Bollard: Major central bank QE could be 'monetary protectionism', but too early to tell; Says NZ property tax distortions still exist; 'They both pushed up the NZ$'

By Alex Tarrant

'Money printing' policies by the world's major central banks may be a form of monetary protectionism, outgoing Reserve Bank Governor Alan Bollard says.

But it was still too early to tell whether this unorthodox form of monetary policy would set in over the long-run, which would create significant implications for exchange rates, capital flows and competitiveness in the global economy.

It would be disappointing if this was the case, Bollard said. There needed to be more countries running "good open exchange rate regimes leading to deeper markets."

These policies had already created significant distortions for economies like New Zealand by mis-pricing exchange rates, which was damaging for the economy's tradable sector.

Quantitative easing - the injection of newly created money into the financial system to try and jumpstart growth - by major central banks like the US Federal Reserve, ECB, and Bank of England, was one of the factors behind the high New Zealand dollar over recent years as those major currencies had devalued.

Noting the high currency posed a problem for the New Zealand economy, Bollard said it would be disappointing if 'monetary protection' did set in, after the global economy had evaded trade protectism-style policies in response to the global financial crisis.

Meanwhile, another cause of the high New Zealand dollar, tax distortions favouring property investment, still existed in New Zealand despite some having been removed in response to a surge in house prices last decade, Bollard said.

Those distortions boosted the house price cycle in the 2000s, and saw the New Zealand dollar pushed up as foreign funds flowed into the economy, as demand for property lending could not be met with domestic funding.

High NZ$

Actions to raise interest rates to cool the housing market during the last decade made New Zealand a more attractive destination for foreign capital as rates were pushed higher than in other economies. Dubbed the 'carry trade', this kept upward pressure on the New Zealand dollar.

The Reserve Bank is coming under increasing pressure from opponents of New Zealand's monetary policy who say the Bank needs to do more to try and reduce the level of the overvalued New Zealand dollar.

Those defending monetary policy in New Zealand say the root causes of the high currency, and hence the ability to help bring it down, do not sit with the central bank. They say tax settings, fiscal policy, consumer behaviour, and actions by foreign central banks are all contributing to the pressure on the New Zealand dollar.

In comments released on Thursday in the Reserve Bank's monthly bulletin, Bollard said that from 2004 onwards, there was pressure on the exchange rate due to the carry trade.

"We were in the midst of a strong housing and asset price cycle, consumption and inflation pressures were strong, and there were growing imbalances, especially in the household sector but also externally. The internal demand for debt was connected with some of the funding issues like the carry trade that we had to deal with," Bollard said.

While the Bank did take action by raising the Official Cash Rate through to 2005, it thought that would be sufficient, and paused. However, a second wind in the housing market saw the problems start up again, leading the Reserve Bank to warn the high street banks about their growing exposures to housing and the agricultural sectors.

"They responded quite noticeably to that informal warning, and it certainly helped. We should probably have done that earlier. That is definitely something we have learned," Bollard said.

But New Zealand was left with an above-average exchange rate which had been pushed up by the carry trade.

"This is a real problem and not an easy one to solve," Bollard said.

"When you look at the progress of applied economics since World War II there have been some big developments. They come from Bretton Woods onwards and they relate to our understanding about economic behaviours, about the role of governments and the management of fiscal policy. We also understand more about inflation control and monetary processes and influences," he said.

"But  our understanding of exchange rates is still lacking."

The exchange rate was essentially the price of one country compared to another country. Ideally it should reflect a country’s long term, sustainable competitiveness, Bollard said.

"When it doesn’t, it is problematic, particularly for a country like New Zealand which is very open and a price taker internationally," he said.

Tax distortions still there

There were two classes of things that could be done to tackle the high exchange rate.

"The first is to address any internal distortions. Tax distortions in the housing property sector probably exacerbated our housing cycle and the carry trade.  Some of those have been removed now which helps, but there are still arguably some distortions," Bollard said.

Monetary protection?

The second was to address international distortions, but this was much harder to achieve.

"These distortions arise from capital controls and fixed or managed exchange rate systems through a large part of the world," Bollard said.

"While a number of emerging markets have been liberalising their capital accounts – which we think is generally a good thing – we have had the global financial crisis.  One of its side effects has been quantitative easing by some of the major economies," he said.

"We have the Federal Reserve, Bank of England, arguably the European Central Bank and for a long time the Bank of Japan undertaking major interventions of an unorthodox sort which in my view have had some significant implications for exchange rates, capital flows and competitiveness.  

"So it’s not just countries like China with managed exchange rates that can create significant distortions for small open economies. Mis-priced exchange rates can be very damaging, for our tradable sector, primarily, but also to the confidence we place in our policy settings generally," Bollard said.

"In the long run we need to see more countries running good open exchange rate regimes leading to deeper markets. But that’s a very long term view," he said.

"We have been through the Global Financial Crisis without seeing the widespread trade protection that grew out of the 1930s, but we may now be seeing a form of monetary protection, which could also have distortionary effects. That would be very disappointing, but it’s still a bit too soon to judge."