An insight into the Reserve Bank, and a suggestion from its former Governor.

Dr Brash, former Governor of the Reserve Bank, used this as the topic for a discussion in Auckland last week.

Key points that emerged from this are both encouraging, but also highlight the complexity of the subject. There are no quick fixes or simple solutions.

The Reserve Bank has long been criticised for the perceived effects their movements of the OCR have on the Exchange Rate. Put the OCR up, and this makes NZ more attractive to offshore investors. They buy NZ Dollars to send money here, this lifts demand for our currency and thus the Exchange Rate goes up.

But Dr Brash was able to point to cycles in the past where this pattern has not followed, during all of one year the two rates moved seemingly independently of each other. Even right now with the RB steadily lowering the OCR, yet the NZD has lifted strongly. Some of this from perceptions by parts of the market that the next drop may be the last. Thus the inference is that rises will follow.

There have been two detailed reviews of the function of our Reserve Bank, and both show that NZ is following "best practice".  Dr Brash explained that RB has to consider for practical reasons, the effects of Exchange Rate in their OCR calculations, but it is not a mandatory part of their rules.

A country cannot increase growth by using inflation, in the long term. Higher inflation leads to lift in wages demand. Inflation is a function of the gap between output and demand. Growth only comes from a real increase in productivity, and that has to be matched by a lift in demand for that extra production.

Historical fluctuation patterns do show a similar pattern between the NZD and other major currencies. Example, during the 1990's, NZD fluctuated 21%, AUD 24$, Sterling 21%, Yen 60%.

One can argue that the Exchange Rate is not necessarily the primary issue either. In the 1970's the NZ economy was booming, but the rate reached $1.48 against the USD. Today that would be seen as a massive disaster. But there was strong enough demand offshore for us to export at huge prices and prosper.

As a contrast, Hong Kong fixed its rate with the USD, so the nominal exchange rate has been stable. But the real inflation rate has been quite a lot higher than the inflation rate in the USA. As a result HK manufacturers steadily lost ground, and now most have had to move into neighbouring Chinese cities to get lower operating costs and remain competitive.

There was a discussion around the powerful growth in house prices in NZ. How much did this contribute to the RB's concern about excessive increase in the CPI figures. Dr Brash advised that direct house prices are no longer part of the CPI figures, but inputs into housing are. The real upwards pressure on house prices does not come from the tax benefits available to those who buy a second/third or fourth investment property. But from the simple constraints on supply imposed by Regional Governments, and a growing demand.

If demand increases faster than supply, price will rise. While our cities are ring fenced and no new subdivisions are permitted outside those boundaries, prices will be forced up by increasing pressure of demand.

Dr Brash raised the concept he had floated earlier in the week, that of the RB having the ability to increase or decrease Excise Tax on fuel. Fuel demand is relatively inelastic in the short term. Longer term people will buy more fuel efficient cars, move closer to work, use public transport etc. So if the RB was able to raise the Excise Tax, people will have less discretionary spending power, and so curb buying other products. Thus reduce inflationary pressures on goods other than those directly affected by fuel cost.

As inflation eases, Excise Tax can be lowered or even dropped below the level it was at previously. This tax would not have the same flow though to Exchange Rates long criticised by Exporters. The public are well used to large moves in fuel pricing. It is faster acting than increasing the OCR and the subsequent flow on in Bank borrowing rates from mortgages or business loans.

Maybe this is an idea worth exploring further?