Economist calls for stable OCR

Rodney Dickens. Photo / Supplied

The Reserve Bank needs to shift from the Grand Old Duke of York approach, marching the official cash rate up to the top of the hill then marching it down again, says economist Rodney Dickens.

He advocates more of an autopilot approach, keeping the OCR close to a neutral level consistent with the country's sustainable growth rate and the medium-term inflation target.

In the post-crisis environment that is probably around the 3 to 3.5 per cent level, he estimates.

Volatility in the cost of debt makes it hard to run a business, Dickens argues in the final of a three-part critique of the monetary policy framework,

"If you had stable interest rates people might be more willing to take risks."

Since 2002 the Reserve Bank's mandate has been not only to keep inflation in the 1 to 3 per cent range over the medium term but also, in pursuing that objective, to try to "avoid unnecessary instability in output, interest rates and the exchange rate".

Given the flexibility of a medium-term target range, the bank does not need to fine tune the OCR based on dubious economic growth forecasts or, even worse, reactively hike and cut the OCR in response to outcomes for economic growth, which is what it has largely done since 1989, Dickens says.

Estimating the neutral interest rate is no more difficult, he argues, than tasks the bank already confronts - estimating the potential growth rate based on labour force and productivity growth, or the unemployment rate below which wage inflation becomes problematic.

"There is uncertainty about exactly what the neutral rate is but it is relatively small compared with the range of interest rates we have experienced, with the 90-day bank bill yield swinging from 4.5 to 10 per cent."

A stable interest rate policy would not eliminate the business cycle, Dickens says, but it would reduce the risk of the central bank amplifying it.

Smaller swings in economic output should also mean less volatility for the exchange rate. There is a much closer relationship between the currency and growth differentials than interest rate differentials.

But recent experience with developments in the United States reinforces the point that what happens in New Zealand is only half the story when it comes to the exchange rate, he says.

Dickens acknowledges that the Reserve Bank's policy rate has not been unusually volatile in recent years compared with its peers. The Fed funds rate has also moved by 6 percentage points.

But that does not mean that the conventional approach is the right one. "In the US a massive case can be made for the Greenspan Fed's experiment with low interest rates causing the housing bubble."

The resulting global financial crisis is an event of the magnitude that requires a rethink of where the neutral OCR rate is, but smaller international shocks like the Asian crisis, Sars, 9/11 or the first Gulf war are not.

"When these sorts of shocks arise, overseas central banks and sometimes governments respond to stimulate economic growth, which solves the underlying problem without the reserve bank having to kick the housing market around," Dickens says.

"Cutting the OCR in response to these sorts of international economic shocks does nothing to fix the underlying problems, so why create unnecessary volatility in interest rates and output in the domestic economy?"