NZ interest rates and monetary policy

Allan Bollard, the governor of the New Zealand Reserve Bank (NZRB), has raised interest rates today by 25 basis points - from 8.0% to 8.25%.

New Zealand has some rather interesting problems. The first is that their current account deficit is a whopping 9.1% of GDP. Essentially, their currency appears to be quite overvalued. The second is that their unemployment rate is very low at 3.8%, which while a sign of economic strength, is also putting pressure on inflation (higher levels of employment lead to higher levels of spending). The third is that, in an effort to devalue the currency, the NZRB intervened in the foreign exchange markets by selling off bonds in NZ dollars, thus causing the currency to drop in value.

So, New Zealand is facing inflationary pressures and a large current account deficit. The NZRB, like all modern central banks, controls inflation by monetary policy - raising interest rates will bring down inflation. The problem is, however, that whenever these rates increase, then the currency becomes more valuable around the world - the rates go up which means that overseas investors see it as a good place to invest money. But when this happens, the country's current account goes into deficit (it buys more from overseas than it sells overseas, and makes up the difference by borrowing from overseas).

But then the NZRB has been selling off bonds to lower its currency - but that runs counter to its inflation controls. It is as though it is trying to solve two problems at once and is doing two things that cancel each other out. Let me make it simpler:

Problem #1 Big current account deficit.
Solution: NZRB devalues currency.
Result: higher levels of inflation.

Problem #2 Higher levels of inflation.
Solution: NZRB raises interest rates.
Result: Big current account deficit.

This problem is not, however, as simple as I make it out to be. The action of raising interest rates also dampens economic growth - which means that the purchasing of goods and services, even those from overseas, may drop off. In other words, even high interest rates and the resulting high currency may result in a lower current account deficit.

I'm a proponent of zero-inflation monetary policy - essentially I believe that central banks should aim for completely neutral price stability.

Let's assume that the NZRB chooses to lay off its devaluation scheme and focuses entirely upon inflation. More than that, let's assume that the NZRB chooses to enact a zero-inflation monetary policy. What would happen?

Inflation in New Zealand is 2.0% and the NZRB's actions today (raising rates to 8.25%) indicate their belief that there is upward pressure upon prices. With a zero-inflation policy, it would mean that the NZRB would continue to raise rates until inflation settled at or around 0%. What would this figure be? I'm not certain, but interest rates would probably be in the range of 9.5 - 10.0%

The effect of a raise in interest rates would be dramatic. Foreign investors would buy up NZ bonds. More than that, investors in the New Zealand sharemarket would begin to sell off their equities in order to buy bonds that offer better returns than some companies. This would result in a sharemarket decline.

But what would the average New Zealander do? Households have a choice between spending or saving their money. Since an increase in interest rates would make saving more attractive, household savings would increase. But this would be at the expense of spending - which would result in a slower economy. With less spending, demand for goods and services - including goods and services procured from overseas - would decline, leading to a drop in the current account.

It sounds counter-intuitive to suggest that a current account deficit can be reduced by having circumstances that promote a strong currency - but the issue is not whether the currency is strong but whether demand is too high. Even an economy with a strong currency can have interest rates high enough to choke off demand and rebalance the current account. The Japanese Yen, for example, is quite strong yet the economy it serves runs a large current account surplus.

But getting back to New Zealand and my proposed zero-inflation model - some of you may be asking why I would even bother suggesting this course of action.

As with Paul Volcker's world recession of the early 1980s, sometimes the best thing to do is to force a recession in order to rebalance everything. New Zealand, as it stands, is living on borrowed money.

At this point I'll re-state a little anecdote I often make to prove my point. Imagine a man who is living beyond his means and borrows money to cover his expenses. At some point, this man's interest payments will become so high that the proportion of his income that he spends in debt repayment results in poverty. In order to prevent this slide into poverty, the man must cut back on his spending and begin to spend less than what he earns. As each subsequent payday goes by, he owes less and less money and is able to pay back his loans more easily. Moreover, he can also afford to spend more as a result of his debt reduction.

Just as this anecdote applies to one man so it can apply to an entire economy. If New Zealand is to stop itself from sliding into debt it must reduce its spending. The best way to reduce spending is to restrict the money supply, which means that interest rates must increase. Despite the extra value this gives to the currency, the effect of higher interest rates will be to reduce all forms of spending, including goods and services procured from overseas.

Tight monetary policy, like tight fiscal policy, has a "J curve" effect. The initial effect will be negative, but as time goes on the effect will be positive. The ultra-tight monetary policy that I am proposing will naturally result in, at the very least, a sluggish economy and, at worst, a recession. But, over time, the economy will rebalance, and will grow again - except this time the growth will be more sustainable over the long term and will coexist with a balanced current account.

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