Will the Fed Follow the Reserve Bank of New Zealand and Overshoot?

The Reserve Bank of New Zealand is raising interest rates because CPI inflation is outside the target range. But with core inflation very likely lower than that, perhaps within the target range, and with falling GDP growth further easing inflationary pressures, New Economist questions the central banks decision to continue raising rates to 7.0%:

New Economist: RBNZ overshooting once again: New Zealand was the first central bank to introduce inflation targeting, so you would think they'd have got the hang of it by now. But no - even with Don Brash safely relegated to the Opposition benches, the Reserve Bank of New Zealand still manages to get it wrong. Today they raised the Official Cash Rate by another 25 basis points to 7.0%, the highest in the OECD (aside from Mexico). In today's statement Governor Bollard explained the rate hike thus:

...medium term inflation risks remain strong. Persistently buoyant housing activity and related consumption, higher oil prices and the risk of flow-through into inflation expectations, and a more expansionary fiscal policy are all of concern. While there has been a noticeable slowing in economic activity, and a particular weakening in the export sector, we have seen ongoing momentum in domestic demand and persistently tight capacity constraints. Hence, we remain concerned that inflation pressures are not abating sufficiently to achieve our medium term target, prompting us to raise the OCR today.

Bollard noted "the continuing strength of household spending, supported by a relentless housing market and rapid growth in mortgage lending", along with "a worsening current account deficit, now 8 per cent of GDP." For those hoping for some respite, he warned of "the prospect of further tightening" and added:

Certainly, we see no prospect of an easing in the foreseeable future if inflation is to be kept within the 1 per cent to 3 per cent target range on average over the medium term.

True, annual inflation is 3.4%, breaching the central bank's target band of 1%-3%. But the pick-up in inflation in large part reflects higher oil prices. The pace of economic growth has already slowed significantly, down from over 4% to around 2.5%, with June quarter private consumption growth the slowest in three years. Softer domestic demand will help ease medium-term inflation pressures. The RBNZ look like they are once again going to overshoot by raising rates more aggressively than they need to - just as inflation is peaking and the economy heads into sub-trend growth. Stephen Kirchner at Institutional Economics agrees...

There are those who worry that the Fed is on the measured path to the same mistake.

Comments

[anne]

There are a significant number of economic analysts who have been continually questioning the way price indexes are structured and hold there is a bias to understate inflation. I have never taken the complaints seriously, but the analyst complaints are widely echoed and persist and should be addressed by central bankers and economists now and again.

[anne]

James Grant who writes well has been complaining about an understanding of inflation, especially asset inflation, for years. Grant has access to the New York Times as well as having quite a following going back to being a panelist on "Wall Street Week." Again I have dismissed Grant's complaints about overall inflation and asset bubbles, but the complaints are influential.

[anne]

http://www.nytimes.com/2005/03/10/opinion/10grant.html?ex=1268197200&en=c3e1f9ca3586448c&ei=5090&partner=rssuserland

March 10, 2005

Five Years Later and Still Floating
By JAMES GRANT

TODAY marks the fifth anniversary of the peak of the great millennial stock market. What were you doing when the lights began to dim? Were you a bull or a bear? Rich or otherwise?

What about today? Are you inoculated against the new alleged sure things? Or perhaps you believe in the permanent hegemony of the dollar in the world's currency markets? In the inevitability of rising house prices? Or of falling interest rates? Answer true or false: the chairman of the Federal Reserve Board is clairvoyant.

From the March 2000 top to the October 2002 trough, the United States stock market gave up more than half of its quoted value, some $9.2 trillion. Five years ago today, Cisco Systems was the world's biggest company by market capitalization. Its line of business, the computer networking business, was universally heralded as the industry of the future. Owners of Cisco still devoutly hope it is. They have lost 75 percent of their investment.

Americans hate to lose, especially when it comes to money, and they've demanded an accounting of the misdeeds of the bubble era. A certain number of former chief executives, like Bernard Ebbers of WorldCom, have had to answer the charges against them in court. And Congress, in 2002, overhauled and stiffened the nation's securities laws. But the chairman, governors and staff of the Federal Reserve have yet to be called to account.

Booms and busts are recurrent in history and in nations. In not every episode was there a culpable central bank. But in virtually every case, there was a clever neighbor. The unbearable sight of a neighbor getting rich in the stock market in the late 1990's made millions of Americans bipolar. Shopping at Wal-Mart, they would pay any price except full retail. Investing in the stock market, however, they would pay nothing but.

By the late 1990's, stocks had lost any connection to the value of the businesses in which they represented partial ownership. Picture an artful consumer settling into a discounted hotel room for the night. Now try to imagine this savvy individual formulating a calculated financial decision to make a meal of the $10 cashews and the $6 candy bars on sale in the hotel minibar. That was Wall Street a half decade ago.

And, to a lesser but still striking degree, it is still Wall Street today - and Main Street, too. The Federal Reserve did not stand idly by after the bubble burst. It radically reduced the interest rate it controls (the so-called federal funds rate), pushing it from 6.5 percent in May 2000 to 1 percent by June 2003. Alan Greenspan, the chairman of the Fed, had worried about a stock market bubble as early as 1995, had warned against "irrational exuberance" in 1996, and batted around the possibility that there might, indeed, be a stock-market bubble in discussions with his Federal Reserve colleagues as late as 1999....

[anne]

http://www.nytimes.com/2005/10/26/opinion/26grant.html?ex=1287979200&en=1f4592430c5ee44b&ei=5090&partner=rssuserland&emc=rss

October 26, 2005

Future Shock at the Fed
By JAMES GRANT

PRESIDENT BUSH's choice to succeed Alan Greenspan as chairman of the Federal Reserve Board has raised a roar of approval. Economist, scholar, presidential counselor and former Fed governor, Ben S. Bernanke is a nominee from central casting.

But there is one rub. The man with the gray beard and the perfect résumé - winner of the South Carolina state spelling bee, Ph.D. from the Massachusetts Institute of Technology, former chairman of the Princeton economics department - professes to believe the impossible. He insists that the Fed can keep the economy chugging and prices stable just by pushing a single interest rate (the so-called federal funds rate) up and down.

Alan Greenspan, of course, has long espoused the same impossibility, as have other Federal Reserve officials and many private economists. A little thought experiment will reveal their error.

Let us say that Mr. Bernanke's field of expertise was energy prices rather than interest rates, and that the president named him to the Department of Energy rather than the Federal Reserve. If Mr. Bernanke then ventured a long-term oil-price forecast, would anyone even bother to write it down? Would anyone expect him, once confirmed, to actually fix the price?

Those who did would have to call the idea by its discredited name - price controls - and would have to explain why the secretary-designate knew better than the market at which price the supply of oil would meet the demand for oil. They would also have to explain why this episode in price controls would turn out better than the long series of flops that preceded it. The world would laugh.

Yet we seem to accept, and even desire, exactly such ludicrous claims of foresight from a Fed chairman. It follows that anyone who is willing to take the job as Fed chief is, by that reason, unqualified to hold it.

Wall Street, of course, has other ideas. Thus the rally in stock prices following word of Mr. Bernanke's nomination was no vote of confidence that the presumptive chairman would settle on the right, or true, federal funds rate. It was, rather, an expression of hope that he would do his all to ensure a speculatively appropriate (meaning very, very low) rate.

Perhaps....

[anne]

Barry Ritholtz, with whom Mark Thoma presents issues, has pointed to a Vanguard chart showing that the value of American stocks relative to GDP soared from historical levels after 1990, and bear market and all is still at startlingly high levels. Is this, should this be important?

http://bigpicture.typepad.com/
http://bigpicture.typepad.com/comments/2005/10/_chart_of_the_w.html#comments

[anne]

This is an interesting time for investors since the lengthy bull market in bonds appears to be over, and besides long term yields have for months been low enough that investors could expect the 25 year period of reaping capital gains was about ended. Then, whether or not there are selective bubbles in real estate there is little reason to expect that price appreciation will be more than marginal for a period. Besides, operating earnings for real estate investment trusts have been fairly limited for more than 4 years. This leaves stocks as the main potential source of asset wealth increase for a while. Interesting.

[ilsm]

Regarding house ownership as a source of asset "wealth" it is an old realtor's scam to get people to "build equity" and use it to "trade up", all it does is generate commissions.

I first became familiar with this realtor scam when I bought my second house in a 'booming' market; fortunately, I sold it a month before that market collapsed. I was in a mobile section of my career.

When house holders "short" their house through converting the "wealth" into cash by refinancing they turn a house into an equity.

All from the realtor's commission generating scams.

Different than stock 'shorting' the house holder expects continually rising house prices.

I do not see many people having homes these days.

[anne]

There is much to consider in taking a house as a store of wealth. After all, if my home rises in value but I choose to continue to live in it than it only becomes a useful form of wealth if I borrow on the increase in value and invest the loan. As far as I can tell however, borrowing on a home is used for consumption far more than investment. Besides, home markets differ much in appreciation but in general home values have only paced inflation over a century.

So, I look to the value of real estate investment trusts as a gauge of the wealth to be accumulated in commercial real estate. These last 30 years, REITs have outgrown large and small, domestic and international stock indexes in value. There is a trick here in that the REIT index at Vanguard has only been available to investors for less than a decade. Nonetheless, the REIT index has shown remarkable growth these 30 years.

[realist]

please, somebody out there tell me how i can new zealand bonds or notes.

[anne]

This is an interesting conceptual question. Before you buy an international bond ask 2 questions. What is your sense of the relation between the dollar and the currency in question? Small currency shifts can cancel any gain in interest from buying international bonds. Then, are you better off buying international bonds or a stock index of the country? Now a stock index is easy to find for any country on the American Exchange and can be bought through Vanguard brokerage. Vanguard will also sell a country's debt.

http://www.msci.com/equity/index2.html

Use the MSCI indexes to follow a country's stock market. Look carefully at New Zealand.

[realist]

i don't know much about new zealand's dollar, but i can't see the u.s. dollar getting much stronger.

[anne]

Yes; the trick is not 7% short term interest rates in New Zealand, but the dollar against the Kiwi :) Interestingly New Zealand stocks have consistently lagged Australian stocks. Why?

[anne]

The dollar is likely to weaken in time, but against which currencies will it weaken? I am not suggesting either way, but the idea needs to be played with from several perspectives. Also, I am going to take a look at Australia for comparison when I have a few moments.

[tyoung]

Interest rates at 7%. As an old fshioned saver,I'll say bring it on. Academics debate how to manipulate shortterm interest rates in order to boost"aggregate demand" or some other wonkish term all the while bemoaning the low savings rate. Offer an honest return to savers and savings will reappear.

[anne]

No; there is a prime problem with interest bearing income. Interest income is taxed at your marginal tax rate, while dividends and capital gains are taxed at 15%. There is always a reason to be wary of interest incoem when there is a reasonable alternative, and there have been and are reasonable alternatives.

[anne]

Were short term interest rates to rise to 7% we would be more than regretful for the Federal Reserve would be forcing a recession to control prices.

[anne]

Notice that Barry Ritholtz has been continually questioning whether inflation is understated, and Ritholtz should always be taken seriously even if we disagree.

[New Economist]

To anyone considering investing in New Zealand money markets or bonds, I'd caution that the New Zealand dollar has rallied enormously over the past 3-4 years, and sooner or later must lose some ground. See for example this chart of monthly ranges since 1998: http://www.tfc-charts.w2d.com/chart/KK/M

Any foreign investors are facing serious currency risk, unless they hedge their exposure.

As to Anne's comment about Kiwi stocks, well with such high interest rates and a strong currency, you would hardly expect most sectors of business - housing aside - to be doing that well would you? Kiwi stocks have lagged Australian in part because Australia does not have the kind of rabid monetary policy makers that Wellington suffers from. Also, Australia mining and energy companies have benefited from China's huge appetite for commodity imports - whereas New Zealand's exports are more biased towards food and other rural goods.