by Miriam Bell
In a speech* for the Otago Chamber of Commerce today, Reserve Bank Governor Graeme Wheeler said the scope and influence of monetary policy, particularly in small, open economies, is heavily constrained by economic and financial developments outside the borders.
This means that expectations of what monetary policy can achieve often run ahead of reality.
Wheeler said that nearly 10 years on from the GFC, economies face a difficult global economic and financial climate.
That climate features below-trend growth despite unprecedented monetary stimulus, declining merchandise trade and rising protectionism, very low inflation and interest rates, and high asset prices presenting financial stability risks.
Many of these issues have complex structural elements that are unlikely to fully self-correct as global growth recovers, Wheeler said.
“As is the case elsewhere, there are a range of views about what monetary policy can achieve and how it should be operated.”
These include the views that flexible inflation targeting is not an appropriate framework for conducting monetary policy; that the Reserve Bank should not lower interest rates; and that the Reserve Bank should rapidly lower interest rates.
Wheeler defended the Reserve Bank’s stance on all these views, saying that there were significant risks inherent in them all.
For example, some commentators worry that lowering interest rates accentuates already excessive house price inflation and sows the seeds for a major housing market correction that will slow growth and lead to a recession.
But Wheeler said there are inter-related risks linked to the exchange rate and inflation expectations which could lead to even lower inflation.
It could lead to an even higher exchange rate and a significantly higher exchange rate that is not matched by a rise in commodity prices would likely slow economic growth, he said.
It could also lead to inflation expectations falling and becoming embedded in wage and price setting outcomes which become self-perpetuating and drive headline inflation lower.
Wheeler said the outcome might be an economy with less house price inflation, but with a higher exchange rate, slower growth, and lower inflation.
“If inflation expectations fall too far, it can be very difficult to raise them back up. In such a situation, further cuts in interest rates would be needed to stimulate economic activity and increase inflationary pressures.”
Conversely, aggressively lowering interest rates could be seen as exacerbating imbalances in the economy.
This would not be regarded as sustainable and would not generate the exchange rate relief being sought.
Wheeler said it would be likely to result in an unsustainable surge in growth, capacity bottlenecks, and further inflame an already seriously overheating property market.
It would use up much of the Reserve Bank’s capacity to respond to the likely boom/bust situation that would follow, he said.
“Such consequences suggest that a strategy of rapid policy easing to extremely low rates would be counter to the provisions in the PTA that require the Bank to ‘seek to avoid unnecessary instability in output, interest rates and the exchange rate’ and to ‘have regard to the soundness of the financial system’.”
The Reserve Bank’s decision to further lower the OCR in August does increase the potential risk of further fuelling increases in asset prices, including within the housing market, Wheeler said.
“This is one of the difficult trade-offs that we have had to confront. The risks here are partly balanced by our macro-prudential policy moves that will further boost the resilience of the banking system.”
But the Reserve Bank’s judgement inevitably involved continually balancing a range of risks and uncertainties, he said.
“Our present judgement is that the current interest rate track, involving an expected 35 basis points of further interest rate cuts, balances a number of risks weighing on the economy, while generating an increase in CPI inflation back towards the mid-point of the 1 to 3% target range.
“We remain committed to the inflation goals in the PTA. We do not believe that the outlook and balance of risks warrants a position of no policy change, nor a position of rapid easings.
“If the emerging information and risks unfold in a manner that warrants a change in our judgements, we will modify our policy settings and outlook.”
In the speech, Wheeler did not mention debt-to-income ratios.
*The speech was delivered by Reserve Bank Assistant Governor John McDermott on behalf of Governor Wheeler.
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