Thursday, March 08, 2007



A futile gesture

Alan Bollard finally raised interest rates today in an effort to keep the lid on house-price inflation, in the process also effectively raising the exchange rate (thus punishing exporters) and discouraging business investment (thus creating unemployment). And he's threatening to do it again if people don't "behave". The problem, though, is that this is a futile gesture which punishes people for no result. After fifteen years, our monetary policy has become ineffective.

Sludge lays out the gory details from the Reserve Bank's briefing. "[F]inancial markets – including bank mortgage rates - have already priced in this entire increase", meaning that there will be no effective change to mortgage interest rates, and thus no change to the property market. Worse, the growing use of fixed mortgages means that even if it hadn't, the lag time for the new interest rates to take effect in the housing market is now almost two years - a quarter of the business cycle, and more than long enough for the situation to have changed radically. By betting long, and averaging things out over the business cycle, the banks have been able to defeat monetary policy.

Unexamined is what makes this possible: the globalisation of financial markets. Our monetary policy is predicated on the idea that our economy is a bubble, in which the Reserve Bank has the sole power to set interest rates. This used to be true, but it isn't any more. Globalisation has burst the bubble, and banks now have free access to other financial markets - and on those markets, interest rates are much lower. The upshot is that they can borrow there, lend here, and pocket the difference - and laugh at the Reserve Bank's puny efforts to counteract the inflation that results.

This hurts all of us, but I'm not sure there's anything we can do about it. We can't control interest rates, we can't control exchange rates, and the New Zealand public won't accept mortgage levies or capital gains taxes, so what lever is there left for stifling inflationary housing market speculation? The answer seems to be none at all.

13 comments:

banks now have free access to other financial markets - and on those markets, interest rates are much lower. The upshot is that they can borrow there, lend here, and pocket the difference

Which has often led me to wonder why the average consumer / home buyer shouldn't be able to cut out the middle man and go direct to other financial markets to borrow money.

Posted by dc_red : 3/08/2007 02:42:00 PM

That's a very simplistic and economically naive view, Idiot. The Reserve Bank doesn't raise interest rates for their immediate effect: there is generally an eighteen month lag between decisions that the Governor makes now, and its effect on inflation. That largely hasn't changed in the last twenty years of deregulated financial markets and the independence of the Governor.

The Governor's doesn't make decisions for what happens now: he's looking through what is, to some degree, an economic crystal ball, aiming to affect inflation trends in eighteen months' time.

Bollard is clearly hoping that today's rise will have a dampening effect on spending. But it's just silly to think he's expecting retail interest rates to rise immediately and that people will suddenly stop spending. That's not how monetary policy operates.

Retail interest rates operate in a relatively free market, with certain lending ratio requirements. That isn't new, and nor is "globalisation" new. Access to foreign capital markets have been a fact in New Zealand for the last twenty years. What Bollard is really saying is that the OCR will will probably rise to 8-8.25% over the next 12 months. Of course that has an effect on home buying considerations.

Fixed rate lending has been a factor, but over time fixed rate mortgages only ever reflect market rate forecasts anyway. If you have a rate fixed at two years that happens to be, say, half a percent below the floating rate in the second year of the mortgage, after two years you're going to have to either revert to the new higher floating rate, or a new higher fixed rate.

Banks can't simply borrow offshore, lend all of it here, and pocket the difference. They have to comply with capital adequacy requirements, and have to factor in an exchange rate risk.

DC_Red: You can borrow in foreign currencies on New Zealand assets now. Several banks in New Zealand offer that. You can get lower interest rates, but the risk is if the dollar goes South you could be in deep shit.

Posted by Insolent Prick : 3/08/2007 03:54:00 PM

Any thoughts on a web-enabled barter-point economy or something?

Posted by Lyndon : 3/08/2007 03:56:00 PM

Idiot,

The facts you list contradict your claims.

You say this has no effect because "the markets have already priced in this increase". That's just backwards: when people that they mean "rates have gone up already in anticipation of this OCR rise". That directly contradicts your claim that rises to the OCR are ineffective at raising interest rates.

The Reserve Bank told everyone the OCR (ie the 1-day interest rate)was likely to go up. The markets reacted accordingly by raising longer-term interest rates. Then it did go up. The you and sludge complain that that there was then no further rise in interest rates after the OCR was raised.

As for the fixed-floating thing: you misunderstand the problem. Someone buying a house now is getting a 2-year mortgage now: they're interested in 2-year rates being offered for mortgages now, not in what rate is being offered to someone else half-way through a fixed 2-year mortgage is getting. So your comments about lag are just wrong. So while that time lag means that raising the OCR is less effective in stopping consumer spending (since the interest people with a house pay is based on rates set a year ago) the time lag doesn't necessarily stop it from being effective in cooling the housing market.

The real problem is more subtle.

Think of interest rates as a curve. The y-axis is the interest rate. The x-axis is time - there's a 1-day interest rate, a 1-week rate, a 30 day rate, a 60 day rate, a 90 day rate, etc, etc, out to 10 years (or more). The ability to get your money back whenever you want is good, so you have to pay for it - that means that usually short-term rates are lower than long-term rates.

The OCR is the shortest term rate around: the overnight rate. So the reserve bank has one end of a piece of string, and to raise or lower the string they're waving it up and down.

If there's a huge amount of slack in that piece of string (the interest rate curve) then the OCR won't move the 2-year mortgage rate by much. If there's no slack they'll step in tandem. The question is: how much slack is there?

The piece of string (the interest rate curve) will never go completely slack. To see why suppose that 1-year rates got too far from 1-day rates. If so it would look profitable to just borrow one and lend the other, and so people would, and so supply and demand would bring the 1-year rate back into line.

But the string does have some slack in it, because it depends not just on the OCR now but on what people think it will be in the futuer. And because pushing foreign money in will affect our rates: effectively what is happening is that Japanese retirees try to buy a piece of my mortgage off my bank instead of taking a safe 0.5% deposit rate in a japanese bank. That pushes our rates closer to Japanese interest rates, which increases the amount of slack in our system. But that effect is finite because interest rates are also a predictor of future value of a currency - if we have a 8% 1-year rate and Japan has a 0% 1-year rate many people read that as a prediction that our currency will go down by 8% vs the yen over the next year. If that wasn't true then the different interest rates in different currencies world-wide would have converged in the last few decades to become the same, and though they have converged a little they very much are not the same.

So the amount of slack in the piece of string is up, but not way up. So the OCR is less effective, but not ineffective.

Posted by Mr Wiggles : 3/08/2007 04:02:00 PM

Well one thing they could do is enforce the current tax regime on people who are clearly trading property for profit. We currently have people effectively speculating on capital gains who are not owning houses for income - they strictly should be taxed on profit from the sale of their "investment" houses but mostly get away with it.

Another is look at rules on depreciation and LAQCs, crack down harder on bogus family trusts, and so on.

Finally, it is a bubble, and bubbles must burst. Eventually the high NZ dollar will suffieiently hurt exporters that the economy goes into recession, and then more people will default on their mortgages, and then the whole "greater fool" inflation of house prices will reverse. And in a few years the boomers now buying houses will want to sell... all at the same time.

It won't be pretty.

Posted by stephen : 3/08/2007 04:05:00 PM

"We can't control interest rates, we can't control exchange rates"
I've recommended a solution before. New Zeaalnd should face up to economic reality and join the euro area - at least there would have a voice in the EU Commission, parliament and ECB (which we would not have at all if we joined, say, Australia, or a US$ area). And we would have no import controls on our produce, and free movement of labour and capital with all EU countries.

Posted by Hans Versluys : 3/08/2007 04:15:00 PM

"Banks can't simply borrow offshore, lend all of it here, and pocket the difference. They have to comply with capital adequacy requirements, and have to factor in an exchange rate risk."

I only partly agree.

Capital adequacy is only a problem if you carry risk. If they do an FX deal now, borrow there, lend here, and sell a future FX deal to swap the principal back at the end they'd end up with no market risk all. But they'd also not make much money.

(FX = foreign exchange, eg swapping some NZD for USD)

The problem is that forward FX rates are calculated using the interest rates of each of the two currencies. If your bank wants to do a deal now to buy USD for NZD in two years time then to figure out the exchange rate to use people will take the current NZD/USD rate, then figure out how much you'd get in each country if you invested the money at a risk-free rate (ie govt bonds) for two years and quote you a rate based on that.

If it wasn't like that then every financial dealer in the whole world would be doing the carry trade (borrowing where money is cheap, lending where rates are high, using FX deals to hedge out the risk) and every bank and pension fund everywhere would be getting vastly rich for no risk. The invisible hand does not permit everyone to get rich, and it'll give you a good slapping if you try it.

Posted by Mr Wiggles : 3/08/2007 05:22:00 PM

How about a land value tax set at 1% of the lans value each year, replacing rates?

An interesting article here in the guardian discusses it:

http://business.guardian.co.uk/economicdispatch/story/0,,1985498,00.html

Posted by Sanctuary : 3/08/2007 06:28:00 PM

There are lots of solutions to controling this part of the economy it is jsut a matter of if you have the political power (and will power) to enact the solutions.
What Bollard is doing isn't entirely futile anyway - it is just somewhat less effective than he would like.

Posted by Anonymous : 3/08/2007 06:36:00 PM

Idiot - you are correct that it was a futile gesture; completely incorrect as to why.

The main issue is that despite the housing 'bubble' households are not the cause of inflationary pressure at the moment (and haven't been for a reasonable time). Oil and Government spending are our 2 biggest inflationary pressures at the moment; so the only thing Bollard can do is to raise rates to increase the exchange rate to keep the oil inflation component understated.

But unfortunatly has no control over Helen and Michael where the real pain is coming from.

Posted by Unknown : 3/09/2007 02:55:00 PM

"Which has often led me to wonder why the average consumer / home buyer shouldn't be able to cut out the middle man and go direct to other financial markets to borrow money"

Because the costs for a UK bank (for instance) to handle the process of taking a charge on an NZ property would be substantial. It can be done, but it's much more efficient for an NZ-based bank to borrow a large amount overseas and handle the retailing operation locally.

Posted by Rich : 3/10/2007 02:34:00 PM

I/S: "Unexamined is what makes this possible: the globalisation of financial markets. Our monetary policy is predicated on the idea that our economy is a bubble, in which the Reserve Bank has the sole power to set interest rates. This used to be true, but it isn't any more. Globalisation has burst the bubble, and banks now have free access to other financial markets - and on those markets, interest rates are much lower. The upshot is that they can borrow there, lend here, and pocket the difference - and laugh at the Reserve Bank's puny efforts to counteract the inflation that results"

Absolutely correct. I spoke to a friend in the RB today in fact, and he said confirmed this was spot on.

I repeated other comments to him and asked "Why do people think that?" He replied "Because they are dumb."

Bravo IS.

Posted by Anonymous : 3/10/2007 06:19:00 PM

House-price inflation should not be the concern of the Reserve Bank. It is not why the RBA was established and is not its business. The RBA was a great piece of legislation which has had its time. The government should forget about daylight saving extensions and focus on better ways to control monetary policy. Their priorities are askew.

Posted by Gooner : 3/10/2007 10:19:00 PM