There is a lot of talk about a 50bp cut by the RBNZ in a couple of weeks due to COVID-19. But what does this mean, and why are we cutting interest rates to battle a bad flu?
In this post I am going to discuss the case for interest rate cuts during a natural disaster, to help to explain what demand shock they are battling and why this cut makes sense. The RBNZ already applied this logic during the Canterbury earthquake in 2011, so it is useful to think about COVID-19 from a similar perspective.
I’d like to thank the people I’ve chatted with about this issue to clarify what is going on – you know who you are, and I appreciate it. The New Zealand economics community is wonderful!
Central Banks around the world have already responded to COVID-19 with emergency interest rate cuts this month. The US has lowered their cash rate to 1.25% from 1.75%, Australia cut their rate to 0.5% from 1%.
New Zealand’s next decision on the OCR is on 25 March, where it’s highly expected that RBNZ will cut the rate by 0.5 bp – although this will depend on how they view the relative macro “demand” and “supply” factors.
Finding this balance is hard as I’ve discussed here and here. So it is useful to look at history to get some perspective. There are a multitude of events that might be useful for thinking through this process (September 11 attacks, SARS, the GFC) but I think the best is the Canterbury earthquakes – both in terms of how this is similar, and how this is different.
Do we need to cut the OCR to respond to the COVID-19?
As I have noted in my previous posts on COVID-19, the central bank is the main agency that must deal with a demand shock caused by the outbreak. Cutting the OCR is the natural monetary policy response to deal with the shock, preventing economic growth from slowing below its potential and keeping inflation rate within the target band.
In this way, COVID-19 is, in many ways, nothing like the Canterbury earthquake. There is a reduction in demand for NZ goods and services due to the pandemic occurring overseas (a decline in the price received for exports), and if it arrives onshore there is a “supply” shock due to people needing to stay at home instead of working.
Let’s think about this external demand shock more carefully.
Everyone is talking about supply chain disruption as if it is a supply shock. But although this is for the world in reality, this is the external demand shock for a place like New Zealand.
New Zealand is largely a primary goods producer, so such disruption is more of a demand shock – it lowers the price we receive for goods and services we sell, rather than increasing the price of intermediate inputs. In fact, with collapsing oil prices the “intermediate” price channel (the supply shock) doesn’t really seem relevant and we have to be careful not to start using this idea as a reason not to do appropriate demand management.
But if this external demand shock is the only shock, it may not be too necessary to stimulate demand – as it isn’t clear export prices have fallen off a cliff. Yes tourism operators are struggling, and forestry is having to hold logs, but the specific demand shock from the export sector may have already been more than made up for by the drop in the exchange rate already – suggesting this is more an issue of business continuity (helping illiquid but solvent providers stay afloat during a shock) than demand management.
But there are more channels.
With stock prices falling and uncertainty measures surging there may be a concern that banks will stop lending – this is another very important issue, the financial channel that was so important in the GFC. But this doesn’t necessarily mean cutting interest rates – instead the Bank can respond by loosening its macroprudential regulations and providing liquidity with unconventional tools.
So why do I still think a cut is appropriate? Let’s go back to the Canterbury earthquakes. There was no drop in external demand, no financial constraints, but there was a panic which lowered consumer and business confidence and negatively affected “animal spirits”. The Bank responded to this then by cutting interest rates – that was the right call then, and the right call now.
We don’t need fancy arguments to justify a cut, when a sharp drop in domestic demand due to fear of a pandemic already indicates that a cut is appropriate.