Brian Fallow: Governor's big call was on the button

The fiscal cost of the recession will cast a long, dark shadow over the coming years, but less so in this part of the world. Photo / Dean Purcell

Governor Alan Bollard ought to be a happy man.

For the last six months the inflation needle has pointed smack in the middle of the Reserve Bank's target band of 1 to 3 per cent.

Given the lags involved, that suggests he got monetary policy right in 2008 which was, after all, a particularly difficult time. It was the year a home-grown recession was compounded and engulfed by a global financial crisis.

Because governments and central banks moved swiftly and effectively to yank us back from the brink before we had a good look down, we probably do not realise how grave the danger was.

Even so, the fiscal cost of the recession will cast a long, dark shadow over the coming years, though less so in this part of the world than among the G7 economies.

It would have been understandable if the same was true on the monetary front, that is, if the bank had erred on the side of keeping monetary conditions too loose for too long, and so set us up for another asset bubble.

But that does not seem to be the case.

Credit growth is subdued, to put it mildly, and the banks seem to be telling the Reserve Bank that that reflects a lack of demand from borrowers, rather than an unwillingness on their part to lend. (Would-be buyers of dairy farms might beg to differ.)

The official cash rate has been at an all-time low of 2.5 per cent for a year now.

Market economists, and the financial markets themselves, are busy trying to divine from the data and the bank's semantics whether Bollard "will start to tighten" in June or July.

But in fact a tightening of monetary conditions has been under way for some time.

The exchange rate has risen, on a trade-weighted basis, by 25 per cent from its lows in February last year.

The margin between the official cash rate and what banks actually have to pay for the funds they on-lend to the rest of us is much wider than it was before the crisis.

That is not just a legacy of the extreme risk aversion of the crisis itself. It has been reinforced by changes to the Reserve Bank's liquidity policy which have had the effect of requiring the banks to fund more of their lending from longer-term wholesale sources and from domestic deposits.

That policy may have been primarily about improving the financial robustness of the banks, but it has had the spillover effect of delivering a de facto monetary tightening without the Reserve Bank having to raise the official cash rate.

In addition the yield curve has normalised, that is, longer-term money costs more than short-term money.

The result has been a shortening of the average interest-rate term of a housing loan, so that the bank will get a lot more traction in the mortgage belt when it does raise the OCR than was the case at the height of the housing boom when borrowers could borrow cheaply two or three years out.

Another reason for Bollard to be feeling pleased is that a big call he made this time last year has worked out for him.

In the April 2009 OCR review he was far more explicit about his intentions than central bankers normally like to be: "We expect to keep the OCR at or below the current levels [2.5 per cent] through until the latter part of 2010."

It is really quite risky for a central bank to make itself so clear about its expectations so far into the future. Too many things can go wrong which would require it to eat its words.

For the rest of us eating your words may be, in Winston Churchill's phrase, a wholesome diet.

But not for a central bank. It acts on the world through the financial markets. Any guidance it gives them has to be credible.

Even though it gets to have the last word, the sound of "yeah, right" from the dealing rooms is the last thing a central bank wants to hear.

There have been times in the past year when the markets, in the bank's view, have got ahead of themselves in pricing in the start of the tightening cycle.

This not just a case of the markets betting wrong, too bad for them. Their bets drive the interest rates borrowers out in the world face.

Six months ago Bollard had to tug on the markets' leash again: "In contrast to current pricing, we see no urgency to begin withdrawing monetary policy stimulus, and we expect to keep the OCR at the current levels until the second half of 2010."

By the end of the year the guidance had shifted to "around the middle of 2010" which is now fast approaching. So a more flexible form of words is expected in this morning's statement.

The point is that for the past year the Reserve Bank's steady-as-she-goes statements have been a more reliable guide than volatile market pricing.

Bollard has been as good as his word.

There has been an element of good luck in this.

Things could easily have evolved in a way which required either further OCR cuts or an earlier start to the tightening cycle.

The world economy has recovered rather more swiftly than was expected in forecasts made during the depths of the recession. But then that tends to happen.

The recovery has been led by Asia, lifting export commodity prices for us, and even more so for Australia, our largest trading partner.

The net effect is that export commodity prices overall are at 25-year highs even in New Zealand dollar terms, while exporting manufacturers have the most favourable exchange rate with Australia for more than nine years.

At the same time fears of what might be called a recidivist recovery, driven by a resurgent housing market, have not eventuated.

The market seems to have run out of steam.

House prices remain high by historical standards, relative to incomes, and the cost of servicing the associated debt is about to start rising relentlessly.

But it looks as if we will manage to avoid either the American or the Australian problem.

The American problem is a matter of house prices falling to the point that a large number of borrowers are under water, that is, they owe more than their properties would fetch if sold.

The Australian problem is a resurgent property boom, pushing home ownership out of reach of more people and prompting five OCR hikes by the Reserve Bank of Australia.

On this side of the Tasman, with any luck the combination of the tax changes in next month's Budget, and rising mortgage rates, will be enough to keep the lid on the housing market for long enough to avoid a future where home ownership is the preserve of the middle-aged middle class.