As our Reserve Bank has lifted our short term interest rates further above the average prevailing overseas our currency has soared, catching exporters but diluting any impact on leveraged importers (including consumers). This interest rate/currency relationship is often a source of frustration, most commonly when exporters bear a disproportionate share of the burden of slowing the economy.
The reality is however the Reserve Bank cannot dictate how monetary policy actually works. This well-known limitation to a central bank’s powers seems to be lost on Governor Bollard right now. He’s blaming his tools and thrashing around searching for alternatives – a very risky place to be. Let’s spell it out.
The fortunes of our currency can be (but aren’t always) highly positively correlated with the interest gap between ours and overseas short term rates. Yet it’s short term rates that the Reserve Bank manipulates, so the impact of adjustments in monetary policy on the currency depends totally upon the prevailing capital market view of the prospects for our macroeconomic imbalances – the balance of payments current account and/or inflation.
If a tightening monetary policy isn’t to have its effect primarily by squeezing the export sector, then the world’s capital markets have to concur with our central bank’s view that our economic imbalances (balance of payments, inflation) are dire. For our international creditors the imbalances cared about most are those that threaten the ability of the country to service its external debt. If “no worries mate” is the prevailing market view then a lifting of interest rates will be reflected fully in a lift in the currency.
This is what is happening at present. Our currency is going up as the Reserve Bank lifts rates. It tells us that global capital markets don’t agree with the Bank’s concerns and as a result they see the rising rates as a bonus reward for taking on NZ risk. Of course it says nothing about who is right – the market or the Bank. Only time will tell us that.
From the Reserve Bank’s perspective however, it has to be frustrated by this situation where it is trying to slow the demand side of the economy down through making credit more expensive, only to find its actions, if anything are lowering longer term interest rates – as global investors conclude policy is already sufficient for containing any relevant imbalances. To them, the Bank’s action diminishes even further the chances of trouble down the road. The lower long term rates that result mean that domestic borrowers continue to face pretty attractive fixed rate mortgages and the potency of monetary policy to roll the property market back for instance, is thwarted.
With a mere 20% of mortgages on a floating rate basis, most borrowers are immune from the direct impact of higher interest rates. Even when they have to rollover, they simply choose fixed again. And the 2 year fixed mortgage rate for instance, has hardly moved from where it was in 2002, sitting stubbornly in the 7.5%-8.5% range.
It is clear then that the central bank can “lose sovereignty” over monetary policy during these periods where market concern over the severity of the macro imbalances are at odds with its own. Monetary policy becomes impotent. Of all people, the Reserve Bank Governor needs to accept this.
Meanwhile inflation may continue to rise as unabated demand squeezes an already-tight labour market, adding to the inflationary pressures already present from higher commodity prices and the capacity constraints being reached in this economy. This of course is the backdrop to the hysteria emanating from the Bank over recent weeks.
It is obvious the Bank sees the current level of interest rates as inconsistent with its own inflation projections and that we are in for a prolonged period of inflation above the roof of its target range. If nothing else this prospect will reveal how “flexible” the politicians have become with their cares about inflation and the contrivance they and Dr Bollard reached in defining the “medium term” – within which inflation has to be kept within 1-3%. There was certainly a time where Dr Bollard would by now be under serious cross-examination as to why he’s let things get away on him, inappropriately easing monetary policy as he did early in 2004 and fuelling the economy’s excess demand situation. Indeed it would have been appropriate to expect his resignation – not that that would alleviate the pressure exporters are now under.
So where from here? Are there other things the Reserve Bank can do without revisiting the house of distortionary horrors Muldoonism subjected us to during his reign of economic terror? I suspect there are but the suggestions from the Bank to date aren’t amongst them.
To suggest that imposing a ratio of loan to house value as an alternative, is a surprising drop in the quality of thinking from No 2 The Terrace. I’d have thought it obvious that over the last few years the strongest area of lending growth has been in (virtually) unsecured (and often subordinated) loans. To widen the opportunity for that type of credit would simply see the prudential standards of the banking sector plummet rather than rein in credit overall. As for the thought that closing down structures such as LACQs would have any significant impact, it would be interesting where the Bank has found evidence for their materiality in fuelling the boom.
Clearer thinking is needed from the Reserve Bank. Firstly it has to be satisfied that activity in the property market is fuelling general inflation. If it cannot establish that then there is no case for targeting activity in that sector as a “supplementary” weapon in the inflation fight. Ceteris paribus, the Bank should have no concern about any specific price change (such as in housing). Its brief is to control rises in prices generally only.
Let’s assume the Bank can establish the business case – and that the housing market boom, via its facilitating higher household debt levels, is fuelling excessive demand in the economy and putting pressure on general prices. Then what might the Bank do during these times when the capital markets don’t see inflation as such a big deal?
Clearly sponsorship of lopsided growth – wherein exporters are squeezed but the domestic economy is encouraged to ever-greater heights – isn’t that attractive an option. I’d have thought the Bank’s first call would be to the government requesting it take pressure off the economy and cut its spending. In particular anything government can do to release government servants for redeployment in the labour-starved private sector can’t be all bad. Given New Zealand’s pathetic productivity performance, a burgeoning State sector isn’t helping.
Next, raising the risk-weighting that the commercial banks must apply to mortgages to meet Reserve Bank required capital-adequacy ratios may have some scope. To the extent it doesn’t – due say to internationalisation of the banks or lending houses sitting beyond the sphere of control of the Reserve Bank – another very important limitation of monetary policy is revealed. If the Bank cannot control the lending behaviour of lenders then it has lost its sovereignty over monetary policy anyway.
To sum up. If those supplying capital to this debtor nation do not concur that there are serious economic imbalances to worry about, the central bank is extremely limited in its ability to control inflation. This limitation is all the more severe if there are lending institutions beyond the sphere of influence of the Reserve Bank.
No amount of piecemeal interventionist distraction will overcome that reality Dr Bollard – a bad workman blames his tools.
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