There are a few things about the way we have run the place over the years that I reckon are not the best. First up, are the side effects of the RB increasing interest rates, on the back of forecast consumer price inflation. My concern has been vindicated recently by research done at the IMF, the font of monetary rectitude. The IMF researchers found that small countries running RBNZ-style policies not only suffered external funds imbalances, but they were also a key cause of the Global Financial Crisis.
How monetary management theoretically works
The theory behind the monetary policy of our RB Act of 1989 states that we reduce consumer price inflation by the RB increasing interest rates. The theory is that higher interest rates choke off some of the demand for credit so people buy less stuff. In time unemployment will increase, so businesses do not have to increase wage rates, and the inflation of the price of goods drops.
The IMF research confirmed my view that the opposite happens
Our analysis over the years has shown that when New Zealand interest rates are artificially increased above those in our main relevant economies, money has flowed into New Zealand, so that the volume of credit has increased. It has not decreased as the theory says it would. The economies whose interest rates we have tracked are Australia, US, UK and Japan.
Recent research from the IMF analysing international data from 1999 to 2007, shows that small exposed economies running monetary management like that of our RB had large capital inflows. They found that the key determinant of the capital inflows was the ‘policy’ interest rate differentials or ‘spread’ between that of the small country and the U.S. short-term rate. The IMF Working Paper WP/10/265 by staffers Ouarda Merrouche and Erlend Niern in 2010 is titled What Caused the Global Financial Crisis? – Evidence on the Drivers of Financial Imbalances 1999-2007. Fascinating evidence! See pages 28-29 and equations at Table 10 Extension: Determinants of Current Account Imbalances.
Direct effects of capital inflows
The immediate impact from the capital inflows is to drive the Kiwi dollar up. These flows are typically ‘hot money, or ‘carry trade’ funds from the apocryphal Belgian dentists, or Japanese housewives and grannies. Their funds must be converted to Kiwi dollars to profit from our artificially high interest rates. These purchases drive up the Kiwi giving us an over-valued exchange rate. The other direct, or ‘accounting effect’ of a net capital account inflow of funds to New Zealand is that, by definition it results in a net current account deficit of the same magnitude. That deficit adds to our accumulated international debt, which is already very high by international standards.
Getting interest rates right
Our present tracking of the interest rates shows that even at our ‘record low’ interest rates, our 90DBB rate is 1.5% above those of relevant economies, and the ‘spread’ is increasing. This first high-level view of the impact of interest rates, and the graph showing that our ‘Spread’ is rising, indicates that we would be doing it right if we allowed interest rates to fall by about 1%.
Yes, you read correctly, our interest rates should be allowed to FALL, not be talked up by interest groups like the banks etc. We could then hold that spread of no more than 0.5% between our 90-day interest rates and those of the main relevant economies. Otherwise we already run the risk that we will kick off another flooding inflow of hot money as we did from 2000 to 2008. We’ll dissect impacts of that inflow next time.
This figure is the simple average of the 90 DBB in Australia, US, UK and Japan. The composition of this is problematic. Funds can come from countries with surpluses or deficit, and are not related to our trading partners. For example I doubt that carry trade funds come from China. The above graph shows that their interest rates actually ARE 1.5% below our “record low interest rates” and likely to go lower, especially for Australia!