By Rodney Dickens
[This analysis continues Rodney Dickens' series on what he sees is wrong with the current policy approach of the RBNZ. For links to the previous analysis, see here and here.]
The neutral level of the OCR is the level that is consistent with keeping annual CPI inflation within the 1-3% target range on average over the medium term consistent with clause 2 (b) of the Policy Targets Agreement.
An assessment of a number of the factors relevant to determining the neutral level of the OCR leads to the conclusion that the neutral level may be a bit above the current setting of the OCR at 2.5%.
But if the financial crisis remains elevated the neutral OCR could be as low as 2.5%.
And there is the risk that the latest international turmoil could be a dress rehearsal for a more significant shock, which means an OCR of below 2.5% could end up being justified.
The factors considered in the assessment of the neutral level of the OCR and whether the current rate should be a bit above or below the neutral rate are:
• The impact of the international financial crisis.
• How borrowers are responding to the current level of interest rates.
• Economic growth performance and prospects in light of the impact of the non-interest rate drivers.
• Whether there is any spare capacity in the economy.
• Whether a warning shot needs to be sent across the government’s bow.
The continued fallout from the international financial crisis means the neutral level of the OCR is well below the 5.5% historical average level of the OCR since its inception in March 1999.
It is hard to quantify exactly how much below 5.5% the neutral rate is currently based just on the direct impact of the crisis on the interest rates faced by borrowers. But the crisis means a much lower neutral rate than 5.5%, while there seems no basis for expecting an early, significant resolution of the crisis and there is the risk that the international financial situation will deteriorate further.
The response by borrowers to the current level of interest rates suggests that the neutral level of the OCR could be below 2.5%.
However, as especially mortgage borrowers work off some of the excessive debt accumulated during the speculative bubble in the housing and section markets borrowers may respond more favourably to the current level of interest rates.
After taking into account the impact of drivers of economic growth other than interest rates, the recent below average performance of economic growth can be explained.
This means that from the perspective of the performance of economic growth the neutral level of the OCR is probably not below 2.5% while it might be slightly higher than 2.5%.
Economic forecasts provide an unreliable basis for assessing whether economic growth will end up above or below the sustainable rate of around 2.5% if the OCR remains at 2.5%. But based on the current states of, and likely near term prospects for the main drivers of economic growth the outlook for underlying economic growth, which is growth excluding the impact of the rebuilding in Canterbury, is not likely to be materially different from the 1.5% performance over the last year.
Of particular concern is the risk of a significant deterioration in the international trade cycle.
The existence of a modest amount of spare capacity in the economy means a case can be made for the OCR being marginally below the neutral level for a brief period.
However, the most important measure of underlying inflation is already sufficiently high to mean an OCR below 2.5% cannot be justified currently unless international financial developments result in a further fall in the neutral rate.
When the reconstruction work in Canterbury eventually gets underway in earnest it will provide a significant but transitory boost to economic growth and some boost to inflation.
The focus of monetary policy should be on underlying economic growth excluding the boost from the reconstruction work.
To hike the OCR more than a touch in response to the rebuilding post a major and tragic natural disaster makes no more sense than does cutting the OCR once the rebuilding work eventually tails off.
To do so would only create unnecessary volatility in economic activity and especially housing related activity outside of Canterbury.
Despite 2011 being an election year the government is running what appears to be a sound fiscal policy with a focus on reducing the fiscal deficit.
A case does not exist for increasing the OCR to provide a warning signal to the government.
2. Assessing the neutral level of the OCR
[This section and analysis is in the attached download.]
3. Restating the case for a more stable OCR
[This section and analysis is in the attached download.]
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* Rodney Dickens is the Managing Director Strategic Risk Analysis. See more detail here.
11 Comments
I admire RD but unless the Reserve Bank uses other bullets than the OCR to dampen speculation we have no solution to the current malaise. We need a significant move toward exporting which the low OCR assists with the exchange rate but only temporarily.
Howevr we also need constraints on the property market which a low OCR does nothing for.
To a simple one like me the discussion on a neutral rate is irrelevant if the results are unhelpful.
Fear not, Basel. That subset of the RBNZ, the Government ( or is it the other way around?) has a mandate call in November. John Key is almost certain to renegotiate, what is likely to be, a contract on his final term in office. And once that's done - he has nothing to lose! It will be interesting to see if he has the courage to do what has-to-be-done ( to subdue property speculation) knowing that, for him, it doesn't matter. Only a few more weeks to wait.....
Excellent analysis from Rodney.
There are two other aspects to this discussion that I see.
1 The current 1-3% target, as chosen by the RBNZ and approved by the government should be openly acknowledged as the consequence of the desire to match New Zealand's internal inflation rate with the current rate of world inflation. This is to protect our ability to exist as an exporting nation
2 As a consequence of this it seems to me the RBNZ should ask for additional power to issue new currency and buy gold reserves when, in its judgement, this increases the overall wealth of the nation. This means when the currency is unsustainably high the RBNZ can clip the ticket in a way that its unique position as currency issuer allows. ie the RBNZ is the appropriate body to profit from unsustainable rises in the currency. It does this in order to achieve 1 above.
The RBNZ seems technically quite competent but its logic is fundamentally flawed at times, this is however easy to fix. NZ has the mechanism to do this in a responsible and world leading fashion and Rodney's work is part of that process.
When will the politicians dare to review monetary policy? I don't think it is the Pandora's box it used to be.
Exactly my thinking. In absolute dire times it is very handy. Don't forget the US demanded all Britain's gold reserves be transferred to them as part of their lend /lease package deal in World War 2 when Britain stood alone. When national currencies are of dubious value gold reasserts itself. The US was happy to exchange war materiel for gold, technology (think computers and radar), and worldwide naval bases, but would never have stepped in except for the lucky break that Japan and Germany declared war on them. Would New Zealand now be a Japanese or German slave state if that had not occurred? Gold reserves are called that for a reason, they are a sovereign treasure.
Actually I'm not that fussed the reserves be in gold as long they are in stuff that takes real human effort to create. Thus the RBNZ exchanges a ledger entry for real stuff plus a small negative effect on the NZD. Not a bad trade for us I think.
Now that I can agree with. Gold is falling out of bed.
I wonder how long the drop will last however.....gold is worth something when all said and done, the Q is what's its fair /sensible price ie treating it as a currency or medium of exchange and not a profit centre. Right now I wonder if the wise money is out of gold and the semi-wise are running.....
Looking at the GD as a guide, buying gold at the bottom and hiding it ie paying cash seems the sensible way to protect some of your worth. Hoarding cash is vunerable to Govn making it worthless over-night by issueing new.....gold and silver goes past that.
regards
I don't own any gold but assuming my boat comes in I would possibly have 5 to 10% of my assets in gold as an insurance policy. Still we leave this world with nothing and I'm not a great fan of inherited wealth. Enjoy it while you can and do good deeds with what you have.
Gold today down - tomorrow up – then in a week down again - in 2 weeks up again – in 3 weeks down again and then at the big crash by Friday the 28th of October 2011 - exploding up to US$ 2000.- plus.
Has our government taken steps to invest in gold in order to bring the books, but also our mismanaged economy in order ? Nobody knows ?
"but the litmus test is how borrowers are responding to the level of interest rates and whether the economy is growing above or below the sustainable rate"
Two points:
There's probably a point at which lowering the rate further has no effect. Credit worthy borrowers just don't want to borrow right now and a lower rate won't encourage them. I see that as a good thing.
At some point, growth is no longer sustainable or desirable. This is a good time to try to think of what a stable economy, zero growth, would look like.
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