Written By: - Date published: 11:15 pm, June 24th, 2010 - 42 comments
Categories: monetary policy - Tags: CTU, david parker, fabians, interest rates, Manufacturers and Employers' Association, phil goff, Productive Economy Council
It’s good to see a consensus forming in the Left that change is needed to monetary policy, and it’s excellent to see so much agreement from the Right. Currently, the Reserve Bank manages monetary policy by moving the Official Cash Rate in an attempt to keep the rate of inflation between 1-3% target.
In the textbooks, they tell you inflation targeting works by taking money out of the pockets of borrowers and giving it too savers (when the interest rate is raised) to slow down the economy and vice versa when the economy needs a boost. And maybe that is how it works in a large economy that is primarily moved by its internal markets (the people who came up with this idea were thinking about the US).
But it doesn’t work like that for New Zealand. Mortgagees have dulled the effect of monetary policy on them by taking fixed rate mortgages that don’t move with OCR changes. As small trading nation with large current account and capital account flows, moving the interest rate impacts our economy mostly by moving the exchange rate. Higher interest rates bring in more hot money from overseas, that means for demand for NZD, meaning a higher exchange rate – and vice versa. Higher OCR = higher exchange rate and that is bad news for exporters. It is by hurting exporters that rising OCR cools the economy.
And this is doubly problematic because the hot money becomes cheap capital for the banks to loan out as mortgages. We saw this before the credit crunch: a wall of foreign credit that fueled the housing boom, while exporters laboured under a high exchange rate. It will happen again. It is already happening again.
Inflation targeting has always been a blunt tool and, in this country, it is hitting the wrong part of the economy.
The Fabians have been doing a great job bringing this issue to the fore. Now, Labour, in speeches from David Parker and Phil Goff, has confirmed that it will change the monetary policy, joining the Greens in calling for reform. Labour’s idea is to give the Reserve Bank more active powers over banks’ capital ratios (the fraction of capital that a bank is required to hold compared to the amount it has on loan).
Basically, rather than making borrowing more expensive via the OCR, the Reserve Bank could control how much the banks can loan by raising their capital ratios . Both serve to decrease the amount borrowed and increase the amount saved when needed to cool inflation. But the advantage of using capital ratios is it should have less of an impact on the exchange rate and would counteract the effect of hot money.
Labour is also talking about giving the Reserve Bank a wider mandate. Simply focusing on inflation is stupid, it makes inflation control an end in itself, which it shouldn’t be. Labour says it will add objectives such as full employment and a competitive exchange rate for the Reserve Bank to balance.
There’s been positive reception from the CTU, the Manufacturers and Employers’ Association, and the Productive Economy Council says “Goff’s announcement will split the business vote”. It may well happen if National remains stuck in the failed neoliberal ideology.
Unique in the world, we task our Reserve Bank with only one goal – keeping inflation in the target range – and give it one blunt tool to achieve it. Adding other objectives would bring us into line with other countries and giving the Bank better tools is long overdue. We need a smarter, more sophisticated approach to monetary policy and it is great to see the Left pushing for it.