The same old problem...
Cost Price Inflation figures released by Statistics New Zealand on Tuesday revealed that the same divide between the domestic and external economies that had haunted the tradable sector last decade are back. Headline inflation was at 1% year on year, but domestic inflation had reached 2.4% while traded inflation was at -1.1%.
We have dual problems emerging in the economy – an export sector destroyed by an overvalued exchange rate and the early indicators of another land and buildings bubble. History has shown we cannot deal with both issues using only interest rates.
This chart shows what happened last time around in the mid 2000s. Another round of low export returns and increasing debt in the domestic economy will further push our economy out of balance and drive even greater deficits in the current account. That is unsustainable.
The price of credit has proven to be an ineffective regulator of domestic demand. An increase of say two percent in the price of mortgage credit is fairly insignificant if house prices are expected to increase between 10 and 20 percent. This has meant that the tradable sector, which has caused little inflationary pressure, has worn the brunt of Official Cash Rate hikes through their impact on the exchange rate.
Regulatory controls on the supply or demand of credit are necessary. An interest rate cut is needed to relieve exchange rate pressure on the export sector, but this will only inflame the problems brewing in the housing sector if no changes are made. Prudential requirements of higher capital reserves for asset backed lending are needed to offset the impact of lower interest rates on asset markets.
We cannot simply continue to plug on with the same failed strategy. Adjustments must be made to the implementation of Reserve Bank Act before the new Governor starts to ensure we have a monetary policy framework that works for the whole economy.