A letter of expectation to the Reserve Bank

In recent years a practice has grown up of government ministers writing to agencies (Crown entities and the like) in a “letter of expectation”.  These are formal documents, but they are not legally binding.  They do not replace, or in any way either reduce or extend the obligations of the agency concerned under either its own legislation, or under any relevant provisions of other legislation (eg the Public Finance Act or the State Sector Act).  But they can still play a useful role in setting out things that are particular priorities for ministers, and particularly aspects around the engagement of the agency with the minister concerned and the minister’s office.

For some time, the Minister of Finance has been sending an annual letter of expectation to the Reserve Bank.  I asked for copies of those the current Governor had received from the Minister of Finance  and –  after pretty well the full extent of the lawfully available time had been used, including extending the deadline by transferring the request from the Reserve Bank to the Minister of Finance –  I received copies in the mail the other day (the technology was a little surprising in this age of e-government, but still….).

The first thing to note is that letters of expectation to the Reserve Bank Governor are not routinely published.  A quick search suggests that those to many other government agencies are.  There are pros and cons to routine pro-active publication.  Do so, and any really sensitive points won’t be included in the letter, unless the minister concerned particularly wants to make a public point.  Then again, these are public agencies, and letters like these can affect the emphasis that agencies put on various aspects of their statutory powers and responsibilities.

These documents can be a bit of a grab bag.  Sometimes the minister himself really does have a point to make, about something in the relationship that isn’t working that well.  Sometimes the contents might just reflect a hobbyhorse issue of people in the relevant policy ministry (when I was at Treasury I made a few comments on draft letters of expectation to the then Reserve Bank Governor).   And a letter of a couple of pages can’t capture everything about the dynamic of an ongoing relationship.  But the letters do go out under the signature of the minister, in this case a long-serving senior minister, and the contents should tell us something interesting about what Bill English is looking for from the Reserve Bank.  The Reserve Bank is an interesting mix – an institution with a very high degree of operational independence in most of its function, but with some key powers reserved to the Minister of Finance.

Graeme Wheeler has received three letters of expectation from Bill English since becoming Governor.  The most recent was sent on 2 March 2015.  A copy of it is here:

letter of expectations

A few things struck me as interesting:

  • The focus is almost entirely on the regulatory functions of the Reserve Bank.  One senses that these must be where the pressure points in the relationship have been  –  around advance consultation and around the analysis underpinning regulatory and legislative proposals.
  • No questions at all are raised about the way that inflation has consistently undershot the midpoint of the inflation target range, even though the target is a formal agreement between the Minister and the Governor, in which the Governor has the operational freedom to adjust policy to meet the target, but the Minister has the prime responsibility for setting the target, and holding the Governor to account for his performance in achieving it.  I was a bit surprised by this omission.  It may reflect some sense, whether in the Minister’s office or in Treasury, that the Minister should avoid being seen putting pressure on the Governor in respect of specific OCR decisions.  That is fine, but the Minister is responsible for how the Governor exercises his considerable powers in this area, and the surprisingly weak inflation has now been around for a long time.  And there was that curious comment in the newspaper a few weeks ago about the Minister’s apparent concerns.
  • The Minister is formally asking the Bank to supply him with advance information on any significant institution regulated by the Reserve Bank “that faces a material risk of financial difficulty”.  At one level, one can understand this request – ministers don’t like being surprised –  but the administration of prudential policy is typically put at arms-length from ministers for good reason.  In many countries (perhaps especially less developed ones), ministers (and their friends and donors) have been too close to major financial sector participants.  Knowing that an institution is at risk –  because sensitive information about its finances has been disclosed to the Minister – does not give the Minister power to intervene, but it does increase the risk of political pressure being brought to bear on the Bank in respect of how it handles an institution in difficulty.    There are no easy answers to where the line should be drawn, but this feels like one of those situations where what is written down goes a little far.
  • 2015 is the first time that the letter of expectation has been copied, formally at least, to the Chair of Reserve Bank’s Board of Directors.  The Board exists largely as the monitoring agent for the Minister of Finance, and it must be helpful for them to have formally the document recording the Minister’s expectations of the Governor.
  • In the last two letters the Minister has noted that “I also look forward to the Reserve Bank’s analytical contributions to deepen our understanding of New Zealand’s economic performance and macroeconomic imbalances”.  Perhaps this is now meant largely as a ritual incantation.   There has been little sign of such analysis in the last couple of years and given the Bank’s apparently much tighter funding constraints (in the forthcoming Funding Agreement) it may not be realistic to expect that they will have the resources to make much contribution in this area.
  • In each of the three letters, the Minister has highlighted his desire to reduce the contingent fiscal risks associated with the banking sector.  He notes the existence of the OBR tool but wants to better understand “opportunities to reduce these risks further”.  At one level, that prompts a reaction of “just say no”.  Ministers, not central banks, make the choices in which banking failures become direct fiscal risks.    But there is also a balance here.  Even under OBR, it is generally accepted that for the tool to work the non-written-down component of the failed bank’s liabilities will need to be government guaranteed.  Many (including me) would argue that, in most circumstances, when a major bank failed the liabilities of the other banks would also need to be guaranteed.  Eliminating fiscal risks associated with bank failure –  or even reducing them much further from the already very low levels (see the Bank’s work on the implications of Basle III) –  would require either a rock solid political determination to let a failed bank fail (and either close, or be taken over quickly)  –  unlikely ever to be a time-consistent strategy –  or even higher  minimum capital requirements.  I think that, at current capital levels, the Modigliani-Miller proposition would hold, and higher capital requirements would not raise overall bank cost of capital.  But I’m sure the banks wouldn’t see it that way.  The Reserve Bank itself can’t quite make up its mind what it believes on that score, but I can imagine a great deal of lobbying of ministers (here and in Australia) if the Reserve Bank were to respond by looking to materially raise required capital ratios.

It was interesting to have the material.  It does add a little to our ability to understand the Reserve Bank and its relationships with the Minister (and Treasury).  Perhaps they could at least consider routine publication in future, as part of enhancing the transparency of the Reserve Bank.

(If anyone does want the letters from 2013 and 2014 they can email me.)

Some overnight reading

Last week I wrote up some thoughts on negative nominal interest rates, and how important it is that finance ministers and central banks start treating as a matter of urgency the elimination of the regulatory constraints and practises that make it impossible for policy interest rates to go materially negative.  If they won’t, they need to raise inflation targets, but that would be a distinctly inferior option.

In that light, it was encouraging to read the blog of Miles Kimball –  one of key academic proponents of action in this area – and learn that he was talking overnight on exactly that topic at the annual central bank chief economists’ workshop hosted by the Bank of England.  The annual BOE meeting is an important and interesting forum (I got to go once) and typically John McDermott, chief economist at the Reserve Bank, attends.  The link to Kimball’s slides (“18 misconceptions about eliminating the zero lower bound”) is here.

I don’t agree with everything in Kimball’s presentation.  In particular I still think he puts too much weight on government providing the answer, rather than just getting out of the way and providing greater scope for market innovation. But then there is (or should be) a much greater urgency to addressing the issue in most of the rest of the advanced world, where policy interest rates have now been stuck at or near zero for a depressing number of years now.

The obstacles to negative nominal interest rates have been around as long as banknotes, but haven’t mattered very much in the past  –  after all, despite the occasional peripheral discussions and local experiments during the Great Depression, there was then a mechanism to generate recovery –  breaking the link to gold.  That option isn’t available this time.  Kimball rightly compares creating the ability to take nominal interest rates materially negative to breaking off gold in the 1930s.

In countries where interest rates have not yet hit zero, such as New Zealand and Australia, the Minister of Finance (who controls the gateway to taking legislation to Parliament), the Treasury (as chief economic adviser to the governments), and the Reserve Bank (as, in essence, implementation agents –  and to some extent the institution that benefits from the current system) need to be planning now to ensure that these old restrictions don’t impede the ability of our countries to cope with the next severe downturn.  This isn’t just something of academic or obscurantist interest – it is about unshackling one limb of macroeconomic policy so that it is ready when it is needed.  And as I’ve noted before, at 3.5 per cent our OCR is less high now than most of policy rates were in 2007 in those countries now stuck with the near-zero lower bound constraint.

And two other brief items:

I drew attention some weeks ago to the work Ian Harrison had been doing on earthquake strengthening requirements, an area of policy which appeared to have the makings of another government “blunder”.   A group Ian is associated with called EBSS (Evidence Based Seismic Strengthening) now has a website, and it includes a brief critique of the government’s revised proposals in this area announced earlier this month.  Those changes seem to amount to a step forward, in reducing the extremely heavy cost burden that the government had planned to impose on building owners, to mitigate extremely low probability and low cost risks.

However, as the EBSS paper notes, the new proposals still seem a long way short of ideal.  Now that I’m based at home I’m often down in the Island Bay shopping centre.  Many of the older buildings there –  including one housing the excellent and popular butcher –  are yellow-stickered, but I neither notice among other people, nor feel any myself,  any unease in using them.  Sometimes I wonder if that is just a short-sighted perspective, oblivious to the risks, but that is where numbers help.  This quote from the EBSS paper caught my eye.

As a point of comparison, flying has similar characteristics to earthquakes. There is a very small chance that there will be a catastrophic event that results in death. The chance of being killed, per hour, when flying is 4000 times greater than being in a typical Auckland ‘earthquake prone’ building. For New Plymouth buildings it is about 600 times greater, and for Wellington 20 times.

We fly because we know that flying is very safe. But the Auckland, New Plymouth and Wellington buildings will be shunned because they will be falsely identified as ‘high risk’ when there is overwhelming evidence that they are not.

And finally China. I must have missed the reports of the recent Chinese government instruction to banks that they must keep lending on local authority projects even if those local authorities can meet neither interest nor principal commitments on existing debt.  Christopher Balding has an excellent summary of what an edict like that seems to mean.  As he puts it “the Chinese bailout is starting to bail fast”.