Belts tight despite cash rate cuts

By BRIAN FALLOW

Monetary conditions are tighter than they were when the Reserve Bank began cutting interest rates in April, says Deutsche Bank chief economist Ulf Schoefisch.

Despite three cuts in the official cash rate, when the strength of the New Zealand dollar and movements in long-term interest rates are taken into account overall monetary conditions are tighter than they were before governor Alan Bollard started easing on April 24.

What is more, says Schoefisch, they remain on the tight side of neutral, inappropriately so given the extent of the economic slowdown underway.

In an open economy like New Zealand's where imports and exports are each equivalent to around 30 per cent of gross domestic product, the exchange rate has a major effect on activity and inflation.

"The current Reserve Bank model appears to contain an implicit 4:1 trade-off between the effects of exchange and interest rates on growth and inflation, that is, a 4 per cent appreciation of the New Zealand dollar [trade-weighted] has the same effect as 100 basis point rise in 90-day interest rate."

The ratio varies through time. During periods of the cycle when the exchange rate is already very low the extra stimulus from a further depreciation will be a lot less, so little if any offsetting rise in interest rates would be indicated.

In periods when the exchange rate is over the pain threshold for exporters it would take proportionately more relief on interest rates to offset even a modest further rise in the dollar.

But taking a ratio of 5:1 or 3:1 delivers broadly similar results, Schoefisch says.

Deutsche Bank has calculated a monetary conditions index (McI) embodying a 4:1 trade-off and using as the interest rate variable an average of 90-day bank bill rates and the 10-year Government bond rate.

The latter is a proxy for longer-term debt such as fixed-rate mortgages and corporate debt issuance and is influenced by what happens in world bond markets, especially the United States.

Since April 23 the dollar has appreciated 2.2 per cent on a trade-weighted basis.

The Reserve Bank has cut the official cash rate three times since then, pulling 90-day rates down from 5.75 to 5 per cent. But in recent weeks a sell-off in the bond market has left 10-year rates only 17 basis points lower than they were on April 23.

The net effect is interest rates are no longer low enough to offset the effect of the dollar's rise, Schoefisch says.

He offers a range of values for a neutral MCI, in which conditions could be said to be neither stimulating nor constraining the economy.

Deutsche Bank remains unusual among forecasters in calling for three further quarter-point cuts in the OCR by the end of the year.

"The Reserve Bank has been reluctant so far to ease more aggressively because of concerns about the buoyant housing market," Schoefisch says.

"However, strength in that sector may be a comparatively short-lived phenomenon, while the longer-term consequences of the high New Zealand allure on the tradeables sector could prove to be far more serious.

"People get on to the export bandwagon and within a couple of years they get their heads chopped off. Ultimately those kinds of experiences are quite damaging for people's propensity in the next upswing to try exporting."