Rodney Dickens looks at the RBNZ's housing experiments, its exchange rate game, and assesses what sort of a Governor Graeme Wheeler is

By Rodney Dickens*

It is normal for Reserve Bank governors to try new experiments, but more often than not they turn out to be bad ideas (e.g. Governor Don Brash's short-lived experiment with a monetary conditions index that put too much emphasis on the exchange rate and Governor Alan Bollard's go-for-growth experiment that resulted in a boom-bust housing cycle among other undesirable things).

It is early days in Graeme Wheeler's tenure and we are still learning what sort of a governor he will be.

On a positive note, Graeme appears to be mainstream, which reduces the risk of boom-bust cycles for the housing market and borrowers.

But he is also showing hints of possibly being a control-freak (e.g. claiming there is a high correlation between the exchange rate and commodity prices to support his crusade to get the exchange rate down when there isn't, and introducing questionable controls on mortgage lending).

This Raving looks first at the case for more stable interest rates and tentatively concludes that Governor Wheeler will deliver a more stable interest rate environment than his predecessors.

I see this as core to the governor making quality monetary policy decisions in light of the unnecessary cycles in interest rates, the housing market and other parts of the economy caused by previous governors.

It then looks at the exchange rate game Governor Wheeler is playing and warns that this rings some warning bells.

Thirdly, it looks at the governor's meddling in the mortgage market and warns that even though this meddling is motivated by good intentions it will most likely result in unexpected and undesirable consequences.

Finally, this Raving restates the case for an independent central bank, but with the proviso the governor receives a due amount of public scrutiny, like that offered by this Raving.

Governor Wheeler may deliver more stable interest rates than his predecessors

I have campaigned in the past for more stable interest rates and it looks like Governor Wheeler may deliver much more stable interest rates than his predecessors.

Governor Brash first had to break the back of inflation with high interest rates, but even after this was achieved in 1992, interest rates were prone to change dramatically from year-to-year (see the Brash era identified in the adjacent chart).

This was the Wild West period for NZ monetary policy.

By historical standards, interest rates were low before the Bollard era started in September 2002, but Alan continued with low interest rates for far too long in what I dubbed the "go-for-growth" experiment.

The experiment with unjustifiably low interest rates resulted in an inflation problem emerging and Alan ended up hiking the OCR 13 times between 2004 and 2007.

To me the key feature of Alan's tenure was painful boom-bust cycles in the housing market and and borrowing costs, rather than him rescuing us from the financial crisis by cutting the OCR from 8.25% in June 2008 to 2.5% in April 2009.

Lots of lessons should have been learnt at the Reserve Bank from Brash's Wild West days and Bollard's "go-for-growth" experiment.

Hopefully, Governor Wheeler won't be so likely to deliver unnecessarily large cycles in interest rates, the housing market and other parts of the economy impacted by interest rates. This assumes Graeme is open to learning the lessons from history.

This doesn't mean interest rates will be boringly stable. Governor Wheeler delivered four quick OCR hikes in the first half of 2014 when it became clear interest rates were too low relative to the level consistent with the medium-term inflation target.

But rather than over reacting to events by hiking excessively, as Governor Brash did at times, or keeping interest rates too low in the hope an inflation problem wouldn't emerge, like Governor Bollard did, it looks like Governor Wheeler is searching for the level of the OCR that is consistent with keeping inflation low on average over the medium-term.

The "neutral" or "equilibrium" level of the OCR isn't easy to calculate and can change over time and even significantly if major events like the financial crisis occur.

But critical to avoiding unnecessary cycles in interest rates etc is a central bank governor who is at least focused on setting the OCR in the ballpark of the neutral rate rather than over or under reacting to events.

However, it is early days and I can't rule out the possibility Governor Wheeler will end up being at least moderately reactive; resulting in more cyclicality in the housing market and borrowing costs etc than is necessary to achieve the medium-term inflation target.

The governor's exchange rate game is somewhat disquieting

Governor Wheeler seldom misses an opportunity to talk the exchange rate down; regular describing it as "unjustifiably and unsustainably" high (e.g. http://www.rbnz.govt.nz/news/2014/5961473.html).

There is nothing new in a governor being concerned about the high level of the exchange rate. A lower exchange rate would be good for exporters and local firms competing against imports, although it would also mean higher import prices.

But the governor's crusade concerns me in two respects.

My first concern is the history of governors putting too much emphasis on the exchange rate and in so doing overlooking a developing domestic inflation problem.

Domestic inflation, as distinct from import price inflation that is largely driven by the exchange rate, is central to medium-term inflation prospects. Domestic inflation reflects what is happening to the prices of goods and services that are produced in NZ and largely consumed locally. This is measured by the non-tradable component of the CPI that makes up around half of the goods and services included in the CPI, with non-tradable or domestic inflation at 2.4% last year versus 0.8% for overall CPI inflation.

At the moment overall inflation is low largely as a result of the high exchange rate last year, falling primary product prices and the fall in petrol prices.

The adjacent chart shows a high correlation between the annual % change in the NZD trade weighted exchange rate index and annual import price inflation (the right hand exchange rate scale has been inverted to better show the relationship). The appreciation in the NZD TWI over the last couple of years resulted in falling import prices measured in NZ dollars and this filtered through to lower consumer price inflation. But the fall in the exchange rate this year points to import price inflation turning positive, which will filter through to higher consumer price inflation.

As is often the case, the bank economists are being myopic and reactionary in focusing on the current low inflation that has nothing to do with the medium-term prospects for inflation Governor Wheeler is supposed to focus on.

There is the potential the labour market, that is central to medium-term domestic inflation prospects, will start to pose a threat this year, which is what the focus should be on. But instead, as has been the case in the past, the bank economists are assuming this threat away.

If the governor's crusade to get the exchange rate down means he takes his eye off what is central to medium-term inflation prospects for a period (i.e. the risk the labour market will head into the danger zone this year), it will increase the future upside risk to the OCR. At the moment this risk isn't anywhere near as large as was the case in the early-to-mid-2000s when Governor Bollard was playing the go-for-growth game, but it still warrants consideration.

The problem is that if domestic inflation is allowed to get a bit of a head of steam up it will require more OCR hikes to fix than would have been the case if the governor had acted proactively in hiking. It isn't a certainty, but the governor's misguided campaign to get the exchange rate down could cause problems down the track.

I suggest the governor's campaign is misguided partly in the context of the unlikelihood it will ultimately have any impact on the exchange rate and partly because the claim the exchange rate is "unjustifiably and unsustainably" high is debatable. It makes sense to me the NZD is high relative to the currencies of most of our major trading partners because of the debt mountains they have that will limit economic growth and how much interest rates can be increased for some years to come.

In the case of the US, there are some signs the economy is normalising, but even there some major challenges to economic growth have emerged or are likely to emerge, as covered in our monthly economic reports.

My second concern may have implications beyond the governor's crusade to get the exchange rate down. What is somewhat disquieting, are the lengths the governor has gone to in his attempt to talk the exchange rate down, including claiming there is a "high correlation" between the exchange rate and commodity export prices.

Assessing correlations between two indicators in level terms can be misleading, while if there is a high correlation it should be evident when annual % changes are compared, as is done in the adjacent chart.

There was a relatively brief period between 2006 and 2011 when the was a high correlation between the two, as highlighted by the boxed area, but since 1990 the correlation between the annual % change in the NZD trade-weighted exchange rate index and annual export price inflation has been a relatively low 0.46 (i.e. a bit like a 46% mark in an exam, which to me is a fail mark not a high mark). Maybe my ex-colleagues at the Reserve Bank have tortured a mathematical model of the economy until it shows a high correlation between the exchange rate and export prices, but there clearly isn't one.

As a former member of the Reserve Bank's Monetary Policy Committee I find it disquieting that a governor will make claims that are wrong.

However, it doesn't surprise to me that the bank economists aren't highlighting the dubious lengths the governor has gone to justify his calls for a lower exchange rate.

The governor can pat himself on the back for championing the cause of exporters and local firms competing against imports, while maybe he thinks it is good for us to have more expensive overseas holidays and to pay more for imported consumer goods.

But totally aside from the merits or not of his campaign is the possibility he may be something of a control freak or zealot (i.e. someone willing to go on a crusade justified by dubious claims). There isn't anything unusual about unjustified crusades in the global geo-political arena. But it concerns me if we have a governor who is willing to make unjustified claims in pursuit of a dubious crusade.

One of the unique features of our six weekly Monetary Policy Briefing reports is that we go where others fears to tread in assessing what type of governor Graeme Wheeler is sizing up to be, as well as including the best available analysis of whether the Reserve Bank's forecasts are well found and the implications for interest rates etc. 

Some lessons from Muldoon's attempts to control mortgage lending are warranted

The Reserve Bank and most central banks experimented with low interest rates in the early-to-mid-2000s. This contributed to the housing bubbles that occurred in many developed countries.

Central banks around the world, including the Reserve Bank, are now trying to protect us against the risk of another housing collapse via bank lending restrictions and other impositions on the banking system related to mortgage lending. There is more than a bit of irony in this.

My view is that central banks want to be seen doing the right thing regarding banking system stability, but can't necessarily be trusted to do the right thing.

No matter how well justified the lending restrictions on low deposit borrowers and the planned targeting of investors by the Reserve Bank may seem, history teaches us that such interventions impose costs and will most likely have unexpected and undesirable consequences.

History has also taught us that central banks do not know best and too often have been a source of volatility rather than bearers of stability (e.g. the experiment with low interest rates in the early-2000s).

A better idea than the bank lending restrictions would be restrictions on experiments by central banks. The banking system was subject to a wider range of restrictions by the Rob Muldoon Government in the first half of the 1980s. Attempts to control mortgage lending by banks resulted in around 40% of total mortgage lending being conducted via lawyers' trust accounts. The restrictions were undermined and borrowers ended up paying higher margins for debt than would have been the case otherwise.

Whenever restrictions stand in the way of people doing what they want to do, most people will find ways around the restrictions, but at a price. Low deposit borrowers will find inventive ways of getting around the lending restrictions, but in so doing some will become more at risk of defaulting because they will end up paying higher total interest costs than would have been the case otherwise. Will that reduce or increase the risk of financial system instability?

Forcing banks to discriminate against investors because overseas evidence during major housing collapses has shown they have a higher default rate than owner-occupiers looks like being extremely reactionary to overseas events of potentially minimal relevance the NZ prospects.

The cost of imposing such restrictions should to be weighed against what I believe is a phenomenally low probability NZ will experience an Irish scale housing collapse.

The case for an independent central bank and for scrutiny of the governor

An independent central bank provides an important constraint on politicians.

It means that if the government became reckless in spending taxpayers' money to buy votes, it would face the threat of interest rate increases.

That threat will only exist if the Reserve Bank is independent from the government (i.e. I am a fan of an independent central banks).

But rightly or wrongly, New Zealand has opted for a system that gives the power over interest rates to one person: the Reserve Bank Governor. This means the governor is more important than the Minister of Finance for borrowers, people and firms impacted by housing market cycles and for many others.

On a regular basis the governor has to report to Parliament's Finance and Expenditure Select Committee, while the Minister of Finance decides whether a governor will be reappointed.

The governor faces some accountability, but this accountability didn't stop past governors from embarking on misguided experiments.

I believe there a need for independent scrutiny by someone with long standing expertise in the area of monetary policy. That is, someone like me, who has been a member of the Reserve Bank's Monetary Policy Committee, worked at two central banks and spent over 25 years outside the Reserve Bank monitoring and reviewing interest rate decisions by successive governors.

I will produce an occasional report card for the governor that reviews his performance based on objectives I think are important from the perspective of the economy.

My particular interest is in whether the governor will operate monetary policy in such a way it minimises unnecessary cycles in interest rates etc.

My secondary focus will be on whether the governor is imposing unnecessary costs on the economy and individuals in pursuit of dubious objectives.

But I will also analyse the governor, which is different from analysing OCR decisions. To some this may seem like "playing the man, not the ball".

But to me it is just as important to assess what sort of person Graeme Wheeler is in the context of him being the governor as distinct from clearly personal issues (e.g. Is he open to healthy debate? Does he exhibit control-freak-type characteristics that could lead him to pursue a faulty course of action for too long? Does he have a clear plan of action or is he making it up as he goes along? Is he dogmatic or pragmatic? Is he reactive or proactive?)

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*Rodney Dickens is the managing director and chief research officer of Strategic Risk Analysis Limited.