Brian Fallow: Monetary policy needs mates

5:30 AM Thursday Sep 20, 2012

It has become one of the major economic debates of the day: What can be done about the high kiwi dollar?

And would changing the Reserve Bank's statutory mandate, which gives primacy to curbing inflation, do any good?

Those calling for a change to the monetary policy framework include the Labour Party, the Greens and New Zealand First.

They point to New Zealand's chronic current account deficits, the resulting mountain of foreign debt, and the stagnation of the tradeables sector for the best part of a decade now as evidence of a serious structural problem.

They see an exchange rate which repeatedly hammers exporters and firms competing with imports as a cause, and not just a symptom, of that structural weakness.

They say it is time to see inflation targeting not as Holy Writ but as a doctrine which has passed its use-by date.

The orthodox view, by contrast, argues that the collateral damage to the tradeables sector is being inflicted not by what the Reserve Bank is doing but by the monetary policy being run by the major players - the US Federal Reserve, the European Central Bank, the People's Bank of China and so on.

It is King Canute-like to imagine in such times that New Zealand monetary policy settings, or the framework in which the central bank operates, make a difference.

We are part of a global economy which has all sorts of problems and the exchange rate is just a channel through which they are transmitted to us.

Better, say the defenders of the status quo, to focus on things within our reach - micro-economic reforms and investment in infrastructure and skills which would assist New Zealand firms' competitiveness.

Before looking more closely at these arguments it is worth noting that a high dollar is not all bad.

It makes imported goods cheaper. That reduces the cost of living for households, and it reduces a lot of input costs for businesses, including exporters, like transport fuels, raw materials, components and capital plant.

And all else being equal, a higher exchange rate will mean lower interest rates.

The most subtle of the political critics of the existing framework is Labour's finance spokesman David Parker.

He found, he says, in a recent international road trip, support for his view that the regime needs to change from such luminaries as International Monetary Fund chief economist Olivier Blanchard and Nobel laureate Joseph Stiglitz. Even at the OECD, that temple of orthodoxy, he encountered a range of views.

Parker points to the fact that New Zealand Inc is up to its neck in debt to the rest of the world - and will soon be up to its nostrils - as a result of chronic current account deficits, which have to be funded by borrowing offshore or selling assets.

"If we don't cover the cost of imports and interest from the value of our exports, then our country's balance sheet gets worse every year."

The same applies to other countries. "And that is one of the main driving reasons they do more to protect the competitiveness of their exports, and export jobs."

Parker is sceptical of claims that inflation targeting is international best practice.

The only other country which really still adheres to it, he says, is Australia, adding that even after a prolonged minerals boom it still has not managed a current account surplus and suffers from a bad case of Dutch disease.

But let's suppose the Reserve Bank Act was changed so that price stability was no longer the primary objective and the bank was in effect free to focus on the exchange rate when that seemed the more pressing problem.

How would it do that?

Here, Parker gets all non-committal.

"I want them to consider all levers. I'm not going to give you the answer that is their duty to give. I am not going to say the Reserve Bank should be doing x. That is not my role. But I am saying that a full range of levers ought to be available to them and they would choose to react differently if they had to look at more than giving primacy to inflation."

But he entirely accepts the point Reserve Bank governor Alan Bollard made, appearing before Parliament's finance and expenditure select committee last week, that cutting the official cash rate in a bid to lower the exchange rate, when it was not a credible response to weakness in the economy, would be something the markets would see through and expect to be reversed, and could prove counter-productive.

Bollard acknowledges the exchange rate as an enduring problem from the standpoint of rebalancing the economy and stabilising its external accounts.

But the exchange rate is influenced by a number of factors and different factors are dominant at different times.

Right now it is not interest rate differentials or commodity prices but money printing by major central banks and the prevailing "risk on/risk off" mentality in the financial markets.

When the news out of Europe or the US is positive, the markets regain their appetite for risk and pile into riskier assets like the New Zealand dollar; when the international outlook darkens again the reverse happens.

"A lot of the drivers of exchange rate pressure are actually international events, with huge flows as a result of quantitative easing, exchange rate policies of other large countries and many of the 'risk on' drivers around the eurozone," he told the MPs. "If those are the drivers, there is not much New Zealand can do to influence things."

But fatalism is not the end of it. Others need to join the tug-of-war team the bank anchors.

What monetary policy needs is not multiple objectives or a different focus, but more "mates". Other areas of policy - fiscal policy, tax policy and competition policy for example - need to reduce the work that interest rates have to do.

Hence the interest, too, in equipping the bank with "macro-prudential" tools which it can use to dampen too-rapid credit growth or emerging property booms.

It has been too easy, a cop-out really, for governments to subscribe to the myth of central bank omnipotence and outsource the task of stabilisation entirely to them. Equally, it is too easy to blame perfidious foreigners not playing a straight bat. Much of the blame lies at the door of our own improvidence.

The current account deficit is not just about exports, imports and the country's interest bill.

Economists can show, with a bit of algebra, that it is the gap between investment and domestic saving.

The more we rely on importing the savings of foreigners, the more demand there is for New Zealand dollars. And the less we are in a position to dictate the terms on which we will accept them, through capital controls.