Grant Robertson's help may be needed to counter a supply shock, argues Adrian Orr. Photo / Getty Images
COMMENT:
Reserve Bank governor Adrian Orr is keen to dispel the idea that the bank is only 100 basis points from impotence when it comes to providing succour to a struggling economy.
The other key message from his speech on Tuesday was that if ever there was a time when monetary policy needed fiscal mates, this is it.
He is more convincing on the latter point than the former.
The speech outlined in a high-level way the bank's thinking about the potential for unconventional monetary policy — tools it could use when its conventional instrument, the official cash rate, has hit the zero bound. The OCR is currently at 1 per cent, a stark contrast with the 8.25 per cent available to be cut when the global financial crisis hit in 2008.
The problem the bank has, and which Orr rather glossed over, is that there are a couple of peculiarities to the New Zealand situation which limit the relevance of the experience of other central banks which have used unconventional tools to deliver a monetary easing, such as negative interest rates or quantitative easing.
One is that New Zealanders are much more inclined to borrow than to save. Kiwi households have collectively consumed more than their disposable income for each of the past six years. That is as historically normal here as it is abnormal elsewhere.
One consequence is that banks need to raise a substantial proportion — albeit less than when the GFC hit — of the money they lend us, from the institutional custodians of foreigners' savings via wholesale financial markets.
As at last September 30, the banks' foreign liabilities were $180 billion (offset by $55b of foreign assets) when their collective loan book was $467b.
This is relevant to where the "effective lower bound" sits. It is the level of the OCR at which further cuts would be ineffectual.
At some point it would be limited by the unwillingness of retail depositors to accept a negative deposit rate. But given the spread between the OCR and retail deposit rates, that is unlikely to be the binding constraint.
More relevant is the fact that the foreign suppliers of wholesale funding are also unlikely to be willing to pay for the privilege of lending us money. So at some point, cutting the OCR would simply see the spread between it and what banks would have to pay for that funding widen enough to nullify the cut. It would, as the saying goes, be pushing on a string.
The central bank would need to proceed pretty gingerly as it felt its way towards where the effective lower bound might be. A Reserve Bank Bulletin article a couple of years ago listed the indicators it would monitor.
They include a rise in demand for physical cash, a failure of the banks to pass on a lower policy rate to corporate and retail customers, an increase in banks' interest margins or a fall in their profitability, which could result if they had trouble passing a lower OCR on to deposit and lending rates.
It remains to be seen at what point a negative OCR would fail one of the bank's key criteria for use of an unconventional tool — effectiveness — but it may not be as far below where we are now as it would like to think.
The other standard form of unconventional monetary policy central banks have adopted elsewhere is quantitative easing, or large-scale purchases of government bonds. The aim is to drive up the price and thereby lower the yields on those bonds, pulling down interest rates further out the yield curve than the OCR, an overnight inter-bank rate, readily influences.
Right now, of course, the market is way ahead of them as investors crowd into the safe haven of government debt, no matter how steep the mooring fees.
The difficulty with this tool is that the New Zealand Government has relatively low levels of debt. As at November 30 there were only $76b of government bonds able to be traded on the secondary market, equivalent to around 25 per cent of gross domestic product.
This limits the ability of the Reserve Bank to buy them up before it would imperil the liquidity of that market.
So an alternative venue for intervention is under consideration: the interest rate swaps market, which in New Zealand is much deeper than the bond market.
A swap is a derivative which involves two parties exchanging interest rate payments over the life of the swap: one pays the other party the floating rate, the other pays the agreed fixed rate.
It is an important mechanism for banks to hedge future interest rate risk and provides the main benchmark yield curve for banks' funding costs and corporates' borrowing costs.
Wading into that market would provide a mechanism for a Reserve Bank, keen to provide credible forward guidance on its intentions, to put its money where its mouth is.
It would enter agreements to receive fixed-rate payments from other parties, on a scale that would reduce market interest rates, and in turn pay them the floating rate, which is closely linked to the OCR. It would then lose out if it raised the OCR sooner or more than the market anticipated.
The constraint would presumably be the number, scale and financial soundness of counterparties willing to take the other side of the deal.
"It's a big liquid market," said RBNZ chief economist Yuong Ha. "But you have to think you don't want to distort the market by being there all the time. That's why there are limits to some of these additional tools. They give you a little more headroom, a little more time and space."
And important as it is to the financial system's plumbing, the interest rate swaps market is arcane.
So the bank has been thinking about how it could convey to the public, in an intelligible way, what it was trying to achieve by intervening in it, or in the bond market for that matter. It has come up with the idea of a "shadow short rate".
The bank has for years provided some level of forward guidance by publishing in its quarterly monetary policy statements a highly conditional expected track for the OCR over the coming four years.
A shadow short rate would attempt to translate or quantify activity in the interest rate swaps market or asset purchases, once the actual OCR had hit its effective lower bound, into the familiar terms of OCR cuts, to signal further easing.
When devising such a communications device, the bank will hopefully be mindful of the lessons of an earlier experiment, before the OCR was adopted, with a monetary conditions index, which was not a success.
Orr ended his speech on a cautionary note and a pointed, if perhaps gratuitous, message to the Government.
The monetary policy committee would have to be considered and realistic, he said, about how effective any potential change in the OCR would be in buffering the economy from supply shocks such as a lack of rainfall or the onset of a virus.
"A specific supply shock, where goods and services cannot be produced for some reason, may be better managed through fiscal support (automatic stabilisers and/or targeted intervention) with monetary policy assisting, rather than leading."
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