Exporters feel 'tough love' tactics

It's curious that compared with the fuss over the rights of parents to smack their kids, most of us ignore the strict parenting approach, known as "tough love", that the Reserve Bank adopts to keep us naughty citizens from spending too much money on houses and the like.

As it battles to keep the cost of living below 3 per cent, the bank has punished us by pushing interest rates to the highest in the OECD. This has led to the Kiwi dollar soaring as overseas investors take advantage of the yawning gap between rates here and overseas. This is causing great pain to exporters.

What is happening here is in stark contrast to the policies followed by the United States Federal Reserve Bank, which is aggressively cutting interest rates to try to stimulate consumer spending and help stave off recession.

New Zealand's tough-love approach of doling out nasty anti- inflation medicine is considered orthodox in much of the world. The central banks in Britain and Australia are also worried by signs of rising inflation, regarding it as the No 1 enemy, though the British bank surprised 10 days ago with a 0.25 per cent cut.

Like here, Britain and Australia have cost of living targets designed as a binding constraint on policy, and act on forecasts of inflation in one or two years' time. Experience suggests that once inflation gets too high, it requires even more pain to reduce it again.

The US sees things differently and is not so concerned about inflation. The Federal Reserve apparently believes it will deal with the problem when it arises. In the US, headline inflation is already running at 4.1 per cent (in the December quarter the New Zealand consumer price index rose to 3.2 per cent, above the Reserve Bank's 3 per cent target).

The US Federal Reserve is regarded as the arch proponent of policies that hark back to the 1930s when the world slipped out of depression by following the theories on demand management by British economist John Maynard Keynes.

He urged President Franklin D Roosevelt to adopt policies to create employment through cheap money to encourage investment in both the public and private sectors.

After the latest US rate cuts, it was reported that they were aimed at achieving 3 per cent economic growth in six to 12 months. Publicly, the Federal Reserve said they were designed to underwrite global markets.

In June last year, when the first signs of the US subprime problems arose, Don Kohn, the Federal Reserve Bank vice-chairman, issued a strong signal that it would act to stabilise markets.

More recently, chairman Ben Bernanke said he would act to prevent negative problems in asset prices in financial markets flowing back to the US real economy.

Critics say that by slashing rates, the US is simply staving off serious problems such as its low domestic savings and big current account deficit.

Robert Lind, an economist with ABN AMRO in London, says, however, that it is obvious such medium-term concerns are secondary to the Federal Reserve's short-term worry about a slump in aggregate demand.

If its actions lead to inflation and current account deficits in a year or two, the Fed will deal with them then – a markedly different approach from the Bank of England and the European Central Bank.

Mr Lind says the Federal Reserve can act this way because financial markets have a greater trust in it. In spite of continuing worries that foreign investors would stop financing the low-saving US economy, there were no signs of this happening, and the US dollar has been surprisingly stable so far this year. This is remarkable given the dramatic changes in interest rates in the past year.

Problems in global financial markets – which seem set to continue for months as international banks and other big players gradually disclose how badly they have been hurt by the credit crunch – will continue to provide headaches in coming months for the New Zealand Reserve Bank and Kiwi investors. New Zealand has its own subprime problem with failures in its weaker finance firms.

The ANZ Bank, in its latest quarterly forecasts, says the Reserve Bank, faced with stubbornly persistent inflation which has averaged 2.9 per cent during the past four years, will remain on alert given that all the ingredients are there for a large spend-up by the Government as it seeks votes this election year.

The ANZ suggests Labour may try an election wild card to make housing more affordable similar to its controversial interest-free student loan policy in 2005. Risks to inflation include a tight labour market, further rises in food prices, and the introduction of the emissions trading scheme.

ANZ expects economic growth will be lower than the Reserve Bank has forecast and inflation will not return to its target band till early next year. This suggests the risk profile for interest rates is tilted toward higher rates as the bank has simply no room to absorb further upside inflation pressures, it says.

We can look forward to more tough love.

- © Fairfax NZ News