Thursday, 8 March 2007

Bollard exacerbating the boom he's trying to bust

Where's the sense in strangling producers and exporters in pursuit of a goal that is, at the very least, highly questionable. In one hour from now, Reserve Bank Governor Alan Bollard is expected to announce a further rise in the Official Cash Rate -- in other words, he's going to whack up interest rates. He's going to whack them up because he's "fighting inflation," specifically rising house prices, and this is the only way he knows to fight it.

He's fighting a losing battle. He's losing it because of a myth, and because of a mis-integration.

The myth is that "inflation" consists of rising prices. It isn't, or at least not exactly. As Milton Friedman was fond of pointing out, “Inflation is always and everywhere a monetary phenomenon” -- or to put it another way, "inflation" is specifically a measure of the expansion of the money supply. This is something of which Alan Bollard seems wholly ignorant -- he's still labouring under the idea that it's rising prices, for which the expansion of the quantity of money is generally the cause.

Inflation (understood in terms of an increase in the quantity of money) enters the economic system in the form of new loans, driving up prices first in those markets in which this credit expansion has taken place.

Ask yourself which market is rising above all others at present? If you answered, "the one Bollard is trying to squelch," then you get the prize.

Now, on to his mis-integration: The thinking, if one can call it that, behind Bollard's raising interest rates is the traditional one that a lowering of interest rates creates a credit expansion (credit becomes cheaper, you see), and by contrast raising interest rates reduces credit expansion. This is considered a general rule of economics, one which Bollard follows assiduously. He is nothing if not a man who follows his textbooks.

He doesn't however appear to have looked around at the New Zealand situation, which is rather different to his textbooks. In the textbooks, credit expansion comes in the main from a large central bank -- in the US, that's 'The Fed.' However here in Godzone, being a rather small (but perfectly formed) country, things are different. In New Zealand, foreign investment has a far greater effect on credit expansion than it does in many other markets: raise New Zealand interest rates above international rates, and you attract a flood of investment -- or to flip that coin, an expansion of credit. Hence the housing boom. New credit and new foreign buyers and investors in the NZ housing market help drive up housing prices -- and each time Bollard whacks up interest rates, he invites more foreign buyers and investors into the NZ market.

But in one hour from now he's going to whack them up anyway.

Bollard doesn't seem to have realised that his own nostrums may have exacerbated the very boom he is trying to squelch -- strangling producers in the process as the interest rates they are paying to expand their businesses go up -- strangling exporters in the process as the New Zealand dollar rises again on the back of the increased foreign investment in New Zealand -- and leaving him looking, not for the first time, like an economic wizard without a wand.

UPDATE 1: The dumbarse has whacked them up, exactly as predicted. Sigh.

UPDATE 2: Here's NBR on the dumbarse and his dumbarse meddling:
Today’s hiking of the Official Cash Rate by a quarter basis point to 7.5 percent will further drive the New Zealand dollar above its fair market value and damage the productive sector of the economy... the chances of the interest rate increase were helped by the [recent] depreciation of the currency: a falling currency stokes inflation though higher import charges, especially for fuels...

The housing market has been surprisingly resilient, with January sales 19 per cent higher year on year and the median time to sell a house was unchanged at 38 days. The economy is showing signs of accelerating in growth.

The RBNZ has shown some tendency to blame society for its exuberance, but it does not cease its own money creation. M2 has been rowing at about 12 per cent a year for some time, and this is a factor in inflationary expectations and a culture of consumption.

Today’s OCR decision will inflict great damage on the productive economy. The rise in interest rates will depress and discourage demand. It will encourage capital inflows, and a high dollar (which until this month was the “best performing” currency)... This is a structural impediment: it encourages imports and is a disincentive to exports...

New Zealand’s benchmark interest rates are 2 percentage points above the US and 6 per cent more than Japan. The governor is doing his best to make New Zealand the most favoured factor in the Japanese carry trade.
LINKS: Cue Card Libertarianism: Banking - Not PC
More myths about inflation - Not PC
What Reserve Banks do to our money - Not PC

PLUS CA CHANGE: Questions, rhetorical and otherwise, about Reserve Bank meddling - Not PC (Dec., 2005)

Economics, Housing, NZ Politics


  1. In his book "the economic consequences of the peace" (1920), John Maynard Keynes admits the government inflation rip-off that according to him - "not one in ten-thousand understand."

    Too many vested interests in the government/central banking/big commericail banking system we have now for anything to change

  2. So why did the exchange rate go down on the back of this?

    25bp is nothing,has already been factored in, and will have no effect on anything over the medium term.

  3. Bollard's job, as defined by the Policy Targets Agreement, which he signed, is to keep inflation between 1 and 3 percent in the medium term. The five quarters that the rate spent outside that band starts stretching the RBNZ's credibility. The only real tool available to a central bank to knock back inflation rates is interest rates -- even if that tool is really blunt in situations like that currently here faced. Yes, we could do other things to knock back housing price inflation -- relaxing RMA restrictions and easing up on new building, for instance. But, that's not within the RBNZ's purview. The Bank basically has one job -- price stability -- and one big blunt hammer with which to do it.

    We'd have had far more cause to criticize Bollard had he not raised rates. He's been desperate not to raise them and to find any excuse not to raise them. But inflation has been outside the target zone too long for the bank to maintain any kind of credibility had he not raised rates.

    Let's see what Brash had to say about it back when he was Governor:

    Another of the interesting by-products of the inflation-targeting regime has, I believe, been some stabilisation of the New Zealand dollar exchange rate. I don't want to overstate this: the New Zealand dollar has been through some pretty big swings in recent years. Against the US dollar, we appreciated by nearly 40 per cent between the beginning of 1993 and the beginning of 1997; and then we lost all of that appreciation (which means that we declined in percentage terms by nearly 30 per cent) over the next 18 months. But on a day-to-day and week-to-week basis, fluctuations in the New Zealand exchange rate have been rather less than those experienced by many other floating currencies - and this in a situation where the Reserve Bank has not intervened in the foreign exchange market for more than 14 years (since we floated in March 1985).

    Why is this? I think it is because financial markets understand that, with a very explicit inflation target, there is a limit to how much movement we will accept in the exchange rate before we look to see some offsetting change in interest rates. No, we do not have an exchange rate target. We have an inflation target. But in a small open economy such as ours, no central bank with a commitment to low inflation can be indifferent to major movements in the exchange rate.

    This is because the exchange rate has important direct and indirect influence over prices. Most importantly, a change in the exchange rate alters the demand for locally-produced goods and services, thereby altering domestic inflation pressures. Of course, the difficulty for a central bank is to know exactly why the exchange rate changes. This has important implications for the appropriate monetary policy response. Thus, if a sharp movement in the exchange rate seems to be related to, say, an adverse development in our external markets, as has been the case over much of the last two years, then we may judge that the adverse external development will have sufficient disinflationary impact on the economy to offset the inflationary impact of an exchange rate depreciation, so that no offsetting increase in interest rates is necessary. Conversely, if the exchange rate change simply reflects some shift in investor preferences, with no justification in the real economy, then inflation pressures will have changed, and some adjustment in monetary policy will normally be appropriate.


    Clearly, this approach does not guarantee that we will make no mistakes. No approach can do that for the obvious reason that monetary policy works with `long and variable lags' and the future is inherently unknowable. But in a world where controlling inflation by targeting monetary aggregates has been abandoned as unworkable by many central banks - and by targeting exchange rates has been abandoned as too dangerous by most of the rest - we believe that the direct and explicit targeting of inflation has a great deal of merit. That does not mean, of course, that we pay no attention to monetary aggregates, and it certainly does not mean that we pay no attention to the exchange rate. It does mean, however, that we look at monetary aggregates and movements in the exchange rate as two of many important influences on the inflation rate.

  4. brilliant analysis. I have long thought the counter intuitive reducing interest rates would solve the problem of rising house prices and an over valued exchange rate. how long do you think before anybody is able to get the point through to bollard

  5. Get a grip.

    Bollard explained why the rates had to go up:

    "Massively increased government spending including Working for Families payments

    Want a sensible mortgate rate? Get rid of the govt.


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