Sunday, 14 June 2015

The dollar's down, interest rates are lower. It's all good. Or is it?

Every now and then I like to go to the fridge and get out the semi-frozen jar at the back that contains what's left of the old Monetary Conditions Index, the MCI. For those of you of tender years, this used to be how our Reserve Bank measured the overall tightness of monetary policy by combining the level of interest rates and the level of the Kiwi dollar into one single number.

It's fallen out of intellectual favour these days, but it still seems to me to say something valuable: it's indisputable that the overall effect of monetary policy reflects the combined impact of both interest rates and exchange rates, and something like the MCI that attempts, however roughly, to measure both at the same time gives you a better overall perspective than following moves in the OCR alone, or moves in the NZ$ alone.

Last time I did it, one result leaped out: the MCI was saying, correctly, that overall policy was way too tight. In that light it's not so surprising that last week we saw the RBNZ start its retreat from Moscow. So what's the MCI saying now?

Well, monetary conditions are still on the tighter side of neutral, if you take neutral to be the average level of the MCI since January 1991, when our Reserve Bank got going in its modern form. At the latest readings for 90 day bills (3.3%) and the TWI (73.2), the MCI comes out at the red star on the graph (876) - still somewhat north of neutral, which would be around the 600-650 mark*. So despite the interest rate cut and the drop in the dollar, businesses still face some modest level of monetary conditions headwind against them.

And, as I did last time, you can do a rough calculation of where 90 day bills or the TWI would need to be to make life merely neutral for businesses. To get to neutral, banks bills would need to drop to around 1% if the TWI stays where it is, or the TWI would need to drop by around 5% if bank bills stay where they are. If you were looking for some plausible combination of the two, bills at 2.75% and the currency 4% lower would do the trick. For things to work out well, we likely need the Reserve Bank to ease a little more than it indicated last week, and the forex markets to play ball: if we don't get that combo, then either inflation will remain below the Bank's target (not good), or the economy's growth rate will take a hit (not good) or both (double plus ungood).

* Since I last posted about the MCI, I've upgraded my calculations to use the new broader 17-currency TWI instead of the old narrower 5-currency one. The trend in the updated MCI  is exactly the same as the old MCI but the absolute numbers are a bit different.

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