Should the Bank be responsible for economic structure?
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.
The fact that mainstream economists talk about “rebalancing” doesn’t mean that they put any credence on it – they’re simply echoing the language that the RBNZ uses. The point is that the RBNZ uses these supposed imbalances – rising house prices, rising debt, rising household spending – as a reason for keeping interest rates low, whereas everyone else is arguing that if these imbalances are indeed a problem then the obvious cure is higher interest rates.
But that’s assuming that they are a problem at all. For instance, Bollard seems to be stuck on the notion that real consumption’s share of GDP is abnormally high and needs to come down. However (and I think you’ve made this point before, Matt) the nominal share of GDP has been stable, and is even a touch below average at the moment – nothing unsustainable going on there.
Also, I’m gonna haul you up on your assumption that a higher OCR means a higher exchange rate. The presence of liquid derivatives markets (and the interest rate swap market is the second-biggest financial market in the world) means that foreign investors can receive NZ interest rates (earning the difference between say NZ and US rates) without any principal involved, hence no capital inflow and no FX transaction. So the “carry trade” simply doesn’t stack up as a driver of the currency. It may be that the NZ$ and interest rates move in tandem because investors are buying NZ$ for the same fundamental reasons that are also driving rates higher. But that’s a very different situation, with completely different conclusions about what monetary policy can or can’t do about it.
@Miguel Sanchez
Hi Miguel,
Agreed, I’m not too worried about an “imbalance” in the sense of too much consumption. My concern sit more with regard to mis-allocated investment, which is a separate issue again.
http://www.infometrics.co.nz/article.asp?id=4803
My point here was that the setting of interest rates is independent of any perceived imbalances – the RBNZ shouldn’t be mentioning them in its statements on monetary policy. Monetary policy is about anchoring inflation expectations end of story.
Also I agree that the cash rate doesn’t have to change the exchange rate – but when/if it does it does provide a trade-off that we often ignore.
I actually came to a different conclusion than you about having separate institutions – my view is that if there is a perceived conflict between monetary policy and financial stability then the RBNZ should be able to have that debate internally, without inflicting it on the public. If the RBA thought like the RBNZ then you probably would see them nagging APRA about stability issues; instead, they agree that the way to deal with imbalances is to raise interest rates, and said as much in their last policy statement.
@Miguel Sanchez
Well on that note the RBA is wrong. You shouldn’t use interest rates to do anything expect control inflation expectation – one instrument one target. Prudential regulation can be included to adjust for structure.
Furthermore we have to ask, why do we have structural issues? I don’t think imbalances in the economy evolved out of monetary policy – I would be quicker to blame fiscal policy myself 😛
I suspect that by “imbalances” the RBA really means excess demand, which means inflation. The fact that they’ve only just started using the word makes me wonder if it was really meant as a shot at the RBNZ.
I really agree with the fact that a separate institutions for monetary policy and financial stability is the need of the hour.
Your article today resonates so well here in Canada. Its a constant back and forth daily issue with a higher Canadian dollar and what its doing to the economy and specifically exporters and manufacturing.
The fact here in Canada, with a higher dollar and likewise in NZ, it will always be a balancing act. When one area is impacted, the other areas get hit. As a home based business owner, I do need to be aware of the impact of a higher or lower dollar because that will impact my bottom line too.
I am not sure what would would strike the right balance.
Regards,
of course they should. As soon as they Fed discontinued publishing M3 we all knew something was up. Actually holding someone accountable other than the small time schmoe taking out a mortgage he cant afford isnt something I see happening. Banks get bailed out and bonuses. Little guys get the shaft
@Miguel Sanchez
I do agree – there idea of imbalances is more “global”.
However, both the RBA and the RBNZ are concerned about too much consumption. I think the question should then be, why do we have too much consumption?
I think if we started thinking about it, policy decisions would seem very different …
@Darrell
“I do need to be aware of the impact of a higher or lower dollar because that will impact my bottom line too”
I agree with this; however, how can you actually regulate it, or perhaps a better question; WHO? and how do we keep regulation accurate?