Cunliffe on Labour’s shift in monetary focus

David Cunliffe has done a guest post on the Rates Blog looking at Labour’s change in monetary policy … policy. [We have discussed this here, here, and here already].

As far as I can tell (tell me if I’m wrong), the content of the post boils down to this paragraph:

More importantly, acting alone it has not achieved inflation control alongside reasonable stability of exchange rates and money supply. Combined with an imbalanced tax structure, high real interest rates helped suck in hot money that drove the housing bubble.

Now, I don’t know why he’s mentioning the money supply unless he’s going back to inflation – so lets ignore that.  Exchange rate stability is not important – if the dollar is moving because commodity prices are moving (which they have been) then it helps to stabilise movements in the value of export prices.  This is a good thing.

So we are left with the housing bubble.  I commented on the post with this:

Imbalanced tax structure – yes.

High interest rates – no.

An imbalanced tax structure with a lower OCR would have lead to a larger housing bubble. We are a small open economy, the supply of credit is infinite – the housing bubble stems from credit demand, which is declining in the OCR.

This is something people forget.  We are a small open economy.  The supply of credit at the world interest rate is infinite, no matter what our OCR is.  As a result, everything falls back to our “demand curve”.  Demand for housing credit is falling in the domestic interest rate – therefore, if our RBNZ increased the opportunity cost of bank lending by lowering the OCR it would lead to less borrowing to fund housing relative to otherwise.

We cannot blame monetary policy for the housing bubble (unless we feel they should have increased interest rate more).  I remember BERL making the same claim a while back, I was a bit unhappy with it then and I still am now.

17 replies
  1. pete
    pete says:

    >Exchange rate stability is not important – if the dollar is moving because commodity prices are moving (which they have been) then it helps to stabilise movements in the value of export prices. This is a good thing.

    This makes sense if the movement is due to changes in commodity demand. But what about movements in the exchange rate due to monetary policy?

  2. Matt Nolan
    Matt Nolan says:


    Movements in the exchange rate due to monetary policy are indeterminate. It isn’t clear that a higher OCR leads to a higher dollar – although it sometimes does, a higher OCR can (and has) also lead to a lower dollar.

    A higher OCR could lead to a higher dollar by:

    1) Increasing the rate of return, so people are willing to take on more risk in ventures, leading to more lending, and therefore a higher dollar as well.
    2) Lowering inflation expectations for the country.
    3) Telling people that the growth profile of the economy is stronger than before.

    Now if these are the reasons why monetary policy leads to a short-term gain in the currency we have to ask – why is this a problem?

    Ultimately, the dollar has increased and fallen with commodity prices – just look at NZ$ commodity prices. Furthermore, any increase in the OCR is limited by its impact on the dollar – as a higher dollar reduces the price of tradable goods, which makes it easier for the Bank to lower inflation expectations.

    If we got the Bank to target the exchange rate it would be double counting …

  3. Patrick Nolan
    Patrick Nolan says:

    Interesting posts. It may also be useful to note that the RBNZ already has other tools (e.g., Bernard Hickey has written on how Bollard is leading the world with the ‘core funding ratio’ ( that could also ‘help’ the exchange rate. Why change the whole framework when these other tools and better fiscal policy would make the difference? Otherwise Labour is just trying to justify using looser monetary policy to support their desire to loosen fiscal policy (increase spending).

  4. Phil Sage (sagenz)
    Phil Sage (sagenz) says:


    I am curious. What do you think the impact on availability of residential credit and the exchange rate would be if the Reserve bank lowered the OCR to 0.5% as in the UK.

    Remember your economics 101 supply and demand while answering the question

  5. Miguel Sanchez
    Miguel Sanchez says:

    Phil – as far as I can remember, Economics 101 doesn’t delve into rational expectations, which is crucial to the link between interest rates and the exchange rate. There’s a reason why we go on to Economics 201, 301 etc.

  6. garethw
    garethw says:

    “if the dollar is moving because commodity prices are moving (which they have been)”
    Are you seriously suggesting our exchange rate is largely moving in a buffering sync with commodity prices? Surely not? I accept the theory but haven’t seen any practical evidence that our exchange rate fluctuation is rational response to export pricing?

  7. Matt Nolan
    Matt Nolan says:

    @Phil Sage (sagenz)

    It depends on why the market saw us cutting the OCR.

    If the RBNZ said they were cutting it, even though there was no perceived difference in the economic situation (they had just completely changed their policy tack) then the impact on the exchange rate would be ambiguous. Probably a drop at first, but possibly some recovery over the intervening months.

    The lower OCR would be passed on by banks who would loan – however, how much lower interest rates would be would depend on RBNZ prudential policy (are the retail banks stuck trying to source credit at the world interest rate, instead of getting cheap credit off the Bank).

    Given an infinite supply of credit at the world interest rate, the lower domestic interest rate would lead to more residential lending methinks.

    However, this is all a mute point – a sudden cut in the OCR would probably be taken as a panic move by most of the world, leading to a lower exchange rate and possibly higher domestic interest rates.

  8. Phil Sage (sagenz)
    Phil Sage (sagenz) says:

    Thanks for that comment. Assume the Reserve Bank understands that following Gordon Brown and Obama and endlessly creating credit is not sensible so banks are left to borrow on the global market.

    lets also agree that global lenders see a degree of long term exchange risk in the new low interest New Zealand and can seek better returns elsewhere. What happens to the supply of credit for residential lending?

    What impact does the move of money based in New Zealand at high rates have on supply of foreign credit and the exchange rate?

  9. Matt Nolan
    Matt Nolan says:

    @Phil Sage (sagenz)

    So, you are saying what do we do when the world is artifically holding interest rates down.

    Over time this should push up the relative value of our currency, and cause inflation overseas. I would be concerned about the potential for this to lead to New Zealand “overconsuming” in the short term.

    However, this isn’t the fault of our central bank – this is the rest of the world f’ing us over. We probably need to sit down and try to figure out how to respond to the rest of the world f’ing us over – and I believe that is what the RBNZ is doing with their prudential policy.

  10. Phil Sage (sagenz)
    Phil Sage (sagenz) says:

    actually no. I am interested to know if we drop our rate to slightly lower than world given relative risk and volatility. mom and pop corner store cannot borrow at the same rate as GE so I assume NZ cannot borrow at the same rate as US/UK, but work on the basis Reserve Bank drops rate to 0.25% vs Aust 3.5%

  11. Phil Sage (sagenz)
    Phil Sage (sagenz) says:

    I am interested to know what will happen to the supply of global credit to New Zealand banks when the NZ “risk free rate” is lower than elsewhere.

    I want to know what happens when Treasury is not sucking up foreign currency

  12. Matt Nolan
    Matt Nolan says:

    @Phil Sage (sagenz)

    @Phil Sage (sagenz)

    Hi Phil,

    I discussed what would happen with an OCR cut to 0.5% in a previous comment. In the follow up comment I suggested why global rates may be too low. Outside of that we aren’t really talking about monetary policy.

    We have to remember that the Bank’s ability to influence the interest rate below the world rate is quite weak – as there is a whole lot of global capital out there. The actual effective risk free rate isn’t going to fall to 0.5% if the OCR is cut to that level.

    With Treasury “sucking up foreign currency” are you talking about the government borrowing to fund expenditure? The main issue of debate here should be on the quality of the government spending relative to the international cost of borrowing.

  13. Phil Sage (sagenz)
    Phil Sage (sagenz) says:

    Matt – Thanks for your prompt comments. I am off for a sleep now but will try to get back to this.

    Your view is that Japanese investors will still lend to Australian banks who will take a healthy margin and lend more to NZ home owners who cannot believe their luck as affordability increases massively. The continuing influx of currency holds up the exchange rate. Certainly plausible.

    Now what happens if the government puts in local punitive prudential assurance measures that make a bank hold more capital than they have been accustomed to on residential lending. You will argue that with their healthy margin they can afford a high capital ratio.

    Where I have been leading is what circumstances New Zealand can dissuade Japanese lenders from supporting the NZ residential market with excessive credit.

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