When discussing the latest OCR decision Bernard Hickey at the Rates Blog suggested that Dr Bollard should lift the cash rate in order to help “rebalance” the economy.
I have heard this suggestion from many, many, other economists as well – suggesting that this view is fairly mainstream. Furthermore, Dr Bollard does keep mentioning the fact that “consumption” is too high and we need a switch away from consumption to exports and investment.
However, we can tell there is something fishy as soon as we listen to exporters. They are saying they want a lower OCR, and a lower dollar, in order to stimulate exporting activity. The fact that both a lower and a higher OCR can be justified on the basis of rebalancing tells us that there is something we are missing in this analysis.
Given my obsession with being contrarian (and the fact I actually do believe a different story this time) lets roll.
So what is going on?
When the RBNZ increases the official cash rate they increase the risk-free rate of return (in New Zealand dollars). This attracts foreign capital, which drives up the dollar. The dollar hits a new equilibrium because the lift in the relative value of our currency increases the “risk” associated with investing in NZ dollars. Ok, so we have a mechanism that tells us how a higher OCR increases the dollar (although this mechanism is complicated by the fact that “foreign capital” actually needs to find people to borrow it in NZ – but this is an issue for another day).
Now inside NZ, when people decide whether to consume or not they look at the interest rate (because if they consume now they miss out on the additional consumption in the future that the interest rate provides) and the price of goods now (both relative to the future and their lifetime income). An increase in the OCR increases domestic interest rates, but it also lowers the price of consumption goods (by increasing the exchange rate) – as a result the impact on consumption is ambiguous.
However, it is taken as a fact that a higher OCR depresses consumption – so lets accept that. Even this is not sufficient to ensure that “consumptions share of GDP” will decline as the OCR increases.
Why? Well other components of GDP can be more responsive to higher interest rates – such as investment. As a result, the higher OCR may have a smaller impact on consumption relative to other bits, leading to a higher proportion of GDP being used as consumption.
Why do we care about that? Well the “rebalancing” we keep asking for involves reduces consumptions share of GDP – moving from more consumption to more investment and exporting. It is in no way clear whether a higher OCR helps in this sense at all.
So that’s it then
No. This brings up an even more fundamental issue. There does appear to be imbalances in the NZ economy. Dr Bollard is right when he brings them up. But he shouldn’t bring them up in an OCR review.
The idea that our economy is imbalanced suggests that fiscal policy and prudential policy may need to change. This is definitely a financial stability issue – and so does fall within the scope of the RBNZ.
However, as discussed above this IS NOT a monetary policy issue. Monetary policy is solely about keeping inflation expectations anchored, and because of the shape of the short-run Phillips Curve the Bank also gets to roll out a bit of economic stabilisation. As a result, the Bank should not be throwing financial stability issues into a monetary policy release – because it makes people believe that it is a monetary policy issue and that they should do something about it!!!
This implies to me that we need to copy the Aussies and have separate institutions for monetary policy and financial stability. Until then these relatively separate roles will keep getting mixed up, making it harder to achieve either stable inflation expectations or a stable economy.