Monday, November 24, 2008


In a few weeks or so the Reserve Bank of New Zealand will go into a huddle for a few minutes and come out gravely nodding that yes, another rate cut, probably of the order of 100 basis points is in order.

Commentators will point to global credit shortages, falling CPI etc etc. They will probably complain it isn't enough - especially given the differential between New Zealand and Europe and the US. And they will be right but Reserve Bank's wouldn't want to do anything hastily so 100 basis points is about as much as they are likely to do.

Homeowners will be happy because their floating mortgages will come down, exporters will be happy because the OCR props up the dollar and bringing it down will bring the dollar down increasing competitiveness and improving New Zealand dollar denominated revenue.

But my question is this. What difference does fiddling with the Official Cash Rate actually make to the Consumer Price Index?

The other day I downloaded a spreadsheet of the CPI changes on a quarterly basis and another on the OCR adjustments. Averaging the OCR adjustments over a quarter of tradable CPI gave me two columns: One with averaged OCR adjustments and the other with tradeable CPI. I then shifted the CPI one quarter to allow for lag and compared the two using simple linear regression. The r2 result was 0.08 which for those who don't do stats basically means there was no correlation whatsoever (you would need .75 plus to suggest a correlation). If the two columns of numbers were generated randomly you'd get pretty much the same result.

In fact the correlation between CPI and OCR is so weak it practically doesn't exist.

Over the past 18 months we have seen the price of a barrel of oil rise from US$40/bbl up to US$140/bbl and back down to US$40/bbl. That is a massive price spike and just as it did in the 70s and 80s it has generated a huge surge in prices. In theory the Reserve Bank looks through spikes like this looking for basic impacts on wages and other structural affects on demand for money. But that can be hard to do because oil prices have affected food prices and between the two of them real costs have risen astronomically.

Prior to this the Reserve Bank was increasing the OCR in order to cool down the rapid increase in house prices. But looked at in the hard light of day it has to be said that it had no affect whatsoever. The only thing that has collapsed house prices has been a massive collapse in the overly leveraged international money supply that was flooding the market.

So what does mucking around with OCR REALLY do?

When the Reserve Bank was targeting house price inflation it increased rates. The effect of that was to lead New Zealanders to borrow offshore via fixed interest rate mortgages. That increased our national indebtedness to 100% of GDP. Was that really a sensible thing to do?

The high OCR also propped up the dollar. This provided a currency guarantee for those foreigners investing in New Zealand property as a tax dodge (as we have no restrictions on foreign ownership and no capital gains tax). The increased value of the currency reduced the price of imports so we had a surge of credit card expenditure on toys which boomed out of sensible bounds and is now roughly $5 billion or over $1000 per person.

Did the OCR have any effect on housing exuberance? Frankly I doubt it. In December 2007 we learned" QV says that while house prices rose, the increase in the three month period to November this year was 11.4% compared to 12.7% the previous year". Who cares about paying 9% per annum on capital when you're getting returns like that! OCR wasn't even in the ballpark.

The ONLY thing that the OCR does is have an impact on exchange rates. We have been extremely fortunate that dairy returns and oil prices lock-stepped over the recent spike. If they hadn't we would have suffered more than we did. Managing the currency up did reduce the impact of sky-rocketing oil costs but it also meant that exporters were starting to be priced off the international market.

So we avoided some of the pain of the oil spike but we encouraged New Zealanders into foreign and credit card debt. Sounds like a policy for encouraging stupid consumerism not one for encouraging productivity.

Whats the alternative? Well here's mine. Set the OCR at 3% and leave it there.

What will that do?
1. drop the dollar ending consumerism pdq
2. encourage investment both now and into the future because 3% isn't much to beat
3. encourage internal funding of investment/mortgages rather than foreign borrowing
4. discourage borrowing from weirdly leveraged sources offshore
5. deflate current wage and price pressures

And if you want to address inflation address the real causes, e.g artificial land restrictions and government and local government charges which have been a main source of CPI over recent years. Neither of these are things the Reserve Bank Governor can do anything about.

With a fixed OCR the Reserve Bank could get back to overseeing financial institutions which - given the collapse of numerous finance companies (structures not dissimilar to 1929 era banks as it happens) - is something we arguably need a good deal more of in this country.

Radical? Perhaps. But I think worth a look.

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