Brian Fallow: How far will Reserve Bank go with its big squeeze?


In signalling that it is now in tightening mode the Reserve Bank has acknowledged, inevitably, recent indicators of a tight labour market and mounting inflation risk.

They include the March quarter’s gross domestic product — up 1.6 per cent, when it expected a contraction of 0.6 per cent— last week’s comprehensively strong quarterly survey of business opinion from NZIER and the fact that the tax take is running way ahead of Budget forecasts.

So if you take a purely insular view of their dual mandate, price stability and maximum sustainable employment, the case for an explicit tightening bias was clear.

But the key word there is “insular”.We can’t ignore the fact that the other 99.8 per cent of the world, including our nearest neighbours, are still in the grip of the pandemic, with cases growing at a daily rate half as large again as it was a year ago. And the virus is doing what comes naturally and mutating into more infectious variants.

So long as the New Zealand population is largely unvaccinated, that threatens the Covid-free status which underpins the domestic recovery which is under way.

“Recent data indicates the New Zealand economy remains robust despite the ongoing impact from international border restrictions,” the monetary policy committee says.

Instead of “robust” they should have said “precarious”, “fragile” or “vulnerable”.

The bank should not think of touching the official cash rate until the country is properly vaccinated. November looks a bit early, and August way too early, given the lackadaisical pace of the vaccine rollout so far.

It expects consumer price inflation to “spike” higher in the June and September quarters, driven by factors either one-off, like high oil prices, or temporary, like supply disruptions and higher shipping costs. The mandate expressly requires them to discount such transitory factors when setting monetary policy.

But more persistent consumer price inflation is expected to build over time due to rising capacity pressures and growing labour shortages.

What is appropriately uncertain, however, is how fast or how much those cost pressures will be passed through to consumers.

The closure of the border, with its attendant skills shortages, has pushed up estimates of the unemployment rate below which inflation would take off.

But it has also throttled back one of the key drivers of demand in the economy — population growth. The working age population in the year ended June increased only a third as much as it had the year before.

That is a lot fewer people needing to buy things.

Economists’ talk of “full employment” will ring hollow in the ears of the 366,000 people who as of March were either unemployed, or underemployed part-timers able and willing to work longer hours, or “potential job seekers” not actively looking for a job but willing to take one if it was available.

At a time when firms are reporting extreme difficulty in finding the skilled workers they need, those numbers testify to a serious structural problem of skills mismatch.

Addressing that is a challenge not just for public policy but for businesses.

The Government is clear that it is planning a reset of immigration policy. Underpinning this is the conviction that the status quo ante Covid was one in which the business sector as a whole was too inclined to skimp on capex per worker, and had become habituated to the idea that skill is something to import rather than impart.

Together with the prospect that the border will remain closed, or only open a crack, for some time yet, that implies that firms looking for a swift return to the days of just importing labour — skilled or cheap, as the case may be — need to think again.

There is also a question mark over how sustained another important driver of demand will prove to be, namely the wealth effect from house price inflation, where people are prepared to spend a few cents in the dollar of increases in their housing equity even if they must borrow it.

Both the Government and the central bank, in its financial stability role, seem determined to keep rolling out road spikes in the path of runaway house price inflation until it stops.

At the moment we are in the strange situation where the number of houses being offered for sales is shrinking, keeping prices high, but the number being built is growing strongly.That suggests that Stein’s Law — that what can’t continue indefinitely, won’t — will kick in at some point.

So while there are some encouraging signs of growth in labour market incomes in the PAYE data, how sustainable the demand which is currently enabling firms to pass on higher costs will be is uncertain.

Faced with uncertainty, the Reserve Bank does “regrets analysis”. It tries to answer the question “If we go this way and it turns out we are wrong, how sorry will we be, compared with going the other way and being wrong?”

It faces the risk of getting behind the curve and having to tighten more than otherwise down the track, but on the other hand there is the risk of going too hard too soon, as it did after the GFC, and having to reverse rate hikes lest it stifle the infant recovery in its cot.

Since the May monetary policy statement, when the bank was indicating that the OCR would be on hold until August next year, it has flipped on where it sees the course of least regret. It now evidently thinks the former risk, of doing too little too late, is the greater.

But there is also a risk in getting too far ahead of the international pack. The Reserve Bank of Australia, for example, is standing there with its arms folded talking about not touching its OCR (which is lower than ours) until 2024.

Someone is getting this wrong.

When this part of the world is viewed from distant dealing rooms, with brash young men looking about for where to park lots of other people’s money, the difference between one central bank (potentially) raising interest rates in 2021 and the other in 2024 is conspicuous and could do unpleasant things to the exchange rate.

It is not surprising that tightening should begin by calling a halt to quantitative easing, 11 months and more than $40 billion shy of the limits the bank set itself last August.

Bond buying by the Reserve Bank under the Large Scale Asset Programme had already been tapering off. At the end of last month the bank held $57.5b of bonds under LSAP, just $500 million more than at the end of April.

There may have been a case during the period of peak peril and pestilence last year for the Reserve Bank to monetise the deficit, to keep longer-term wholesale interest rates low.

But the deficit has turned out a lot smaller — $5.8b smaller, in fact — than expected, even as recently as last May’s Budget, posing little risk of market dyspepsia.

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