Past time to start reversing OCR increases

Today’s CPI numbers must surely kick one of the last few remaining supports out from under the Reserve Bank’s view of inflation and monetary policy.  Yes, the headline number was slightly less low than they had forecast. But the real issue here isn’t about actual inflation vs the projections of a few weeks ago, but about the underlying picture of inflation.

Ever since the end of the 2008/09 recession, the Bank has been telling us that inflation was going to pick up again.  And it did briefly, as in quite a few other advanced countries.  New Zealand’s non-tradables inflation (ex GST) got up to around 3 per cent in 2011.  Like New Zealand, a wide range of other OECD countries (although not the US or UK) actually raised policy interest rates in 2010/11.  With hindsight it was unnecessary, but on the evidence to hand they were probably reasonable calls at the time.

But our Reserve Bank has gone on picking that inflation would rise.  For a time it still seemed plausible, as the scale of the repair process in Christchurch after the 2010/11 earthquakes became apparent.  In fairness to the Reserve Bank, most of the local market economists have been even more convinced that inflation would rise (and more “hawkish” on policy).

But it just has not happened.   There have been isolated pockets of inflation.  Some of it was just taxes – Tariana Turia’s gift to closing the deficit in the form of repeated increases in tobacco taxes.  And construction costs did rise, especially in Christchurch.  Big real shocks typically induce relative price changes.   And there was no widespread spillover of Christchurch construction cost inflation to the rest of the economy.

Where do we stand now?  I’m not mentioning headline inflation –  it didn’t matter much when it was nearly 5 per cent, and it doesn’t matter that much that it is currently nearly zero.  But the Reserve Bank’s best estimate of core inflation –  the sectoral factor model –  was last above 2 per cent in the year to December 2009.  It hung around 1.5 per cent for some time, and in the last couple of quarters has fallen again, and it is now around 1.3 per cent.  This is a very slow-moving series, and being that close to the bottom of the target range should be of serious concern to the Reserve Bank.

core cpi

Concern should be mounting because other core measures, while perhaps less informative (noisier), are at least as weak.  Trimmed mean inflation –  the best of the rest in my view –  was 0.6 per cent in the year to March.  That measure is constructed in a way that will have given no weight to falling petrol prices or rising cigarette prices.  I could go on.  Non-tradables should probably be around 3 per cent when overall CPI inflation is on target at 2 per cent. Non-tradables inflation got as high as 3 per cent in the year to last March as construction cost inflation picked up, but was only 2.3 per cent in the year to March 2015 –  barely above the lows reached in the depths of the recession.

Is there comfort anywhere else?  I don’t think so.  Wage inflation is showing no sign of picking up, inflation expectations are likely to keep falling, and a high exchange rate can’t even really be blamed for low headline inflation –  the exchange rate in recent months has been lower than (certainly no higher than) it was early last year.

Inflation globally is weak.    Commodity prices are falling.  Growth in China –  the largest component in global growth in recent years –  is weakening.  And although there is still a lot of building activity going on in Christchurch there is little sign of pressure on resources (or inflation) getting more intense  there.  It is very difficult to see core inflation rising from here, on anything like current policy.

The case for OCR increases last year was always weak, but it was within a range of plausible outcomes.  But time showed that those increases were unnecessary, and the Bank has gradually abandoned the plans the Governor had talked about of raising the OCR by 200 basis points.   What isn’t clear is why the Bank won’t now reverse the unnecessary OCR increases.  Inflation is well below target, and has repeatedly surprised on the low side.  Unemployment is still above any reasonable sense of a NAIRU,  the recovery has not been strong by historical standards, and the Bank repeatedly anguishes in its policy statements about an overvalued exchange rate.

No one knows the future, and even forecasts of the near-future should be held rather lightly.  But when (Bank and market economist) forecasts have been consistently wrong, there is a strong case for looking out the window and reacting to what we see now.  And what we see is low and falling inflation, subdued credit growth, quite-high unemployment, and a troublingly high exchange rate.  House price inflation is certainly higher than most would like, but the Governor told us at the March Monetary Policy Statement that house prices were not a particular factor in his recent interest rate decisions.

Most other advanced and emerging countries have been cutting policy rates in the last year.  Today’s inflation number is further evidence that New Zealand should join them.     A strict inflation targeter would (if there were any such) but a flexible one certainly now should be.

The Herald on housing and history

First, welcome to those readers who’ve come here today as a result of Tyler Cowen’s brief mention on Marginal Revolution.  I’ve set out something of my background, and what I’m trying to do, here.  My focus tends to be on New Zealand issues – macro and micro – but I’ll also be offering some perspectives on international issues, especially around inflation targeting, financial regulation, and the euro.

Last week, my old boss Grant Spencer, Deputy Governor of the Reserve Bank, gave a speech outlining his view of what needed to be done about the New Zealand housing market.  National house prices are high, and rising, but the house price inflation is now mostly a phenomenon of our largest city, Auckland . I was quite critical of a number of aspects of the speech, and commented here, here, and outlined my own perspective on New Zealand policy here.  My main criticism of the speech was the absence of any serious analysis on the scale and nature of the financial stability risks it is asserted that New Zealand faces.

New Zealand’s biggest-circulation daily newspaper, the Auckland-based New Zealand Herald has given Spencer’s speech considerable, and almost entirely favourable, coverage, with both an editorial and political and business columnists weighing in in support.   The Reserve Bank might be a little embarrassed by some of the support.

The Herald’s political correspondent John Armstrong began his Saturday column asserting that “the overheated Auckland property market makes the South Seas Bubble of the 1700s look like an exercise in financial probity”.  As Charles Kindleberger wrote in his classic account of Manias, Panics, and Crashes, “Some bubbles are swindles, some are not. … The South Seas Bubble was a swindle”.  In a more litigious society, the local banks might this morning be consulting their lawyers on this preposterous claim, and the associated slur on the banks’ lending practices and standards.  As a reminder, the stock of loans to households is growing at around 5 per cent per annum (as it total Private Sector Credit), while nominal GDP can be expected to grow at around 4.5 per cent.  There has been no growth in household debt/disposable income, or in private sector credit/GDP since 2007.  There is simply no evidence of widespread poor quality lending practices – and neither Armstrong, nor the Reserve Bank, has provided evidence to the contrary.  That is a very different  than the US position towards the end of its housing boom, which I discussed last week.

Fran O’Sullivan has been writing about New Zealand business, economics and politics for decades.  In her weekend column on Spencer’s speech (under the sub-heading “Failure to heed Reserve Bank’s words on possible crisis plain irresponsible”) she reaches back into New Zealand history, and the lead-up to the large exchange rate devaluation in 1984, which acted as the trigger for the wave of reforms adopted in New Zealand over the following decade.  O’Sullivan adopts unquestioningly  the Bank’s talk of potential crisis and threats to financial and economic stability, and draws parallels with the advice provided by the Reserve Bank and Treasury to the then Minister of Finance in the early 1980s to devalue the exchange rate.

The Bank’s then Deputy Governor, Rod Deane, had been at the forefront of the analysis and advice provided to Robert Muldoon, then Minister of Finance and Prime Minister.  Deane was probably the greatest figure in the history of the Reserve Bank of New Zealand, building up its policy and research capabilities and giving it voice and influence within Wellington official circles.  His legacy at the Bank lasted for many years.

In the early 1980s Deane paid a high price for the courageous analysis and advice that he was primarily responsible for:  Muldoon refused to appoint him as Governor.  The Bank at the time generated a lot of practically-oriented research and analysis, and had done a lot of work not just about how to end New Zealand’s lamentable inflation record, but also about how to restructure and reform the New Zealand economy, with a focus on the macroeconomic dimensions of those issues.    There was a generally shared view among the economic elites at the time that a much lower real exchange rate was likely to be an essential part of rebalancing the New Zealand economy, and putting it on a path in which the growing external debt and the decline in New Zealand’s relative living standards could begin to be reversed.

As New Zealand readers know, New Zealand was forced into a 20 per cent devaluation in July 1984 – the timing was “forced” by a combination of interest rate controls and a growing conviction that the likely new government wanted to devalue anyway.  Among elite bureaucratic circles there was a strong sense that the devaluation was a first step to rebalancing the economy and re-stimulating the tradables sectors.  I was a first year graduate at the time, sent along on occasion to take minutes of meetings of key figures in the Reserve Bank and Treasury: there was a very strong sense that the biggest macroeconomic policy challenge was to “cement in” the new lower real exchange rate.  There was no discussion around the possibility that the new lower real exchange rate might not prove to be sustainable.

And yet here is the chart of the New Zealand’s real exchange rate (using the BIS measure, as the RB has not yet backdated their measure far enough).  The 1984 devaluation certainly stands out, but not as some turning point in New Zealand’s competitiveness.   Rather it stands out as a level only once reached  again –  and then very briefly – in the subsequent 30 years.


In short, they were wrong.  Not wrong, in my view, about the longer-term challenges. I’ve argued that the failure of the real exchange rate to move sustainably lower, to reflect long-term adverse productivity growth differentials, is a key proximate marker (please note that I did not use “cause”) of what has gone wrong with New Zealand’s economy over the long term.  But real exchange rate can’t be adjusted, by ministers and senior officials, in a vacuum.  I have the utmost regard for people like Rod Deane, and some of his Treasury counterparts.  But on this issue – where Fran O’Sullivan lauds them as heroically correct – they were simply wrong, or incomplete in their analysis of what achieving a sustainably lower real exchange rate would require.  And that despite a lot of expert analysis and research, laid out in books, and discussion papers, and Bulletin articles.  The limitations of knowledge we all face – great figures like Rod Deane not much less than the rest of us – seems to get continually swept under the carpet.

As I pointed out the other day, I’m not remotely relaxed about Auckland property prices. They are a social and political scandal.  But they look like the rational outcome of a misguided set of central and local government policies (supply and land use restrictions, combined with high trend target levels of non-citizen immigration).  No one knows when, or even if, such policies will be changed.

But the weight that should be given to the Reserve Bank’s arguments around housing depends on its claim that financial stability is being materially jeopardised.   New Zealand banks have high levels of capital, and are subject to high minimum risk weights on housing loans.  The Reserve Bank’s own stress tests suggest a high degree of resilience at present, even if house prices were to fall sharply in Auckland (they have been falling in various  other places in the country).  If the Reserve Bank really believes there is a growing risk of financial crisis, they should set out their analysis and evidence.  A good start might be to answer the question as to whether there has ever been a systemic financial crisis in a system where the stock of credit has been growing at only around 5 per cent per annum, and at growth rates than haven’t exceeded average nominal GDP growth for a number of years.  Perhaps there are such cases – the Reserve Bank has more resources than I do, and should be able to lay them out for us.     In the meantime, John Key and Bill English might usefully set the Bank’s warnings to one side (while still thinking hard about housing supply and immigration issues) and perhaps have a quiet word with the Bank’s Board about their performance monitoring of the Governor and his team.

UPDATE: A nice piece from Oliver Hartwich on the importance of expectations.  Of course, this is true not just of possible housing supply responsiveness reforms such as those he (and I for that matter) would favour, but of any changes in migration targets, or (indeed) complex tax regime changes as well.