Thursday, October 20, 2005



Is monetary policy doomed?

I've just got hold of the latest Listener, and the cover story - "High Anxiety" by David Young (offline) - reminded me of some stuff I've been throwing round in my head for a while about the future of monetary policy. Back in June, the Dominion-Post carried an opinion-piece by Bernard Hickey with the rather memorable title of "Bollard probably needs a new gun". Talking about the Reserve Bank governor's then-latest interest rate decision, Hickey said:

This week Dr Bollard kept interest rates on hold, but warned that inflation was right at the limit of his patience and the merest hint of higher prices would have him pulling the trigger to raise official interest rates.

In the language of central bank governors he is talking very tough.

He practically pulled out his gun and waved it in the face of the market and yelled: "I have an itchy finger and I know how to use it."

The markets and the banks gave him the figurative finger right back. ANZ, National and Kiwibank all cut their fixed mortgage rates by 15 to 20 basis points.

Needless to say, this is not how monetary policy is supposed to work. What was supposed to happen is that the banks would raise their rates, thus discouraging borrowing and (eventually) cooling off the housing market. The reason they didn't is down to one thing: globalisation. Our banks can also borrow overseas where interest rates are lower, and can thus ignore the Reserve Bank's signal. Young's article talks about the consequences for home-loan borrowers and whether the economy will have a hard or soft landing. But the problem goes deeper than that - in fact, it undermines the whole basis of our monetary policy. If banks can borrow cheaper overseas, and pass those lower interest rates onto borrowers (including home-loan borrowers, but particularly business), then the strong linkage between interest rates and economic activity which the Reserve Bank depends upon to control inflation is broken. And suddenly, they have no control at all...

Young points out that this is due to the fact that our economy is out of step with the rest of the world: while we've been doing well, they've been in recession, with the consequence that their interest rates are significantly lower than ours (low enough for all parties to profit while still undercutting the Reserve Bank). In the next few years, that gap should narrow - but I'm not sure whether it will do any good. As Young points out,

The best hope is to take advantage of the foreign cash and continue shifting to relatively cheap, longer-term mortgages, and try to stay slightly ahead of the wave.

And the Reserve Bank.

The upshot is that for the forseeable future, the Reserve Bank is essentially powerless. And this probably goes for the long-term as well. Globalisation has cut the foundations out from under our monetary policy, leaving us at the mercy of the market - and I don't think there's a damn thing we can do about it.

6 comments:

"and I don't think there's a damn thing we can do about it"

- yes we can. Or at least we can when it comes to inflation: fiscal policy. We could raise taxes and run higher surpluses. It would be an eminantly sensible thing to do for other reasons as well (i.e. putting some money aside to help pay for our aging population). But all this is politically impalitable at present, which to me says something depressing about the quality of our democracy. Not measured against other democracys, of course; but measured against the ability to make the hard choices that we are increasingly going to have to make.

Posted by terence : 10/20/2005 08:17:00 AM

It's more complex than Idiot paints it.

Let's talk about wholesale interest rates.

Interest rates are not a point on a graph. They are a curve. There's a 1-day rate, a 30-day rate, a 90 day rate, a 1 yr-rate, etc.

The Reserve Bank only ever controlled the overnight rate - the point where the curve starts off from the y-axis. Moving that affects the short end of the curve a lot, but the long end very little. So they hold one end of a slightly loose piece of string and jerk it up and down.

Even ignoring the globalisation slant, banks can sometimes credibly say "ooh, he's being sensible and raising the overnight rate now, a small correction now means he won't need to do a big correction later, so him putting short term rates up now means that our long term rates can go down."

But the kicker for this globalisation claim is that there is a different interest rate curve for each currency. If Idiot was right then those curves would all have converged into one uber-curve. But they haven't.

I'm not saying overseas rates have no affect. I am saying that they're just one factor among many.

Posted by Icehawk : 10/20/2005 10:18:00 AM

Icehawk: I was more thinking that its the existence of (and access to) those different rates which undermines monetary policy - not that they would have converged. This means that the price of money isn't just set by local expectations, but also by how cheaply you can get it elsewhere (coupled with competitive pressures).

It is of course only one factor - but ATM its a strong one, and in the long term it does undermine the whole idea of trying to manipulate the economy through changing local interest rates.

Posted by Idiot/Savant : 10/20/2005 11:15:00 AM

hhhhhmmmmm....I'm thinking that, in a post Bretton Woods world, the other complicating fact with monetary policy is forex flows. That is - if you raise interest rates, this makes your country a more desirable place to deposit money - so money comes in and up goes your currency. Which can be a chore for your exporters. I guess this could be self correcting...hhhhmmmmmm

Posted by terence : 10/20/2005 11:33:00 AM

If NZ-based banks can borrow overseas, why not the NZ homebuyer, consumer or business borrower? Cut out the local middleman and go direct to the overseas instituions offering the best rates (like 2% mortgages in the US not so long ago).

Possible?

Posted by dc_red : 10/20/2005 03:57:00 PM

Jap 2nd hand import mortgages of 3%. Or The Warehouse Chinese parallel import mortgages of 2%.

Now why ain't that gonna happen?

Posted by MERC : 10/22/2005 01:55:00 PM