Former Economics Editor of the NZ Herald

Brian Fallow: Monetary policy attack off target


Labour's desire to tame the exchange rate could end up hurting the poor and powerless it aims to help.

If a lower exchange rate meant faster-rising domestic and import costs, exporters might be no better off. Photo / Mark Mitchell
If a lower exchange rate meant faster-rising domestic and import costs, exporters might be no better off. Photo / Mark Mitchell

A fundamental reason New Zealand interest rates and exchange rates are systematically higher than we might wish is that collectively we do not save enough ... to fund the economy's investment needs.

Labour's finance spokesman, David Parker, when arguing the monetary policy framework needs to be changed in some way as yet unspecified that would make life easier for exporters and firms competing with imports, is fond of invoking the International Monetary Fund.

He really should stop doing that.

"The IMF thinks that New Zealand's economy would be improved if we had broader targets for the Reserve Bank, so that instead of putting the primacy of control of inflation ahead of all other matters of economic management, it would have a broader set of objectives, including the health of our export sector and our exchange rate," Parker told his fellow MPs in a speech late last September.

"The IMF chief economist Olivier Blanchard thinks that monetary policy that focuses on inflation targeting ahead of all other aspects of economic management is past its use-by date."

But that was five months after Blanchard wrote this: "Should central banks have two targets, the inflation rate and the exchange rate, and two instruments, the policy rate and foreign exchange intervention?"

Would that be feasible and desirable?

On feasibility the answer was "almost certainly no for small, very open advanced economies - say New Zealand", Blanchard said.

And on desirability: "Intervention is typically not desirable when it is aimed at resisting an appreciation driven by steady capital flows rather than by temporary swings (that is, when the movement in the exchange rate reflects a change in underlying fundamentals rather than, for example, temporary swings between risk-off and risk-on)."

The IMF uses similar language in a paper it published this week, Monetary Policy in the New Normal.

The Reserve Bank already has authority to intervene in the foreign exchange market. It does so very rarely, though, in part because it recognises the limits on its ability to impose its will, by way of selling or buying currencies, in a market where more than 100 billion New Zealand dollars are traded every day.

At best it can hope to shave the peaks and troughs off the cycle. The mandate to place large bets with public money is, quite rightly, constrained.

So instead of changing that, perhaps the plan - and in the absence of any clarity from Labour we are speculating here - is to alter the central bank's mandate in some way which would require it to keep interest rates lower than needed to keep inflation low and stable, in the hope that would deliver a lower exchange rate.

"There is no doubt the Reserve Bank would make different choices if its objectives were broader than giving primacy to inflation targeting," Parker said in the same speech. "If other matters of economic management were given equal weighting, including the health of our export sector and our ability to earn enough in our exports so that we did not have a current account deficit, well, you know, New Zealand would be better off with the Reserve Bank using the tools at its disposal differently."

There are several difficulties with this.

The first is that when it comes to international competitiveness it is the real exchange rate that matters.

If the price of a lower exchange rate were faster-rising domestic costs, as well as higher imported costs, exporters might well be no better off.

And the rest of us would undoubtedly be worse off.

It is a paradoxical feature of this debate that it is a Labour Party which is sanguine about running risks with inflation, when it is the poor and economically powerless who suffer most in an inflationary environment.

Just how monetary policy is supposed to weaken the international value of the New Zealand dollar without weakening its domestic value, and with it the purchasing power of wages and savings, is a key question their policy will have to explain.

The second difficulty is that it is simplistic to assume there is some reliable mechanical connection between interest rate differentials (the other end of which no one in New Zealand has any influence over in any case) and the currency. Clearly it is a factor, but not the only one.

A chart in the March monetary policy statement shows a tight correlation, at least since 2000, between the exchange rate and the terms of trade. Right now we have the most favourable terms of trade for 40 years, though recent declines in dairy auction prices suggest the peak might have passed, and the dollar is high.

Differentials in expected economic growth rates matter too and New Zealand's cycle is not always in sync with its trading partners'.

If we are currently doing better than most developed countries and the exchange rate reflects that, it is not something you would want the Reserve Bank to hobble, would you?

The third difficulty is that if the central bank is given two or more objectives when it conducts monetary policy and none is accorded primacy, what is it to do when they conflict?

If the choice of which should be the dominant consideration at any given time is left to the central bank, the question of who gets to decide becomes crucial.

If decision-making on interest rates is moved from the Governor (in practice in conjunction with his two deputies and the bank's chief economist) to a committee with a majority of politically appointed external members, what would happen if the latter outvoted the central bankers? That could get messy.

But if the priesthood of central bankers dominates the committee, would that be any different from what we have now?

Where central banks have a dual or multiple mandate they tend to quantify the inflation target but are wary of putting any numbers around the other target(s) so that any tension between them is not put into too sharp a focus.

In the end, a fundamental reason New Zealand interest rates and exchange rates are systematically higher than we might wish is that collectively we do not save enough, by a long chalk, to fund the economy's investment needs.

We have been reliant, one might say abjectly reliant, on importing the savings of foreigners for 40 years.

The current account deficit is the measure of that gap. Parker is right to be concerned about it. Policies to boost saving (by both the household and government sectors) are clearly needed.

But in the meantime, to quote MIT economist Ricardo Caballero: "When you run a fever, don't attack the thermometer. Deal with the real issues."

- NZ Herald

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Former Economics Editor of the NZ Herald

Brian Fallow is a former economics editor for the New Zealand Herald. A Southlander happily transplanted to Wellington, he has been a journalist since 1984 and has covered the economy and related areas of public policy for the Herald since 1995. Why the economy? Because it is where we all live and because the forces at work in it can really mess up people's lives if we are not careful.

Read more by Brian Fallow

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