Sunday, 25 March 2007

How the Reserve Bank of New Zealand should manage Monetary Policy

Monetary policy appears to be ineffective and the Reserve Bank is losing credibility. Through 2006 the Governor, Alan Bollard, regularly threatened the markets with a rate rise, but in the end none came.

It should make some sense that with that much talk surely there must have been some action? I argue to the contrary; to make a bigger impact the Reserve Bank needs to say less. A lot less.

For the Reserve Bank to be effective, it needs to employ silence. Alan Bollard has yet to twig that markets love volatility and cannot make money in times of stability. Each time the Reserve Bank speaks, ostensibly in the interests of transparency, the New Zealand markets react. Not to what Mr Bollard says, but the way he says it, and more importantly, what he doesn’t say. They ignore the lines of text in favour of reading the bits in between.

2006 was a good example of this. First the markets were convinced that the Reserve Bank was going to lower interest rates as the economy slowed. Indeed, in March, the Reserve bank said that it did “not expect to raise interest rates again in this cycle”, which itself was a further softening of the language it used in January.

By June the rhetoric had slipped further, to “we do not expect to tighten policy in response to the high headline inflation in the short term. But, equally, we cannot afford to ease policy until we have more certainty that future inflation outcomes will be trending down comfortably below 3 per cent. Given this situation, we see no scope for an easing of the OCR this year.”

Then in September the language started to reverse: ”we are less confident that no further policy tightening will be required in this cycle. In this regard, we will want to be clearer about the economic situation and outlook. However, there is clearly no prospect of an OCR cut for some considerable time.”

By the end of the year the Reserve Bank was outright threatening: “further tightening cannot therefore be ruled out. This will depend on economic outcomes and in particular the emerging trends in housing and domestic demand indicators. Any easing of policy must remain some considerable way off.”

All this had a dramatic impact not only on the market setting of interest rates, but more dramatically on the value of the New Zealand dollar. And yet in the course of the year the Reserve Bank actually did … nothing.

In contrast to the style of management here the Reserve Bank of Australia (“RBA”) has a much simpler plan. If it has nothing to do, it has nothing to say. As a result the Australian currency and interest rate markets tend not to be pitched around by loose words.

The RBA meets 11 times a year to discuss the setting of interest rates, but when it makes no interest rate change it says nothing more than it agreed to make no change. Four times a year it states its case for how and why it is managing monetary policy, but these Statement on Monetary Policy documents are mostly read by insomniacs. The Statements only get read thoroughly when the RBA has something to say.

That meant that through 2005 there were few words written by the RBA and the markets had little to react to. It was only last year when the RBA communicated often, as it was changing rates (relatively) often.

For New Zealand’s monetary policy to be more effective the Reserve Bank need only mimic the RBA’s process:

Discuss interest rate settings each month (not 6 weekly).
If there is no change made, make no comment.
Publish the Monetary Policy Statement 4 times a year at different dates from the regular monthly meeting.

By limiting what is said through the year to only what is relevant the words published will receive the interest they deserve. Volatility will diminish and markets will not create instability as they jump at each Reserve Bank threat.

Who knows, households may then move back to floating rate mortgages, as 90% of Australia is and so when the Reserve Bank does do something it will be noticed…and have the impact it desires.

1 comment:

Kiwi Trader said...

Unfortunately the RBA's title as the "Best Central Bank in the World" has slipped......
They are going to comment more often, and try to be more transparent.

Rats...they were doing so well!