‘An economic downturn is here. We just don’t know how deep the hole is’
Central banks are cutting interest rates, trying to ward off the economic consequences of coronavirus.
Good on them but we need to be realistic about what monetary policy can achieve and what we should expect central banks to do. Fiscal policy needs to front up, and quickly. The Budget is too far away.
Central banks are low on ammunition and going into a gunfight with a switch-blade. Some countries don’t have much more than a cap-gun. They are up against it.
New Zealand’s Official Cash Rate (OCR) was cut 575 basis points during the global financial crisis. It’s one per cent (100 basis points) now. We don’t have many bullets left in the chamber and need to be careful what we fire at.
The Reserve Bank was criticised (by banks and others) for wanting banks to hold more capital to strengthen the resilience in case turbulence appears. Just as well the Reserve Bank stood firm.
For years we have been worried about how central banks will be able to handle a turn in the global economy. That possibility is now reality. A downturn is here. We just don’t know how deep the hole is.
Central banks deal with demand. They cut rates to stimulate it. Raise rates to constrain it.
Coronavirus is first-and-foremost a supply shock, albeit with spill-over into the demand side of the economy as confidence disappears. The global economy has been vulnerable for a while and coronavirus has simply acted as the trigger.
Lower interest rates are not going to make coronavirus disappear. It will not fix supply chains. It won’t shift people’s desire or ability to travel in the current environment. It can’t summon up more refrigerated containers or clear port congestion.
Goods ordered – if you spend – need to be available. Why buy if your item is not going to turn up? An interest rate cut is not going to conjure up those items you need at the building site.
Apart from the challenges associated with low ammunition, a quick look at some of the channels monetary policy (lower interest rates) work in highlights problems.
❚ Lower interest rates work by stimulating investment and spending. Lower interest rates discourage saving. We bring forward spending plans. A lower cost of capital encourages investment.
Problem 1: You need the supply chain to be functional for a spending uplift to
take hold. Why spend money on a fridge if you are not sure when it will be turning up? Will those items turn up at the construction site? What about the plant and equipment?
❚ Lower interest rates put money in people’s pockets because it reduces interest payments. That stimulates spending.
Problem 2: Banks are constrained how low they can take mortgage rates because deposit rates (the other side of bank balance sheets) have a floor or level at which investors find it unpalatable to put money in the bank. Household term deposits fell over the second half of 2019, so we appear at that juncture.
❚ Lower interest rates lower investment hurdle rates and make investing more attractive.
Problem 3: The price of money is already low and hardly a barrier. Access to money has become a major issue for the commercial and agriculture sectors. Accessibility is likely to become more difficult as economic conditions deteriorate. Credit gets rationed. This is what we call the credit channel of monetary policy.
❚ Lower interest rates stimulate asset prices, and most notably in New Zealand, house prices. Rising wealth encourages spending. Business values increase as discounted cash-flows rise in a lower interest rate environment. Rising asset values relative to their replacement cost encourages
investment.
Problem 4:
Monetary policy aims are going head-to-head with financial stability risks associated with higher house prices. Housing affordability is households’ key concern. Surging house prices contribute to income inequality. Liquidity is going to be key for businesses over the coming months and through 2020. Firms will likely be hoarding cash not deploying it. Layoffs will appear.
❚ Lower interest rates tend to be associated with a lower New Zealand dollar which supports the export sector, reduces import activity and boosts growth.
Problem 5: Everyone wants a lower dollar in the current environment, so you need to cut your OCR just to stop your currency going up. Witness the NZD/AUD, which stands at just below 0.96. It also doesn’t really matter where the currency is if the supply chain is disrupted and you can’t get a container to ship the goods in.
Monetary policy is not impotent but it doesn’t have the same punch in the current environment.
Of course, monetary policy works through other more subtle avenues. Stabilising sentiment when markets are on edge is a key one. Central banks will always try to pour water on a fire, even if they only have a bucket at their disposal. But the basic premise remains that monetary policy is near its limit.
Yes, the Reserve Bank needs to join the chorus of central bank action. But let’s not waste too many bullets battling challenges monetary policy cannot influence.
Meantime, the ball is in the Government’s court. The Budget is too far away given how fast things are unfolding.
The Reserve Bank of New Zealand needs to join the chorus of central bank action. But let’s not waste too many bullets battling challenges monetary policy cannot influence.