Aaron Drew has a contrarian view, and says interest rates are too low in NZ if financial stability risks are taken more into account

Aaron Drew has a contrarian view, and says interest rates are too low in NZ if financial stability risks are taken more into account

By Aaron Drew*

In reviews of previous New Zealand business cycles, the RBNZ has found it was too slow to raise interest rates as the economy recovered. As a consequence interest rates had to go higher for longer than would have ideally been the case. We fear history is set to repeat. We also suggest that rates could be justifiably higher if monetary policy took more account of asset prices and financial stability risks than what is part of the RBNZ’s present policy target agreement (PTA).

The formulation of monetary policy is as much art as science.

The RBNZ must rely on very imperfect measurement of the economy, and factor in potential up and downside risks, when setting interest rates.

This year the RBNZ has cut rates on the basis that in its view, very low headline inflation and downside cyclical risks, especially with respect to China, outweigh sectors of ongoing strength in the economy, or the risk that rate cuts will add fuel to the fire of Auckland’s over-valued property market.

Are present policy settings in line with the balance of risks?

Interest rates were last at the levels we see today in the depths of the GFC (which, don’t forget, stands for Global Financial Crisis), when the slump in economic activity and confidence was widespread, and following the second Christchurch earthquake, when it was very unclear how it would impact on confidence and activity. Is it really the case that the economy requires “emergency” policy settings today?

The dairy sector is a key downside risk, but recent increases in dairy prices are encouraging and other sectors remain robust including: tourism, services, construction and many other agricultural exports. GDP growth for the year ended June 2015 was 3 per cent and we expect growth to trough (on annual basis) around 2.5 per cent.

Services sector strong

Data recently released by the BNZ shows that the services sector, accounting for around 70% of all jobs in the economy, continues to expand, as it has since October 2009.

Net migration remains very strong, running at over 60,000 per annum, indicating the confidence kiwis and new immigrants have in our economy. Auckland’s downtown premium commercial office space is set to dramatically expand over the next 5 years (by around 50%), indicating developers are confident that Auckland’s business sector is going to keep expanding. At a broader level, data we have collated from the National Infrastructure Unit and various large corporates suggests that infrastructure spending may top $100 billion (around 40% of current GDP) over the next decade.  

The pipeline of construction and related services is as large as it has ever been. It is not a stretch to suggest that in the Auckland, Bay of Plenty and Waikato regions the main factor limiting growth is not soggy aggregate demand, but rather the pace at which supply capacities are expanded. This “growth triangle” presents a very different picture on the economy than that in national averages. Low global long-term interest rates imply the cost of financing these developments is also very low - it is an opportune time for businesses, local and central government to press ahead. 

So what is the right level of interest rates? A popular guide for policy makers is the Taylor rule, which in the context of an easing cycle describes how much rates should be below “neutral” levels when inflation is lower than central bank targets and when there is resource slack in the economy. We estimate the OCR “should” be around 3 to 3.5 per cent using this guide assuming a “neutral” level of around 4.5 per cent, which is low by historic standards. This calculation takes into account the low level of headline inflation today, and inflation is set to increase over next year as the depreciation of the exchange rate over the past few months feeds through to higher import prices and CPI inflation.

The Taylor rule is only a guide because other factors, in particular the exchange rate, also impact inflation and hence required policy settings. With the exchange rate now around “equilibrium” levels, however, it is not obvious this factor should be dragging rate settings down lower. It can be argued that a higher level of rates would simply encourage the “carry trade” and drive the exchange rate into over-valued territory again. It can also be argued there is no consistent empirical support for this – it is easy for individuals and central bankers alike to tie themselves into knots around cause and effect when it comes to the exchange rate.

Confounding Auckland housing

Low interest rates also confound macro prudential measures by the RBNZ to take the air out of Auckland’s property market. On current data, if anything, low interest rates are encouraging the spread of the housing bubble to other parts of New Zealand. This increases the financial fragility of the economy. We would argue that the real black-hat economic risk to the economy is not a slowdown in China, rather it is that a slump in housing and other New Zealand asset prices  - for whatever reason - wipes out the net equity in highly leveraged businesses, households and the banks, which then feeds through to financial instability and a severe recession.

The RBNZ argues it can separate the policy it undertakes to control inflation from policy measures directed at promoting financial stability. Given the central role interest rates play in both, however, it is not clear such a separation can be made. Price stability and financial stability go hand-in-hand. Recent warnings by the Bank of International Settlements that low interest rates are encouraging excessive asset price inflation and debt build-up are a clarion call to central bank policy makers.

Under the Act which governs the conduct of the RBNZ, financial stability is a subsidiary goal to price stability. When inflation is as low as it is today, and global inflation is trending lower as a result of ongoing productivity improvements and movement of emerging market economies up the value-chain, low interest rates can certainly be rationalised. But should financial stability be the subsidiary goal? History shows that financial crises are incredibly damaging, causing prolonged periods of unemployment and in extreme circumstances hyper-inflation or debt-deflationary periods. In contrast, mild periods of moderately high or low inflation have a relatively small impact on an economy’s growth path. Partly for this reason, there is a lively debate amongst central bank researchers and academics, and within the NZIER, on whether inflation targeting frameworks need to be more flexible and explicitly lean against asset prices when broad-based bubbles emerge. Such a consideration is not part of the RBNZ’s current PTA with the Government, but there is no reason in principle why it couldn’t be included in a future PTA.

We could be wrong about the balance of risks. China may slump into low growth or recession over the course of this year. It is extremely difficult to get a good handle on the Chinese economy for economists based in China, let alone New Zealand. One complicating factor, for example, is that weak headline growth from a reduction in fixed asset investment may still be good news for New Zealand so long as Chinese household spending remains robust. There is no sign yet that weak Chinese activity is dampening the demand of Chinese visitors to visit New Zealand. A key goal of Chinese policy-makers, after all, is to re-balance their economy away from investment to consumption and data over the past year shows that this is starting to occur.

More ammunition

The weak commodity prices we see today are also a boon for households globally - it puts more money in their pockets - and for emerging markets expanding their own infrastructure and supply-side capacities. It is notable, for example, that growth in India has accelerated as commodity prices have fallen and this has enabled more public spending on infrastructure, which is desperately needed in the Indian economy.

Given the complicating factors and the difficulty of forecasting the Chinese economy a reasonable option for the RBNZ is to set policy on what it can have the most confidence in – its ability to read and react to what is happening in New Zealand.

If this and asset prices factored more into the RBNZ’s monetary policy decisions on interest rates, we argue interest rates would be higher today, giving the RBNZ more ammunition should the downside risks actually materialise.


Aaron Drew is a Principal Economist at the NZIER and head of Auckland business. You can contact him here.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

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Unfortunately, the RBNZ is captured by a government dependent on bank funded "liquidity" executed under the cover of a self imposed regime of inflation redefinition to underpin the unholy alliance of politically expedient wealth redistribution.

do u write poetry.... ?? U have a way with words... :)

No, but thank you for your kind encouragement.

You mean he has the ability to string garbage together and make it look like um, prose? LOL....oh dear.

John Key has the ability to string gargage together and make it look like policy....(change flag...include red peak or not.....get pandas for zoo... bars open early for world cup games....:)

There is no point in pretending that monetary policy can be separate from fiscal policy. It is an arbitrary distinction that exists in theory but not in practise. The government, in order to appear prudent, and to pressure the civil service to perform, has chosen to balance the budget when cpi inflation does not exist. This is a monetary policy decision as much as it is a fiscal policy decision.

If the government wants 2% inflation (it's in the target for the RBNZ) the obvious place to achieve it is to run a 2% budget deficit. By trying to balance the books they force the RBNZ to keep interest rates too low. Lowering interest rates is identical to putting up asset (ie house) prices.

Secondly, the result of our immigration policy is to also put up house prices and to depress wages.

The confusing to me is why the government has chosen this path. Is it for personal benefit, either in terms of getting re-elected or gains in house prices? Is it due to poor advice?. Is it because of inertia, the slow result of poor policy direction over many years?

wow...Indeed, the Govn is sitting on the sidelines letting the RB do the lifting. Well, I suppose at least they are not doing the austerity thing and really braking the economy. You are assuming that the Govn can indeed spur the economy and get some acceleration. Conventionally this should be the case but with an OCR at such a low rate you have to wonder if any damn thing will make a difference, I really suspect not. " immigration policy" I agree here, JK says its debatable? I cant see how this is so.

"is why the government has chosen this path" you and me both, about all I can say is they could have made it a lot worse so I suppose brownie points for not doing as much damage as they could have. Also would Labour have been any better? hard to see the answer as yes, maybe we should count ourselves lucky.

Chosen Path

Bewildering. The only plus in this path is an early illusory gain followed by a very obvious delayed pain - about 5 years down the track - exactly like a company inflating profits by bringing forward next years sales and postponing this years costs into next year

Personal benefit.
When they get voted out they'll have nice cushy jobs to go to, with all those businesses they gave squillions to during their term in government.

Roger - when you state that the government "has chosen to balance the budget when cpi inflation does not exist", I feel that this should be qualified. Like most western governments, budget "balancing" has not occurred in any serious capacity in the last 50yrs+, and they are unlikely to start anytime soon. Taxes keep rising and government spending keeps rising at an even faster pace. The only viable end point is that government debt must be defaulted on at some point, and this takes care of the never ending deficits in one hit. Anyone foolish enough to invest in government debt/bonds deserves to take a haircut, for the greater good. We are heading down the European path, which is an exciting prospect when you look at some of the impressive numbers they have attained:
- The French goverment controls around 54% of French GDP. Another 20% of NZ GDP and we'll be in that elite group...a tantalising prospect in any socialist's book;
- The 28 countries in the EU are about 7% of the world's population, yet the EU spends 54% of all the global social welfare spending. This great result didn't come about by accident, and I feel that as NZers demand and deserve more spending on health, education, etc, we might be able to achieve the rebalancing of the current inequalities that we have.
Some economists (the minority), go on about how the current low interest rates are destroying pension funds and savers. They fail to realise that the government will make up for these losses and support our pensioners and old age savers, so this is really no issue.

Well where to start on your comment, it seems all wrong.

a) balance budgets, Cullen paid down debt that needs a surplus so sort of a balance really.

b) There is virtually no signs of taxes keep on rising. Here in NZ in 2008 we had a tax cut and a GST rise and that is about it. So one rise and one drop hardly a "keep on"

c) never ending deficits, um see a)

d) Govn bonds, well they are way safer (especially as a sort term thing, ie 6 months) than any other investment I can see around me, or would you care to enlighten us on what is better?

e) the world is heading down the EU path, NZ actual has a contained public debt at a reasonable rate.

f) What ever France gets up to is well up to France, hardly a worry here in NZ, besides which the for ever claiming from the right for decades on France's demise has not eventuated as yet.

g) Some economists on pensions, well not really, id say it is a majority, but then teh same majority missed the GFC coming.

h) Govns simply wont be able to fund pensions or at least the expected bailouts, see "peak oil" for that guarantee so I think yes it will be a huge issue.


(b) was the tax cut compensation for the GST increase?

Aaron Drew glosses over the exchange rate variable in the mix, suggesting there is "no empirical evidence" linking exchange rates and interest rates, and he therefore discounts the link because it is inconvenient for his argument. I would have thought the actual evidence over the last few years is absolutely compelling.
Given it is compelling, then our relative interest rate compared to other countries is very important, and I think the key mistake the RBNZ made last year was in raising rates in a ZIRP world.
I was also disappointed when the Fed did not raise rates last week, but given they didn't, our relative position needs to stay low.

Exactly. The currency level, interest rates and budget deficit/surplus are interlocked by accounting identities. Michael Pettis is the expert here.

It is very easy to create inflation by running a budget deficit - that is why the RBNZ was given partial independence. The consequence is a lower exchange rate, which leads to job growth in export facing sectors which puts pressure on the RBNZ to put up interest rates. The order is important.

Tinkering with interest rates to try to put inflation up can only result in asset inflation. Put another way, raising interest rates above the natural rate is an effective way to dampen inflation. Putting them down below the natural rate creates asset inflation.

The RBNZ is clipping the ticket on money that doesn't exist....but for a keyboard entry at the bank.....and the banks get to clip the same ticket too......and this economist Aaron Drew is concerned they are not clipping the book entry item enough!! How does putting the costs up of something that doesn't exist assist in financial stability surely it is this very problem that lead to the financial crisis in the first place!!!

Regulators making money out of thin air.!!!