Brian Fallow: Sooner or later there will be a reckoning

When it comes to further measures to stimulate the economy it looks as if it is the Reserve Bank which will have to do the heavy lifting.

That was the advice of the OECD last week, which saw some scope for further monetary easing but considered fiscal expansion to be already at the limits of prudence.

The reason is that the country, as distinct from the Government, is already up to its nostrils in debt, with net international liabilities equivalent to 93 per cent of gross domestic product.

The Prime Minister seems to agree. John Key told the Financial Times last week that the Government "cannot afford" any further fiscal stimulus.

"We don't want to do anything that would precipitate a [credit rating] downgrade."

So how much more can the bank cut the official cash rate, and what options does it have beyond that point?

Most market economists expect the bank to cut the OCR another 50 basis points to 2.5 per cent next week.

Swaps market pricing is about equidistant between a 25 and a 50-point cut. In its monetary policy statement last month the bank indicated it saw the OCR bottoming out at 2.5 per cent in this cycle.

"If we were to see worse conditions it could go a little lower," Governor Alan Bollard told MPs on the finance and expenditure select committee.

"But we would want to see real reasons for it to go much below 2 per cent."

The lower the OCR goes the less relevant it becomes to the interest rates banks have to pay depositors and overseas investors for their funding.

"There has got to be enough in it for them to still show interest in supplying the New Zealand economy [with credit]."

The point is that New Zealand's systematically higher interest rates mean that the OCR level at which conventional monetary policy - conducted through the raising and lowering of an overnight interest rate - loses traction will be well north of zero. Other central banks, notably the US Federal Reserve and the Bank of England, have already reached the point where conventional monetary policy is impotent and have had to resort to unconventional measures, normally called quantitative easing or, more simply, printing money.

Central banks buy interest-bearing securities like Government bonds, which increases the amount of money banks have available to lend and puts downward pressure on longer-term interest rates.

It does not have to be Government debt they buy. It can be corporate debt, mortgage-backed securities or anything else they choose to exchange their product (money) for.

Does it work?

The US Federal Reserve thinks so. Its vice-chairman, Donald Kohn, in a speech last weekend said "the announcement of our purchases of mortgage-backed securities and Treasury bonds have reduced mortgage and other long-term interest rates appreciably, by some estimates as much as 100 basis points".

Westpac economists, in a note on quantitative easing entitled "The Money Tree", argue that traditional monetary policy tools are likely to keep working in New Zealand longer than many other countries.

Rates were a lot higher to start with and because the banks are in better shape official rate cuts have been passed through to mortgage rates to a far greater extent than equally large cuts in countries with dysfunctional banking systems.

Just as well, because as they also point out there are some major catches to quantitative easing.

One comes when central banks want to unwind the transactions and sell the assets they have accumulated.

They will wait until the economy has recovered, by which time yields will have risen to more normal levels and the price of the securities correspondingly will have fallen, leaving the central bank with a loss.

"Depending on the scale of the quantitative easing undertaken this could be an enormous hole in the government books further down the track," the Westpac economists say.

Another consequence, which economist and Nobel prizewinner Paul Krugman points to, is that selling the bonds at market prices will not be enough to withdraw all the money now being created.

But the bigger risk the Westpac economists see is the potential for unleashing a serious inflation problem.

Quantitative easing is not necessarily inflationary if it is unwound in a timely and orderly way. But that may be easier said than done.

And as with conventional monetary policy there is always a risk that central banks will keep monetary conditions too easy for too long.

"The temptation will be to wait too long, to be sure that the recovery and asset markets are robust, before unwinding the stimulus by dumping the assets back into the markets. Indeed a commitment to keep quantitative easing in place well into the recovery is a necessity to make it effective."

Kohn tried to assuage concerns that these policies would lead to a future surge in inflation.

The key to preventing inflation would be to reverse the programmes, reduce the Fed's "skyrocketing" reserves and raise interest rates in a timely fashion.

"The size of our balance sheet will not preclude our raising interest rates when that becomes appropriate for macro-economic stability," he said.

This would be more reassuring if the Fed's tardiness in raising rates after the last US recession had not inflated the bubble which has now so messily burst.

The Fed is debating whether to adopt an explicit numerical target for inflation, Kohn said.

It is telling that even the mighty Fed feels it necessary to reassure the markets about both its commitment to price stability and its independence of the government.

The bigger picture is that governments are running up prodigious debts in a bid to escape the rip tide in which the world economy is caught.

The G20 communique on April 3 put a figure of US$5 trillion ($9 trillion) on the major powers' collective fiscal stimulus so far.

At some point hard decisions will have to be made about allocating the cost of that increased debt.

It would be nice to think that politicians will be up front about it and say which taxes must go up, or stay up, and which spending must be cut, and take the electoral consequences.

The risk is that they will resort surreptitiously, if they can, to the "unlegislated tax" - inflation.

That would shift the burden of governments' burgeoning debt to savers and the low-paid, the economically weak who have no one to pass increased costs on to.

It is for that reason that inflation has been called the cruellest tax of all.

So the modern model of independent, inflation-targeting central banks is set to face its most severe test yet.