Reserve Bank’s two roles are getting a little confused

Looking through the Reserve Bank’s latestMonetary Policy Statement, I was left wondering what degree of separation thereshould be between the Bank’s roles of monitoring financial stability andsetting monetary policy.   The Policy Targets Agreement between the governmentand the Reserve Bank specifies that setting monetary policy is primarily aboutensuring that inflation is kept under control.   Yet the Bank has becomeincreasingly prone to bringing up financial stability issues when settinginterest rates as the pressure on central banks to maintain market stabilityhas intensified since the Global Financial Crisis.  

Apparent structural problems such ashouseholds’ lack of savings, overinvestment in housing, and excessiveinternational debt levels are not short-term issues that can be affected bypushing interest rates up or down.   They are more appropriately addressed inthe Bank’s Financial Stability Reports.   If problems are present, they willonly be solved by a broader mix of financial regulation or fiscal policymeasures.

The Bank’s preoccupation with structuralissues gives the impression that it is trying to engineer a particular mix ofeconomic growth with a strong export sector and a subdued domestic sector.   Inits latest statement, the Bank’s bias towards the external sector shows throughin its belief that the New Zealand dollar is too high, which "is detrimental tothe tradable sector [and] undermines GDP growth".   Of course, firms in theexport sector, or competing with imported product, will always be keen for alower dollar.   But those advocating a lower dollar ignore the fact that astrong currency represents a real income lift for all consumers.

If the dollar was sitting at around US60cinstead of US80c, there would be massive complaints about the cost of living.   Thelocal price of food commodities is determined by international demand andsupply.   Any drop in the exchange rate increases the revenue that could begenerated by selling product overseas, thereby forcing domestic prices up commensurately.  How do you fancy paying another 10%, 20%, or even 30% for milk and meat?   Whatabout a similar price rise for petrol or appliances?   Yes, the stimulus for theexport sector from the lower exchange rate would be massive, but the averageworker would really struggle when faced with those price increases.

The dollar on balance reflects that.   Inmid-2011, the ratio of New Zealand’s export prices to import prices was at itshighest level since 1974.   Put simply, we need to sell fewer lambs to pay for anew ute.   The high exchange rate ensures those income gains are more evenlyspread around the country, rather than just being concentrated in the hands ofa few exporters.

Tied up with the desire for more growthin the export sector is the belief that a period of "rebalancing" is necessaryfor the New Zealand economy.   Over the last four years, this mantra has been basedon a number of factors that mounted during the strong growth period of themid-2000s.   Advocates of rebalancing have cited a housing bubble, excessivedebt levels, strong growth in household spending, and a very low saving rate.  The Bank still seems to believe that further rebalancing is required, eventhough, within the last year:

  • New Zealand’s netinternational debt, relative to GDP, has been at its lowest since 2003
  • the household saving rate has been at itshighest since 2000
  • housing has been at its least overvalued since2003, when measured against the long-term trend in house prices
  • household spending as a percentage of GDP hasbeen at its lowest since 1987.

The shift in these ratios over the lastfew years the economic cycle has already worked to moderate the excesses thathad built up last decade.   A lift in unemployment, weaker wage growth, and adrop in house prices have led to more cautious spending behaviour.   Morerestrictive credit conditions have also played their part.   The fact thathistorically low interest rates over the last three years have failed torapidly turn around economic activity indicates that consumers have learnt somelessons and modified their behaviour.

Perhaps the one ratio still causing somealarm is household debt to GDP, which is still well above historic norms.   Buteven this figure needs to be weighed up against a big lift in the value ofhouseholds’ assets, so the increase in debt has not led to a massivedeterioration in households’ net asset position.

Most of the increase in household assetshas been concentrated in property, but house prices would need to fall about30% before households’ balance sheets would start to look shaky.   Given thathouse prices fell only 10% immediately after the Global Financial Crisis, afurther decline of 30% seems far-fetched.

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