KEY POINTS:
Dr Bollard has started playing hardball. The implications for the economy are enormous. The Reserve Bank recently cut the official cash rate by 0.5 per cent when financial markets were expecting a cut of 0.25 per cent.
The difference may seem tiny but the message is huge. The results for households will also be significant.
Market observers are used to our Reserve Bank acting in a predictable manner. The size of the cut caught them by surprise and created uncertainty about future bank actions.
The cut will affect floating mortgage rates but its real effect is to drive down the kiwi dollar. This impact was immediate largely because the Reserve Bank's actions caught the markets by surprise.
Financial observers are used to our Reserve Bank acting very predictably. If inflation is running at the top end of the 1-3 per cent target, the Reserve Bank raises interest rates in an orderly manner of 0.25 per cent each round. This has provided a safe one-way bet on the kiwi dollar.
It was widely anticipated that as the economy is now in recession the Reserve Bank would reverse this process in an equally predictable and orderly manner. Last Thursday's announcement upset this expectation.
The implications for the average household are significant. Despite media pundits suggesting that interest rate cuts will help those caught in the mortgage trap, the reality is that there will be little immediate relief.
Most Kiwi mortgages are fixed so the cuts will have little impact on these people's discretionary spending. The more ominous point is that the Reserve Bank's OCR cuts affect short-term interest rates.
Long-term interest rates that fund our fixed mortgages are largely determined by the relationship between our savings and borrowing. Because of New Zealand's low savings rates, a large portion of our borrowing has been sourced from overseas.
Dr Bollard's surprise action means that when overseas lenders receive their kiwi dollars back they will be worth less. This will quickly reduce their willingness to lend to us.
So there will not be immediate relief to the average household repaying a mortgage. Dr Bollard is sending a clear message that we have been living well beyond our means and are now having to pay the price.
He has been issuing warnings about this for years. The evidence is New Zealand's gaping current account deficit. This deficit represents the difference between exports earnings and import payments and is funded largely by overseas borrowing.
These loans have been pumped into our housing market which does little to enhance our ability to repay them.
Dr Bollard has unsettled those speculating in the New Zealand dollar. The predictable market poodle has developed a bit of mongrel.
This will cause speculative funds to flow out of the New Zealand dollar and drive the kiwi down against other currencies. As the kiwi drops it will become increasingly evident we have been living on other people's money.
Expect petrol and food prices to climb. As the dollar falls, imports will become more expensive. Goods that are exported will also increase in price as exporters gain better prices overseas. This will continue to put pressure on households.
The cost of holidays abroad will increase as will cars and electronics.
In the past few months our economy has been sitting in the eye of a cyclone. The overseas credit crunch has driven our economy into a recession but we have felt insulated from the housing market dramas abroad, unwilling to admit the same processes have been at work here.
The easy credit unleashed in the early part of the decade flooded into the housing sector.
The huge surge in house prices based largely on credit created a feel-good wealth effect. This encouraged people to take on more debt.
Lenders fell over themselves to encourage this. Shoddy lending practices have created this mess. Now the credit tsunami is rapidly receding and the wealth myth is being exposed.
Dr Bollard is likely to cop significant criticism over the coming months. His recent action in slashing the OCR is a bold and brave move.
Ironically, lowering the OCR is aimed at lancing the debt boil that easy credit has created. Dr Bollard is trying to hasten the rebalancing of the economy from debt-fuelled consumer spending to export-led growth. This process is likely to be painful but it is necessary and the sooner the better.
* Peter Lyons teaches economics at St Peter's College in Epsom and has authored several economics textbooks.
