Monetary Policy and the Economy

There has been much in the news recently about monetary policy and its impact on the economy.
Recently we had the RBNZ Governor increasing interest rates to combat inflation (there are rumours that he will do it again). This had a significant impact on the NZ Exchange rate:

• the increase in the interest rates makes NZ an interesting investment opportunity for overseas investors. NZ has one of the highest interest rates in the western world and therefore offers a great return for overseas investors.
• This leads to an increase in the demand for the NZ$ as the overseas investors need NZ$'s to invest with. This increase in the demand for the NZ dollar in the short term leads to a shortage of dollars at the existing exchange rate, this leads to an increase in the quantity supplied of NZ$ and an increase in the Exchange rate.
• The increase in the Exchange rate then makes it more expensive for our Exporters to sell their products overseas, and makes it cheaper for NZers to buy imports. Making NZ earn less (from Exports) and spend more (on imports) this has the effect of worsening out deficit on trade with the rest of the world.
• The less income earned by exporters makes it difficult for them to create jobs and so the economy begins to slow down. This should lead to a reduction in inflation as with less income NZers begin to spend less, and as our imported raw materials cost less to import.

However, NZ banks are owned by overseas banks and they are able to draw money from overseas at cheaper interest rates than the rates the RBNZ charges (the OCR) and so are able to maintain a lower level of mortgage interest rates than they probably should be given the level of the OCR. And so Dr Bollard has been increasing the OCR repeatedly trying to dampen down inflation, which has the impact of increasing the exchange rate and further hurting the Exporters.
This has led some economists and media analysts to ask about the effectiveness of the OCR as a tool to dampen inflation.

So recently, after being concerned about the Exchange rate, the RBNZ decided to intervene in the Exchange rate market, they sold $NZ (a lot of them) this increase in supply pushed down the price (Exchange rate) of the NZ$, however it lead to only a brief reduction in the exchange rate as overseas investors with deeper pockets simply took the reduction as being only temporary and invested again in the NZ$ again increasing the demand for the NZ$ and the exchange rate back up to its record high levels.

The RBNZ then decided to intervene again, only this time the decrease in the Exchange rate lasted for an even shorter time with some overseas investors making a small bundle each time.

Even more recently and reported in the Australian press the RBNZ has recognised that this method of intervention doesnt have the impact it would like, it isnt as effective as it would wish. the RBNZ will intervene in the future but in a much less obvious way in manipulating the curriencies that they have as reserves. This will only have limited effects as well as the players in the exchange rate markets are too big for us to influence in a longer term way.

• The politicians have now begun to wade into the discussion, with Winston Peters beating his chest loudly suggesting that there should be more that the RBNZ should focus on instead of just inflation.
• And in a tag team move worthy of the WWF Michael Cullen hinted to the media that there was a clause in the the Reserve Bank Act that would enable him to force the RBNZ to consider other Economic factors (such as the Exchange rate) as well as price stability.

This is a suggestion of political intervention into the monetary policy decisions for NZ and is a step away from the independence of the central banking system that NZ established in 1989. it will be interesting to see if Michael Cullen acts on his suggestion putting us back into a political model more in line with the 1980's, or if he is simply making a political point and attempting to score some economic points with the voters.