Reserve Bank striving to avoid self-fulfilling shackles on growth

By BRIAN FALLOW economics editor

The Reserve Bank's estimate of the economy's sustainable growth rate, at present about 3 per cent, is not a self-fulfilling prophecy, says Acting Governor Rod Carr.

He was responding to questions from a finance and expenditure select committee, one of which was: "Why is New Zealand only allowed to grow 3 per cent per annum?"

Carr replied: "We would strongly dispute the notion that New Zealand is only 'allowed' to grow at any particular rate. But to sustain any particular rate of growth over long periods of time, it needs to be the case that such a rate of growth doesn't persistently add to inflation or deflation."

The 3 per cent estimate was not a limit beyond which the economy cannot grow. "In fact, the economy is probably growing faster than that at the moment. It certainly grew faster than that in the year to March 2000 (at around 5 per cent) and in the year to March 1994 (at around 7 per cent).

"To be sure, if growth continues to exceed our estimate of what can be sustained without inflation, we would tighten monetary policy, which in turn would slow the economy. But if we were wrong about our estimate, inflation would fall too far, too fast. Unexpectedly low inflation provides independent evidence that the economy can grow faster than we assumed without generating inflation pressure."

In that case the bank would respond by cutting interest rates, to stimulate a period of growth faster than its previous estimate of the sustainable rate.

Estimating the sustainable rate was difficult, Carr said.

"It has to do with productivity growth, the determinants of which are poorly understood."

The bank used past productivity growth trends to help predict future ones and paid close attention to the degree of inflation pressure on the economy's resources.

The select committee also asked about the risk that the present tightening would end up combining next year with the effect of declining export returns to slow the economy too much.

"We fully expect that the withdrawal of stimulus associated with the official cash rate increase will combine next year with declining export returns to dampen economic growth. We have allowed for a fall of 5 per cent in total export returns," Carr said.

"But a 5 per cent fall is to be set against a 40 per cent rise over the last three years, leaving most of the recent gains intact to support spending. And there are other supportive factors, such as still stimulatory monetary policy, the momentum of domestic consumption and investment spending, a recovering world economy, and a sharp increase in the population, that collectively are large enough to overwhelm the negative effect of lower export incomes."

As for the effect of higher interest rates on the dollar, Carr said: "With New Zealand interest rates higher than foreign interest rates, and with expectations of exchange rate appreciation widespread, it may be the case that the exchange rate comes under more upward pressure than we have allowed for."

But he added, "We say that with some hesitation. Only last year, it was common for countries with relatively high and increasing interest rates to experience exchange rate depreciation. We cannot be at all sure that such a reaction won't return. Given that uncertainty, all we can reasonably do is adapt our policy settings as needed through time."

The bank's response to the MPs is at Reserve Bank of New Zealand