Monetary policy transmission mechanisms and currency unions A vector error correction approach to a Trans-Tasman currency union

Differences in transmission mechanisms can generate asymmetric behaviour among currency union partners when they experience shocks. This has the potential to widen existing cyclical variation between members of a currency union. Our analysis suggests that the transmission mechanisms of GDP and the CPI of a monetary shock appear to be similar in Australia and New Zealand. However, there are differences in terms of the size of the responses of some variables to identical monetary policy shocks. In a currency union with a different exchange rate pattern and with different monetary policy shocks, New Zealand may experience some new challenges.Impulse responses; vector error correction; monetary transmission mechanism

The relationship between inflation expectations survey data and inflation

Inflation expectations play an important role in shaping the inflation consequences of economic activity. Hence, they are of special importance for monetary policy. Survey measures of inflation expectations are available, but whether they are a good representation of true beliefs is a moot point. Survey measures of inflation expectations often do not track well with realised inflation rates, sometimes producing large forecast errors. Indeed, survey measures of inflation expectations often tend to track better with current or past inflation than with future inflation, raising questions as to their usefulness as proxies for true expectations. This article examines the relationship between surveyed inflation expectations and inflation in New Zealand since inflation stabilised in the early 1990s. It turns out that while survey data may be inaccurate predictors of the level of inflation, they can still provide useful directional information regarding near-term inflationary pressures. Survey data can be used to supplement other economic indicators, giving a better indication of future inflation.

Inflation in New Zealand’s trading partner economies

Inflation pressures in other economies have important implications for inflation, activity and monetary policy in New Zealand. This article examines inflation trends in New Zealand’s trading partner economies over the past decade. Looking at a range of inflation measures, we observe that the low inflation seen in our trading partner economies in the mid- 1990s has now given way to a period of higher inflation. Increases in inflation rates have been seen in all regions, with particularly notable increases in Asian economies. Higher inflation in our trading partner economies has been related to strength in global growth and the closer integration of Asia and emerging markets into the global econoy. These developments have contributed to increased demands on productive resources and strong growth in commodity prices. Such increases have been reflected in higher consumer prices and export prices in our trading partner economies. In New Zealand, these developments have contributed to a more challenging environment for monetary policy, with stronger consumer price inflation and increased headwinds for growth.

The Reserve Bank's forecasting performance

For most of the period since 1994, the target range for annual Consumers Price Index (CPI) inflation, established by the Policy Targets Agreements (PTA), was 0 to 3 per cent. Over this period, actual CPI inflation has averaged 2 per cent. As one might expect, analysis shows that our medium-term CPI inflation forecasts since 1994 have been biased towards under-prediction, which is the subject of this article. In any particular period, inflation is unlikely to be exactly as forecast, given that the economy is affected by unforeseeable events and inflation is far from perfectly controllable. However, it is important to have a good understanding of why inflation has evolved as it has, and not as predicted. We need to know whether particular events in the period under consideration have dominated inflation outcomes, or whether there is a fundamental problem with the policy process - such as a fundamental misunderstanding of the workings of the economy - that would systematically affect future monetary policy outcomes unless corrected. In this article we focus particularly on our CPI inflation forecasting performance, but also examine our forecasts of other key macroeconomic variables, given their relevance for explaining our CPI forecasts. We conclude that, in the mid-1990s, underestimation of growth, and overestimation of the economy's capacity to grow without generating inflation pressures, were the source of most of our under-prediction of medium-term CPI inflation. From 1998 until recently, the major factor explaining the under-prediction of inflation appears to have been sizeable and persistent differences between the assumptions we used for the path of the exchange rate and its actual evolution. We also conclude that contributions to forecast inaccuracies have at times been made by our understanding of the noninflationary output growth rate, the equilibrium exchange rate and exchange rate pass-through into CPI inflation. However, these factors do not appear to be systematic sources of inflation forecast bias.