The bad news, the good news and the question mark?
The Reserve Bank's recent move to ease monetary policy by keeping interest rates high and pushing the Kiwi dollar down has divided commentators. Canadian-based fund manager Friedberg Mercantile Group offers its opinion on the matter.
Thursday, March 26th 1998, 12:00AM
The much respected Governor of the Reserve Bank of New Zealand has either lost his mind or lost his nerve, or both. In announcing that the bank would like to see much easier monetary conditions over the next two years in spite of the fact that underlying inflation will be accelerating from the present 1.6 per cent to 2.1 per cent in June 1998, he jolted the market and caused a shocking 2c overnight fall in the already-battered Kiwi.
In one fell swoop Mr. Brash joined the club of the those central bankers who base their stance of monetary policy on forward-looking assessments of inflationary pressures (the Fed, the Bank of Canada, and the Bank of England). Moreover, he, like they, demonstrated a heretofore unsuspected attachment to Keynesian economics: "Weaker international demand is expected to have an adverse impact on export activity, domestic business and consumer activity, and the terms of trade. In anticipation of the impact of these developments on inflation, the bank has conditionally projected easier monetary conditions throughout the policy-relevant horizon. This will act to prevent a sharp decline in domestic economic activity, while still keeping the level of annual consumer price inflation near the centre of the target range".
Voilà. Weak demand translates into lower inflation. And easier monetary conditions reactivate real economic demand. Is this the same Donald T. Brash of yesteryear? Lack of time has not allowed us to find earlier pronouncements of his that very clearly disown these theories (we hope to document this in months to come), but it is quite clear that an important change has taken place in the governor's economic thinking. That's the bad news.
The governor has even gone one step further than his colleagues. For the past year, he has been indicating an appropriate level for monetary conditions using a Monetary Conditions Index (MCI) that takes into account movements in interest rates and the exchange rate. While admittedly he does not set interest rates as his colleagues do, an argument can be made that he has become even more interventionist than his counterparts who do not express specific opinions about the appropriate level of future monetary conditions. The governor may view this aspect more charitably than we do, arguing that the Reserve Bank is, for that matter, a more transparent institution. For all that welcome transparency, though, the Reserve Bank has become an overbearing Lord, who will neither trust nor accept the opinion of the market and who has come to believe that It knows better despite sharing the same bits of economic information.
This is a rare monetary bird, not fixed, not pegged, not floating. It is a guided exchange rate that, when misbehaved, is threatened and cajoled. Consider the very typical comment made by the Chief Manager of the Reserve Bank's Financial Markets Department on August. 18, 1997: "Overall monetary conditions have become too loose, given our current monetary policy stance...We...have been waiting to see whether the drift in conditions in recent days would reverse. It hasn't, leaving overall conditions beyond levels that we are comfortable with. As usual, the bank remains ready to act if necessary." The threat was to no avail, as the market continued to trade about 100 MCI points below the desired conditions. Just a few weeks later, the Reserve Bank sanctioned the lower market level! Threats and bluffs, not followed by any action -- and then, capitulation.
This form of "dirty float" (the Reserve Bank, thankfully, does not intervene in the foreign exchange market -- and has not intervened in over a decade) is unnerving and unwarranted. One can safely presume that the market knows better than the bank the appropriate level of monetary conditions, because it is privy to the same type of information. This point should ring true to a bank that has adopted an admirable banking supervision approach, which placed considerable emphasis on the role of the market in promoting a sound financial system.
Moreover it does not behoove a central bank to threaten and bluff; should it disagree with the market's assessments, it could easily resort to changing monetary conditions via a reduction or an increase in its cash settlement target. It is interesting to note that this cash settlement target was not changed once throughout 1997 even as the market was "overreacting" on the downside.
In a traditional and properly functioning floating rate regime, the central bank can vary high power or central bank money in an attempt to control money supply. The Reserve Bank can take its cue from the behavior of prices and act upon money supply when prices are moving away from target. It should not however engage in a futile game of forward-looking assessments, decide on specific MCI levels, and bluff/coax market participants to go along. If it persists, it will very soon lose all its hard-won credibility. And that too is bad news.
The good news is that short of an overt easing move, the market will do what it wants to do, regardless of Reserve Bank signaling. It pushed the exchange rate lower in anticipation of, or contemporaneously with, falling terms of trade, developing problems in Asia, a widening current account deficit, a stronger US dollar, and very importantly, political uncertainty at home (the Winston Peters' factor). Some, though not all, of these negative factors have begun to recede. Next month we will discuss them in more detail. Suffice it to say that the Reserve Bank's overreaction, signaling greater ease than the one indicated by the market, may merely reflect poor bank intelligence -- in very much the same way as the previous decline was resisted, with words only of course, by the bank for more than nine months. Selling at the bottom?
STRATEGY: The market is heavily short New Zealand dollars. This can be deduced by the extraordinarily high level of short-term interest rates, hovering around 9% when inflation is running below 2 per cent. The Reserve Bank may not realise it, but interest rates will offset movement in the exchange rate thanks to the activity of the short sellers. When speculators sell short Kiwi, they borrow New Zealand dollars and tighten up rates, everything else being equal. When speculators cover short positions, they repay borrowers, and interest rates ease. Present levels have discounted most or all of the bad news. Though we hesitate to put out a buy signal yet, it is clear to us that it is too late to sell.
This feature is a newsletter Friedberg Mercantile Group, Toronto sent to its North American clients.
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