Brian Fallow: Embattled bank still firing blanks

The issue may be behind us for this cycle, let's hope so at least, but the structural question remains: how can the Reserve Bank curb inflation by means of the official cash rate without doing serious collateral damage to the economy through high exchange rates?

Over the past couple of years, as he tried to cool down an overheated domestic economy, governor Alan Bollard found himself caught between two powerful forces: New Zealanders' love affair with housing and a global pool of capital in search of a safe and high-yielding home.

There must have been times when he feared he was - as a Herald headline writer put it - firing blanks.

Since the New Year the exchange rate has, at last, corrected and the evidence is now unmistakable that the economy has slowed to a crawl.

But the underlying problem remains.

Professor Roger Bowden of Victoria University, in a paper written late last year, said successive rises in the official cash rate had had remarkably little cooling effect on aggregate demand in the economy.

"The primary impact, perhaps the only one, has fallen on the exchange rate, which is at any time only the most indirect way of cooling off an economy ... [It] is also a damaging way of doing so."

It is a well-known story. The housing market boomed on the back of an export-led rise in household incomes and a surge in net immigration after 9/11.

An additional factor, Bowden suggests, has been that impending changes to international prudential requirements for banks, which will allow them to hold less capital for a given amount of mortgage lending, have intensified the scramble for market share at the expense of margins.

The amount New Zealanders wanted to borrow to buy houses greatly outstripped the amount other New Zealanders were willing to lend.

But that did not matter. Our interest rates were very attractive to Japanese housewives and Belgian dentists. As their yen and euros were converted into New Zealand dollars the exchange rate climbed to painful levels for non-commodity exporters and firms competing with imports.

Last year the rest of the world needed $31 billion to buy New Zealand exports, but another $25 billion was needed to buy the eurobonds the banks were using to fund fixed-rate mortgages.

This is likely to keep happening in future cycles. The very circumstances which make the central bank want to apply the brakes and raise interest rates are the circumstances which create a demand for offshore financing for mortgage lending and therefore for kiwi dollars.

The problem from the Reserve Bank's standpoint is that the level of interest rates sufficient to attract Japanese savers, faced with zero interest rates at home, is much lower than would be necessary to burn off demand from New Zealand home buyers. And the demand is not only for home purchases but for renovations and holidays and anything else people are willing to put on the mortgage.

It has got harder for the bank to influence demand in the economy by using the only tool at its disposal - raising and lowering short-term interest rates.

When most home loans were at floating mortgage rates and funded off 90-day wholesale money, the governor could reach straight into people's pockets - people with mortgages anyway - to take out spending power or put it back.

But now 80 per cent of home lending is at fixed rates, typically taken out for two-year terms.

Bowden says that part of the yield curve has demonstrated a mind of its own almost independent of what the central bank does to the official cash rate.

"It is almost as though, one way or another, the market for housing credit has inoculated itself against the OCR."

The power of the vaccine, however, has come in part from the fact that the New Zealand economic cycle has been out of sync with the big economies, which have kept world bond yields - the main influence at the longer-date part of the interest rate curve - unhelpfully low until recently. That may or may not be true next time.

But there will be a next time.

So what can be done?

An official search party sent out by Finance Minister Michael Cullen to look for a "supplementary stabilisation instrument" came back empty-handed.

But the terms of reference of that exercise were restrictive: Don't even think about a capital gains tax on property, for example.

In principle there is no self-evident reason to tax people when they increase their wealth by working, but not when they do it by owning the right asset at the right time and place. The broader the tax base, the lower the rate can be.

In practice it is a politically poisonous proposition. At the height of the mid-1990s boom, then-governor Don Brash suggested a capital gains tax on investment property, but the MPs on the finance and expenditure select committee shrank back in their seats as if he was offering them plutonium lollipops.

Bowden suggests a capital gains tax on houses could function as an automatic governor if it cut in above the level of gain the vendor would have earned had he or she invested the same amount in Government stock over the same period.

That might blow some of the speculative froth off the market. Last year nearly a quarter of all sales were of properties which had been owned for less than two years, compared with 10 per cent in 2001.

That suggests the owners had bought with the intention of selling on for a quick capital gain. But under existing law, income tax may apply to gains realised on property - other than residential land - which was bought with the purpose or intention of resale.

Bowden suggests some measures which a government might adopt so that the burden of stabilising the economy does not rest entirely on the central bank.

It could use fiscal surpluses to acquire overseas assets, at a time when the dollar was strong, and then repatriate those funds when the cycle turned down, passing them on to the New Zealand Superannuation Fund to invest in infrastructure bonds newly issued to finance public works.

The Treasury's debt management office might also borrow money at the same maturity as where the main mortgage action was, in competition with the banks, with a view to bidding interest rates up.

But such suggestions raise a couple of questions.

One is whether the sort of money which the Government would be able, or should be willing, to risk in such an endeavour would make much difference, given the vast sums which flow around globally connected capital markets.

The other is whether the Treasury would be any better than anyone else at picking when the time for such intervention had arrived.

It looks as though policymakers will have to keep pondering this dilemma for a good while yet.