Brash ultimatum for big spenders

By BRIAN FALLOW and NZPA

How much higher interest rates need to go depends in part on how people respond to the increases that have already occurred, Reserve Bank governor Don Brash says.

Last week, Dr Brash raised the official cash rate for the third time and projected further increases which would push floating mortgage rates to 9 per cent or higher early next year.

"Whether rates need to go as high as we are currently predicting, or potentially higher, will depend very much on how much the economy responds to the gradual increase in rates that we have seen," he said at an Auckland Regional Chamber of Commerce breakfast yesterday.

"If the household sector, being more heavily indebted than it was, reacts to any increase in rates by pulling in its horns and spending less, then by definition interest rates will not need to go up as much.

"Conversely, if we all keep spending ourselves silly by spending at a rate well ahead of our growth and income, which was the case in the mid-90s, it may be that rates will have to rise further than we are now projecting."

He said consumers' perception of rates would determine how high they would go. If people borrowed at the higher rates, but did not save, then they were not seeing those rates as high and rates would probably have to go higher still.

Dr Brash said there was not much evidence yet that increased debt levels had encouraged a slowdown in consumption.

"So it is possible that demand arising from the household sector will be stronger than we now project, requiring firmer monetary conditions than we now project."

Another important factor was the exchange rate, now close to its lowest levels ever on a trade-weighted basis, Dr Brash said.

"To the extent that the exchange rate is weak because of low commodity prices, we know that offsetting the stimulus of the low exchange rate is the disinflationary effect of weak export prices. This would suggest no need for monetary policy to react."

But if the weak exchange rate reflected concerns about the current account deficit or nervousness about the political environment, the bank might well need to raise interest rates to avoid total demand pressures on the economy exceeding its capacity to supply.

The trend rate at which the economy's capacity to supply grows depended on factors over which the Reserve Bank had no control, like growth in the labour force, the quality of the education system, the quality of management decision-making, the openness of the economy, the industrial relations framework and so on, Dr Brash said.

"At the present time, we estimate that the sustainable growth rate of the economy is around 3 per cent per annum. Of course the economy can grow faster than that if it starts from a situation of excess capacity, as was the case in the early 90s and in mid-1998.

"But when that excess capacity is used up, the economy needs to slow to about the sustainable growth rate or risk inflation beginning to pick up."

The decision to raise the official cash rate last week reflected the bank's judgment that spare capacity has largely disappeared after the economy grew about 4 per cent last year.

But what of the danger the bank will hobble the economy by underestimating its sustainable growth rate?

"If the economy is really capable of growing at 5 per cent, and the bank runs policy on the assumption that it is only capable of growing at 3 per cent, then quite quickly demand will fall below capacity to supply and there will be a strong tendency for prices to fall, and the inflation rate gets pushed towards the bottom of the 0 to 3 per cent target range," Dr Brash said.

"And since we take not going through the bottom of the target range as seriously as we take not going through the top, we are forced to ease monetary policy in order to let demand expand.

"In other words, we can't avoid making a judgment about monetary policy and we can't get it wrong for too long before we are forced to adjust our estimate."