RBNZ introduces some liquidity
The RBNZ has made it easier for banks to borrow money off them, in order to stave off a squeeze in credit in the banking sector. This sounds fine to me, and the measures they put in place seem reasonable, there was one thing I did not understand though. It says that the bank is selling more short-term bonds, wouldn’t this contract the money supply and reduce liquidity?
Maybe the reporter put it down wrong, but making it easier for banks to borrow money, and then providing them riskless assets to buy with it doesn’t sound like a way of increasing liquidity in the New Zealand credit market. Hopefully the RBNZ does a release soon, and explains to me how I’m an idiot, or if you’re quick maybe you can beat them to it 😉
Yep, the reserve bank just buys money and sells money like it was like . . . . money. I’ve never heard of an “overnight reverse repurchase facility (ORRF) a last resort instrument” but let me guess, when a bank comes up a bit short at the end of the day, it says quick give me an ORRF and here’s my security and hey I’m prepared to pay the extra interest. Why are they short? per Rod Oram’s Column recently http://www.stuff.co.nz/4169909a23615.html. NZ banks have been able to raise a good portion what they borrow from overseas lenders and now these lenders want their money back as soon as they can get it. Also on the news today there was mention that the banks are now holding onto more cash than they normally do and are unwilling to lend as much to each other. So, like you I think more needs to be explained. In addition to your question here’s another. The reserve bank has been raising interest rates for some time now in order to combat inflation (ie it has been trying to reduce liquidity and has totally failed) Because, when the reserve bank raised their rates, the opposite happened, it attracted money into the country raising the exchange rates and making money more available to the punters. Now despite our high rates, this money is leaving (having said that there is more money coming in over the last couple of days).
The one problem I have with this is the mechanism you described for reducing inflation. The bank wants to reduce domestic demand, so the the pressure on domestic prices abates. The inflation problem has been through domestic goods, with non-tradable inflation running over 4%.
As a result, lifting the OCR is an effective mechanism for reducing inflationary pressures, however liquidity from outside the country and the prevalence of fixed term mortgage rates everywhere have extended the lag between when the OCR is introduced and when it is effective. We will always be able to get sufficient liquidity as we are such a small economy, the main aim should be to increase our claim to real resources.
Sorry it took me so long to reply, it refused to show me your comment, whenever I tried to look it logged me out 🙁 , its working now though 😉
Matt, I’ll rephrase my question, because I think it’s a really important question.
From the above can we say that we agree that raising the OCR CAN be an effective way of reducing inflation, rather than IS. As soon as the NZ OCR lifts appreciably above the interest rates in other countries instead of reducing liquidity in NZ it increases it because what you end up trying to do is reduce global liquidity which as far as the NZ economy is concerned can be treated as infinite. Back late 2003 when our OCR was raised and started to get a bit higher than the rest, instead of tightening up credit it started a mortgage war between the banks. So why, in the face of this evidence did the Reserve Bank continue to raise the rate only to fuel the property market (and cause inflation). So what was the actual mechanism causing the increase in liquidity? Question 1:
The reserve bank takes deposits from banks at higher rates of interest. Banks therefore can offer higher rates to their depositors and this attracts more money. In addition NZ banks can now offer attractive rates to overseas depositors and overseas money also floods into the banks. What happens now, is that not all of the money the banks take is deposited with the reserve bank, some of it (and it probably doesn’t have to be a high percentage) ends up being available for domestic mortgages. Is there still a reserve bank asset ratio, ie banks are only allowed to lend a certain percentage of their deposits, the rest had to be deposited at the reserve bank. If this still exists (in the deregulated environment) then surely it should have also been increased at the same time the OCR went up to counter the above described effect. If it doesn’t still exist (or the deal with the banks is that it won’t be changed) then continuing to increase the OCR in the face of clear evidence that all it is doing is increasing liquidity is obviously wrong.
The counter to this argument might be that, this increase in liquidity is only a short term effect, and that long term, with a higher OCR the inflationary pressures will be reduced. All we have to do is wait and inflationary expectations will be burned off. The problem with this approach is that it is loose loose. If inflation is killed off then a whole lot of investors are burnt, if it isn’t, then everyone looses.
The issue is that we have a high OCR relative to everyone else and this creates distortions. Those who observed that when the Reserve Bank sold NZ$ that they were “loosing/making money” overlooked the fact that the high rates of interest being paid by the reserve bank is also “lost” money, money that is being paid to “Japanese Grandmothers” for doing nothing (by the way this additional money when it is paid out is also inflationary in that it increases the money in circulation). Why should we as a country be paying these grandmothers (and all of the banks, and currency dealers clipping the ticket on the way) good rates of money for taking no risk at all? In addition, these investors get a tax break!
So what should have been done? Well (if we really want the OCR at a level that attracts money into the country), unwind the tax break and go the other way, charge a fee on the banks that sell deposits to overseas investors (if they can register their depositers to get a tax break, they can register them to be charged an additional fee). I don’t like this idea as it would probably be easily circumvented. What I actually think should happen is that the OCR should be dropped back to a par with Australia.
In summary there are two questions; Why exactly does liquidity increase when the OCR is increased and additional money is attracted into the county. Is my description above correct. Secondly; In fighting inflation is there really only one tool at the Reserve Bank’s disposal, the OCR, what about requiring asset ratios for registered banks?
First question: You are right that when our interest rate is well above the rest of the developed world (note that there are other countries with higher real interest rates outside the OECD), there will be demand for NZ$ and liquidity will increase. However, banks still did react to an OCR increase by lifting mortgage rates. The mortgage war during 2004-2005 did keep rates lower than the RBNZ would have wanted, but it did appear that the housing market had peaked by mid-2006. The level of liquidity is more important for firm investment, which remained relatively cheap even as the OCR rose.
Recent empirical analysis shows that the growth in house prices depended on growth in demand for houses, not on the level of interest rates. As a result, the level of migration is a good indicator of what will happen in the housing market.
Second point: We only use the OCR now, we used to use an asset ratio as well. I think the main reason our RB doesn’t use it anymore is that they think operating banks have a better idea of the risks associated with the credit market, and so will make efficient reserve ratio decisions. Banks do hold a reserve ratio, but it is not public or regulated. Maybe that is something they will discuss in the monetary policy forum that is going on.
Ultimately I think the OCR is still an effective instrument, however as our business cycle seems to have become disentangled with a lot of the worlds there are a few problems. I think the Bank will look at potential mechanisms that will differentiate the return to investors (which brings in liquidity) from the incentive to save (which eases domestic demand).
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Cheers
Marko Fando