By Simon Louisson of NZPA
Friday 27th October 2006
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Yesterday, the central bank decided not to hike official interest rates when most economists thought it would. Money markets had priced in a 65 to 70% chance of a rate hike.
Dramatic and hectic market reaction to the decision indicated surprise.
In June, Reserve Bank governor Alan Bollard said the tightening phase was over.
Then he surprised markets in September saying another rate rise could not be ruled out.
He reiterated that warning yesterday, but the market was no longer listening.
The Reserve Bank itself has done studies to show that volatility in interest rates and the exchange rate is bad for business and the economy.
Indeed, when he assumed office in 1999, Finance Minister Michael Cullen modified the price stability target (defined as 1-3% inflation over the medium term), to require Dr Bollard to avoid undue volatility in exchange and interest rates.
Westpac chief economist Brendan O'Donovan has been a trenchant critic of Dr Bollard's monetary policy.
Not only does he think its nuts the bank is talking interest rate hikes when economic growth has been well below potential for 18 months, but now he believes policy implementation is wrong.
"We think it was the right decision not to hike. In any other economy, if you had economic growth sub 1-1/2%, you wouldn't be talking about interest rate hikes at all."
O'Donovan believes the bank's communication is all wrong and that is damaging the bank's credibility.
"It makes no sense at all," he said.
"The aim of a central bank is not to get gyrations on a day of this magnitude."
He wants the bank to follow the model of the US Federal Reserve, as the Reserve Bank of Australia does.
"There, the central bank leads the market by the nose and you get consistency of message."
Here, he said, the central bank had done a mediocre job in signalling its intentions. There has been a gap between the bank's rhetoric and its actions.
Senior bank officials had talked up the risks of higher interest rates, giving the distinct impression a rate hike was likely.
The bank's talking up the prospect of a rate rise must carry much of the responsibility for the 11% rise in the New Zealand dollar in the last six months.
How Dr Bollard expects exporters to deal with this kind of volatility is anybody's guess.
Yesterday he said that the drop in oil prices and the rise in the exchange rate were behind his decision to leave rates unchanged.
Yet these two factors were evident in September but given little emphasis in the September 14 statement warning of a possible rate rise.
On the other hand, Dr Bollard said these were only temporary factors and wouldn't affect the medium-term inflation outlook, apart from their impact on expectations.
But inflation expectations are critical. There is an 85% correlation between headline inflation and expectations.
As a result of the dramatic fall in fuel prices and the anti-inflationary effect of the exchange rate rise, expectations for inflation in the second half of next year have slumped to 2.8% from 3.8%.
"That's a dramatic turnaround," O'Donovan said.
The Reserve Bank's September forecasts painted a pretty bleak picture of the economy. They assumed a 5% drop in house prices, two years of household income recession, three years of sub trend GDP growth, a waning but horrendous current account deficit, and a lingering inflation problem.
Dr Bollard indicated he would target the housing market and the domestic economy to excise the inflation problem and the exchange rate would go where it does.
O'Donovan noted there was an opportunity for Dr Bollard to lance the boil with around $15 billion of fixed rate mortgages due to be rolled over before Christmas.
`By not hiking yesterday, the bank has forsaken the opportunity to hit the housing market.
"That certainly does risk the housing market resilience persisting. There has to be a chance this rally in swap rates gets translated into cheaper fixed rate mortgages."
While bank margins are thin are present -- around half a percentage point -- banks are chasing business at almost any cost.
And if ANZ National's profit yesterday was anything to go by, the mortgage war doesn't seem to be hurting the bottom line. It became the first bank or company here to notch up a billion dollar net profit.
O'Donovan believes the resumption of the mortgage rate wars could potentially be a poison pill for the Reserve Bank.
If the bank starts to talk up the prospect of a rate hike again, the market will downplay it. It's the story of the boy who cried "Wolf!"
"That may not stop the RBNZ from hiking if it feels such action is warranted, but it will be delivered to a market that will be very disbelieving before and after such action -- and perpetuate the perception of the RBNZ's poor signalling."
O'Donovan believes that by the middle of next year when headline inflation has dropped sharply, Dr Bollard will start to focus on the sick growth story and it will begin a rate-cutting cycle. That will precipitate a hefty fall in the exchange rate.
However, it will be still be a monumental battle to get inflation under control as the price of petrol and other imported goods rise.
Also, people will probably be factoring in likely inflation-inducing tax cuts in 2008 by then.
Let's hope by then, bank officials will be singing from the same song book. In the meantime, we have to bear the cost of interest and exchange rate volatility.
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