In defence of the RBNZ’s upcoming hike

By Matt Nolan 05/02/2014


Although I no longer have the time to keep up with the literature on financial stability policy (and so am not commenting on it – this is due to my switch to detail income data analysis), I still spend a bunch of time looking at the national economy and monetary policy.

I see that a section of my work place thinks we need the RBNZ to be more hawkish than it is.  There are also many people who think lifting soon is madness.  I am not personally not in either camp – I actually think the Bank has got this right now!  The Bank’s decision to lift soon and get rates back to neutral does make sense given what they are facing, and that they are doing it the right way.

[As a disclaimer, I was more hawkish than the Bank during the crisis (I was wrong) – although my forecasts of economic variables were surprisingly accurate then, that was because their actions were more appropriate, not because I had any foresight … another indication of why forecast performance isn’t always the best judgment variable ;) .  From late-2011 until the end of 2012 I was more dovish than the Bank was.  Now, I find their discussion consistent with my own narrative and models – including the discussion of the risk.  So it is hardly surprising I’m so willing to defend them :) ]

I will focus on those who fear rate hikes when discussing this.  To some hikes seem untenable, unemployment is still over 6%, our interest rates are higher than most high income countries, our exchange rate remains historically elevated (although I would note it is around fair value in PPP terms with a number of countries – and even now is still UNDERVALUED in PPP terms against Australia!!!).  There is an understandable concern, given the length of the impact of the Global Financial Crisis, that policy that is ‘too tight’ could have real and long-lasting costs on the economy.  Clint on Twitter was the main person bringing this up here.

Older readers might perceive a similarity with the late 1980s and early 1990s, when a determination to get credibility helped (combined with external and fiscal factors) to drive New Zealand into a far worse recession than it experienced in recent years.

However, that is not the RBNZ of today.  There is an argument why getting rates back to the 4-4.5% range in the next 12-18 months makes sense:

  1. Rate hikes influence economic activity with a lag – so the RBNZ is moving rates, and the yield curve, now in anticipation of where we are in 2 years time.  During this time, their action are expected to be consistent with an economy with an unemployment rate of 5% and and inflation rate of 2%.  The forecasts will probably be wrong – but that is due to the large standard errors and unforecastable shocks they have to deal with!  You can’t actually ex-ante improve policy based on that.
  2. The sharp lift in export prices is a “demand” shock.  A nice easy way to think of this is to imagine farmers getting money.  They decide they want fancier haircuts, nicer services, more meals out.  As a result, demand for non-tradable services picks up – which drives up prices for non-tradable goods. [Note:  If the lift is permanent, a good way of thinking about how it impacts on the measured economy is shown here – think of it like a productivity lift]
  3. Monetary policy is being tightened overseas – the cut backs in additional QE purchases are equivalent to rate hikes.  As a result the “relative interest rate” differential is (slowly closing).
  4. MOST IMPORTANTLY – we have a massive, massive, huge, ridiculous, non-tradable investment binge happening.  It is called the Canterbury rebuild.  A sharp lift in demand for non-tradable investment goods has to be funded, either this involves borrowing from overseas or domestic savings.  Increased demand for domestic savings, and domestic resources for the rebuild, are both factors that push up the “interest rate” within the economy – something the RBNZ has to respond to by lifting its OCR.

Note:  Some, including the Bank, have noted rising pricing expectations and inflation expectations.  I haven’t seen them.  Some have noted rising building costs – to which I say “relative price shock, not inflation”.  Even so, the points above (including a rapidly strengthening labour market) sell it for me!

Now there are areas of the country that really need support right now, there are specific poverty programs that need support given the massive changes in the NZ and global economies over the past 5 years!  None of this is monetary policy – but instead are things we should be chatting to the government about.

The Reserve Bank is responding to a very specific set of events, and as a result they are responding very differently than the rest of the world.  If the Canterbury earthquake had not occurred, interest rates would not be doing what they are doing.  This non-tradable investment surge is a huge part of the story – and it is really the necessity of this that is “hurting exporters in the short term”.  Not manufacturers, as a large number of manufactuers are actually servicing the rebuild, and the building sector in general.

This is also why we must be careful talking about the exchange rate – what this means for the dollar isn’t really clear.  You’ll note that as well as saying interest rates differences will be higher, I also noted that the lift in rates (combined with other regulatory policies) induce higher savings which displaces borrowing from overseas for investment.  This is why the “hot money flow” idea is a bit of misnomer.  On top of this, we can also note that part of the reason domestic interest rates are so high is because of the “savings-borrowing” imbalance in NZ – understanding why, and dealing with this if appropriate, is not a monetary policy issue, but is an important issue.

Update:  Nice post by Brian Fallow on monetary policy.  Sort of related ;)