Playing it safe or party pooping?

By Brian Fallow

Between the lines

Federal Reserve chairman Alan Greenspan once characterised the central banker's role as taking away the punch bowl just as the party gets going.

His New Zealand counterpart, Don Brash, has drawn fire for premature party-pooping, in foreshadowing last week a rise in short-term interest rates before the end of the year.

Who is right, Dr Brash or his critics, will not be clear for a couple of years. Because of the lags with which monetary policy operates, a tightening now would have its main effect in dampening demand in the economy in the year after next.

It is designed to pull growth back from the 4 per cent level it is expected to hit next year, down towards the 3 per cent pace which the bank reckons is the sustainable rate if you want to keep inflation well behaved.

Dr Brash's critics, who fear that he will smother the infant recovery in its cot, cite the relative fragility of business confidence. Certainly confidence has retreated from the euphoric heights reached earlier in the year, to arguably more normal levels.

But if confidence relies on a continuation of interest rates at what are historically very low levels, then it is brittle indeed.

Low interest rates were never going to last forever. Longer-dated rates have been on the rise for months, under the Fed's gravitational pull (plus some increase in the risk premium attached to New Zealand bonds). Fixed mortgage rates have risen accordingly.

There is always scope for argument about when Dr Brash should follow suit.

He is placing a lot of weight on the improvement in world growth forecasts but, unhappily, there is no simple mechanical link between that and better times for New Zealand exporters.

How much of any increase in world commodity prices, for example, will be swallowed up by a firmer kiwi dollar?

Dr Brash's caution no doubt relates, in part, to the fact that he is using what is, for him, a new policy instrument, an official interest rate. Nobody can be sure how responsive the economy will be to a given rise in interest rates. But the fact that most mortgages are on fixed rates suggests the response will be more sluggish than if most were floating.

Dr Brash will also be conscious of the dangers of repeating the mistake he made at the same stage of the last business cycle, when growth got away on him. Having been too slow to start tightening, he then had to stomp on the brakes, with painful effects on the export sector in particular.

That undoubtedly contributed, along with drought and the Asian financial crisis, to last year's recession.

A good reason not to make the same mistake again.