Why Time Consistent Monetary Policy Matters

The other week I explained why Bernard Hickey is wrong about the likelihood of the Greens, NZ First and Labour changing the Reserve Bank’s mandate and reducing central bank independence.

One of the reasons why central bank independence is important is because it affects inflation expectations. When inflation is expected to be higher, the nominal interest rate will increase to account for inflation lowering the real value of money lent to the government.

What this means for the New Zealand government’s finances is that the cost of servicing debt will rise. This means that in exchange for chasing after kooky policy goals like full employment and lowering the exchange rate, there is an increase in the risk premium on New Zealand government debt.

Time consistency of policy is an economic concept that in order for the government and Reserve Bank to be taken seriously, they have to commit to a policy in advance and not suddenly change their tune.

The Reserve Bank currently does this through their regular statements that accompany Official Cash Rate decisions and a plethora of working papers, articles and market updates throughout the year that give a clear indication of what the Reserve Bank thinks on topical monetary policy issues.

If the troublesome troika get their hands on rewriting the Reserve Bank Act after 2014, a substantial rise in the risk premium payable ultimately by taxpayers through lower government spending and higher taxes, is inevitable.

The independence of the Reserve Bank and provisions of the Public Finance Amendment Act mean that the New Zealand government can borrow to finance deficit spending but nowhere near to the extent that many other countries can.

In effect, there is a built in dilution effect that means kooky ideas cannot run their true course. A Greens/Labour/NZ First coalition would not be taken seriously by market participants. When that scenario becomes likely as John Key’s popularity subsides, forward interest rates and exchange rates will reflect that.

Any step towards reducing the Reserve Bank’s independence runs the risk of far higher debt servicing costs for the government. This means less money for things New Zealanders care about like welfare and hospitals, and a widening revenue gap needing to be plugged by higher taxes.

Bernard Hickey Is Wrong About Market Reaction

In the Herald over the weekend, Bernard Hickey argued that because Labour, NZ First and the Greens have realised the importance of monetary policy and its relationship to key macroeconomic variables, they will undermine how the Reserve Bank conducts monetary policy.

The problem with our system is that we think that all opinions are equal. The intellectual deficits present in Labour, NZ First and the Greens have been truly exposed with their calls for kooky ideas that are completely unjustified and have been proven in the real world to cause terrible side effects. Arguing for exchange rate intervention is an example of the stupidity we could expect if politicians had more influence on how monetary policy operates.

I am pleased that Graeme Wheeler has made it clear what job goals as Reserve Bank governor is – using inflation targeting as the monetary policy tool of the day and eschewing calls to intervene in the exchange rate and monetise government debt. Complaining that the Reserve Bank doesn’t make decisions by committee is childish in the extreme. Almost every other central bank in the world is worse than the RBNZ. They are extremely credible and a central reason for that is their strict adherence to their statutory mandate in the Reserve Bank Act.

There is no doubt that monetary policy is linked to our housing bubble in the 2000’s and a resurgent housing market. But to adjust monetary policy now by adding slippery targets on unemployment numbers, what the exchange rate should be and how much house prices should be defeats the entire purpose of having a reasonably independent central bank. Gareth Morgan’s comments that they should all be fired for incompetence are so far off the mark it’s not even funny.

With respect to housing, while increased M3 has enabled banks to lend more on housing, that’s them simply responding to incentives. There is an enormous demand for housing loans, there are severe supply restrictions on housing and loan-to-value ratios are not regulated so poor people who have no business buying a house easily qualify for 95% mortgages.

Did we not learn anything from the sub-prime debacle in the United States? One of the key drivers behind lax regulation around new mortgage lending was the “housing affordability” and “owning a home makes you a real American” nonsense. Just because many people can’t afford to buy a house doesn’t mean that the OCR should be lowered to stimulate more investment in housing. A lot of that extra credit will sit on bank balance sheets for their own risk-free carry trades.

If the markets really were spooked about the possibility of Graeme Wheeler having the Policy Targets Agreement rewritten by a troika of populist politicians, they would be pricing that risk in now. The 3 year bond rate would have spiked some time after October 26 and the drama-filled select committee meeting. Using the data at Interest.co.nz we see that since the 26 October speech by Graeme Wheeler the change in bond rates has been negligible. And here’s a nicer chart from Westpac that fits out time frame just nicely:

The risk premium for New Zealand debt has barely changed either. So what gives? If there was any likelihood of economic kooks coming to power, that risk premium would have shot up. So would the price of NZ government debt CDS swaps. If expectations were that the exchange rate would be lower then that would be reflected in the March 2014 NZD/USD futures. They’ve barely dropped a cent over the past month.

Non-residents own about $28 billion of the $72 billion of government debt on issue. If what Bernard Hickey is saying was credible – the risk of lower yields in future – why was there no rapid capital flight? We have extremely free movement of capital these days and if overseas institutions wanted to they could drop billions of dollars in NZ government debt in an afternoon.

The truth is that if market participants were thinking like Bernard Hickey, there are about 4-5 different things they would have done to lower the risk of any changes in monetary policy impacting on the capital they have invested in New Zealand.

Bernard’s column is sadly unique in that no one actually thinks Labour, NZ First and the Greens will get anywhere near destroying the independence of the Reserve Bank. In not arguing that the policy changes Labour, NZ First and Greens are proposing fall into the category of kooky economics, he is ignoring the reality that quantitative easing reinforces inequality, makes housing affordability even worse and lowers real money balances.

If the market starts pricing in the possibility of kook monetary policy being implemented, I’ll revise my opinion. Needless to say I’ll be watching the yield curve and forward exchange rate numbers with interest.