Blog: Why alternative monetary policy may not lead to investment spending in the economy

This blog post is written by Taxpayers' Union Economist Karan Menon.

Facing the biggest economic shock in our lifetime, Reserve Bank Governor Adrian Orr is signaling his support for the use of “alternative monetary policy” to jog the Kiwi economy.

He is currently holding the Official Cash Rate at 0.25%, the lowest it has been since the OCR was introduced in 1999, till March 2021.

The cash rate is predicted to be cut even further by the end of the year to fall below zero – that means banks will now be charged on their deposits with the Reserve Bank. The intention of this expansionary monetary policy is to curb a deflationary spiral (an overall decrease in price levels) caused by the COVID-19 pandemic and to disincentivise retail bank deposits held in the central bank.

The Reserve Bank of New Zealand (RBNZ) is already implementing another form of ‘alternative’ monetary policy with its LSAP (Large Scale Asset Purchase) programme.

The LSAP programme will reduce market interest rates further and thereby reduce borrowing costs for retail banks as their wholesale borrowing costs have reduced. This is due to interest rates being inversely related to bond prices. As the RBNZ purchases government bonds, the demand for bonds increases, thereby increasing the price of those bonds and decreasing interest rates.

The RBNZ will purchase $60 billion of government bonds over the next 12 months to achieve these reductions in interest rates on mortgages and term deposits. This value roughly amounts to 29% of NZ GDP.  This process is known as an open market operation where money supply is linked to the sale and purchase of government bonds

These tools are used by the RBNZ to control inflation – in this case, to keep it from dropping too low.

The RBNZ is given operational independence to keep inflation between 1 and 3 percent on average over the medium term, but with the recent COVID pandemic, sharp projected contractions in economic activity will likely reduce inflation and employment targets below RBNZ’s objectives.

Therefore, the RBNZ aims to lower the borrowing costs for households and businesses and increase spending across the economy. Retail banks are in the business of lending, and this lending is financed by depositor funds or borrowed funds. The ability to service this lending is based on a bank’s liquidity which is calculated by taking the total lending as a proportion of total deposits.

With expansionary monetary policy decreasing “hoarding behaviour”, we can expect lower retail interest rates on both mortgages and deposits for businesses and households.

The complication with decreased interest rates on deposits is that we could see (and in fact already are seeing) investments diverted away from bank deposits to other financial investments with higher rates of return.

The relationship between expansionary monetary policy and the diversion of investments can be seen internationally. The US currently has its cash rate at 0%, while its stock market has seen steady increases. The NASDAQ closed on a high Tuesday and the S&P 500 index saw a 0.43% gain. The increases in those indices obviously have additional explanations, but deposit interest rates are also decreasing, implying investors are looking to the financial market for higher returns.

Real economic conditions in the US are simply not reflected in the US stock market. A wave of optimism is sweeping through Wall Street, which stands in contrast to the stark economic realities of the US. Unemployment, which hovered around 4% in February shot up to 13% in May.

The real-world macroeconomic implication of expansionary monetary policy, and the subsequent diversion of investments, would be to diminish the capacity of retail banks to lend and further, lending would be on the back of bank borrowings.

Adrian Orr’s intention of increasing investment spending and incentivising businesses to spend more on their operations is in fact reasonable. The risk, however, is that the outcome of his approach will be an over-extension of the banking sector, which could further exacerbate the economic crisis. If in fact the RBNZ achieved its goal to encourage spending for both households and businesses, banks would be unable to increase their cash position in the case of any further shocks to spending.

If banks become unable to lend, any good achieved by Orr’s expansionary monetary policy would be wiped away and the economy would be left in an even worse condition than currently projected.