I’m not sure if today’s rate cut was the right decision – I understand the justification for it, it is just hard to get past my inherent hawkish personality 😉
Still, I think that the rate cut is being slightly mischaracterised by those disagreeing with it – so I’m going to discuss it a little here.
In the Herald Bernard Hickey suggested (ht Kiwiblog and interest.co.nz)that the rate cut was inappropriate, quoting from the Bank’s statement and then commenting. As a result, I will take the conclusion and comment 😉
There is a danger that just as this monetary policy easing is flowing into the economy in earnest in 12 months to 18 months time, the inflation from the rebuilding effort and inflation from higher commodity prices globally hits the economy in a double whammy.
I think the Reserve Bank should have waited for more data on the true impact of the earthquake and put a bit more faith in the resilience of the New Zealand economy.
It has now opened up the risk that a slow growing economy is burdened by inflation and higher unemployment. Today’s cut may be seen as the day New Zealand invited in stagflation.
Let’s think about what the Bank did, what it said, and what it expects.
The Bank cut the OCR now by 50 bps. BUT, the Bank said it will increase the OCR by 50bps more than it was going to during the tightening cycle. By the time construction activity is really ripping – the OCR will moving into restrictive territory.
Given this path of interest rates, it has forecast that inflation will stay well within the band. As a result, it is consistent with its inflation mandate.
Are there risks – yes, hell yes. But, given current uncertainty and expectations having TEMPORARILY lower interest rates while output is depressed allows the Bank to “smooth the economic cycle”.
Also – I don’t think the 50bp cut will “cause” unemployment, there is nothing to suggest that and in fact almost all literature would suggest that a rate cut will still reduce unemployment.
But the literature suggests …
I recognise there are papers that say that you should tighten policy following a natural disaster – I have read them. They make sense.
However, they are generally premised on the economy being in “equilibrium” to start with – the New Zealand economy is currently very depressed. When an economy is depressed a negative “demand” shock carries a greater risk of leaving the economy is a poor state (corridor hypothesis). As someone that grew up learning microeconomics, I find this view appealing – although it is subjective.
This is why the Bank needs to respond to new information – I agree with Bernard here that if it turns out the confidence effect doesn’t exist they need to respond. However, ex-ante their justification for cutting makes sense (I am bound to say that, as I felt that this would be the given justification).
Furthermore, I would have expected rates to be HIGHER further out – giving us a much steeper yield curve. However, even with this and my inherent hawkishness I felt today’s decision by the Bank was sensible – demand is a nebulous concept, and when domestic demand is already very weak the downside risk associated with another decline is substantial.
Trust me – this “hysteresis” type path is one of the two main paths to stagflation. The Bank’s actions reduced the likelihood of this possibility – they didn’t increase it.