Even economists struggle with inflation

I have to admit that when I read this news story last night I was very angry. BERL seems determined to tell everyone that increasing interest rates increases the money supply, and a higher money supply leads to higher inflation. This would make sense, if money supply wasn’t INFINITE. But it is.

In NZ we have an OCR target, the RBNZ will provide an unlimited supply of money for a given target rate. By doing this the Reserve Bank sets the interest rate, and the quantity of money is determined by money demand not money supply.

Now, the amount of foreign capital available does have an impact on us. If our interest rates rise then additional foreign funds become available for firms and banks to borrow. The foreign funds are available for a rate higher than the previous interest rate (as they required a higher return to become available) but this rate is lower than the domestic rate. If our interest rate is far above the world rate, then a significant amount of capital becomes available at this rate.

The important thing to note here is that this capital will only be spent if there is demand for it. As a result, the fact that foreign capital wants to enter the country will limit the degree with which an increase in the OCR will lift interest rates, it won’t magically make people want to borrow and spend more money.

The problem NZ has faced is that the RBNZ has not been able to drive interest rates up as much or as quickly as they would have liked (I’ve heard a time lag of 18 months mentioned in some circles!). However, the reason inflation has risen strongly is that money demand has increased significantly since from 2003, and the RBNZ was unable (and at times relatively unwilling) to significantly drive up interest rates.

The OCR is still the right tool to use, however if our interest rates are too far above the world interest rates, the marginal effect of an increase in the OCR is very small. In cases like this some type of alternate instrument might be of use. However saying that the OCR increases the money supply is at best ignorant of New Zealand monetary policy, and at worst a desperate plea for attention from a set of economists.