I don’t think its appropriate to look at it in absolutes. Keeping interest rates higher wouldn’t make the whole financial system collapse, but there will be a cost. We need to compare the costs of doing so to the benefits. Ben believes the costs of a weak financial market (stemming from the financial accelerator model) are more important than the long term costs stemming from inflation – that is why he is cutting rates.

Beautiful – to think that last year they were saying the RBNZ should have lifted sooner, love it.

RBNZ paper is here

Really, I was under the impression from all these ANZ and Westpac releases last year that they said policy needed to be tighter in 2004/05. I know I’ve wanted policy to be tighter over most of the past 5 years (up until July http://tvhe.co.nz/2007/07/26/one-hike-too-far/).

“I think that faulty (ex-post) expectations of the OCR track explain the lack of response in long rates.”

I see, very interesting – do you have a link to the paper, I would be interesting in reading about it. I enjoyed the explaination that foreign capital flows reduced the marginal impact of the OCR, but if there is a better explaination out there I’m willing to concede.

“most economists couldn’t believe that the Bank was leaving rates at the top end of neutral territory when we needed to squeeze inflation.” Ha! I wish that was the case, but sadly the economists calling for tighter policy over the last 4 years have been a tiny minority, and to the best of my recollection there has never been anyone calling for drastic tightening (ie even to the degree that actually took place). But a nice try at revisionism there Matt, keep up the good work :-).

Now, to return to my earlier point: I accept that access to foreign funds should move interest rates in a small economy closer to the world equilibrium, all else equal. But since you’ve posited that the Reserve Bank has fixed interest rates at the short-end, how is access to foreign capital be lowering long rates below what term structure expectations imply? Do foreign investors require lower risk premiums than domestic investors?

In the New Zealand case, I’m not convinced that “foreign capital reduced the effectiveness of lifts in the OCR”. I think that faulty (ex-post) expectations of the OCR track explain the lack of response in long rates.

The RBNZ also has a recent research paper arguing that monetary policy is no less effective now than in the past.

I don’t know, I’m not really convinced that bank’s by themselves could push demand for houses up to the level that we have seen. Personally I think the additional demand initially came from immigration – then people speculated when they saw prices rising, but the supply of houses picked up and demand for new houses slowed taking away the fundamental reason for higher prices and just leaving froth.

I agree that we agree about most of the factors though – I just view liquidity as a supply side issue, the strength of the demand side factors is a VERY important issue that will be hard to quantify. After all it asks the question “why did the housing market get so active” – something I don’t believe the bank’s are solely to blame for.

“high interest rates didn’t do the job 3 years ago”

Interest rates weren’t high enough – most economists couldn’t believe that the Bank was leaving rates at the top end of neutral territory when we needed to squeeze inflation. That is why inflation expectations are so high now, and why the growth sacrifice will likely have to be worse.

“The brakes are well and truly on now and need to be relaxed a bit. Will be interested to see what actually happens next”

I agree with many of your points, especially about investment. However NZers seem to have a preference towards housing.

It will be interesting to see what happens next. We might have a recession, we might not, what is more important is what happens to inflation, productivity, and the labour market. Hopefully the terms of trade shock will help counterbalance some of the downward adjustments our economy seems likely to make.

You say: domestic inflation is still high, can’t move interest rates, and therefore sacrifice some growth now. I say; well high interest rates didn’t do the job 3 years ago, they finally start to bite last year, and we have had three years of a propped up exchange rate, 3 years of poor quality capital investment (ie directed mainly at housing instead of towards business and productivity improvement). The brakes are well and truly on now and need to be relaxed a bit. Will be interested to see what actually happens next.

The level of loans that go out depend on the demand for loans as well. We agree that foreign capital reduced the effectiveness of lifts in the OCR – but they didn’t increase the level of lending. Interest rates were still higher than they would have been if the OCR hand been lower.

The housing “bubble” was likely the result of speculation, after strong population growth increased the price of houses. Seeing house prices go up people got a little bit excited etc. The same thing happened in the US and they kept their interest rates low – I don’t think we can blame the Reserve Bank for lifting rates (note that a significant amount of the lifting in the OCR occurred last year – look at housing now.)

“Yes there is a demand supply curve, but when you are a small fish in a big pond it just doesn’t work.”

The supply curve gets really flat, I agree – but the demand curve still exists. If people don’t want loans they won’t get out loans.

“Hard times for the construction industry – not a bad thing? Well it won’t make houses cheaper”

The industry is capacity constrained – as a result a fall off in demand will impact more heavily on the cost of building.

“everyone will just piss off to Australia … All because of a doctrinaire approach to inflation”

I think the other reason to go to Australia might be the strong income growth and better social services. Housing affordability is WORSE in Australia and their Reserve Bank has lifted rates to within 100 basis points of our rates.

There are a number of structural reasons that we are stuck with higher interest rates. One is the fact that we are a small country with a shallow capital market. Another is the fact that the tax take is above what is required for social services and so the private sector is borrowing based on the belief in a lower future tax burden (Ricardian equivalence).

As I’ve said, controlling inflation has costs in the short-term (when we have to lower output) – however not controlling inflation has long-term costs (as inflation expectations rise). If we had risen interest rates sooner a couple of years ago we would not be in this situation.

“Anyway what would you do now, keep interest rates high because fuel is more expensive?”

You realise that non-tradable inflation is still stronger than tradable inflation – implying that the inflation problem is a lot more systematic then you are letting on. The RBNZ does look through the food price shocks and the fuel price shocks – they are negative aggregate supply shocks and we can’t do anything about them. However, underlying inflation is still a significant problem.

What would I do? I would tell the market that I’m mandated to keep inflation inside the target band and that I’m willing to sacrifice short-term growth to do it – that is the only responsible course of action.