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?