Highest interest rate in developed world just got higher

The RBNZ has just raised their key interest rate this morning in another desperate bid to out-flank inflation. Enough has been said by me about the difficulties of our giant current account deficit and the plight of our exporters with our high dollar built on the back of our reserve bank's high interest rates. The bank has just issued it's statement:

The Official Cash Rate (OCR) will increase by 25 basis points to 7.25 per cent.

...We remain concerned about the tightness of resources and the persistence of inflation pressures.... The main driver of the strong demand is household spending, linked to a still-buoyant housing market. Increasing government spending and continued strong business investment are also boosting total demand. The resulting excess demand, reflected in a growing current account deficit, is continuing to fuel inflation.

Excluding one-off oil price effects, inflation has been trending upwards. Furthermore, while headline inflation is expected to return below the upper end of our target band by mid-2006, it is projected to remain high throughout the projection period. In addition, there is a risk that inflation could track higher. Mortgage credit growth and house prices have held up longer than anticipated; we are forecasting these to slow markedly in 2006, but continued strength remains a risk. The current high rates of increase in labour and other business costs present a further risk, particularly if inflation expectations become locked in at current high levels.

The main downside risk to our projections is the prospect of a faster-than-expected correction in domestic demand, leading to a harder landing for the economy and a more rapid easing of inflation pressures...

...Whether further tightening is needed will depend on the extent to which housing and demand pressures show signs of moderating over the months ahead. However, we do not yet see any prospect of a policy easing in the foreseeable future.

I drew attention some months ago to a Treasury report that has warned the government in rather dramatic language about a sudden and market-led currency devaluation. I have hypothesised about what could trigger it. Since most of the demand comes from speculators/"investors" then lowering the official cash rate would achieve that by reducing the yield on the dollar and increasing the risk of inflation (by encouraging housing spend). Both things would dissuade overseas investors in our dollar. But because controlling inflation is the primary objective (as it should be) Governor Bollard is very much restricted in doing anything than hiking the rates up. I, and others, have been recommending recently the Governor use other powers he has (such as increasing the amount of funds trading banks must keep in the RBNZ) to contract the ability of banks to lend to the housing market (amongst others) - Dr Cullen has also called on an investigation of these issues. But it all seems rather far away.

Another possible trigger to a loss of confidence in our dollar to provide the same "safe" returns as now (and we are very high at US0.71c and €0.60 at the moment) is a down grade in our credit rating with one of the big agencies rating sovereign debt. And what are they now speculating about?

The increase comes as international ratings agency Standard & Poor's warned that if New Zealand's current account deficit increased much further, the country's international credit rating was at risk. [NZH]

So that trigger looms large now. If Bollard said he expected inflation to be at more than the current 3.4% in the next two quarters would that add pressure enough to precipitate a fall? Along with a credit rating down-grade?

The point in sharing all of this is that I believe, as most economists, businessmen and people do that the amount of money this country collectively owes the rest of the world is becoming increasingly difficult to service by this country and that we are continuing to borrow money from the rest of the world, not to invest in growth industries and productive capital and infrastructure, but on over-valued speculative property and plasma screen TVs. This is a bad situation, and unsustainable... surely?

I think our Reserve Bank was one of the first (if not the first) to design a monetary system that puts a low inflation target as the key reason for the bank's existence and has developed an inter-bank cash rate as the mechanism to do it. Other central banks have followed our lead. So we are a harbinger of things to come for the other banks in some ways - the UK followed us and now the Bank of England has higher than acceptable inflation too. With our high immigration, housing demand and interest rates we will be a case study of sorts.