Brian Fallow: Rate rise ignores dangers that could slow growth

Will the economy rebound quickly when the roadblocks and other Covid measures are lifted? The Reserve Bank thinks so. Photo / Michael Craig

OPINION:

The "heightened uncertainty" that caused the Reserve Bank's monetary policy committee to hit pause on an official cash rate hike seven weeks ago has evidently dissipated somewhat.

That is a bizarre conclusion for it to have reached when the country is in transition to we know not what.

It will not be a return to the freedoms of alert level 1, that much is clear. But where it lands, and how it moves, in the spectrum between that and the misery evident overseas, and how the economy responds to that, can only be guessed at.

Anything the Reserve Bank has to say about this should come with a caveat like "so far, anyway" or "at least we think so, but who knows?"

Instead, when announcing its decision to raise the official cash rate for the first time in seven years, the committee came out with this assertion, sodden with complacency: "The current Covid-19-related restrictions have not materially changed the medium-term outlook for inflation and employment since the August statement."

The strength of household and business balance sheets, ongoing fiscal policy support and strong terms of trade provide confidence that economic activity will recover quickly as alert level restrictions ease, we are told.

The bank, in short, shares the confidence evident in the surveys of business and consumer sentiment that the economy will rebound swiftly as it did after last year's national lockdown.

This is taking optimism to the borders of delusion. The Delta variant changes everything; the only questions are how much and for how long.

What awaits us is not a return to Covid-free normality. Rather, it is the prospect of living with endemic Covid and a reopened border, and hoping vaccination rates and compliance with other public health strictures will be high enough to keep infections, hospitalisations and the death toll low enough to avert the need to return to draconian measures. The key word there is "hoping". It is, for New Zealand at least, uncharted territory.

One major area of uncertainty is the pace and extent of reopening the border.

This will drive population growth, which in the past year has dropped to 32,000, a rise of just 0.6 per cent, compared to an average increase of 2 per cent a year in the previous six years. As the border is reopened, one hopes gingerly, net migration is unlikely to return to those pre-Covid levels.

This has implications for aggregate demand in the economy and skilled labour shortages, reportedly acute.

Another imponderable is the possible impact of endemic Covid on household saving rates.

It is one thing for involuntary saving during lockdown to be followed by a surge of pent-up demand when it ends. But will mounting consciousness of a more precarious future see precautionary savings increase, especially if deposit interest rates become less repressive than they have been?

Then there is the waning of the wealth effect. People's willingness to spend a few cents in the dollar of stonking great paper gains in housing equity and financial assets has been an important source of buoyancy beneath the unexpectedly strong private consumption in the first half of this year. How fast will that abate when house price inflation slows from its unsustainable pace?

A final major source of uncertainty is whatever emissions reduction plan the Government comes up with next May.

To be fair, the committee does note "significant uncertainty about how changes to public health settings, border restrictions and rising incidence of Covid-19 in the community will impact on economic outcomes as response to the pandemic evolves."

The pandemic will have longer-term implications for activity domestically and internationally, it acknowledges, and it will be watching closely how the economy adjusts.

Reserve Bank Governor Adrian Orr. Photo / Mark Mitchell

If ever there was a time to be especially mindful of the eternal ability of the other 99.8 per cent of the world to sideswipe us, surely this time of peril and pestilence is it.

But Wednesday's reference to the global outlook is sanguine.

It does note "rising risks to the Chinese economy" but overall sees a world economy continuing to recover. How secure is that outlook, though, when China, Europe and India are all facing energy crises?

"[Some] central banks have started the process of reducing monetary policy stimulus," the committee says.

The Reserve Bank of Australia, unfortunately, is not among them. It confirmed this week that it expects to keep its cash rate at 0.1 per cent until 2024. An increasingly conspicuous gap between their policy rate and New Zealand's when viewed from distant dealing rooms could put upward pressure on the exchange rate, and weaken the boost from what have been strong export prices.

The employment leg of the bank's monetary policy mandate barely gets a mention. The August statement made it clear the bank judged the labour market to be at maximum sustainable employment.

That is despite the fact that headcount measures of employment and unemployment have been flattered by a surge in self-employment — when we know the mortality rate for new enterprises is high — and by underemployment (part-time workers able and willing to work more hours).

Instead, the focus is all on the medium-term inflation target.

The Reserve Bank sees an imminent increase in headline consumer price inflation to more than 4 per cent, propelled by higher oil prices, rising transport costs and supply shortfalls, and a mounting risk that that will lead to more persistent inflation.

So it is raising interest rates in an economy, a third of which is locked down, and telling us to expect further removal of monetary stimulus "over time".

The brutal reality of monetary policy is that a central bank cannot do anything about supply-side pressures like shipping costs, oil prices and supply chain disruptions, or things like skilled labour shortages which crimp the economy's potential growth rate.

All it can do in response to them is pump spending power out of the economy by raising interest rates to the point where firms are deterred from passing on their increased costs and take the hit to their bottom lines instead.