Does inflation targeting encourage borrowing?

That is the view put forward on the Rates Blog by Neville Bennett. It is also a view that Berl has enjoyed some airtime with. It is also, in part nonsense from a bunch of very smart people. Lets flesh it out a bit.

The quote that captures the essence of the argument (and the one that I least disagree with):

Its high Interest rates, like NZ’s, encouraged the borrowing of foreign currency.

In part this is could be true – if the Reserve Bank can only control the domestic interest rate then the relative “price” of domestic credit is higher, so banks will substitute to foreign credit. Very good. However, although this initially sounds bad or maybe scary, this factor by itself ignores ALOT about how inflation targeting impacts on the economy. It only tells us that banks MAY source a greater proportion of credit overseas – not more credit.

Furthermore, it gives the impression (which appears to have at least been implied here, and has been fully stated by Berl) that higher interest rates lead to more domestic borrowing. This my friends is complete nonsense. Let me wave my economics wand and show you why 😉

Inflation targeting and borrowing

So inflation is above our target for some reason, we increase interest rates, this also increases the exchange rate (not necessarily the case, but seems to happen anyways). Very good.

People are attracted to the higher interest rate, but they are nervous about the higher dollar – as this creates risk surrounding the future value of the capital they shift into the country. As a result, when investors come in to lend capital they push up the exchange rate – creating a risk-return trade-off for themselves. Because of this, the RBNZ is still able to control the domestic interest rate – as by increasing the OCR they increase the interest rate domestic savers face, and by increasing the exchange rate it increases the risk to overseas investors, increasing the return they need for additional capital to flow in.

This actually suggests that the above statement about the relative level of foreign to domestic capital may not even hold – as it depends on the assumed risk from the exchange rate.

This is all very exciting, however it misses the point. The main point isn’t the supply of capital – it is the demand for said capital.

The above argument about supply told us that the RBNZ CAN increase the interest rate by increasing the OCR, as it increases the cost of both domestic and international credit. As the increase rate rises the quantity of capital/money demanded falls. When you have to pay a higher interest rate you borrow less – WOW.

This fact, by itself, is what matters. By increasing the interest rate the Reserve Bank reduces domestic borrowing. People that try to sell an argument by only looking at the “supply” of capital, with explaining why the constraint of demand does not hold are playing trickery!