Opinion: Mixed messages from the Reserve Bank can be costly

By Simon Louisson of NZPA

Friday 10th December 2004

Mixed messages are seldom good. In a marriage they can have serious personal consequences but coming from the Reserve Bank they have far wider effects.

RB Governor Alan Bollard surprised no one yesterday when he left the Official Cash Rate unchanged at 6.5%. Rather it was the hawkish tone of his quarterly Monetary Policy Statement, where three times in the introduction he said a further tightening of monetary policy could not be ruled out, that took some by surprise.

Lest anyone still not be clear he states: "The current outlook offers little scope for an easing in policy in the foreseeable future."

That seems unambiguous enough - interest rates are unlikely to fall until the "very strong" economy displays evidence of slowing.

There are two problems with this.

Firstly, it appears to conflict with the message given in October, and secondly, it seems incongruous that, given economic growth is picked to more than halve next year, the central bank with the highest interest rates in the developed world should be thinking of hiking them.

In October Bollard put out a short, but apparently clear, statement that the tightening cycle had run its course.

"We believe that the current settings of monetary policy are now doing enough to ensure price stability," he said then.

Bollard was adamant yesterday's statement was consistent with October's, and he claimed the only difference was the way the markets interpreted the October statement.

"It's not my flip-flop, it's the markets'," he said.

But Deutsche Bank chief economist Ulf Schoefisch, himself a former Reserve Bank policy maker, said it was a "cheap" shot to blame markets for misinterpreting the October statement.

"The bank is responsible for getting the message across clearly."

Looking at the "letter of the law" there was nothing explicitly stating rates would ease in the October statement but the point was it was delivered into a context where people were still talking of a further tightening, said Schoefisch.

"At that point, they came up with a very clear, short statement saying `we're happy where things are'. That was a shift to a neutral bias in everybody's book."

But do the flip-flops in tone from hawkish in September, to dovish in October and back to hawkish again, matter except to the entrail-readers in financial markets?

Schoefisch said it creates volatility in markets and the central bank was supposed to be minimising that. Volality tends to undermine international investors' confidence and in the long run that causes interest rates to be slightly higher.

"It's something that's completely unnecessary," he said.

"I'm not sure it has a major effect, but... with investors overseas it looks like the bank doesn't really know what it's doing."

Schoefisch said the chopping and changing view on whether or not to keep tightening had largely resulted from the fact that the economy had throughout 2004 surprised on the upside.

"They always think the economy is slowing but it doesn't quite slow as fast, or doesn't slow at all."

"I think Dr Bollard's lost a little bit of confidence and wants to see a bit more evidence that the slowdown is well underway before he does something."

And that brings us to the second problem with yesterday's statement - that Bollard is signalling a tightening bias while forecasting a sharp slowdown in economic growth.

"The risk there is that then he starts easing too late," said Schoefisch.

Despite the RB forecast that the 2004 projected growth rate of 5.2% will fall to 2% in the March 2006 year, Bollard said financial markets had assumed more downside risk than upside.

"We don't think so. We think they are balanced risks and that's why we have an outward track for 90-day interest rates which is flat," Schoefisch said.

And that is also in spite of a lower forecast for inflation, which is not now expected to rise above 3% as it was in September.

Bollard acknowledged using interest rates to control the economy's growth was a blunt instrument. And it had been further blunted by the $10 billion issue of New Zealand dollar bonds to foreigners this year, which had delayed the full effect of this year's six rate rises.

He likened setting monetary policy to a car going down the motorway - "you have the accelerator and the brake, although not necessarily the steering wheel".

"In doing that, you are looking at things a long way ahead, it takes quite a long time to stop just as it takes a long time to accelerate."

So if it takes up to two years for monetary policy to take effect, why is Bollard not looking past current conditions where labour markets are historically tight and factories are running close to capacity?

He expects exporters to feel the effects of the high currency as corporate hedging policies run their course. Dr Bollard clearly stated he considered the turning point in the business cycle was near.

House price inflation and construction had eased back as expected, as had migration. But Bollard is still worried about the effects of a consumption boom fuelled by home-owners leveraging more debt from their higher value homes.

"Growth in consumer spending may continue to sustain economic activity as household confidence remains supported by strong employment prospects and past improvements to wealth.

"In these circumstances, inflation would likely be higher and could spark unhelpful changes to price and wage-setting behaviour."

Such circumstances would spark a further tightening.

Despite all this rhetoric, most economists still believe Dr Bollard will ease rates next year.

Westpac chief economist Brendan O'Donovan said he still expects the next move in the OCR to be a cut in mid-2005.

Schoefisch, who expects the easing cycle to begin in September, said central banks can't advertise the start of an easing cycle and must "lean a little against the wind" or markets will bring it forward.

That is what appears to be happening now, which is hard cheese for exporters who will be faced with a currency that overshoots, particularly against the US and Australian dollars.

Luckily, said Schoefisch, New Zealand has a cushion against such a blunder because of the very strength of its economy.

"We are not going to fall immediately into a hole. There's a bit a buffer if they are behind the game on the easing cycle. They can recover from that fairly quickly."

Too bad if you are an exporter and see your profits evaporate or work for an exporter and lose your job.

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