In a recent Herald article, Geoff Simmons discusses the core funding ratio. I work near the GMI team, and I have a lot of time for their outside the box thinking on issues – however, this is one case where I will have to respectfully disagree with the conclusions.
What was the conclusion? It was that the RBNZ should look at varying the Core Funding Ratio (CFR) at its next meeting in order to reduce inflationary pressures, instead of increasing interest rates.
Now it has been suggested that adjusted the CFR during the “extremes” of the cycle may carry weight – but here I want to get into the trade-offs involved, and why I don’t think it is appropriate now.
We can think of the logic behind a CFR sort of like a reserve ratio (RR) from back in the day. [Note they are quite different, I just find this an easier way to describe their structural role]
These were greatly discredited due to the belief that “private agents (banks) will account for risk” – however, nowadays people realise that there are two issues that make a RR necessary:
- Moral hazard: Retail banks know that the central bank will bail them out – and so will take on more risk then we would like.
- Information asymmetries and incentive schemes inside banks can lead to excessive procyclical risk taking.
By setting a structural RR, we ensure that the “doomsday” scenario is ruled out – and improve the stability of the financial system and general economy.
Very good. However, in the article changing the CFR is suggested as a way of controlling monetary policy. How does this work?
Impossible Trinity and capital controls
A CFR ensures that a certain proportion of any asset class held by a bank (a loan) there is a certain match in terms of the quality and length of the liabilities they have (the money they bring in to fund the loans). By doing this, the central bank is partially dictating the type of risk banks can take on, and also ensuring that banks don’t always face the lowest “cost” when they try to lend out.
By increasing said “cost” of lending out, a CFR in turn increases interest rates in the economy and lowers lending – relative to the case where there is no ratio.
Now I get the feeling that the Herald article believes we can get a “free lunch” out of this. By increasing the CFR we increase interest rates and lower lending, but since new “funds” from overseas can’t “flow” in we don’t get the increase in the exchange rate. Huzzah, we have increased interest rates without pushing up the exchange rate!!!
This is only a partial story though. Essentially the CFR increase is acting as a capital control in this context … this is an application of our good friend, Mr Impossible Trinity.
Since the exchange rate is not rising, in order to control inflation we either need a larger increase in domestic interest rates then we otherwise would have face (real underlying interest rates that businesses and households face, not the OCR) and a sharper drop in economic activity. We stabilise our exchange rate by explicitly lowering our incomes by more than we needed to, in order to control inflation.
Let us not forget that by doing this, we are effectively blocking a whole lot of lending on investment that makes sense given economic conditions – if we are worried that a high exchange rate will “lower long-term growth” (debatable, as we need to discuss what is going on and why – and even then, a one-off boost due to tightening monetary conditions will likely be independent of these), we are trying to “solve” the problem by lowering investment … which will UNDENIABLY lower long term growth.
Conclusion and opinion
In the current context, where we are crawling out of a recession and where inflationary pressures are starting to manifest themselves we can all agree we are nearing the time when monetary policy must “tighten”. However, I would disagree that changing the CFR makes sense as the way to tighten. Using the CFR will lead to a larger increase in domestic interest rates and/or sharper drop in output, just to keep the exchange rate stable.
There are two important additional points I must raise here:
- IMO, the only reason why we would use the CFR instead of the OCR for monetary policy targets is if we believe there is some “structural” break going on – such as an asset bubble in the exchange rate. In this case we may wish that the CFR is at a higher level – but it should be justified on financial stability grounds – not monetary policy grounds.
- The idea that there are “hot flows” of money driving up the dollar vexes me a little. It is true that there is some “infinite supply” of funds out there, but we need domestic demand for it as well! If the CFR is binding, it link between the dollar and the exchange rate is not necessarily clear (as any increase in borrowing from overseas will need to be matched by some amount of domestic saving as well). And if its not binding, then there isn’t an issue …
Update
I’ve been told that this is the way the RBNZ see’s CFR’s – and that it is consistent with my conclusion that rolling it out now would be a touch inappropriate:
Liquidity tools
Core Funding Ratio
The Core Funding Ratio is a tool that can help promote greater financial system resilience by requiring banks to fund credit using more stable sources than they might choose in the absence of the requirement. This discipline is particularly desirable during periods of rapid credit growth, when recourse to relatively cheap short-term wholesale funding rather than more stable longer term funding is more likely.
As a tool to actively lean against excessive credit growth, our simulations suggest that the Core Funding Ratio could, in some circumstances, play a useful supplementary stabilising role by requiring banks to always maintain a proportion of core funding which is typically more expensive than shorter-term wholesale funding. Alternatively, the Core Funding Ratio could be used as a counter-cyclical policy tool. Although the Core Funding Ratio could be a less effective anchor on credit growth during a global boom (when funding spreads become compressed), it would still be effective in its primary role of ensuring that banks resort to more stable funding sources.
From Allan Bollard speech in Mar 2011
2 comments
2 pings
Geoff
July 29, 2011 at 1:52 pm (UTC 12)
Hi Matt, your analysis is technically correct, but I believe limited by a narrow, short term view of the current problems we face.
I am not trying to achieve the Impossible Trinity. I think the current orthodox Holy Trinity of free exchange rates, free capital flows and controlled inflation has failed us horribly, and it is time to start questioning that orthodoxy.
Lets look at the achievements of the past two decades:
- an explosion in bank fueled private sector debt which has only succeeded in creating a bubble in our property markets
- increased amounts of profits and interest payments heading overseas such that our real gross national income per person has not risen since 2003.
- low inflation (Hurrah!), achieved almost entirely by suppressing tradeable inflation, while inflation in non tradeables has been persistently above the target zone.
- this suppression of tradeables has meant that our exports haven’t grown since 2005.
I don’t think that this is a sign of great success for our current approach.
You are right that capital controls will hurt short term growth, and that there are no free lunches. But I think capital controls have to be considered in the short term at least to break the pattern that has led to the problems above. In fact many of the things we need to do right now will hurt short term growth. Raising productive investment also hurts short term growth, because it drives money away from consumption. But the fact is that if we are to own any part of our country in the future we need to start earning foreign exchange, saving and investing. This is particularly the case in a world where other nations are already manipulating their exchange rate.
I think the CFR deserves some strong consideration to help achieve that, amongst other ideas such as a tax on capital, and putting stronger limitations around lending on housing. If you disagree, I would like to hear your alternative way of solving the problem, rather than simply denying that a problem exists, and putting it all down to market forces.
Matt Nolan
August 3, 2011 at 3:51 pm (UTC 12)
@Geoff
Hi Geoff,
The issue I have here is that your comment is largely unrelated to what you have asked the Bank to do, which is what I was arguing against in this piece.
You were saying the Bank should change the core funding ratio to achieve monetary policy aims – you were not actually discussing the structural reasons for a core funding ratio (which is why it was introduced in the first place).
As you stated in the article:
“That is why the time is nigh to use this new tool as an alternative to traditional interest rate rises.”
Which is inappropriate in the current circumstance according to what I have written about. If you wanted to make the point that the core funding ratio is at the “wrong” level then that is fine – but saying that we should adjust it as a monetary policy instrument is not good policy.
….
Now to discuss some of the other points you have raised.
There is also the elephant in the room here – namely that the data behind the stylized facts you have mentioned above are consistent with the increase in the terms of trade we have experienced. Rather than indicating the economy is a basket case, it may merely suggest that we have experienced both a strong increase in our long-term income (true) and have experienced a housing bubble (which is largely deflated according to the data).
A lot of the increase in the terms of trade is expected to persist in the future, and as a result it is unclear whether anything should be done in the face of it. On the income side RGNDI is actually above 2003 levels, even though we are below potential output – this is a great result from the best measure of income available to us.
“I think the current orthodox Holy Trinity of free exchange rates, free capital flows and controlled inflation has failed us horribly, and it is time to start questioning that orthodoxy. ”
I also disagree with this fundamental point. New Zealand has outperformed the world during this crisis – and the ability for monetary policy to respond as it has was a great boon.
The core funding ratio itself was introduced to meet a perceived issue in the structure of the economy, as was the changes to the tax status of housing in 2010. These issues have been dealt with, and the economy look well on its way in terms of adjustment – this isn’t 2007 anymore, the economy has moved on now.
“This is particularly the case in a world where other nations are already manipulating their exchange rate. ”
This is something we should think about a little more – if other countries are “manipulating their exchange rate” we need to ask how, and why. Only once we do that can we talk about winners and losers.
In the long-run you can’t influence the exchange rate by definition – unless you are fiddling fundamentals. So the long “devaluation” of the Chinese currency is akin to them building up savings and investing it overseas. By definition, once currencies “realign” they lose out due to the capital loss on their foreign currency holdings.
Furthermore the “stimulus” to GDP for the fiddling country comes from them implicitly subsidising their exports – they are paying part of the price for consumption goods for the rest of the world. That is why consumption spending by New Zealanders has been BELOW its historic average proportion of income even though New Zealanders have been getting more goods and services – this is a fact.
As a result, we currently have an imbalance in terms of real goods and services that is due to overseas factors – that imbalance is that we are being paid to consume. In this situation are we really the ones losing out? We need to think about these issues carefully before we decide to arbitrarily intervene.
“If you disagree, I would like to hear your alternative way of solving the problem, rather than simply denying that a problem exists, and putting it all down to market forces.”
So I can disagree as long as I don’t disagree with the fundamental issue – which I do, and I have for the last five years
The key point for me is that NZ is a small open economy – if the composition of our economy changes it is more likely to be the result of external factors than internal factors. That is exactly what we have seen during the last decade.
I do not agree with the hot money argument – at all. It misses the demand curve that exists, someone actually has to borrow for the money to be loaned out. Given that borrowing does fall with the interest rate, we cannot turn around and say “higher interest rates lead to hot money flows” – especially when the CFR sets a proportion of domestic lending!
When the Bank discusses “imbalances” they do not focus on the past ten years – they compare the economy in the 60s to now, and state that they believe there is some factor keeping the real exchange rate too high. Now this could be currency manipulation by China (which we may actually be beneficiaries of) or it could be that the government sector is too large (a cost we may be willing to take on if we care about redistribution). However, we should really be sitting down, seeing what the variation is, and trying to understand why – rather than blaming monetary policy which is weirdly receiving the wrap for any perceived imbalance at the moment.
A small open economy is best served by an inflation targeting, flexible exchange rate, framework – for large economies it is not so clear (they tend to be fighting “prisoners dilemma” type games with each other). I have no problem with structural policy that helps to stabilise the economy during the excesses that do exist – but saying that we should adjust the CFR right now is not an example of this.
Often when people tell me a problem exists and we have to do something I feel uneasy – even if a problem does exist, how do we know we have a sensible solution unless we understand the problem. I do not believe there is a problem, but I am willing to have policies in place (CFR) that provide some insurance – I am 100% certain that even if a problem exists, no-one understands it and can as a result provide active policy that will improve outcomes. Arbitrarily changing the CFR to meet monetary policy aims (which is what was implied by the article) comes into that last category.
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