in exchange-rates.
Several authors have also argued that the exchange-rate
volatility not only hinders international trade but also takes a
toll in terms of economic welfare. One of the leading articles
attempting to explore the welfare costs of exchange-rate
variability in general equilibrium is Obstfeld and Rogoff
(1998). The latter authors conclude that exchange-rate
volatility could lower welfare through two channels.
The hypothesis that exchange-rate volatility reduces trade
First, exchange-rate volatility increases fluctuations in
flows found support from the very beginning of the
consumption and leisure, thereby lowering welfare. Second,
theoretical literature. The latter argument focuses on the
risk-averse firms hedge against future exchange- rate shifts
notion that unexpected changes in exchange rates affect
by adding a risk premium when setting their prices to cover
the decisions of risk-averse commodity traders, lowering
from the costs of exchange-rate fluctuations. Higher prices
output and trade volumes (Artus 1983, Brodsky 1984).
lower demand, production and consumption to sub-optimal
Either (1973) and Clark (1973) were the first to formalize
less that are less than the optimal for society.
Testing stabilisation policy limits in a small open economy
127
More recent research, however, argues that exchange-rate
Regarding the costs of exchange-rate volatility on welfare,
volatility may be even beneficial for welfare. This is the case
Tchakarov (2003) finds that welfare effects of exchange-
when prices are not fixed in the currency of the exporter
rate volatility are likely to be very small for many countries.
but of their foreign customers (Devereux and Engel, 2003)
For instance, for the US economy the loss in consumer
and when consumption and leisure are complements, not
utility due to exchange-rate volatility is equivalent to 0.1%
substitutes, in utility (Bacchetta and Van Wincoop, 2000).
of annual consumption.
While theoretical economists are extending the analytical
Therefore this brief review of the literature suggests that
frontier on the effects of exchange-rate volatility on trade,
there is no clear-cut relation between exchange-rate
growth, and welfare, empirical research examines the data
volatility, on one hand, and trade flows or welfare, on the
to quantify actual costs. The early empirical work did not
other. The presumption that trade or welfare are adversely
deliver consistent results. Many studies reported little or
affected by exchange-rate volatility depends on particular
no support for a negative effect. Hooper and Kohlhagen
assumptions and hence does not hold in the general case.
(1978) examined the impact of exchange-rate volatility on
The empirical literature is not conclusive either, reporting
aggregate and bilateral trade flow data for all G-7 countries,
mixed results. However, the latter findings should not be
finding little evidence of any negative effect of exchange-
taken to imply that exchange-rate fluctuations should be
rate volatility. Similar results were found by Cushman (1983),
viewed as beneficial or harmless. As noted by Clark et al.
IMF (1984), and Gotur (1985).
(2004), currency crises (a special case of exchange-rate
Several recent studies report effects of exchange-rate
volatility that range from moderate to negligible.19
Dell’Ariccia (1999) examines the effect of exchange-rate
volatility on the bilateral trade of the 15 EU members and
Switzerland over the 20 years from 1975 to 1994, using
four different measures of exchange-rate uncertainty.
volatility) have required painful adjustments in output and
consumption. In this case, however, what is important is
to take appropriate policy regimes to avoid the underlying
causes of large, unpredictable and damaging movements in
exchange-rates. A floating regime goes a long way toward
this goal.
The paper concludes that eliminating volatility to zero
would have raised trade by 10 to 13%, depending on the
Exchange-rate misalignment
particular measure of variability. Similarly, Rose (2000) uses
Larger volatility in developing countries’ real exchange-
a very large data set involving 186 countries, reporting that
rates has been typically associated to larger exchange-
lowering exchange-rate volatility by one standard deviation
rate misalignments. The IMF (2004) reports that if real
(7 per cent) would raise bilateral trade by 13%.
exchange-rate volatility rises by one standard deviation, the
In contrast, Tenreyro (2003) finds that, controlling for possible
average misalignment (defined as the average deviation of
endogeneity in exchange-rate volatility, the negative effect
the exchange-rate from its trend level) increases by about 5
of exchange-rate volatility on trade vanishes; a result that is
percentage points.
robust on the choice of instruments. Clark et. al. (2004) also
Aguirre and Calderón (2006) argue that misalignments
conclude that for the world as a whole, there is no obvious
are used as a way to predict future exchange-rate changes
association between periods of low exchange-rate volatility
among floaters and to evaluate the required exchange-rate
and periods of fast trade growth. The latter findings suggest
adjustment among countries with fixed or intermediate
that, from the perspective of world trade, exchange-rate
exchange-rate regimes. It has been argued that sustained
volatility should probably not be a major policy concern.
real exchange-rate (RER) overvaluations are an early
warning indicator of possible currency crashes (Krugman,
1979; Frankel and Rose, 1996; Kaminsky and Reinhart,
19
128
De Grauwe, (1987), Rose (2000), Dell’Ariccia (1999),
Anderton and Skudelny (2001), Arize (1998), and Fountas
and Aristotelous (1999).
1999). RER overvaluations also have led to drastic relativeprice adjustment and lower growth.
Reserve Bank of New Zealand and The Treasury
The literature concludes that RER misalignments may affect
both internal and external equilibrium. As discussed above,
growth and welfare (Edwards, 1989). A misaligned RER
deviations from the ERER (RER misalignments) have potential
may create distortions in the relative price of traded to non-
serious economic effects that could depend on their size and
traded goods, causing incorrect signals to economic agents
their direction. In order to assess the latter potential effects,
and hence leading to sub-optimal resource allocation and
I start by estimating a model for ERER for New Zealand,
more economic instability.
that allows computation of a time-series measure of RER
Others have argued that the growth effects of misalignments
could differ if the RER appreciates in excess of the equilibrium
appreciation (overvaluation) or if it depreciates in excess of
the equilibrium depreciation (undervaluation). It has been
misalignment. Based on international evidence on the link
between RER misalignment and growth, I infer potential
growth effects of RER misalignment in New Zealand and its
implication for the conduct of policy.
argued that undervaluation, which could be attributed to
I follow the approach of Aguirre and Calderón (2005) who
competitive devaluations, could encourage higher export
identify the role of four fundamentals in traded and non-
and output growth. On the other hand, overvaluations,
traded goods markets in shaping the RER. A permanent
which may reflect macroeconomic policy inconsistency, are
increase in external liabilities requires running a larger
likely to discourage growth (Razin and Collins, 1999).
trade surplus to service them, requiring a RER depreciation.
RER stability and avoidance of misaligned RERs have been
mentioned as determinants of economic performance in
developing countries (Krueger, 1983; Edwards, 1988).
Sachs (1985) claims that the different development
experiences in East Asia, Latin America, and Africa may be
attributed to their different trade regimes and exchangerate management practices. Unstable and overvalued RERs
provided weak incentives to exports and were supported
by protectionist policies, while persistent misaligned RERs
in Africa caused a severe drop in agricultural output (The
World Bank, 1984).
A permanent rise in the ratio of traded to non-traded
goods productivity (strictly speaking, relative to the rest
of the world) causes excess demand in the non-traded
sector and therefore an appreciation of the RER in order
to restore internal equilibrium (Harrod-Balassa-Samuelson
effect). A permanent increase in the terms of trade boosts
the demand for both traded and non-traded goods but
the excess demand in the non-traded sector causes a RER
appreciation. Finally, considering that government spends a
larger share on non-traded services than the private sector,
a permanent rise in government consumption causes an
excess demand in the non-traded sector, contributing to a
Much more recently, Calderón and Aguirre (2006) evaluate
RER appreciation.20
the growth effects of RER misalignments and volatility.
They find that RER misalignments hinder growth but the
effect is non-linear: growth reductions are relatively larger,
the larger are misalignments. A large undervaluation of
the currency hurts growth but small to moderate levels of
undervaluation enhance growth. They also find evidence of
a negative relationship between economic growth and the
volatility of RER misalignments. The authors suggest that
The first step in estimating the ERER is identifying the longrun effects of fundamentals on the RER. I do this by estimating
a cointegration vector for the RER and its fundamentals,
using annual 1965-2005 data for New Zealand, following
the specification in Aguirre and Calderón (2005):
 yT 
 F
+
β
ln
2
 y N  + β3 ln
 Y  t


(2) qt = β0 + β1 ln 
 PX 
 G
 M  + β 4 ln  Y  + ξt
 t
P

t
this negative relationship is also possibly non-linear.
Equilibrium real exchange-rate and
misalignment in New Zealand
According to the literature, the equilibrium real exchange-rate
(ERER) is the unobserved RER level consistent with achieving
Testing stabilisation policy limits in a small open economy
20
The first and fourth are demand effects, the second is a supply
effect, and the third embodies both demand and supply
effects. Under extreme assumptions (uncovered interest
parity, exogenous labour supply), the RER is determined only
by supply factors.
129
Table 10
Real effective exchange-rate estimations for New Zealand and the world
World sample estimations, 1965-2003 (Aguirre and Calderon, 2005)
Time series
estimation for
New Zealand,
1965-2005
Variable
Panel data
Time series
(median estimator
for 60 countries)
All countries
Industrial
countries
Developing
countries
Constant
2.32**
(0.04)
n.a.
n.a.
n.a.
n.a.
Net foreign
Assets
0.11 *
(0.09),
0.15**
(0.01)
0.10**
(0.01)
0.14**
(0.00)
0.09**
(0.00)
Government
Spending
0.41 *
(0.08)
0.27**
(0.00)
0.28**
(0.00)
0.57**
(0.00)
0.22**
(0.00)
Terms of trade
0.49**
(0.01)
0.23**
(0.02)
0.23**
(0.00)
0.36**
(0.00)
0.20**
(0.00)
Productivity
0.21
(0.38)
0.39**
(0.00)
0.15**
(0.02)
0.30**
(0.00)
0.10**
(0.00)
R2
0.30
Note:
p-values are reported in parenthesis. ** (*) denotes coefficient significant at 95% (90%) confidence level.
where q is the effective RER, F/Y is the ratio of net foreign
Table 11
assets to GDP, yT/yN is labour productivity in the traded
Error correction model for the real effective
sector relative to that in the non-traded sector, PX/PM
exchange-rate (WTI) in New Zealand,
is the terms of trade index, and G/Y is the government
expenditure ratio to GDP.21
1965-2005
Coefficient
Std. Error
In testing for cointegration, I found that the trace test
indicates that there is one (and only one) cointegration
vector at a 95% confidence level. This implies that the
Constant
0.01
0.01
Equation [1] residual, lagged -0.74**
0.14
Dif RER, lagged
0.49**
0.14
and it is possible to infer the long-run effects of RER
Dif government spending
0.27
0.24
fundamentals. In the estimation of the RER equation, the
Dif net foreign assets
-0.05
0.12
problem of reverse causality is addressed by implementing
Dif terms of trade
0.35**
0.15
dynamic ordinary least squares (DOLS).22 Results are
Dif productivity
-0.94**
0.35
Dif government spending
-0.26
0.23
Dif net foreign assets
0.13
0.11
Dif terms of trade
0.08
0.15
Dif productivity
0.67**
0.33
coefficients estimated in equation (1) are super consistent
reported in Table 10. For comparison purposes I also report
the cross-country regression results by Aguirre and Calderón
(2005). Although the R2 is relatively low, all coefficients for
New Zealand exhibit the expected signs. The impact of net
foreign assets on the RER is similar in New Zealand to the
21
22
130
Note: ** (*) denotes coefficient significant at 95% (90%)
confidence level.
For the RER I use RBNZ’s real WTI index, starting in 1970.
For 1965-1970, I use the RER measure constructed by Aguirre
and Calderón (2005). The source for all other variables is
Aguirre and Calderón (2005) until 2003. For the 2004-2005
period, I use RBNZ and National Statistics data. In the case
of the productivity variable, I obtained better results using
a variable that reflects labour productivity for the aggregate
economy
See Siakkonen 1991, Phillips and Loretan 1991, and Stock
and Watson 1993 for details.
Reserve Bank of New Zealand and The Treasury
Table 12
Table 13
Partial-adjustment model for the real
Partial-adjustment model for the real
effective exchange-rate (WTI, RBNZ) in
effective exchange-rate (Reer, Aguirre and
New Zealand, 1990q1 – 2005q4
Calderón 2006) in New Zealand, 1965 – 2005
Ø1
AR(1)
AR(2)
AR(3)
AR(4)
0.982
1.321
1.251
1.187
(0.036)*
Ø2
(0.122)*
(0.131)*
(0.124)*
-0.357
-0.099
-0.159
(0.124)*
(0.212)
(0.199)
-0.202
0.279
(0.133)
(0.199)
Ø3
Ø4
-0.382
Ø1
AR(2)
AR(3)
0.578
0.843
0.830
(0.141)*
Ø2
(0.142)*
(0.165)*
-0.473
-0.380
(0.144)*
(0.191)
Ø3
-0.199
(0.159)
Note:
Standard errors are reported in parentheses.
* Significant at 95% confidence level.
** Significant at 90% confidence level.
(0.127)*
Note:
AR(1)
Standard errors are reported in parentheses.
* Significant at 95% confidence level.
Table 14
Estimates of first-year closing and half-life of deviations of real exchange-rate from equilibrium
or sample average levels in New Zealand, various models
Deviation closed after
one year
Half-life of deviation in
years
1. RER error-correction model
74%
0.68
2. AR(1) model of RER misalignment
42%
1.30
3. Partial adjustment of RER deviation from sample mean
(RBNZ quarterly data)
-23%
4.82
4. Partial adjustment of RER deviation from sample mean
(Calderón and Aguirre 2005 annual data)
76%
0.66
Model
Note:
The estimates are calculated from the error correction model reported in Table 11, an AR(1) model of the deviation of the
effective RER from its time-varying equilibrium in equation (3) , an AR(2) model using the deviation of RBNZ’s TWI RER from
its sample mean for 1990q1-2005q4, reported in Table 12, and an AR(2) model using Calderón and Aguirre’s RER deviation
from its sample mean for 1965-2005 period, reported in Table 13
world sample, but the effects of both government spending
(Table 11). The coefficient size implies that 74% of the RER
and the terms of trade are larger in New Zealand than in
deviation from the ERER is closed after one year.
the world sample, but close to those found for industrial
countries.23
Alternatively, I estimate a partial adjustment model for the
RER deviation from its sample mean, using the following
I also estimate an error correction model to investigate
model:
the short-run dynamics of the RER. The results show that
(3)
the lagged residual of the long-run RER equation is highly
p
(
)
qt − q = ∑ φi qt −i − q + ξt
i =1
significant, which represents additional evidence for the
where q is the effective RER and q is the sample mean. In
existence of a cointegration vector among the variables
Table 12 I report the results for equation (3), using quarterly
data for the TWI real exchange-rate for 1990q1-2005q4,
while Table 13 reports comparable results for equation (3),
23
The effects of productivity are not comparable because
Aguirre and Calderón (2005) use the labour productivity
difference between traded and non-traded sectors..
Testing stabilisation policy limits in a small open economy
using annual data constructed by Calderón and Aguirre
(2006). Using annual data, the estimates imply that 76%
131
of the RER deviation from its sample mean is closed after
The estimated ERER series is depicted for New Zealand’s
one year. In contrast, quarterly data show an initial increase
1965-2005 sample period in Figure 27. The ERER has been
in the deviation of around 23%. Therefore, the estimates
stable during the full sample period, exhibiting a slight
using annual data imply a half-life close to 0.7 years, while
equilibrium depreciation phase in the 1960s and 1970s and
the half-life of the quarterly model is around 4.6 years
a slight equilibrium appreciation period starting in the late
(Table 13). These figures can be compared to the estimation
1990s and throughout 2005. Note that the magnitude size
of a half-life close to 1.3 years using a simple autoregressive
of exchange-rate misalignments has increased after 1985.
model for the misalignment using the time-varying ERER.
After an undervaluation period in the aftermath of the
The evidence on RER adjustment in New Zealand according
to the different models, sample periods, and frequencies
is summarized in Table 14. Using annual data for a long
time period indicate a fast adjustment of the RER toward
its equilibrium level in New Zealand that stands in contrast
Asian Crisis, the RER appreciated steadily between 2002
and 2005, attaining an estimated over-valuation of 14% in
2005. The latter is the largest level of RER over-valuation in
the last four decades, similar to the RER over-appreciations
observed in 1988 and 1996-1997.
to the international evidence, where half of exchange-rate
Figure 28
deviations are closed only after 3 to 5 years (e.g., Rogoff
Real effective exchange-rate misalignment
1996, Calderón and Schmidt-Hebbel 2003, and Cashin
and potential growth effects in New Zealand,
and McDermott 2003). However, the estimates using more
recent quarterly data suggest that the dynamics of RER
misalignment in New Zealand are not so different from the
international evidence.
1965-2005
40%
30%
20%
10%
0%
Now I determine ERER levels based on the coefficient
estimates of equation (2) and long-run levels of the RER
determinants, reflected by the following expression:
-20%
-30%
-40%
0
1965
*
*
-10%
 PX 
 yT 
F
G
q e t = βˆ0 + βˆ1 ln   + βˆ2 ln  N  + βˆ3 ln  M  + βˆ4 ln  
 Y t
 Y t
 y t
 P t
*
(4)
*
1969
1973
1977
1981
1985
1989
1993
1997
2001
2005
Neutral effects on growth
S igni ficant positi ve effects on growth
S igni ficant negati ve effects on growth
where qe is the ERER, the βˆi are the coefficient estimates
of equation (2), and starred variables denote long-run levels
of the corresponding variables. In estimating the latter longrun levels I use the Hodrick-Prescott filter.
Based on Aguirre and Calderón’s (2005) cross-country
analysis, it is possible to make some inference about the
effects of RER misalignment on growth. The latter authors
Figure 27
estimate cross-country growth regressions, including
Real effective exchange-rate (TWI),
RER misalignment as an explanatory variable. Their non-
equilibrium real exchange-rate, and real
linear relation between misalignment and growth allows
exchange-rate misalignment in New Zealand,
1965-2005
to identify varying effects according to the direction and
size of RER misalignment.24 In Figure 28 the estimated
misalignment for New Zealand is contrasted with the
4.8
90%
4.7
intervals of misalignment levels that have significant effects
70%
4.6
50%
4.5
30%
4.4
10%
4.3
-10%
4.2
-30%
1965
132
1969
1973
1977
1981
1985
1989
1993
1997
2001
2005
RER (L HA, L og)
ER ER ( LHA, L og)
RER misalignment ( RHA)
Confidence interv al (RHA, 1 st. dev .)
24
It has to be clear that the effects of misalignments on growth
used in this report are only partial and do not take into
account general equilibrium effects of the variables behind
the misalignment. For example, if an increase in the terms of
trade is the main cause of the misalignment, the effects of the
latter on the GDP growth rate have to be complemented by the
direct effect of the terms of trade on growth.
Reserve Bank of New Zealand and The Treasury
on growth rates. The inference from this world evidence,
The exchange-rate in the conduct of
which may not apply to growth in New Zealand, is that
monetary policy
New Zealand’s estimated overvaluation observed during
Monetary policy rules or reaction functions describe
the most recent years has been within the neutral range,
the response of policy instruments to deviations in key
where growth effects are negative but not statistically
macroeconomic variables, typically deviations of inflation
significant. Moreover, the RER correction that has taken
and output from target and full-employment levels,
place since early 2006 has reduced the likelihood of getting
respectively. The debate about how exchange-rates should
into the range of excessive appreciation that may reduce
be taken into account in simple monetary policy rules is
growth. Finally it is important to note that New Zealand has
relatively new; recent theoretical and empirical research
had many episodes of slight undervaluation in the 1-11%
has started to focus on several important exchange-rate
range (that is, growth-enhancing according to the world
questions. How should monetary policy authority react to
evidence), but these periods were short-lived.
25
the exchange-rate? Should policy makers avoid any direct
reaction and react to the indirect effects of exchange-rate
shocks on inflation and output?
7
How best to achieve domestic
Obstfeld and Rogoff (1995) argue that deviations of the
price stability, while avoiding
real exchange-rate from its long-run equilibrium value calls
cyclical extremes in the
for a monetary policy response. If the real exchange-rate
exchange-rate
With a clear focus on price stability, central banks recurrently
face the issue of how to avoid persistent exchange-rate
misalignments that may be costly, as discussed in the
preceding section. Therefore I start this section by briefly
reviewing the literature and international evidence on the
role of the exchange-rate in the conduct of monetary policy.
If monetary policy is neither adequate nor sufficient to deal
with exchange-rate stability concerns, (sterilized) exchange-
is excessively appreciated, then the central bank should
lower the short-term interest rate, relaxing the monetary
policy stance. Ball (1999) suggests a similar response but
considers more complicated dynamics in the optimal
monetary policy response. Using a model for an openeconomy with sticky prices, the author calls for an initial cut
in interest rates to mitigate the contraction caused by the
appreciation. However, as the appreciation drives inflation
down, monetary policy should not be eased further but the
initial reduction should be partly offset.26
rate interventions may offer an alternative tool to central
banks. Hence I briefly review the international practice
and evidence about interventions and their effectiveness.
In the light of the latter reviews and the findings about
New Zealand’s monetary and exchange-rate policy reported
in preceding sections, I draw policy lessons for New Zealand
at the end of this section, identifying possible fiscal and
financial-policy instrument to deal better with exchangerate misalignments and current-account imbalances.
Taylor (1999) and Svensson (2000) also explore the
performance of these types of monetary policy rules.
Taylor (1999) found that the exchange-rate reaction led
to a better performance for France and Italy but had a
poorer performance in Germany. Svensson (2000) uses a
model with forward-looking agents and more explicit micro
foundations to explore the benefits of having a rule that
reacts to the exchange-rate. His simulations show that
including the exchange-rate as a separate argument in the
26
25
According to the estimations by Aguirre and Calderón (2005),
the misalignment has to be maintained for almost 5 years in
the corresponding intervals, and the volatility of misalignment
has negative effects on growth.
Testing stabilisation policy limits in a small open economy
In Ball’s model, a 10% appreciation of the real exchangerate would call for an initial interest cut of 3.7 percentage
points, followed by a partially offsetting rise of 1.7 percentage
points in the next period. This monetary policy rule implies
a long-run reaction of a 2 percentage point cut in the interest
rate. In this model, such a rule leads to a better performance
than a rule that is insensitive with respect to the exchangerate, reflected in reduced levels of the standard deviation of
inflation.
133
policy rule lowers inflation volatility but increases output
in the exchange-rate have effects on output and inflation.
volatility. Thus a policy rule that reacts to the exchange-rate
This may explain why allowing central banks to react to the
can actually lead to a deterioration of output performance.
exchange-rate may not improve the performance of the
More recently, West (2004) examined the possibility of using
interest rate policy to trade exchange-rate stability against
stability in other variables for the case of New Zealand. In his
model the central bank adjusts interest rates in response to
temporary exchange-rate shocks, by cutting (raising) interest
rates in response to transitory depreciations (appreciations)
of the New Zealand dollar. Using a model consistent with
the recent New-Keynesian literature on monetary policy
in small open economies, he finds that the central bank
could achieve a 25% reduction in the standard deviation
of the real exchange-rate at the price of increasing output
volatility by 10 to 15%, inflation volatility by 0 to 15%, and
economy, to say the least. This argument may also explain
why many authors have found that a closed-economy
policy rule describes closely the actions of the central bank
in small open economies (e.g. Huang, et al. 2000, Lubik and
Schorfheide 2005). Taylor lists two reasons why reacting to
the exchange-rate may not lead to better macroeconomic
performance. First, there may be exchange-rate deviations
from purchasing-power parity that should not be offset
by changes in interest rates. For example, exchange-rate
adjustments may reflect productivity changes that should
not be offset. Second, exchange-rate shocks may have small
costs relative to the costs of smoothing them out.
interest rate volatility by 15 to 40%. However, the author
Taylor’s considerations and the results of the literature
adds two caveats. First, his model assumes that interest-rate
reviewed above strongly suggest that conventional central
adjustments affect exchange rates in a reliable and clearly
bankers’ preference for indirect rather than a direct
understood way. Second, the central bank is assumed to
response of monetary policy to exchange-rate shocks is
know the equilibrium level of the real exchange-rate.
hard to dismiss.
Do central banks actually react to exchange-rate shocks?
Lubik and Schorfheide (2005) estimate a small-scale
structural general equilibrium model for a small open
economy, where the monetary authority reacts to changes
in output, inflation, and the exchange-rate. They focus
on the conduct of monetary policy in Australia, Canada,
New Zealand, and the UK, and test for the hypothesis
whether central banks respond to exchange-rates. Their
estimations suggest that the central banks of Australia and
New Zealand do not respond to the exchange-rate, whereas
the central banks of Canada and the UK do so. Chadha,
Sarno, and Valente (2004) examine empirically whether
exchange-rates are included interest rate rules, using data
for the US, the UK, and Japan. Their findings suggest that
Foreign exchange interventions
Empirical studies and statements by central banks suggest
that central banks intervene in foreign exchange markets
to correct perceived excessive exchange-rate volatility
or misalignments. Their concern is that high short-term
volatility and longer-term swings in exchange-rates that
deviate from equilibrium levels determined by fundamental
conditions may hurt their economies, particularly sectors
heavily involved in international trade. Excessive inflation
pass-through and adverse balance sheet effects provide
additional motivations for central bank interventions,
particularly in developing countries.
the exchange-rate enters only in Japan’s policy rule. Huang,
Non-sterilized interventions may affect the exchange-rate
Margaritis, and Mayes (2000) find that a closed-economy
through changes in liquidity. On the other hand, sterilized
type rule describes quite well the monetary policy of the
interventions may affect the exchange-rate through three
Reserve Bank of New Zealand, finding no role for the
main mechanisms: portfolio, signalling, and information
exchange-rate.
channels.27 The portfolio balance channel assumes that
Taylor (2001) argues that rules with no explicit role of the
exchange-rate in the policy rule are consistent with indirect
27
See Dominguez and Frenkel (1993) or Edison (1993) for a
thorough literature review and Tapia and Tokman (2003,
2004) for an analysis of the information channel.
reaction of interest rates to the exchange-rate, since changes
134
Reserve Bank of New Zealand and The Treasury
investors hold foreign and domestic bonds that are imperfect
A strand of the empirical literature has focused on the
substitutes. Sterilized interventions alter the relative supply
effects of interventions on exchange-rate volatility. Chang
of local bonds, thereby changing the composition of investor
and Taylor (1998), Baillie and Osterberg (1997), Bonse-Neal
portfolios, which alters the exchange-rate accordingly.
and Tanner (1996), Huang (1997), and Dominguez (1993) do
The signalling channel refers to the signals sent by the
not find much or strong support for the notion that central
central bank to the markets regarding the future stance of
bank interventions lead to lower exchange-rate volatility.
monetary policy. For example, a sale of foreign currency
may anticipate a future monetary policy tightening. The
information channel assumes a significant role of forex
market speculators that cause significant exchange-rate
misalignments. In this case interventions aim at stabilizing
the markets, by affecting expectations about exchange-rate
fundamentals.
Since interventions are typically very small relative to the
stock of outstanding assets, many authors, including
Rogoff (1984), have expressed scepticism about the impact
of interventions through the portfolio balance channel.
Dominguez and Frenkel (1992) questioned the conventional
believe that interventions through the portfolio channel are
ineffective. Using data on US dollar-Swiss franc exchangerate expectations, the authors find strong support for the
portfolio balance effect and therefore argue in favour of
internationally coordinated interventions. However, other
studies do not find evidence of this channel and those that
do, including Ghosh (1992) and Evans and Lyons (2001),
suggests it is weak.
The evidence on the effectiveness of interventions through
either the portfolio balance channel or the signalling
channel is still mixed (Sarno and Taylor, 2001). However,
the evidence presented by authors using high-frequency
post-1990 data suggests that official interventions can be
effective, especially if interventions are publicly announced
and concerted. Furthermore, these interventions should be
consistent with the monetary and fiscal policy stance.
The Reserve Bank of Australia (RBA), as many other central
banks, intervenes in the foreign exchange market to influence
the Australian dollar exchange-rate. According to Edison,
Cashin, and Liang (2003), there are four reasons why the
RBA intervenes: to help reverse an apparent overshooting
of the exchange-rate in either direction; to calm markets
threatening to become disorderly; to signal future changes
of monetary policy or calm expectations if monetary policy
is changed unexpectedly; and to maintain an inventory
of net foreign currency assets. The RBA conducts all its
interventions in the spot market vis-a-vis the US dollar, and
sterilizes these operations. The interventions of the RBA are
The impact of intervention through the signalling channel
infrequent, coming mainly at or near the peaks and troughs
has often been found to be substantially stronger than
of the exchange- rate cycle. A recent study by Becker and
through the portfolio balance channel (Dominguez 1987,
Sinclair (2004) evaluates the effectiveness of exchange-rate
1990, and Dominguez and Frankel, 1993). Dominguez
interventions in Australia, concluding that the have had a
(1990) uses daily data for the Japanese yen-US dollar
stabilizing influence on the exchange-rate.
and the German mark-US dollar from January 1985 to
December 1987. He finds different effects for coordinated
and uncoordinated interventions and, in general, the
coefficient on coordinated interventions is statistically
significant and correctly signed. Kaminsky and Lewis (1996)
find that interventions supported by consistent movements
in the interest rate, move the exchange-rate in the expected
direction. However, when the intervention is followed by
inconsistent monetary policy, the exchange-rate tends to
move in the opposite direction.
The Central Bank of Chile (CBCh) has also responded to
exchange-rate deviations from perceived equilibrium levels
through sterilized interventions. After a flexible exchangerate regime was adopted in 1999, the CBCh has intervened
twice in response to massive exchange-rate depreciations.
The peculiarity of this experience is that interventions are
pre-announced at the time they start, when the CBCh
provides information about the length of time it will
intervene (4 months), the maximum amount of overall
interventions, and the financial instruments to be used. De
Gregorio and Tokman (2004) argue that the rationale for the
Testing stabilisation policy limits in a small open economy
135
choice of high transparency is twofold. First, the authorities
By all accounts, the RBNZ’s new framework has not been
commit to intervene in a transparent manner, rather than by
tested yet. (In fact, there is evidence to suggest that the RBNZ
surprising the markets, in order to maximize effectiveness
has not intervened during the last two decades). In light of
through the information channel. Second, interventions are
the empirical evidence on New Zealand dollar exchange-
intended to provide liquidity and stabilize the markets rather
rate volatility, misalignments, and possible implications
than fighting speculators. Tapia and Tokman (2004) provide
for economic growth, reported in the preceding sections,
empirical evidence that the intervention announcements
the RBNZ’s apparent lack of intervention to date seems
by the CBCh had a significant, moderate, and temporary
fully justified. Considering the latter and the international
impact on the exchange-rate, while subsequent actual
evidence
interventions had small, non-significant effects.
effectiveness, I conclude that:
on
policy
best-practice
and
interventions
(1) New Zealand’s RER trend, cycles, misalignments, volatility,
Implications for New Zealand
New Zealand’s monetary and exchange-rate framework
is sound and at the frontier of international best practice.
Monetary policy, consistent with flexible exchange-rate
targeting practice, is effective and efficient. Inflation targets
are met and monetary policy contributes actively to minimize
and correlations with other key variables are similar
to those of other industrial, small, open, commodityexporting, and inflation-targeting economies. From a
cross-country perspective, New Zealand’s RER behaviour
is certainly not anomalous.
(2) New Zealand’s
medium-term
RER
behaviour
is
inflation and output volatility. The RBNZ’s apparent conduct
consistent with the same fundamentals that drive RERs
of monetary policy, consistent with standard central-bank
elsewhere. Misalignments defined as deviations from
practice, tends to react to the exchange-rate indirectly;
the (unobserved but estimated) equilibrium RER driven
only as long it affects inflation and output forecasts. This
tend to occur in New Zealand, as elsewhere too. These
is consistent with the view that responding independently
deviations, from below and from above, recur regularly
to the exchange-rate would be at the cost of causing larger
in New Zealand. The most recent deviation episode
volatility of inflation, output, and monetary policy itself
(a significant RER appreciation in 2004-2005 that has
(West 2004).
partly corrected most recently) does not reach levels at
However, New Zealand’s nominal and real exchangerates exhibit significant and persistent deviations from
average levels, which may be costly for optimal resource
which, inferring from the world evidence (Aguirre and
Calderón 2006), medium-term growth rates would be
affected.
allocation, export success, and economic growth. This
(3) Even when facing a large perceived misalignment that
raises the question about the desirability of exchange-rate
may trigger an intervention (larger than the 2004-2005
interventions.
episode) substantial uncertainty surrounds the measure
The RBNZ put in place in 2005 the world’s presumably
most advanced and transparent framework for possible
of the equilibrium RER and hence the misalignment
estimate.
future interventions (Eckhold and Hunt 2005). Interventions
(4) The reviewed international evidence on intervention
would be triggered if four prerequisites were to be justified:
effectiveness ranges from nil to moderate, at best.
exceptionality (the exchange-rate is outside historical
From the latter points I conclude that interventions are best
norms), disequilibrium (exchange-rate level cannot be
used as an instrument of last resort to correct a situation
justified by market fundamentals), intervention is consistent
of very large and persistent misalignment. The RBNZ’s
with the monetary policy stance, and market opportunity
new intervention policy provides the internationally best
(likelihood of favourable market reaction).
designed framework for such an exceptional circumstance.
136
Reserve Bank of New Zealand and The Treasury
Hence if neither monetary policy (indirectly) nor foreign
exchange intervention policy (directly) are the best ways to
deal with persistent but not extreme RER misalignment, what
should be done to achieve more exchange-rate stability?
While a detailed answer to this question is outside the scope
of this paper, which deals with monetary and exchangerate policies under the control of the monetary authority, I
1. Structural government spending and balance rule
A Chilean-type structural fiscal balance rule would
involve determining a structural fiscal balance according
to structural or permanent long-term estimates of
selected components of spending and revenue,
based on their permanent or trend estimates of their
exogenous determinants, such as trend GDP.
close by listing a few fiscal and financial policy options that
could help in reducing the likelihood of incurring in large
and persistent exchange-rate misalignments and current
account imbalances.
2. Pro-cyclical
tax
rates
or
counter-cyclical
government spending items
As opposed to adopting a comprehensive structural
Counter-cyclical fiscal policy
fiscal balance rule, The Treasury could identify a certain
New Zealand’s fiscal policy, like that in most industrial
levy (for example, the sales tax rate) and vary its tax
countries, is only weakly counter-cyclical. Therefore it plays
rate pro-cyclically, or a particular expenditure item
only a limited role in stabilizing aggregate spending, output,
(for example, public works) and vary its activity level
the current account, and the real exchange-rate over the
counter-cyclically. Another alternative – geared at
business cycle.
avoiding excessive cyclicality in a particular economic
A few countries have put in place strong counter-cyclical fiscal
policies that go beyond automatic stabilizers. One example is
Norway: its Pension Fund acts both as an inter-generational
transfer instrument that smoothens government spending
over the very long term and as a cyclical stabilisation device,
in the limited sense that oil price windfalls are saved and
only their permanent component is spent. Another more
sector or financial activity, such as construction and
mortgage lending, could imply raising pro-cyclical fees
or levies on the corresponding sector transactions, such
as a pro-cyclical mortgage fee. In the case of a procyclical sector tax or transaction fee, it is important to
consider the distortions it imposes on sector resource
allocation.
strongly counter-cyclical fiscal policy has been implemented
by Chile since 2001, where government spending is strictly
Counter-cyclical financial policy
proportional to permanent tax and copper price revenue.
Instead of focusing on fiscal revenue or expenditure flows,
Hence all revenue windfalls caused by positive (negative)
the objective of counter-cyclical financial policy is to
differences between actual and permanent GDP (affecting
implement a government investment management policy
tax revenue) and of actual and permanent copper prices are
geared at reducing the domestic costs of idiosyncratic
saved (dissaved). Casual evidence from both Norway and
shocks (including excessive exchange-rate misalignments
Chile suggests that their counter-cyclical fiscal policies may
and current-account imbalances). This involves considering
help in stabilizing the real exchange-rate and the current
the two following policy alternatives.
account over the business cycle.
New Zealand could evaluate the potential benefits and
costs of the following policy alternatives for strengthening
1. Investment
guidelines
for
international
government funds
the counter-cyclical stance of its fiscal policy.
Investment guidelines for government funds invested
abroad (like the RBNZ’s international reserves and the
New Zealand Superannuation Fund) should weigh
heavily those criteria that minimize the domestic
Testing stabilisation policy limits in a small open economy
137
consequences of idiosyncratic shocks that hit the
correlations, are roughly consistent with those observed in
New Zealand economy, by investing in assets whose
a relevant comparator country group. New Zealand’s overall
returns exhibit low or negative correlation with
macroeconomic policy mix is also broadly consistent with
those domestic and international variables that drive
international best practice. Regarding the inflation-targeting
New Zealand’s cycles, such as its terms of trade.
framework, there is room for some potential improvement
by specifying more precisely the policy horizon for monetary
policy. On fiscal policy, New Zealand lacks a strongly
2. Acquisition of international insurance
Caballero (2002) argues that traditional approaches to
deal with external shocks (accumulating international
reserves or reducing external borrowing) are both
costly and inefficient. In the context of developing
countries, he proposes as an alternative buying assets
(or issuing liabilities) whose returns are correlated
(with the appropriate sign) to the dominant foreign
trade and financial shocks that affect developing
economies. However, this proposal is relevant for any
small open economy that faces external or domestic
idiosyncratic shocks. For insurance against terms-oftrade shocks Caballero (2002) has proposed issuing
public debt indexed to commodity prices for insurance
against “sudden stops”. Caballero and Panageas (2005)
propose including assets indexed to the S&P implied
volatility index (VIX) in emerging-market holdings of
international reserves.
counter-cyclical framework like those successfully adopted
by a few comparator countries.
There
are
many
similarities
between
New Zealand
and comparator countries regarding monetary policy
transmission and efficiency. One is that the inflation response
to an exchange-rate fall, relatively small but significant in
New Zealand, a result quite similar to that observed in other
OECD inflation targets. Pass-through to tradable goods
inflation is much larger and somewhat quicker than passthrough to headline inflation in New Zealand, which also
accords with international experience. The dynamic response
of headline inflation to an oil price hike is also relatively small
in New Zealand. This is likely to be a reflection of credible
monetary policy and stable inflation expectations, as in the
low exchange-rate pass-through. The dynamics of the oil
price impact on inflation in New Zealand is not statistically
different from those observed in other countries. However,
New Zealand’s tradables inflation is much more and more
The implication for New Zealand is that the RBNZ and
persistently affected by an oil shock than headline inflation,
the Treasury could engage in a coordinated financial
a result also in line with the international evidence.
evaluation of the costs and benefits of acquiring or issuing
international insurance instruments that provide explicit
protection against external trade and financial shocks, or
domestic idiosyncratic shocks, that have a large impact on
New Zealand’s main macroeconomic variables, including
output, the RER, and the current account.
Monetary policy transmission in New Zealand is broadly
comparable to, or at least as strong as, that observed in
the comparator country group. Long-term rates respond
to short-term rates in New Zealand, although this response
exhibits less persistence. As in most comparator countries,
the exchange-rate appreciation in response to a shortterm interest rate rise is not significantly different from
zero. Inflation declines significantly in New Zealand in
8
Summary and policy
the second year after a monetary policy shock, similar to
conclusions
what is observed in some comparator countries but not in
In this paper I have presented several findings on
New Zealand’s monetary and exchange-rate policy and
drawn some policy lessons.
others, where the inflation does not respond significantly
to monetary policy innovations. The output gap responds
negatively and persistently in New Zealand to a monetary
policy shock, like in most other comparator countries.
The trend and cyclical behaviour of New Zealand’s key
macroeconomic variables, as well as their volatility and cross138
Reserve Bank of New Zealand and The Treasury
A simple but partial way of gauging monetary policy
ranging from nil to moderate at best. Even when facing a
efficiency under inflation targeting is computing deviations
large perceived exchange-rate misalignment that may trigger
between actual inflation and target levels. New Zealand’s
an intervention, one larger than the 2004-2005 episode, a
accuracy in hitting its inflation target is much higher
high degree of uncertainty surrounds the measure of the
than that of the average IT country but its deviations are
equilibrium RER and hence the misalignment estimate.
skewed: deviations from above are substantially more likely
than those from below. A more comprehensive way of
assessing monetary policy efficiency is in its delivery of low
inflation and output volatility. Here the evidence shows that
New Zealand’s monetary policy efficiency has improved
From the latter points I conclude that interventions are best
used as an instrument of last resort to correct a situation of
very large and persistent misalignment. The RBNZ’s new forex
intervention policy provides the best designed framework
worldwide for such an exceptional circumstance.
massively after 1997, to levels that are better than that of
the representative IT country or even industrial IT country,
but ranks below that of the representative industrial nonIT country in a group comprised of the US, Japan, and
Hence if neither monetary policy (indirectly) nor foreign
exchange intervention policy (directly) are the best ways to
deal with persistent but not extreme RER misalignment, what
should be done to achieve more exchange-rate stability?
European nations.
The answer to the latter question could lie in developing and
The evidence on the scope for an independent monetary
policy (drawn from simple correlation coefficients between
domestic and foreign short-term interest rates and impulse
response dynamics of short-term rates to foreign rate
using counter-cyclical fiscal and financial policy instruments
that could help in reducing the likelihood of exceptionally
large and persistent exchange-rate misalignments and
current account imbalances.
shocks) shows significant degrees of policy independence
in setting short-term rates, both in New Zealand and
comparator countries.
There is a large world literature on the costs of real
exchange-rate volatility and misalignment on trade, growth,
and welfare, including recent work on non-linear effects of
RER misalignment on long-term growth. New Zealand’s
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Results from Agnostic Identification on Monetary Policy and
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Annex A
Variable definitions and sources
Variable
Definition
Source
Real effective exchange-rate index
Expressed in terms of US dollars
per unit of the national currencies.
An increase in the index reflects an
appreciation.
IMF International Financial Statistics,
and RBNZ
Current account balance ratio to GDP
Last four quarters
OECD Economic Outlook database,
Central Bank of Chile, and RBNZ
Terms of trade
Price index of exports of goods/ Price
index of imports of goods
IMF International Financial Statistics,
Central Bank of Chile, and RBNZ
Real Gross Domestic Product
OECD Economic Outlook database,
Central Bank of Chile, and RBNZ
Exchange-rate
US$/Local Currency Unit. Therefore,
an increase reflects an appreciation.
OECD Economic Outlook database,
Central Bank of Chile, and RBNZ
International interest rate
FED interest rate
IMF International Financial Statistics
Oil price
IMF International Financial Statistics
Real estate prices
Australia
House price indexes, established
houses (weighted average of 8 capital
cities)
Australia Bureau of Statistics
Norway
House price index of dwellings.
Statistics Norway
New Zealand
Quotable value index for dwellings
RBNZ
Sweden
Real estate price index for one- and
two-dwelling buildings for permanent
living
Statistics Sweden
Canada
Price of land and construction.
Statistics Canada
Chile
Cost of construction
Cámara Chilena de la Construcción
House permits
OECD National Accounts and RBNZ
Real GDP in residential construction
OECD National Accounts, RBNZ, and
Cámara Chilena de la Construcción
Private housing investment
OECD Economic Outlook database
Testing stabilisation policy limits in a small open economy
143
Annex B
Definitions and sources of variables used in VAR estimations
Variable
Definition
US Federal Funds Rate
Source
Federal Reserve Board
US output gap
Difference between actual real GDP OECD economic Outlook database
and potential GDP estimated from a
Hodrick-Prescott filter
Output gap
Difference between actual real GDP OECD economic Outlook database,
and potential GDP estimated from a Central Bank of Chile and RBNZ
Hodrick-Prescott filter
Inflation
Rate of change of headline CPI
Deviation of inflation from target
Difference between actual year-over- OECD economic Outlook database,
year headline inflation and mid-point Central Bank of Chile and RBNZ
inflation target (in IT countries) or
headline CPI inflation trend estimated
from a Hodrick-Prescott filter (in nonIT countries)
Domestic short-term interest rate
Money market rate
OECD economic Outlook database,
Central Bank of Chile and RBNZ
Money deviation from trend
M1 deviation from quadratic trend
OECD economic Outlook database,
Central Bank of Chile and RBNZ
Exchange-rate
Nominal exchange-rate US$/LCU thus, OECD economic Outlook database,
an increase represents an appreciation Central Bank of Chile and RBNZ
of the local currency
Long-term interest rate
10-year government bonds.
144
OECD economic Outlook database,
Central Bank of Chile and RBNZ
OECD economic Outlook database,
Central Bank of Chile and RBNZ
Reserve Bank of New Zealand and The Treasury
New Zealand’s monetary and exchange-rate policy in
international comparison by Klaus Schmidt-Hebbel
Discussion by John Edwards, HSBC
Both the valuable paper by Klaus Schmidt-Hebbel and the
The Treasury pointedly announced that they commissioned
remarkable conference which produced it address what
work on more direct ways of slowing house price inflation
was perhaps a crisis of confidence in the effectiveness
than changes in the cash rate.
of New Zealand’s economic policy instruments, which
deepened over the course of 2005. In the two years from
the beginning of 2004 to the end of 2005 the RBNZ
had increased the cash rate nine times to one of the
highest levels in the OECD. The results were persistently
disheartening. There was some preliminary evidence of a
slowdown in growth, but much of the slowdown was in
exports and there in response to the higher exchange-rate
induced by the higher cash rate. House prices continued
It was perhaps in this crisis of confidence that the RBNZ
conceived the bold idea of inviting a group of foreign
analysts to examine the New Zealand economy from a
completely external perspective. In one way or another,
the papers address the question of whether the monetary
authority in a small developed economy with open and
globally integrated financial markets, a freely floating
currency, and no capital controls could actually run an
effective monetary policy.
to increase, consumer credit growth remained formidable,
household consumption was markedly stronger than GDP
growth as a whole, import growth substantially exceeded
export growth, and the current account deficit ballooned
towards a new record as a share of GDP.
Between the conception of the conference and the actual
event,
however,
New Zealand’s
circumstances
quite
dramatically changed. The June quarter national accounts
published late in September that year showed a sharp
drop in output growth, and it was evident by the end of
While the currency had responded to a higher cash rate,
the long end of the yield curve had not. In the second half
of 2005 five year rates were as low as they had been when
the tightening began. Since New Zealanders borrow more
on fixed rather than variable rates, and are quick to move
where rates are cheaper, the impact of higher cash rates
on the household sector was muted. Oil prices accounted
for most of it, but it was nonetheless disconcerting that
inflation was markedly higher in the third quarter of 2005
than the first quarter of 2004. Even without oil, inflation
the year that the slowdown had continued through the
fourth quarter. After spiking higher earlier in the year,
local government approvals for new home construction
began to slide. In the second half of 2005 the US federal
funds rate first reached 4%, and it was evident the Federal
Reserve would continue to increase it. Once the top of the
New Zealand cash rate tightening episode was signaled at
the beginning of 2006, the currency sharply depreciated.
Both business and consumer confidence dropped, and
house price growth began to slow.
was much the same as it had been.
Through the early months of 2006 it appeared that
In these circumstances the Monetary Policy Statements, cash
rate review announcements and speeches from the Reserve
Bank of New Zealand took on, in my opinion, an edgy,
almost plaintive tone. It was acknowledged that there were
lags in policy, but sooner or later households would have
to roll over their mortgages and at higher rates. The Bank
directly and repeatedly talked down the currency, warning
foreign holders of New Zealand dollar financial instruments
monetary policy was not only effective, but perhaps too
effective. Growth stalled in the fourth quarter, raising the
possibility of a technical recession. Employment fell. The
market began to price in the possibility of an easing of the
cash rate sometime in 2006. It was well into the second
quarter and almost on the eve of the conference at which
this paper was delivered that it became apparent that
growth had probably been a little stronger in the first half of
that currency depreciation was highly likely. The RBNZ and
Testing stabilisation policy limits in a small open economy
145
2006 than the second half of 2005, despite the continuing
The great strength of the paper in my view is that it offers
downturn in residential construction. The downturn in
precisely what was needed to address the controversy
household consumption steadied, business investment
over New Zealand policy effectiveness. It considers it in
firmed, and export growth picked up. There had indeed
the context of other medium sized inflation-targeting
been a slowdown in growth, but New Zealand seemed
commodity-exporting economies, it considers over several
to have dodged recession. Not only had recession been
periods of time, and it considers it over a wide range of
averted, but the gradual strengthening of exports and the
variables. It does it with a daunting display of econometric
flattening of house price inflation suggested the economy
technique. In some respects the conclusions of the paper
was beginning to make the transition to export led growth
suggest New Zealand is much like other economies in
long sought by both the RBNZ and the Government.
roughly similar circumstances, though it has some features
The confirmation that monetary policy did work in
New Zealand (or at all events worked when the rest of the
world decided to go New Zealand’s way) coincided with
another important economic policy discovery. For over
a decade it had been widely believed that New Zealand
labour and multifactor productivity growth were among
which are notably different. The conclusions also suggest
quite strongly that New Zealand’s over all economic
performance has greatly improved over the last decade
compared to the prior decade. To briefly recapitulate what I
take to be the main points, Schmidt-Hebbel shows that:
•
New Zealand has on average performed reasonably well
the lowest in the OECD and well behind Australia. This was
on a test of output growth. At 2.5% over the period
a puzzle, because New Zealand had reformed its economy
1986-2006, annual average GDP growth in New Zealand
in much the same way as Australia and perhaps to a greater
is much lower than Chile’s but close to the other four
extent. It had utilized many of the same technologies, its
inflation-targeting comparable economies – Australia,
workforce was educated to much the same standard in
Sweden, Norway and Canada. He confirms, however,
much the same way, and it was anyway highly integrated
that output volatility is much higher than most of these
with the Australian economy. It may not have invested as
countries. Interestingly, output volatility declined in the
much in capital equipment as Australia but it had certainly
second half of the period, from 1996-2006.
invested a great deal. Why then should its productivity
•
growth be so much less? It was perhaps the lack of scale,
Notwithstanding the recent circumstances, New Zealand
does not have a particular problem with house prices,
some suggested. Or perhaps the elimination of minimum
or at least not in the long run. Though house price
rates awards in New Zealand in 1994 had permitted a
inflation has been quite dramatic in recent years, over
decline in real wages which in turn lowered the capital to
the whole period real house price growth has averaged
output ratio. This considerable controversy was brought to
3.96% annually, similar to Australia’s. Over the whole
a halt at the end of March 2006 when a new methodology
period, house price growth is actually less volatile than
applied by Statistics New Zealand revealed the productivity
comparable countries.
growth gap with Australia had disappeared, qualitatively
confirming some earlier work produced by the New Zealand
Treasury. In fact New Zealand productivity growth was if
•
New Zealand does, however, experience more impact
from the housing construction cycle. Real private
investment in housing (4.1%) is a little below the average
anything somewhat higher than Australia’s.
(4.4%) of comparable countries. But New Zealand has
Within a six month period two big pieces of “conventional”
wisdom
about
New Zealand’s
economy
had
been
undermined by new data. These were the circumstances
immediately preceding the RBNZ conference, at which
Schmidt-Hebbel’s paper delivered another heavy blow to
the highest volatility in real housing investment of the
whole group. Schmidt-Hebbel plausibly suggests this is
caused by immigration swings. The standard deviation
of population growth in New Zealand is three times
Canada’s.
the notion of New Zealand’s economic ungovernability.
146
Reserve Bank of New Zealand and The Treasury
•
With farm products a substantial share of exports, it
add depth to the debate on New Zealand monetary policy
is sometimes supposed New Zealand gets less and less
effectiveness.
for its exports and pays more and more for imports.
I have only a few additional thoughts to offer:
Schmidt-Hebbel shows that far from being persistently
disappointing New Zealand’s terms of trade have risen
•
Schmidt-Hebbel offers but does not I think argue
through a suggestion that New Zealand should
on average 1.34% a year over the whole period –
announce a more precise horizon for the achievement
somewhat above the average of the comparator group.
of the inflation target. It is only in recent years that the
More surprisingly, New Zealand’s terms of trade are
RBNZ has been permitted more flexibility in the time
among the least volatile of the 6 country group.
period over which the inflation target is achieved, and
Turning to the analysis of shocks to inflation Schmidt-
also permitted a somewhat higher target mid-point.
Hebbel finds that:
•
•
Yet this is also the period in which Schmidt-Hebbel
In New Zealand headline inflation did not respond to
finds monetary policy has become more effective,
exchange-rate shocks in the period 1989-1997, but does
target achievement has improved, and the economy
for 1998-2005. Overall Schmidt-Hebbel concludes that
has become less volatile. I would have thought these
exchange-rate pass through to inflation is significant
findings would make New Zealand cautious about
but relatively small in New Zealand because of “well
returning to an earlier and less successful monetary
anchored inflationary expectations.”
targeting regime. That said I think there is great merit in
the suggestion that New Zealand (and for that matter
Headline inflation responds positively and significantly
Australia) look seriously at the Norwegian, Swedish and
to oil price shocks in both periods. The effect is much
Chilean models of explicit counter cyclical fiscal policy.
the same as elsewhere, but stronger in New Zealand.
•
Long term interest rates do respond to changes in
•
It is important to keep a good sense of what the
results do and don’t tell us. The paper relies mostly on
the cash rate and so does the exchange-rate,but the
average annual rates over a long period. For example,
exchange-rate does not respond much.
the results show that on average over the period house
And on the central question of monetary policy effectiveness
price growth in New Zealand is about the same as
he finds that:
•
Australia’s and is less volatile the average of the group.
There is a significant negative response of both inflation
But Schmidt-Hebbel is not I think saying that house
and the output gap to monetary contraction.
price inflation cannot be a big issue in New Zealand
monetary policy. His introduction makes it plain that it
He concludes that “..monetary policy transmission in
is. What we should be concluding is that New Zealand’s
New Zealand is broadly comparable to, and at least as strong
problems in this respect are not unique or especially
as, that observed” in the group of comparable economies.
intractable.
Indeed, he finds that the mean absolute deviation from
the Banks inflation target is lower than average for other
•
So too the exchange-rate may not on average have
IT countries, and accuracy has improved between 1990-97
much impact on inflation but there are certainly periods
and 1998-2005. Comparing the two periods he also finds
in New Zealand when currency appreciation has usefully
a big reduction in inflation and output gap volatility in the
slowed general price inflation, and periods when
latter period.
depreciation has added to it. It is true that in recent
These are valuable findings, the result of bringing an
impressive complexity and variety of techniques to work
on a number of different economies and a wide range of
variables. It is exactly the comparative study needed to
Testing stabilisation policy limits in a small open economy
episodes the pass-through has been less but I doubt this
is because inflation expectations have been changed by
targeting. If this was so then we would expect more
pass-through in the earlier period than the later period
147
instead of the reverse. We would expect that oil prices
•
•
Finally, while both the long term average outcomes and
would also not have much pass-through, but Schmidt-
the recent experience establish that the RBNZ retains
Hebbel finds they do. In the Australian case the import
a reasonable degree of effectiveness, it remains the
price index still responds quite directly to currency
case that the experience from 2003 to 2006 was quite
changes, but retail prices do not. Both economies are
difficult. Long term rates may on average respond to
far more open and competitive than they were. There
short term rates, but on this occasion they did not. The
is as the retailers complain less “pricing power.” These
exchange-rate may not always respond to monetary
structural changes are I think much more important
contraction but on this occasion it seemed to respond
than the inflation targeting regime of the central bank in
quite a lot. Demand and inflation in the long term and
controlling pass through of exchange-rates. One might
on average respond to monetary contraction, but in this
add that having little pass-through from exchange-rates
case it was a long time coming. A particular difficulty
vitiates the function that exchange-rate changes are
in this period was that major central banks in the rest
expected to perform, so it is not necessarily a welcome
of the world imposed unusually low cash rates, and
trend.
global markets were sufficiently confident of continuing
Schmidt-Hebbel calculates that at an annual average
of 1.33% the trend appreciation of the real effective
exchange-rate is much higher than the average, and
low inflation to permit unusually low bond rates. On
average the RBNZ is effective. In any particular policy
episode, however, lots can go wrong.
also more volatile. A glance at a chart confirms that over
the last 20 years the nominal New Zealand exchangerate has cycled around an average of 60 on the trade
weighted index, and is today much where it was in
1986. Real appreciation over the period presumably
reflects higher inflation in New Zealand. Since the
increase in the price level was substantially greater
over the period from 1986 to 1990 than from 1991 to
2006, the real appreciation would have been mostly
in the earlier period. This underlines the very different
episodes caught up in the period 1986-2006. SchmidtHebbel is of course well aware of this distinction and
usefully makes it elsewhere.
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Reserve Bank of New Zealand and The Treasury