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Opinion: What on earth was the Reserve Bank thinking about?

By Simon Louisson of NZPA

Friday 9th March 2007

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BNZ economist Stephen Toplis best expressed reaction to the Reserve Bank's proposals this week on ways to control the runaway housing market and thereby inflation.

"What on earth are these guys thinking about?"

The RB suggestion that banks be forced to increase reserves would simply force people to seek funding offshore or from non bank sources.

"Perhaps we could then impose currency controls, then raise reserve asset ratios further. And if all that doesn't work, what about a wage price freeze? Sound familiar?"

The ghost of Muldoonism is clearly audible.

RB Governor Alan Bollard's latest effort at communicating has been even more muddled than usual.

His message should have been clear and simple -- inflation remains a problem mainly because rising house prices are making people feel wealthier and thereby encouraging spending. The bank must put up interest rates to quell this and will do again and again unless it sees a spending retreat.

Instead, we got a discussion on supplementary tools the bank might use to help the cash rate do the job of reining in inflation.

That Bollard suggested tightening asset ratios -- where banks have to keep a greater proportion of their assets in reserve -- plus a call for greater enforcement of existing capital gains tax rules on investment properties was no accident.

Every word in the quarterly Monetary Policy Statement, and especially the accompanying news release, is pored over in detail by bank staff.

They know market participants examine the words like the ancient priests did with animal entrails. That's why clear communication is so vital.

Toplis said what came out of yesterday's mess was an easing of monetary conditions instead of a tightening -- the opposite to what was intended. The dollar fell sharply and bank bill futures rallied.

By raising the issue of the "supplementary tools", Toplis said the bank signalled Bollard didn't want to raise interest rates again.

"Just the suggestion that the bank believes other policy measures can achieve what the OCR can't, implies less likelihood of a future rate move," he said.

He also queried what business it is of the RB to be discussing tightening enforcement of capital gains tax. Surely, this is Inland Revenue's bailiwick or, possibly, the Government's.

The main point though is that these supplementary tools were looked at last year at the behest of Finance Minister Michael Cullen in 2005. The report in April, which included all the issues raised by Bollard yesterday, including ring fencing losses from investment properties, came up empty handed.
So why is the issue being re-litigated?

The answer apparently lies with Cullen, who in a newspaper interview on Thursday, said he wants Treasury and the RB to keep looking for alternatives to interest rates to cool the housing market.

That Bollard used his monetary policy statement to back up Cullen raises issues about undermining the all-important independence of the RB.

There are two problems the two doctors are dealing with.
First, raising interest rates to squeeze out inflation (invariably fuelled by over-spending in the consumer sector) usually sends the currency up and hurts the export sector we depend on. This is an inherent side effect of having a free floating currency as a monetary policy tool.

Secondly, because 80% of mortgagees have gone on to fixed rate loans, the cash rate has proved a lethargic and less effective tool in dampening enthusiasm for property.

Bollard asserted the bank already had the power to force banks to increase asset ratios, although that power was given to the central bank for prudential supervision, not to control monetary conditions. Even Cullen acknowledged it might require extra legislation.

In Australia, that power rests with a separate body.
ASB Bank managing director Hugh Burrett, who is also chairman of the Bankers Association, observed that the measure might not work.

"If we were required to hold more capital, that may not necessarily mean an increase in rates for borrowers, because it would depend on competitive pressures in the market."
Some banks could forgo profit to retain market share, he noted.

Roger Kerr, of the Business Roundtable, slammed the idea.
"Monetary policy isn't impotent. The fixed rate issue is another red herring.

"Monetary conditions tighten when the Reserve Bank raises interest rates. Someone on a fixed rate interest isn't affected, but someone else, or the bank, is."

All the suggested measures at best would only have a one-off effect on inflation. The bank should look at its own performance, he said. It should have been tightened quicker and harder three years ago.

Government could help monetary policy by reining in its spending, deregulating and unblocking infrastructure bottle-necks.

Bollard's hope that proper enforcement of existing capital gains tax will have any effect is a vain one. The law has a big enough loophole to drop a mansion through. Investors simply have to state they were investing for the long-term and there is little IRD can do.

Cullen has repeatedly refused to tackle the capital gains tax issue, saying there is no public stomach for such a measure. He might also add that politicians such as himself have no stomach to lead and actually do something about the problem.

The good news in all this is that the rise in dollar and house prices may have run their course. (The fact the RB abandoned its mantra of the last few years that house prices are about to fall may be a hopeful sign.)

Even Martin Evans, president of the NZ Property Investors' Federation, says the housing market is at the top of the cycle.
"The bubble will definitely burst. It has to do, they always do. It's just a matter of waiting."

On the dollar front, there are increasing signs in the wake of last week's slump in the Shanghai stock market, investors are less willing to take on risk. That could mean a reversal of the kiwi's fortunes and each time Bollard hikes rates, it will head lower.

The more worrying issue is whether some form of capital adequacy ratio is introduced that will inevitably permanently raise the cost of money without helping lower inflation on a long-term basis. As well, there has already been collateral damage to the bank's credibility.

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