Key and the Bank: a step away from the old normal

The aftershocks keep coming. One ran through the Reserve Bank early this month. The epicentre was the Beehive ninth floor.

The original quake hit the Bank the day of Christchurch’s disaster but there was too little data on which to make a sensible official cash rate (OCR) call so it waited until the regular date last Thursday. Meanwhile, Governor Alan Bollard made a reassuring speech, which some took to foreshadow a rate standstill. Others took the opposite view and began to bet on a cut by cutting market rates. Bank economists were vocal on both sides.

Then John Key added his aftershock. He told Bloomberg his “expectation” was that there would be a cut and that “we’d certainly welcome it” (“we” being the government).

Those betting on a cut gained thereby powerful added weight on their side of the game.

Bollard cut.

His reason: the February 22 Christchurch aftershock would have a substantial short-term economic impact, directly in cutting actual output and indirectly in unnerving businesses and households nationally, which could compound the direct impact. Could the Bank then “sit on its hands”, as one commentator puts it?

Bollard’s 0.5 per cent cut was in effect an anti-depressant jab for Auckland and elsewhere.

He called the cut “insurance” — near risk-free. Much business and mortgage borrowing is now short-term or floating, so the cut would, he said, quickly and fully flow into actual market rates (which it did), so he could get an equally fast response when he reverses the cut after the anti-depressant does its work.

Moreover, the earthquake is the sort of one-off event the Bank is supposed to “look through” and act only if it becomes embedded. October’s GST rise was such an event.

Even so, Bollard is projecting inflation in the top half of his mandated 1-3 per cent band through the next three years.

He can do that (as he and predecessor Don Brash have done most years since 1989) because politicians “look through” periodic spikes above the top of the band. Politicians (and interest groups) would get very agitated if inflation went through the bottom of the band.

Key’s “expectation” is in that vein: in politics, to adapt an old saying, inflation is the better part of rigour.

That wrong-footed the no-cut brigade who worry inflationary pressures have been building. In fact the Bank itself said that when the huge, and inflationary, reconstruction gets going the OCR must not then be “stimulatory” — that is, under 4.5 per cent.

The rigour brigade’s other logic, that nationwide interest rates are a blunt and ineffective tool to fix Christchurch, which requires targeted government spending, fell victim to the Bank’s perception of national sentiment.

But Bollard did incorporate fiscal considerations: his staff talked confidentially to Bill English’s to get a feel for English’s still-forming fiscal intentions. (He appears, like Bollard, to be looking through the earthquake for now but then aiming to compensate for ongoing costs to stay on track to fiscal balance by 2014-15.) Fiscal and monetary policy are ends of a seesaw: looser fiscal settings require tighter monetary settings and vice-versa. Bank staff shared their thinking on the OCR.

All in order in an emergency, as far as it went. Bollard and English understand and respect the unwritten rules.

Key’s going public, however, betrays a lack of that understanding and/or respect. That is a bother because our freedoms depend in part on the powerful observing constitutional and legal niceties.

Key did qualify his “expectation” by saying it was for the Bank to set the OCR. But in Singapore Annette Beacher of TD Securities was unconvinced. She told Bloomberg: “He should be maintaining the appropriate distance.”

We can be reasonably confident Bollard was not influenced by Key’s comment. But it was “noise” the Bank could have done without, as one insider said, because some might have seen the Bank as having met Key’s “expectation”. And appearances count in financial markets, as Beacher in effect said.

The point is that if a Prime Minister “expects”, that is close to an instruction, as Admiral Nelson could have told him.

A byproduct is that, by in effect prioritising economic sentiment and activity, Key has given Labour room to claim he has done informally what it wants to do formally. Labour wants a Reserve Bank Act change to “broaden (the Bank’s) objectives to include external balance and growth, including exchange rate conditions” and not target inflation above all else, on which New Zealand led in 1989 and has been an exemplar since.

More broadly, Labour might coopt Key’s comment as fitting into the shift in economic thinking from the “old normal” of free markets and light regulation to a “new normal” with more rules set by more active governments. That is Labour’s direction.

Key has thus served Labour a small tonic it badly needs, even if in an arcane corner of economic policy.

After an earthquake come aftershocks. The effects can be unpredictable.

* Since this was published, I have been told that the Reserve Bank asked the government whether it wanted to have input into the official cash rate decision, given the state of emergency, and the government said no.