KEY POINTS:
This week Reserve Bank Governor Alan Bollard sits downs with his monetary policy committee to decide what to do with interest rates.
In some ways it's like trying to crack a nut with a rubber ice pick. You're hoping when you hit the nut it'll ricochet into something
hard, then crack.
Monetary policy is meant to create optimal conditions for long-term economic growth by keeping prices stable. The way it's supposed to work is that interest rates encourage people to spend less and save more, in turn reducing demand and lowering inflation.
But these effects take time; it's estimated that interest rates take around two years to make a dent in inflation.
As with all economics, the local situation determines how closely actuality matches theory.
In New Zealand, some important issues combine to further soften the rubber ice pick. For example, we're pretty poor at saving regardless of the interest rate.
Also, we're a small, open economy: our high interest rate continues to attract international investors, leading to a high currency, which hurts our export-led businesses.
As it is consumers, not businesses, fuelling the demand for consumables, being the short-run brake on inflation is a heavy - and misaligned - burden for the productive sector to bear.
Under the RBNZ Act, the governor has just one target - the CPI. While the role of the bank is ultimately as risk manager for the economy, the governor has limited ability to factor in possible events to interest rate decisions.
In other words, the act itself may be preventing the bank from doing its job while inflation pressure remains.
Oil costs, for example, are high, yet not all inflation drivers are relevant to interest rates. (Given that gas prices act as a real brake on demand, some have suggested the governor be given control of excise taxes on petrol to reflect this reality.)
New Zealand firms face five main risk factors which, combined with current global market conditions, create a potential tipping point where a lot of little things come together to create the potential for a recession:
* Labour markets in all sectors (helped by recent immigration cutbacks) are tight, exerting upward pressure on wages with no concurrent increase in productivity.
* Interest rates are high, making it costly for firms to invest in capital - essential for productivity growth and non-inflationary expansion.
* The exchange rate stays high.
* Our sharemarket has lost significant value in line with other global markets. While this is partly caused by global investors selling from all-equities positions, it's also a reflection of the medium-term outlook here.
* Other pointers to slowing domestic growth include the medium-term commodities outlook coming off all time global dairy price highs, and our weakening housing market.
Taken together, these are signals decision-makers can't afford to ignore.
Moreover, if the US Federal Reserve cuts interest rates by up to 100 basis points over the next 12 months, as expected, the differential between us and the US will be more than 100 bps higher than today's 400 bps gap.
If this occurs, money will flood into New Zealand seeking yield, pushing our dollar higher.
Interest rates will be too high to borrow so businesses won't invest, stalling (already low) productivity growth.
Exchange rates of yet higher levels will finally rip the guts out of our export and manufacturing sectors - the growth engines of our economy.
This has the classic makings of a tipping point. It's a scenario call: if the RBNZ raises rates this year it will, in my view, be the catalyst to push us into recession in 2009. If it doesn't cut rates, the same may very well occur.
MANAGING RISKS
On the positive side, steps can be taken to avoid the tipping point scenario.
* The RBNZ should attach real weight to the medium-term economic context and, as a prudent risk manager, cut interest rates gradually over the next 18 months.
The lower the rates in the rest of the world, the more imperative this is and the sooner it should happen.
* The Government should rewrite the Reserve Bank Act (recognising that it works well in stable, ordinary situations, but lacks flexibility), and modify the Policy Targets Agreement. The fact is we live in a globalised world. The act, drafted to ensure maximum transparency and minimum political fiddling, takes a strict CPI inflation target. We believed this would buy us international credibility. It did.
Now we can afford to adopt a more nuanced approach, balancing inflation targeting with long-term growth. The PTA should give the RBNZ the same twin long-run goals as the US Fed has: price stability and economic growth.
* If abandoning a price target feels like a step too far, a more palatable option might be to aim at a medium-term target of around 2.5 per cent.
* As the election approaches both main parties must refrain from lolly scrambles. Come September, if voters expect sweet treats the chance of inflationary stimulus from the Government in 2009-10 is 100 per cent, and the RBNZ will have to raise rates.
Electing the politicians who throw the most lollies will hit voters right where it hurts: in the bank balance.
But elections wouldn't be elections without short-term sugar highs. Here are a few alternatives that won't rot our teeth or compromise the RBNZ's effectiveness:
TAXES
* Cut corporate rates to 25 per cent. This will increase our competitiveness and improve our ability to pay in line with Australia.
* Deal quickly with some of the competitive tax issues such as imputation credits and withholding tax.
* Tie some personal tax cuts to savings, potentially by putting the cash into KiwiSaver.
(This would be a good time, with markets relatively low, to put money in for the long term.)
* Make some modest changes in the personal tax rates, but only to non-inflationary levels.
IMMIGRATION
Virtually all employment sectors are feeling the squeeze. The medium-term viability of all our companies depends on a ready supply of skilled people.
Younger workers struggle to enter under our points system, and tend not to have enough wealth to buy houses. Therefore they can improve productivity while not driving inflation.
As an article from the New York Times states:
"Everyone wants to know who is to blame for the losses paining Wall St and homeowners."
In New Zealand we can add "exporters and businesses".
But if we make sensible decisions to cut rates, reform the Reserve Bank Act and hold back on the lollies, our economy will be held to have been managed by safe, responsible hands.
* Mark Weldon is chief executive of NZX, the New Zealand stock exchange.
