SIMON On Thursday the Reserve Bank announced in its quarterly monetary policy statement that the official cash rate the OCR would rise by 25 basis points to 5.75%. Of course mortgages have already followed suit but has the housing market already peaked and was a rate rise needed. Late yesterday I spoke with Reserve Bank Governor Alan Bollard and began by asking him to explain what the bank's monetary policy was trying to achieve.
ALAN Monetary policy is really that part of economics that's trying to stabilise the economy. Left alone an economy can go through a number of cycles, it can get quite volatile depending on what's hitting it from inside or outside and monetary policy is there to try and stabilise that to give an environment that people can get on and do their business with most certainty. In New Zealand we focus our monetary policy on price stability so the Reserve Bank actually says that it's got a primary objective of price stability and then we go further and in New Zealand we have what we call a Policy Targets Agreement, it's a contract between me and the Minister of Finance, and it says that I've gotta do my best to keep inflation within a range of 1 to 3% on average over the medium term but it's got a few other parts to it that are quite important. It says do your best to minimise unnecessary instability in things like the exchange rate and interest rates and output as well.
SIMON What are the critical factors then making it necessary to raise the OCR now?
ALAN Yes well our decision recently to raise the official cash rate was very much based on the fact that we will go out and do a forecast of the economy and compared to where the forecast is for example we can't actually tell where things are precisely even at the moment, so we try and work out by talking to a lot of businesses and looking up a lot of data where the economy's at, we have forecasted out into the future, we know some things we can forecast quite well but others we really have to assume and we're getting a picture this time of quite a strong economy under a lot of pressure with the economy hitting capacity constraints in a number of areas and when we factor that into our forecast for inflation we start to get a picture of quite significant cost and price pressures starting to build up, not there at the minute, at the moment inflation figures are below 2% but pretty clear track that they're starting to come in over the rest of this year and in order to counter that we have felt it necessary to tighten monetary policy that is increase the official cash rate and that means the banks would then use that to set their own interest rates lending to customers and so on and we've also indicated that looking forward there a possibility of one or two further increases out there if the conditions that we think are there continue to prevail.
SIMON You referred to capacity constraints what exactly do you mean by that?
ALAN Yeah we mean an economy that's been growing very strongly, actually we've almost been over 3% growth for five years now, that's a really strong record of economic growth and it's a very good sign for an economy, but at the moment we're starting to see in our business surveys and our other surveys and other data that we have got businesses who complain they can't get staff, they're having to pay a lot more for them, they're very tight on capacity, so often they just can't get in the sort of components they need or the materials they need or in their own plant they're running to full capacity. As I say we use a lot of indicators to judge that and at the minute some of those are running as strong as they have for 20 or 30 years. We've got unemployment right down which is again very good, it's as low as it's been for 14, 15 years but actually that also means that the labour market is now very tight as well and when that happens an economy is effectively running hotter than it can afford to and you start to see those capacity constraints showing through in cost increase, price increases, and when that starts to get entrenched in an economy is when damage gets done and we're determined that won't happen and that's why we've taken this action.
SIMON The bank economists' reaction generally though have been quite mixed, why are you so hawkish now and going forward?
ALAN Yeah well because we've got a picture of inflation out there into the future if we don't take this action. As it is on our forecasts we think inflation is next year going to go above 3%, we're not panicking because of that because the Policy Targets Agreement says you worry about it going above that on average over the medium term and we don't think it's going to do that, but if we didn't take this sort of action then there is a danger it could do that. Actually the other forecasters are all working out their forecasts at the minute and I think you're going to start to see some of those factoring in more inflation as they really look at the data that's there. Compared to perhaps three months ago we've had a lot of good news on the international side, strong world economy, that's factoring through with strong commodity prices, recently for example Fontera have just upped their estimates of payouts and you're seeing that in other parts of the economy as well, that's all good news. Despite the fact that all the prices have gone up, terms of trade have gone up, the exchange rate has dropped compared to three months ago and while that makes us more competitive it also means that we're in danger of importing more inflation and when you add up all those different things it means our inflation track is looking hotter than it was before.
SIMON I want to come back and examine a number of those variables shortly but is this a case from what you're saying the rate rise is designed to engineer a soft landing in order to avoid having to act tough next year?
ALAN You see the interesting thing about doing economics is we don't know where the economy is now and we can't be exactly sure where it's going into the future but we know when we take an action like this it doesn't have an immediate impact, it's a bit like driving a car down a busy motorway and having to look miles and miles ahead because that's how long it will take for a brake or an accelerator to have an effect. By moving the interest rate we would expect it to take its full effect 18 months to two years out. Now as I said at the minute inflation is low but it's strengthening and we've gotta look out into the future like that, and really try and make a decision now for it to take effect further out. If you ever got this perfectly yeah you'd stabilise the economy you wouldn't see those little movements round it. We know we've got a blunt instrument and an imperfect view of the future so it isn't perfect but that's partly why we move gradually and then we look at what effect it might be having and we look at all the other data coming in and we make our next decisions a couple of months down the track.
SIMON Well given that uncertainty in the short term outlook how then can you be so confident that the economy will contract in the longer term as you seem to be?
ALAN Well I mean we don't have total confidence as I said we're doing this with the best data we can have and we're forecasting and we know it won't exactly pan out quite like this, but the aim is to get monetary policy work for a year to two years out and to carry out all the tests that you can to say well what if things go wrong, what if unexpected things happen as they will, we do a bit of an exercise we call a Regrets Analysis where we say well we're going to be wrong does it matter most if we're wrong in an upward direction or a downward direction. One of the things that's meant that we've delayed some of this action has been that up till now our exchange rate has been very high and we thought it was quite dangerous to be taking too strong action when we were right at the top of the exchange rate cycle. That's come off a little bit and given us a little bit more room to move and it's partly why we've moved this time.
SIMON Isn't it the reality though that we're really at the mercy of global markets in particular the US the old scenario that the US sneezes and we catch a cold?
ALAN Oh well look you know you make your own track record in this and yeah we're a tiny economy trading heavily into a very big world where all sorts of influences happen and over the last year we've had very strong effects coming out of the United States as they try to deal with their deficits and their dollar drops and therefore ours rises, nothing particularly to do with us but we've gotta deal with that. More recently the unrest in the Middle East and the rising price of oil again we've gotta deal with it, but that's what it's like in New Zealand at a macro economic level just as that's exactly the environment that business have to deal with every day when they're trying to steer their firms through this.
SIMON Well you did mention oil, a price hike, you know the economy contracts as a result of money flowing out, how much of a drag is oil on the economy?
ALAN Well New Zealand is still quite sensitive to the oil price because we're a very big user of oil in our transport sector although not so much in the rest of the economy, so that means yeah we're sensitive to it, but it's a different sort of story from the oil hike back in 1974 and 1979 the OPEC crises, those were restrictions on supply, this is very strong demand, we've got to remember we're operating in a world which is growing very fast and has picked up and had very big increases particularly in places like China which are big users of oil, so it's a strong demand setting and that's one reason why we think it's quite appropriate to tighten monetary policy given that strength and contrast what one or two of the bank economists are saying who seem to think it's the same story as back in the 70s i.e. basically a supply site shock.
SIMON Another one of the drivers you mentioned of course before was the employment factor the labour market, unemployment now running below 5%, at what point does a tight labour market begin to concern you?
ALAN Well it concerns us only when you can't find the people or the skills at sensible prices to supply the sort of product that people are trying to buy because in that sort of case you get heat building up and pressures going through, we don't look for a particular unemployment rate, I think it's great that we're down to that sort of unemployment level. We do look to see how markets are dealing with this. For I guess the best part of a year and a half now we've had a very strong housing market and for much of that time the markets have worked pretty well in terms of people coming in with skills from the manufacturing sector into the housing construction sector. We've had migrants returning from Australia, in a few specialised cases you've actually had business people importing people with particular skills to help in that sector, but now increasingly we're getting stories about overheated labour markets, having to pay higher prices, looking to negotiate at higher levels and once that sort of change in thinking starts getting entrenched then you do run into this problem of getting higher inflation expectations and that's bad news for everybody when that happens because that's when you get inflation in the system and it starts confusing investment signals and expenditure signals and things like that and that's when you have to have a couple of doses of medicine to get that out of the system, we don't want to go there.
SIMON Of course some are saying that those variables are really irrelevant that the only key driver at the moment is the housing market and that's in decline and therefore the interest rate rise isn't need and Brendan O'Donovan Chief Economist with Westpac has said that, what's your reaction to that?
ALAN Well some have said that and some are wrong in saying that.
SIMON Overly sarcastic?
ALAN Sure there's a whole bunch of things going on round the economy, yeah of course the housing market is strong and has been and we've been pointing to this for a year now and actually it's been reacting pretty much as we had expected, it's coming off but what you're seeing is price hikes reducing but there's still price pressure there, building consent's starting to come down but there's still very strong building activity levels there and still strong residential investment figures, so it's coming off its peak but it's still go quite a bit of strength in there and it's still got some way to come off and if it takes higher interest rates to get that message across to people who think that they're going to get fast returns and capital gains out of that sector then that's ultimately what has to happen, but it's not - I mean let's get out of the mindset that it's just Auckland housing, it's not at all, it much wider than that, and we of course see a lot of strength in other sectors too.
SIMON Will house prices drop, do they have to?
ALAN Well they'll come off their peak as they're already starting to, we don't forecast exactly where they're going to go but they have dropped in the past and there's no reason why they're not in the future, in the meantime there's a bit of a mindset amongst some people, particularly perhaps people who are investing in investor housing that it's a sure thing and of course it's not a sure thing, house prices do drop, rentals do come down and the upshot of that is yields come down and investing in rental housing can end up being very poor investments especially if interest rates go up further and people have got to service big loans.
SIMON Well you've signalled that they will go up further, what reassurances can you offer mortgage owners in that regard?
ALAN Well we're not offering mortgage owners any sort of assurances, we've been saying for some time that if too much money goes into the housing sector it's not good for New Zealand and it's money that might otherwise go into the production sector where we're always looking for good quality investment.
SIMON New Zealanders have 69% I believe of household assets in housing, the highest rate in the western world, are we economically endangered at that level?
ALAN Well I don't think we're financially endangered we do regulate the banking system and we do look at bank balance sheets and they have increased their exposure to lending quite a bit over the last year but generally that tends to be good quality debt because people don't reneg on those sort of loans, they do everything to meet them, but sometimes they put themselves under quite a bit of stress to get there and I mean if they don't have money to spend in other areas or invest in other areas, yeah we're funny people we're a funny economy in some ways and particularly with housing, for some reason people think if they see bricks and mortar or actually weatherboards and corrugated iron that that's gotta be a good investment because it's concrete and it's solid, but that just doesn't follow at all. We put a lot of our money in our household balance sheets into housing and now we seem to be putting more into investor housing and yet we've got very little exposure to other investments compared to countries like the United States we got almost no investment in the stock market. Now stock markets go up and down as well and people shouldn't expect to get easy gains there either but they certainly should be diversifying and using some of those markets and taking decent expert advice on where they put their money.
SIMON Those household debt levels are certainly very high but how high compared with overseas?
ALAN Well there has been a lot more exposure into the housing market and debt has been growing but it hasn't been growing as a proportion of household balance sheets because house prices and house values have been going up as well.
SIMON Is that leading to a sense of false wealth?
ALAN Well it's just that households here and in Australia and I think in the United States as well, certainly do have a renewed sense of wealth and they're exhibiting that by spending quite strongly.
SIMON But how realistic is that wealth?
ALAN Well it's realistic provided house values stay up but as I said we don't guarantee that and people have gotta make their own assessments around that.
SIMON How dangerous is this household debt level, I mean is it sustainable?
ALAN Well it can't keep on increasing at this sort of level, no it's not sustainable in that sense. It's gone on to a new plateau compared to what it was five years ago, ultimately that will depend on where house values stay but people shouldn't think it's just going to keep increasing because it won't.
SIMON We often hear too of course how our personal savings habits are so poor what should New Zealanders be doing with their saving in regard to saving generally?
ALAN They should be taking good advice and they should be investing in different areas.
SIMON What good advice could you give them?
ALAN Well central banks don't give households advice they recommend that they go to expert advisers and talk about their individual circumstances and take their advice off that.
SIMON Let's look at the exchange rate, it's dropped back a bit recently off some quite spectacular highs, was it overheated the dollar?
ALAN Oh well we know it was well above our longrun exchange rate and it still is well above our longrun exchange rate, we'll go back to that longrun exchange rate we don't know when that will happen and what will happen between now and then and unfortunately exchange rates are something that economists don't - can't forecast in the short term, they can in the medium long term but not in the short term, so they make assumptions. We've made an assumption that it stays up for six months or so and then starts heading back towards that longrun exchange rate but that is just an assumption, it could do a lot of things in that time.
SIMON The Kiwi firmed of course immediately after the OCR rise particularly against the Australian, are we in danger of inhibiting export growth, export driven growth?
ALAN The effect on the exchange rate was something that did weigh quite heavily on our minds in terms of making this decision and we don't want to carry out monetary policy that has none intended effect of pushing up the exchange rate, it has gone up slightly by about a cent since the decision we made, actually some of that may well be short term volatility that will come out, at the moment the markets are looking at Australia and they're seeing a very weak one off GDP result and they've refocused a bit on New Zealand as a result of that, but the chances are that's just a one off figure and they'll put their focus back on Australia and probably take a bit of pressure off us in doing that.
SIMON You're projecting a decline in growth, how do we reconcile that with others back at the top half of the OECD is it possible on that basis?
ALAN Well as I say we've been growing very strongly, apart from one year of 2.7%, over the last five years we've grown over 3%, that's a pretty good record, actually we talk ourselves down a lot on that, I don't know why we do but most people don't seem to understand just how well we've done compared to the OECD over the last five years, we've been growing well above OECD average rates. To get back up the ladder if you like is a complicated thing because we've got quite along run ahead of us, I think the next country ahead of us is Italy, Italy's being doing very poorly over the last couple of years but they're still valued out at GDP per capita on a purchasing power parity base that's well ahead of us but actually I think some of that comes down to how you value those things and that may not be working in our favour.
SIMON Is there anything the Reserve Bank can do to help stimulate that growth that we need?
ALAN Well I wouldn't say stimulate the growth I would say allow the country to grow at its potential growth level, yeah I mean one of the very important things we do is estimate how fast this economy can grow at any particular time, and then monetary policy should be allowing the country to grow at that sort of level but not pretending it can go above that level because in the short term above that level it starts pushing up in inflation.
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