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Background note for journalists and analysts on the new Policy Targets Agreement, and the consequential decision to discontinue the calculation and publication of `underlying inflation'.

December 1997

The new Policy Targets Agreement

Attached are both the new PTA and the previous one. Differences are as follows:

a) The preamble differs only because the new PTA, like the one signed in December 1992, refers both to the balance of the Governor's current term of office and to his new term, ending on 31 August 2003.

b) Clause 1, amended as a result of the discussions leading to the formation of the present Coalition Government in December 1996, is unchanged.

c) Clause 2(a) changes the basis of measuring inflation from the CPI to the CPI excluding credit services (or CPIX). In the past, the Bank has routinely deducted credit services from the official CPI in calculating its measure of `underlying inflation', as provided for in clause 3(b) of the previous PTA. By basing the new PTA on the CPIX, the historically most frequent difference between the CPI and the Bank's measure of underlying inflation has been removed. The change also makes the new PTA consistent with the intention of Statistics New Zealand to remove credit services from the official CPI in 1999.

d) Clause 2(b), specifying the policy target, retains the 0 to 3 per cent range of the previous PTA.

e) Clause 2(c) notes the likelihood that in 1999, following the introduction of a number of changes to the calculation of consumer price inflation foreshadowed by the Government Statistician recently, there may need to be a change in the index used. It is possible, for example, that the index adopted in 1999 will simply be called the CPI (since it is the Government Statistician's intention to drop interest rates from the official CPI in that year). Alternatively, it may be desirable at that time to move to an index of the prices of the goods and services actually entering into consumption, so that, for example, the price of housing services would be represented by rents and rental equivalents, not by a measure which includes the price of new houses and sections, as at present. No decision on the best index to be used can be made until the precise composition of the new indices is clear, but it is the firm intention of the Treasurer and the Governor to retain a focus on consumer price inflation.

f) Clause 3 is a re-wording of the old clause 3, making it clear that the temporary factors mentioned which might drive CPIX from the agreed target range are intended to illustrate the kind of factors which might produce such a result, and are not intended to be a complete list of such factors. Interest rates are no longer mentioned, of course, since they are no longer in the index on which the Agreement is based.

g) Clause 4 of the previous PTA has been omitted in the new PTA. That clause enabled the Bank to request agreement on a new policy target if the Governor felt that his ability to deliver the agreed target had been impaired by some change in the availability of policy instruments. This clause was originally put into the first PTA in early 1990 at a time when there was concern that the Crown Settlement Account might move to a private sector bank and that this might impair the Bank's ability to influence monetary conditions. The clause is no longer relevant.

h) Clause 4 in the new PTA embodies clause 5 in the previous PTA, and makes the Bank's responsibility for the implementation of monetary policy, and its accountability for the judgements and actions taken, unambiguous.

The decision to discontinue the calculation and publication of `underlying inflation'

From the very first PTA, it was clear that the Bank should, when implementing monetary policy, ignore the impact both of interest rates and so-called `supply shocks' (such as sharp changes in international commodity prices and changes in indirect taxes and government charges) on the official measure of consumer price inflation, the CPI. To have done otherwise would have resulted in monetary policy behaving in quite perverse, and sometimes seriously destructive, ways. For this reason, and to assist in public understanding of what it was doing, the Bank began both calculating and publishing the measure of inflation which, in its judgement, was consistent with the intention of the PTA.

This calculation always started with the official CPI, always deducted interest rates from the official CPI (in recent years by simply taking the official CPI excluding credit services as the starting point), and sometimes deducted also `significant changes in the terms of trade', changes in the rate of GST or a `significant change in other indirect tax rates', and `a significant price level impact arising from changes to government or local authority levies'.

These adjustments were always consistent with the intent of the PTA, and their accuracy was never challenged by an independent observer. As compared with Australia, where the official measure of underlying inflation has included only about 50 per cent of their CPI regimen, the Bank's measure of underlying inflation at no stage included less than 85 per cent of the CPI regimen and usually included in excess of 90 per cent of the regimen (except in 1989-90, when the impact of the increase in GST from 10 per cent to 12.5 per cent clearly affected most of the regimen).

But there were some significant problems, of which the most serious were:

  1. A perception in some quarters that the Bank was potentially able to manipulate the measure of inflation on which the Bank's, and the Governor's, performance was judged.
  2. The imprecision of the word `significant', used on several occasions in previous PTAs in describing the supply shocks which the Bank should ignore in implementing monetary policy. In practice, the Bank disregarded the impact of temporary factors where they were judged to have an impact on the CPI of less than 0.25 per cent over any 12-monthly period. But this produced some rather silly outcomes where, for example, a shock of 0.23 per cent was not removed from underlying inflation but a shock of 0.27 per cent was. Yet in economic terms, and even in statistical terms, there is no meaningful difference between the two.
  3. The difficulty of actually calculating the impact of `supply shocks'. For example, when Housing New Zealand moved its rentals to `market' as a result of a policy decision by Government, how much was it appropriate for the Bank to `subtract' from the rental component of the CPI in calculating underlying inflation? We could make reasonable estimates on the basis of information from Housing New Zealand on the extent to which their rental increases pushed up the CPI, but how much of that was a result of general inflationary pressures in the housing market (which we did not want to remove in calculating underlying inflation) and how much the result of a government policy decision (which we did want to remove)? Similarly with changes in petrol prices: to what extent were we entitled to remove that effect from underlying inflation when international oil prices were moving sharply, the New Zealand dollar was moving against the US dollar, and competitive pressures in petrol retailing were also changing? And what of increases in private sector medical premiums: were they the result of Government policy changing the basis of access to elective surgery, and so eligible for potential exclusion from underlying inflation, or were they just a reflection of private sector inflation?

After considerable internal discussion about alternative ways of calculating underlying inflation, and about the possibility of having its calculation undertaken by some party other than the Bank, the Bank has decided to discontinue with the calculation of underlying inflation.

That decision has been made materially easier by having the new inflation target defined in terms of the CPI excluding credit services, since interest rates were historically by far the most common reason for divergence between the official CPI and the Bank's measure of underlying inflation. That is clearly illustrated on the attached graph, showing the CPI, the CPIX, and underlying inflation since the beginning of 1991.

In the year to December 1991, the Bank subtracted a fall in international oil prices and an increase in government charges for a difference between CPIX and underlying inflation of just 0.2 per cent; in the year to December 1992, the difference between CPIX and underlying inflation was entirely a result of an increase in government charges, and was estimated to be 0.4 per cent; in the year to December 1993, there was again an offset between a fall in international oil prices and a rise in government charges, for a net difference between CPIX and underlying inflation of 0.3 per cent; in the year to December 1994, the difference between CPIX and underlying inflation was 0.8 per cent, a result of both international oil prices and higher government charges; and in the years to December 1995 and 1996, the difference between CPIX and the Bank's estimate of underlying inflation was negligible.

Although the Bank will no longer be calculating underlying inflation, it will of course implement monetary policy in line with the PTA, which means that from time to time it will not adjust monetary policy in response to the sorts of temporary factors which are illustrated in clause 3(a) of the new PTA (and clause 3(b) of the old PTA). This means that the CPIX may well depart from the target range from time to time as a result of those temporary factors, as envisaged in the PTA. Instead of calculating underlying inflation and excluding the impact of those factors, the Bank will seek to explain the actual inflation outcome in terms of how those temporary factors may have affected the outcome. That will, of course, still involve the Bank making an estimate of those effects, and explaining those estimates in regular Monetary Policy Statements and Economic Projections.