Monetary policy just one lever in engine of domestic growth

OPINION: Yesterday's official cash rate (OCR) hike was the kind of back-handed good news that only a central bank can deliver.

For those who are concerned that tightening monetary policy now is wrong for such a fragile economic recovery, there was perhaps some comfort in the 50- point tumble the kiwi took within seconds of Reserve Bank governor Alan Bollard's 0.25 per cent increase in the OCR to 3 per cent.

"Hooray," the message for exporters seemed to be. "At least interest rates aren't likely to rise as much as they were going to, so nor will the dollar be stronger."

Having already factored in a small rate hike yesterday, financial markets were interested only in the outlook, and Dr Bollard is starting to agree that the outlook is, at best, murky, in no small part because the New Zealand dollar has remained so much stronger than the RBNZ expected.

"This appreciation is inconsistent with the softening in New Zealand's economic outlook and moderation in our export commodity prices," noted Dr Bollard, confident that currency traders know a "sell now" command when they see one, however blandly expressed.

Economist Christina Leung at the ASB said: "There was some surprise in the markets at the explicit acknowledgement from the RBNZ that it may pause at some point", although the OCR is still seen climbing to at least 5 per cent some time in 2012, albeit more slowly.

In the meantime, a sustained weaker currency should help underpin the economic rebalancing that Prime Minister John Key and his Finance Minister Bill English are so anxious to say is occurring.

With such a fragile local and global environment, now more than ever internationally competitive industries need the chance our volatile currency so often denies them: to entrench both new and existing export relationships, while banking half- way predictable margins. Only then does the rebalancing occur, rather than a lopsided collapse in domestic demand with too little to make up for it.

In this scenario, the domestic economy stays weak, and in fact could weaken further, not only because households are keeping their wallets closed and paying down debt, but because the fiscal stimulus driven into the economy over the past two years to stave off deep recession is peaking now.

The winding down of that stimulus represents another leg to the domestic economy's wobbly stool working that little bit looser.

And as the rest of the world moves back to something closer to "normal" monetary conditions in the next couple of years, the RBNZ will be watching like a hawk for any signs that current support for the New Zealand dollar is waning as larger, more stable developed economies raise their interest rates and become more attractive again.

This is the perpetual knife-edge for Dr Bollard and the Government: maintaining New Zealand's good name for price stability, and rational, predictable policies to stave off the fateful day when the mood of the markets flicks round to focus on the country's bloated levels of private foreign debt.

If and when that happens, especially if there are better options emerging elsewhere, the kiwi could drop like a stone, with dire economic consequences.

Central banks have an unenviable task at the best of times. When the economy's booming, they're the wowsers judging whether high spirits are turning to intoxication, with the inevitable inflation hangover to come.

In that sense, Dr Bollard is our most highly paid designated driver.

But when the economy's recovering as weakly as it feels at the moment, the central bank's job is still to take a flinty view of what's really likely to happen in the future, since the full impacts of monetary policy knob-twiddling today are always 18 to 24 months away.

That far out, the RBNZ doesn't think things look so bad at all. While it expects growth to flatten out below the 4 per cent or so it previously forecast for 2011, it still sees "respectable near-term GDP growth, with manufacturing confidence remaining elevated and forestry exports continuing to expand".

Of course, the problem with monetary policy is that it is just one lever, albeit a big one that gets pushed and pulled more actively than most.

The underlying issue remains how to achieve faster economic growth over the medium to long term. That's not a question that's answered by a perpetually weak exchange rate.

No wonder the prime minister was urging private equity investors at a JBWere function in Wellington this week to look to their opportunities.

In the absence of the business financing role once played by the finance companies, new engines of domestic growth must come to the fore.

Unless they do, John Key knows we will end up "tenants in our land", no matter what interest rates or the dollar are doing.

Pattrick Smellie is a co-founder and editor of BusinessDesk.

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