Brian Fallow: Bank searches for lighter hammer

The Reserve Bank's No 1 strategic priority is to "investigate the potential for macro-prudential policy tools for New Zealand".

Deputy Governor Grant Spencer says a number of smaller open economies are looking for, or already using, a broader range of policy levers than just a policy interest rate such as the official cash rate to dampen cycles in credit and asset prices.

"The motivation for this approach has been the difficulty some of these countries have had in controlling domestic financial conditions in the face of easy global liquidity or large swings in commodity prices," he writes in the bank's latest Bulletin.

"Raising the policy interest rate to counter stimulatory financial conditions - often reflected in surging asset prices - has at times put significant upward pressure on exchange rates."

This is understated central banker talk for something exporters are bitterly aware of.

There are times when the bank is struggling to rein in a bolting domestic economy yet it is the export sector where the bit bites, through interest rates' effect on exchange rates.

During the last boom, when rapidly rising house prices encouraged an inflationary borrow-and-spend binge, the Reserve Bank's repeated moves to tighten were frustrated by the fact the world was awash with cheap money, which the banks happily slurped up to on-lend to eager borrowers at rates little affected by the OCR.

What traction monetary policy had was mainly through the impact of large inflows of foreign money in driving the exchange rate higher and hammering exporters (and firms competing with imports) even though the seat of the inflation problem was not there but in the suburbs.

In the end it was the bursting of property bubbles in the United States and elsewhere which triggered the financial crisis and awakened interest among policymakers in new tools to reduce the risk of a recurrence.

The sorts of instruments under consideration, according to the Bank for International Settlements (central bank central), include:

A countercyclical capital surcharge, which would require banks to build capital buffers in good times, to restrain risk-taking, and run them down in bad times to allow the financial system to absorb emerging strains more easily.

Core funding ratio and other liquidity requirements, which would reduce banks' tendency to rely on short-term funding markets to support rapid lending growth.

More conservative provisioning against potential bad loans, which anticipates what might be expected when the economy turns down rather than looking backward at recent experience.

Caps on loan-to-value ratios for property lending and/or caps on how much of a borrower's income can be pre-empted by debt-servicing costs.

As for how much of this might happen here, Spencer says the Reserve Bank is considering the possibility of additional capital requirements that would increase when asset markets and credit are expanding rapidly and decrease when they are slowing.

He expects the Basel Committee on Banking Supervision to endorse their use. "However, it is too soon to say whether time-varying capital requirements will have merit in the New Zealand situation."

On the core funding ratio, however, the bank has already acted. Since April 1, banks have been required to fund a minimum proportion of their lending from "stable" or "core" funding sources, namely retail deposits or longer-term (more than one-year) wholesale funding.

This was introduced mainly for financial stability or micro-prudential reasons, to reduce the amount of a bank's funding that needs to be rolled over during times of stress.

New Zealand banks' vulnerability on this score was underlined at the height of the global financial crisis when offshore credit markets on which they relied froze.

But the Reserve Bank believes it will also take some of the burden off the official cash rate.

"The [core funding ratio] requirement will tend to hold retail lending rates up relative to policy rates, thus mitigating 'carry trade' pressures on the exchange rate during boom periods."

A possible extension of that policy would be to adjust the core funding ratio up and down with the aim of moderating the cycle.

"Thus in a credit-based housing boom, for example, the required [core funding ratio] could be increased by a fixed percentage for all banks and then reduced to normal levels once credit/housing pressures eased," Spencer said.

However the BIS warns against expecting too much from macro-prudential tools.

They may assist, but they are no substitute for, conventional monetary policy.

"If inflation risks are emerging, macro-prudential measures cannot take the place of interest rate increases," it says in its annual report.

Their effects on aggregate demand and inflation expectations are weak and uncertain compared with those of interest rates.

"The overall experience to date does not suggest countercyclical variations in buffers have powerful and lasting effects on credit and asset cycles. Despite the fairly active use of measures related to property lending in Asia the region's economies continue to see quite large and frequent property cycles," the BIS says.

"Yet the benefits of successfully moderating both phases of the credit and asset price cycle are clearly worth pursuing over the longer term."

If these sorts of measure can only play a supportive role to traditional monetary policy, how likely is a repeat of the destructive pattern of the middle years of the last decade?

Fortunately, it does not look very likely at this point.

The prospects of another housing boom so soon after house prices doubled within the space of five years are remote.

Traditional metrics of affordability, like the ratios of house prices to income and household debt to income, remain very high by historical standards.

People have embarked on what may prove to be an extended period of deleveraging. In real per capita terms household debt is falling.

Tax changes in the Budget, while milder than many feared, have reduced the incentive, and to a lesser extent the opportunity, for investors to use rental properties as a tax shelter. That should reduce demand in at least some parts of the housing market.

Meanwhile, on balance a return to a world awash with cheap money seems less likely than not.

It is possible, if those who believe the western world is slipping inexorably towards deflation are right.

But the more widespread view is that high levels of household and government sector debt will inevitably mean higher interest rates and slower economic growth.