Opinion: RBNZ needs effective tools to control non-tradeable inflation and volume of credit

By John Walley Raise the Official Cash Rate (OCR) to dampen inflation in the housing market and the already unrealistically priced dollar rises higher. Lower the cash rate to lower the dollar and the already overcapitalised housing market takes off, fuelling inflation. This is the dilemma for the Reserve Bank. Adding a supplementary measure aimed at controlling the volume of credit (rather than its price) coming into New Zealand to the Reserve Bank's repertoire would allow Dr. Bollard to control inflationary pressure without encouraging the carry trade. The OCR has proved to be ineffective against non-tradeable inflation, other tools are needed in this regard.

A number of volume-based supplementary measures have emerged, which could provide RBNZ an additional policy tool to address inflation in the non-tradeable sector without fueling the exchange rate and inflicting severe damage to the tradeable sector. Rather than setting the price of money, a volume-based tool directly reduces inflation by restricting the amount of money within the economy (i.e. money supply). This can be implemented in various ways: "¢ Excise tax on fuel "“ Don Brash An excise tax is a tax levied on the production or sale of a good. By imposing the excise tax on fuel, it increases the price of fuel. In the short run, the demand for fuel is highly inelastic, which means that the fluctuation in fuel prices would have limited impact on the quantity demanded, hence consumer spending will increase. Since a greater proportion of consumers' income is contributed to fuel consumption, they have to cut back spending on other goods and services, which leads to lower inflation. "¢ Variable Savings Scheme KiwiSaver is a voluntary, long term saving initiative which came into operation on 2 July 2007. An average worker specifies the contribution rate at 2%, 4% or 8% of gross pay. The variable saving scheme is basically a compulsory savings scheme with variable contribution rates that are set by the RBNZ for inflation control purposes. When inflationary pressure is high, the RBNZ will increase the contribution rate, which limits spending power; similarly, lowering the contribution rate would give the economy a spending boost. "¢ Variable GST Goods and services tax (GST) is a value added tax. It is applied to most goods and services in New Zealand. Currently, GST is added to the price of taxable goods and services at a rate of 12.5%. Adopting a variable GST regime will allow the RBNZ to adjust the GST according to the perceived inflation pressure. A higher GST rate will withdraw money from the monetary system, while a lower rate will inject additional liquidity into the economy. "¢ Interest Linked Saving Scheme (ILSS) Technically, OCR interventions can be seen as an interest surcharge above the free market interest rates, and the Interest Linked Savings Scheme (ILSS) is a saving surcharge that is linked to interest rates, which to a degree, mimics the OCR approach. Monetary policy is implemented via the setting of the savings surcharge rate instead of the OCR, and interest rates are determined by market. The RBNZ can choose different levels of stringency for the application of a savings based approach. At the lowest level, the surcharges are directly credited to the KiwiSaver account of the payers; at a higher level, the credit process will be deferred until the sought anti-inflation response is attained. The most stringent instrument is similar to a non-governmental tax that credits the surcharges to a taxpayer-owned fund. The funds saved can be dedicated to promote economic growth, which further counters inflation through supply-side stimulus. "¢ Variable Capital Reserve Ratio The Cash Reserve Ratio is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes. These reserves are designed to satisfy withdrawal demands, and would normally be in the form of fiat currency stored in a bank vault (vault cash), or with a central bank. The variable regime will give the RBNZ the power to control the level of bank lending by setting the level of reserve. Again, a high ratio will discourage banking lending, limit liquidity flow, and vice versa. The 'one tool one target' system has failed; any new tool would be used in conjunction with the OCR "“ in the current situation the OCR could be lowered to take pressure off the dollar while the supplementary instrument could be raised to deal with the heating housing market. The New Zealand dollar would cease to be the instrument of choice in currency and interest rate arbitrage and we might have a show of a balanced recovery. ____________ * John Walley is the CEO of the New Zealand Manufacturers and Exporters Association.