O'Sullivan: World leaves bank behind

By FRAN O'SULLIVAN

Reserve Bank Governor Don Brash faces yet another tough choice.

Should he leave the official cash rate at 6.50 per cent this Wednesday - or take out some insurance against the slowing world economy by cutting rates now, rather than in May as most economic pundits prefer?

External conditions have deteriorated markedly since a bank team completed the first phase of the eight-week fact-finding exercise which precedes each monetary policy statement.

Japan is in near bankruptcy, relying on its eleventh economic rescue package in a decade to pull it back from outright collapse. The Lucky Country has gone into economic reverse now that Australia's Olympic boom has turned into a bust. The virtuous circle which the new economy brought for the United States may in reality prove to be a vicious cycle, if inflationary expectations continue to rebuild in that country.

It is a volatile environment, similar in potential to the Asia Crisis of 1997-98. "Asia II" as one commentator on a Standard & Poor's forum suggested this week.

There is no current expectation that any flow-on effects to New Zealand will be as significant as those sparked by the Asia Crisis: the New Zealand dollar has already collapsed.

There are a huge number of "what ifs" that the bank must consider in making any meaningful calculations on world economic growth.

But the bank's crystal-ball gazers have some recent experiences to enable them to read the signs and react swiftly if conditions rapidly deteriorate. Don Brash, please note.

Brash has repeatedly spelled out that monetary policy is not an exact science.

Gut instinct and intuition will inevitably play a part in his decision to either cut the official cash rate or leave it where it is as he releases the bank's first monetary policy statement for 2001.

Gut realities are also factored in by financial market players who have already priced the deteriorating international outlook for New Zealand's major trading partners into 90-day bill futures.

Economists believe that Brash will leave rates where they are for now to ensure local inflationary pressures do not escalate.

This view is shortsighted.

Consensus Forecasts predict New Zealand's 14 key trading partners will now grow by 2.9 per cent for 2001 - down from 3.5 per cent at the end of 2000.

The downturn for our major trading partners - Australia, Japan and the United States - will be more severe.

Prudence would dictate exercising an insurance clause now, rather than risking a rerun of the Asia Crisis miscalculation which saw the bank ease monetary policy conditions too slowly to avert a recessionary effect.

But Brash has powers to move swiftly. If he underplays the external risk this week, he still has the ability to step in and ease rates at any time if conditions deteriorate again before the next official cash rate review, on April 19.

Though the Reserve Bank is committed to an indicative schedule for interest-rate reviews, it reserves the right to make changes when necessary.

What is of more moment is whether the process the bank uses to form its monetary policy statements is flexible enough to deal with rapidly changing external factors.

In his recent review of New Zealand's monetary policy framework, Swedish professor Lars Svensson criticised the bank for being too slow to react to the Asia Crisis in 1997. That year the bank used an arcane Monetary Conditions Index - since abolished - to implement monetary policy.

With the focus now on the use of the transparent cash rate instead of the controversial MCI, the issue, as ever, comes back to that of human judgment. An internal monetary policy committee, chaired by Deputy Governor Murray Sherwin, does the donkey work. But Brash is the sole decision-maker on interest rates.

As with business: it is the results that count, not the process.

Lesson number one: we are in volatile times and monetary policy statements need to reflect this.

In January, Brash responded to criticism over comments in the December monetary policy statement which foreshadowed further interest-rate rises in 2001.

Brash maintains that anyone reading the December statement would be aware that the views were conditional.

He points out that in late November it still seemed likely that the economies of New Zealand's main trading partners would remain reasonably robust this year. The New Zealand dollar was near its all-time lows, petrol prices were high and business confidence had recovered strongly.

"It seemed entirely appropriate to signal the likelihood that, if those circumstances continued, some increase in the official cash rate would be needed in the first few months of this year."

But instead, evidence accumulated that the US and possibly the Australian economies were slowing quite rapidly; the New Zealand dollar appreciated significantly; and petrol prices fell, suggesting that the spike in the headline inflation would be of rather shorter duration than previously expected.

The rate stayed at 6.5 per cent.

Lesson number two: make sure the Reserve Bank and the Statistics Department get their ducks in a row.

Bank analysts typically talk to about 40-50 businesses or organisations in the first fortnight of the eight-week monetary policy review process. Investment and employment intentions, cost pressures, sales expectations and more general impressions of the state of business are canvassed.

But the March statement is hampered because of the difficulty of finding suitable people willing to talk with the bank in the last week of January. The information gathered is collated and used as a cross-check against official statistics as the bank forms its views on economic developments.

There is then an institutionalised debate between designated "hawks" and "doves" - internal analysts who do not play an integral role in the bank's formulation of monetary policy - who mount opposing scenarios to extend the review committee's thinking.

The bank's work is complicated by time lags in the publication of data. Key numbers such as inflation (CPI) are usually published about two or three weeks after the end of the quarter. But other series, such as growth (GDP), are unavailable for almost three months.

So the Reserve Bank will release its next interest rate decision on Wednesday, while still two weeks from knowing how rapidly the economy was growing between October and December last year.

In January, Brash was sanguine about the reality of making judgments on the economy with "very incomplete information about its current, and even its recently past, state."



It defies belief that the two organisations have not lined up their activities so that Brash has relevant data on which to operate, rather than information six months out of date.

Lesson number three: keep the eye on the international ball.

Brash says the international economy is a key factor in the bank's assessment of likely developments in New Zealand, and needs to be agreed early in the forecast process.

The difficulty is that in volatile times, the international situation is probably the last element the bank should be factoring into its equation.

The reality is that under the bank's process the outlook is all but buttoned down some three weeks out from the release of the monetary policy statement.

The one comforting element is that Brash can change his view up to the day of the announcement.