Tradable sector needs policy focus
We are at a time where, on the surface, our economy looks to be doing well. Most of the headline numbers would indicate this, the domestic economy is growing, boosted by the Christchurch rebuild, and the agriculture and primary processing sectors have benefited from strong commodity prices. While this is all true, a deeper look reveals worrying structural imbalances in our economy.
Currently our policy settings have the effect of deflating the tradable sector, while favouring domestic, non-tradable activity. This leads to falling investment and employment in the tradable sector and so increasing pressure on our balance of payments. The tradable sector supports activity in the non-traded economy, and over time, this shrinking of the tradable sector compared to the non-tradable will have lasting damaging effects on our economy. The tradable sector is the biggest driver of productivity in any economy, and as ours shrinks, how can we really expect our productivity to grow?
Policy response to inflation is the key, predicted inflation outside the target band (1%-3% in the medium term) triggers a response from the Reserve Bank of New Zealand (RBNZ), lifting the Official Cash Rate (OCR) to address domestic inflation, but in the process deflating the tradable sector via the exchange rate mechanism. The non-traded sector shrugs off changes in debt servicing, the result is that inflation in the non-tradable sector barely responds to the change but the massive impact on the traded sector brings the headline result into target band. Not much hope of economic rebalancing in this policy framework.
What does this mean for our policy settings in New Zealand?
To begin with, it is clear that our simple one target, one lever process of using the OCR to control inflation is not enough. It is too indiscriminate, and cannot tackle domestic inflation without damage to the traded sector. The RBNZ needs more, better targeted tools that can deal with non-traded sector inflation and support exporting activity, and generally growth in the traded sector.
The Reserve Bank Act could be updated to accommodate the world of today and move beyond inflation targeting and include other factors such as employment and exchange rate, as well as placing a greater reliance on existing macro prudential intervention and the deployment of other tools. For example, capital management and debt to income limits could all be part of the RBNZ’sapproach and be included in all forward guidance.
The RBNZ’s introduction of Loan to Value Ratio (LVR) requirements, in addition to other prudential interventions, are recognition that interest rates alone will not fix the inflation problem. We have already seen some indication that the LVR policy is impacting house price inflation, taking some upward pressure off interest rates.
It is clear that the OCRs effect on domestic inflation is ponderous, blunt and limited, it is equally clear that the OCR is highly effective at deflating the traded sector. All up the impact is to kill traded sector investment and growth; any talk of rebalancing the economy is dreaming while current policies are in place. The two graphs presented here underscore that position.