Saturday, May 26, 2007

Monetary Policy and Inflation (5) - Bollard and Boom

For most of the last two decades, the Reserve Bank of New Zealand has been fairly responsible and quite successful in controlling the money supply. However, the recent housing boom has shattered any complacency. The Reserve Bank has repeatly raised interest rates in an effort to reduce inflation, but the boom has carried on regardless.

The problem began at the end of the dotcom boom in the United States, when Alan Greenspan turned on the monetary taps to prevent the recessions spreading to the rest of the economy. The result has been a great flood of money sloshing round the world. I suspect the torrent of money is now being fed, by lax monetary policy in the European Union as well. Normally, this excess money would have resulted in runaway prices, but China has saved the day by producing an endless supply of clothing and durable goods at cheap prices. Most prices have been held in check, but inflationary pressure has flowed into asset markets.
This deluge of money caused the housing boom in the US and is now being now being sucked up private equity firms to finance the purchases of businesses all over the world. Some of that money has sloshed in the New Zealand housing market. The result is that New Zealanders have access to an infinite supply of money when purchasing a house.

The governor of the Reserve Bank has cranked up interest rates in order to quench the flow, but like King Canute, he is powerless, trying to stop the tide. Raising interest rates has just increased the flow of money by making New Zealand a very attractive place to lend money. One measure of money (M3) increased by 16.5 percent during 2007, so it is not surprising that house prices have continued to grow.

The problem is that is a small open economy like New Zealand cannot be insulated from the rest of the world. If the world is awash with money, we cannot avoid getting wet. Gumboots and raincoats make life uncomfortable, but they will keep us dry. Raising interest rates has not stopped the housing boom, but it has really harmed the productive part of the economy.

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