Opinion & Analysis
OPINION: The Reserve Bank left its official cash rate at 2.5 per cent recently, but there is increasing disagreement about the future path of interest rates.
The proximate cause of the dispute is the recent rise in asset prices and the role the Reserve Bank might take in cooling down asset- price inflation, in particular surging prices for real estate in Auckland.
This has prompted some to argue that the Reserve Bank faces a dilemma; leave interest rates unchanged and risk further asset- price appreciation, or raise them and risk a further surge in the New Zealand dollar. Although this argument sounds plausible, it isn't.
The Reserve Bank's mandate as outlined in the Policy Targets Agreement signed by the finance minister and the governor on September 20 last year states clearly that the target of monetary policy is to "keep future CPI inflation outcomes between 1 per cent and 3 per cent on average over the medium- term".
The PTA mentions asset prices, but only in an ancillary role, with the Reserve Bank merely obliged to "monitor prices, including asset prices". Reading between the lines, the bank may well justify hiking the OCR in the event that the bank believes that spillover effects from rising property prices on the CPI may cause it to breach its inflation target. In our opinion, the chances of this occurring over the coming year are minimal.
In March, CPI inflation rose by just 0.9 per cent. CPI inflation has now been below the Reserve Bank's 1-3 per cent target zone for a year and looks set to fall further over the winter as the effects of the recent surge in the New Zealand dollar and falling petrol prices feed through.
CPI inflation is almost constantly surprising both the Reserve Bank and financial sector economists on the low side, with notable forecast errors over the past year, and this pattern looks set to continue.
Longer-term indicators paint a less clear picture of inflationary pressure. Some indicators of economic activity, notably the Quarterly Survey of Business Opinion, indicate that much of the surplus capacity created during the 2008-09 recession has been re- employed and the economy is operating with only a modest degree of slack. This may be so, but labour market conditions remain weak, with the unemployment rate close to 7 per cent of the labour force and considerably higher for younger and/or less skilled workers.
With the economy still operating below its potential and labour market conditions fragile, firms and workers have minimal pricing/ bargaining power and this is reflected in falling inflation expectations.
The Reserve Bank often argues that it can control the level, but not the mix of monetary conditions. With the OCR at just 2.5 per cent and the real value of the kiwi dollar at levels barely seen since the 1967 devaluation, a key issue for the Reserve Bank is to assess the degree of tightness of monetary conditions.
We have resurrected and updated the bank's Monetary Conditions Index: an indicator that weights both the 90-day bank bill rate and the trade-weighted exchange rate. Our analysis suggests that since the 1990s the importance of interest rates has increased, with the ratio of interest rates to the exchange rate rising from 2:1 to 4:1. Our MCI, which closely tracks the level of excess capacity in the economy since the early 1990s, suggests that the rise in the kiwi dollar since the March monetary policy statement has been the equivalent of an 80 basis-point rise in the 90-day bank bill rate.
Moreover, the MCI is at a level consistent with a positive output gap of 2 per cent of GDP, far in excess of current estimates. With inflation in abeyance, activity hovering below the economy's potential and monetary conditions already firm, it's unsurprising that Reserve Bank Governor Graeme Wheeler said in the March monetary policy statement that "at this point we expect to keep the OCR unchanged through the end of the year".
Although CPI inflation is low, the rise in house prices is prompting concern. Over the past year, prices have risen more than 8 per cent, led by double-digit gains in Auckland and Christchurch. While the Reserve Bank may be uncomfortable with the recent surge in property prices and its potential impact on financial stability, it is unclear that lower mortgage interest rates and easier credit availability have played much of a role at this juncture.
This is evident in relatively subdued rates of growth in money and credit aggregates, with M3 expanding by 6.6 per cent and private sector credit rising by just 3.4 per cent in the 12 months to February 2013.
It is possible that rising property price expectations and easier credit conditions will lead to a credit- driven rise in property prices.
However, our experience suggests the OCR is a blunt tool for dealing with this issue, with even significant hikes in the OCR likely to have only a limited impact on house prices and lending activity.
Competition between lenders will limit the pass-through of a higher OCR to mortgage lending rates while longer-term interest rates remain well anchored by easy global liquidity conditions and low long- term interest rates. Rises in the OCR would merely act to invert the mortgage-lending yield curve, driving borrowers to lock in lower cost fixed-rate debt.
Indeed, this process appears to be under way. At about 5.5 per cent, two-year lending rates are now below the variable floating mortgage rate and in their March monetary policy statement, the Reserve Bank highlighted a meaningful decline in the stock of mortgage debt held on a floating interest rate, with the bulk of borrowers shifting toward one to two-year fixed-rate mortgages.
We conclude there really is very little pressure on the bank to alter its monetary policy settings. Arguably, monetary conditions are probably too firm, with the New Zealand dollar close to multi-decade highs. Property price inflation is rising and this is a concern for the Reserve Bank, but the OCR is a blunt instrument for dealing with this, would probably be ineffective, and is unlikely to be used.
It appears that all roads are leading towards the Reserve Bank announcing measures to curb lending activity through a combination of tighter capital requirements and the introduction of loan-to-value ratio lending constraints.
Peter Redward runs independent economic consultancy Redward Associates and was previously chief economist for Barclays Asia.
- The Dominion Post