Brian Fallow Reserve Bank low on ammo
There comes a time when a lower OCR no longer achieves the desired result
Reserve Bank governor Adrian Orr has been musing publicly about the possibility of a negative official cash rate. He should drive that thought from his mind with blows and curses.
When his predecessor Don Brash, in the early days of inflation targeting, was out to persuade us that we would all be better off with an honest dollar, he frequently described inflation as the theft of people’s savings.
That resonated with a lot of people who had seen the purchasing power of their hard-earned savings shrivel in the inflationary heat.
How ironic, then, that we now face the risk that the central bank will inflict exactly the same harm — negative real returns to savers — in a bid to push inflation up to the 2 per cent mid-point of its target band.
These days, the deposit interest rates on offer from the banks have a 2 on the left-hand side of the decimal point. After tax, what is left is almost entirely gobbled up by CPI inflation of 1.7 per cent.
And yet, even with an official cash rate at the all-time low of 1 per cent, pressure remains on the Reserve Bank to push the OCR lower still, with global interest rates astonishingly low.
Consider the yields at which 10-year government bonds — a traditional benchmark risk-free rate — are trading. In New Zealand it is just over 1 per cent, less than half its rate just six months ago.
There are 26 advanced economies where it is below 1 per cent, including two large ones, Germany and Japan, where it is negative in nominal terms.
In such a world, the Reserve Bank has little choice but to cut its policy rate and give forward guidance that it is prepared to do more of the same, lest the exchange rate rise and tighten monetary conditions. When banks import more than a fifth of their funding and are far and away the most important source of financing for the economy, what is happening in global financial markets is not something we can ignore.
Reflecting last week on the challenges facing central bankers after their annual gathering at Jackson Hole, Orr was pretty clear about that: “The New Zealand waka is tied off to the global ‘risk-free’ interest rate wharf. When the global rate declines we need more rope, or face a rising exchange rate and tighter financial conditions than needed.”
The bank’s problem, which is becoming increasingly acute, is that
Even with an official cash rate at the all-time low of 1 per cent, pressure remains on the Reserve Bank to push the OCR lower still.
every cut to the OCR brings it closer to something called the effective lower bound.
That is where cuts to the policy rate have lost traction. They are no longer passed through to retail interest rates for depositors and borrowers, because deposit interest rates are only compressible to a point and the same is true of banks’ margins between funding rates and those at which they lend.
At that point, to cut the policy rate is just skidding around on black ice.
ANZ’s chief economist Sharon Zollner has been reflecting on this.
Below the effective lower bound, lowering the OCR may actually have the perverse effect of reducing the net stimulus to the economy, after accounting for the impact on the quantity of credit available as banks resist further compression of their margins, she says.
“Where this effective lower bound may be is not a simple thing to ascertain, since observed credit growth is always a mix of both demand and supply factors,” Zollner says. “But in New Zealand the movement of lending and deposit rate spreads in this low rate environment suggests the OCR may already be not too far from the limits of its impact, on short-term retail interest rates at least.”
Deposits from households and businesses make up around 60 per cent of banks’ funding. Before the global financial crisis it was more like 40 per cent, and the banks got nearly half their funding from short-term wholesale debt, much of it from the international markets which were to freeze on them during the GFC.
To avoid a repeat of that, and the sudden taxpayer risk it triggered, the Reserve Bank imposed a core funding ratio which requires a high proportion, now 75 per cent, of bank funding to come from either deposits or longer-term wholesale debt.
The trouble is that New Zealanders are much keener on borrowing than saving. We have a chronically negative household saving rate, that is, collectively households most years spend more than their income. This makes the experience of countries like Switzerland and Denmark with negative policy interest rates of dubious relevance here.
The effect of the core funding ratio has been to permanently widen the spread between the OCR and retail interest rates. But as Zollner points out, not to a fixed degree; the spread has varied inversely with the OCR.
“In other words as the OCR has fallen (or increased) less of it has been passed on to retail interest rates, as banks compete to retain deposit funding,” she says. “This suggests that [policy] interest rates in New Zealand may already be nearing an effective lower bound in terms of their impact on retail interest rates.”
And one might ask why the Reserve Bank frets so much about current CPI inflation.
Over the past 10 years consumer prices have risen at a compound average annual rate of 1.6 per cent. That is comfortably within the bank’s 1 to 3 per cent target band, albeit in the lower half of it, while inflation expectations are almost always in the top half of the band.
It is worth remembering that its statutory mandate is “stability in the general level of prices”. The Reserve Bank Act does not specify consumer prices; it is the secondary instruments, previously the policy targets agreements and now the monetary policy committee’s remit, which do that.
By contrast, house price inflation has been going great guns, resulting in levels of household debt which are conspicuously high, relative to incomes and to the size of the economy, in both historical and international terms.
So financial stability concerns join the proximity of an effective lower bound as limiting factors on how much lower the Reserve Bank can push its OCR before it starts doing more harm than good.
There aren’t many bullets left in the bandolier of conventional monetary policy.
Hence the governor’s plea last week for both businesses and the Government to just look at how low interest rates are now, and invest.