Economists say OCR use triggers vicious circle

The Reserve Bank's use of monetary policy only to keep inflation between 1 per cent and 3 per cent is costing the nation money and weakening the financial sector, says a leading economic research company.

"In choosing inflation control over other objectives, we are trading off progress towards other economic and social objectives," said representatives of Business and Economic Research Ltd (Berl).

Kel Sanderson, the managing director of Berl, told the finance select committee at Parliament that these trade-offs needed to be measured in an explicit and transparent way.

The committee is carrying out a parliamentary inquiry into the future monetary policy framework.

The review was promised before the previous general election after government coalition members said they wanted changes after perceived damage caused to the economy during the mid-1990s.

At present, the Reserve Bank's sole monetary policy objective is to keep inflation between 1 per cent and 3 per cent, but Finance Minister Michael Cullen has said that the bank's operation of monetary policy and the mechanisms for achieving the target could change as a result of the inquiry.

In a presentation with senior economist Dr Ganesh Nana, Mr Sanderson said the RBNZ's use of a single interest rate tool to control inflation had the unintended consequence of attracting foreign funds into NZ dollar deposits, increasing the domestic money supply.

This increased money supply, enabled an increase in house prices and the movement of money into sub-prime lending – or even offshore as happened in the case of the Bridgecorp and Nathan finance companies.

"Greater increase in money supply can see the lending institution looking for additional homes for that money, and that reduces the soundness of the financial sector," said Mr Sanderson.

The process of foreign funds flowing into NZ caused wide fluctuations in the NZ dollar's exchange rate, reducing the soundness of the "tradeable" sector. House price increases reduced housing affordability generating associated social costs, and were associated with increases in household consumption.

"The RBNZ can interpret these consumption increases as threatening to increase forecast CPI inflations," he said. And under the central bank's single interest rate rule, the RBNZ was required to lift NZ's relative interest rates – completing a vicious circle.

Mr Sanderson quoted Nobel Prize-winning economist Robert Lucas to make the point that though central bankers and even some monetary economists talked of using high interest rates to control inflation, there was no evidence that they were linked in a useful way.

Dr Robin Pope, a senior fellow in an experimental economics laboratory at Bonn University, delivered a detailed call – in a live televised presentation from Japan – for returning NZ to its flush economic position of 1970.

Dr Pope, who has parents and a sibling living in NZ, expressed concern over "asset bubbles" – such as a boom-and-bust property market.

She called for the zoning of land for industrial, commercial and residential development to be slowed down, designing high-rise buildings so that construction can be stopped after five stories if the money ran out, and resumed later, and capital gains taxes on re-zoned land, with a 10 per cent capital gains tax on buildings.

But Dr Pope warned the Australian Labor Party failed to get such a tax through Parliament, allegedly because a large number of federal MPs they would have had to pay for capital gains on land they had bought around Canberra in anticipation of it being re-zoned.

"If the NZ Parliament wishes to bring in such a tax, it would be advisable to make an assessement of the taxes for which its parliamentarians would be liable," Dr Pope suggested. "Then, in the case of those with big liabilities. . . assess well in advance what methods of moral suasion (CRRCT) or public exposure might aid in ensuring their support".

She also proposed the NZ dollar be immediately fixed against a basket of currencies based on trade and capital flows, and that the country explore a currency union with partners such as Europe or the United States.