A severe commentary

Plenty of commentaries have remarked on the very low inflation numbers out this morning.

None (that I have seen) has highlighted what a severe commentary these numbers are on the Reserve Bank’s conduct of monetary policy over the last few years.

Reciting the history in numbers gets a little repetitive, but:
• December 2009 was the last time the sectoral factor model measure of core inflation was at or above the target midpoint (2 per cent)
• Annual non-tradables inflation has been lower than at present only briefly, in 2001, when the inflation target itself was 0.5 percentage points lower than it is now.
• Non-tradables inflation is only as high as it is because of the large contribution being made by tobacco tax increases (which aren’t “inflation” in any meaningful sense).
• Even with the rebound in petrol prices, CPI inflation ex tobacco was -0.1 over the last year – this at the peak of a building boom.
• CPI ex petrol inflation has never been lower (than the current 0.7 per cent) in the 15 years for which SNZ report the data.
• Both trimmed mean and weighted median measures of inflation have reached new lows, and appear to be as low as they’ve ever been.

This wasn’t the way the Bank told us it was going to be. And more importantly, it wasn’t the basis on which they held interest rates up through 2012 and 2013, and then raised them last year. As late as December last year, they were still talking of raising the OCR further. Real interest rates never needed to rise, and as a result of the misjudgement they rose even further than the Bank intended (inflation expectations fell away).

It has been a sequence of cumulatively severe misjudgements. The word “mistake” keeps springing to mind, although of course the Governor rejected that characterisation at the time of last month’s MPS. Perhaps he is rethinking now? As I’ve pointed out previously, inflation outcomes so far weren’t mostly the result of unforeseeable external economic shocks. And if core inflation measures are this weak now, we have to start worrying what will happen to them as economic growth slows further, construction pressures ease, and the deepening loss of income from the declining terms of trade bites. Wage inflation has been very low, and more recently wage inflation expectations have been falling.

The Reserve Bank has belatedly recognised the need to modestly change direction. The Governor cut the OCR by 25 basis points last month, and foreshadowed that at least one more cut was likely. But the problem is that they are still well behind the game. The data are weakening faster than they are cutting, and the OCR was already too high right through last year. Difficult as it might be to make a large move at an intra-quarter review next week, the substantive case for a 50 point move is certainly strong. If not next week, then at the latest it should happen at the September MPS. There also needs to be a recognition that there is nothing wrong or inappropriate even if the OCR goes to new lows. The OCR simply needs to be set consistent with a realistic appraisal of the inflation outlook (not the upwardly biased one that has guided too many central banks in recent years). An apology, and a heartfelt mea culpa, from the (single decision-maker) Governor would also be appropriate.

As inflation expectations measures are likely to keep falling, this mistake is also increasing the risk that the zero lower bound will end up being binding in New Zealand. But, if we take the Reserve Bank’s Statement of Intent seriously, this is not something they worry about. They should.

But questions also need to be asked about the role of the Bank’s Board as agent for the public and the Minister of Finance. Inflation outcomes now are reflecting policy choices made last year. But here is all the Reserve Bank Board has to say about monetary policy in their latest Annual Report, published only nine months or so ago. In introducing the document, they note that:

Our formal review of the Bank’s performance is included in the Bank’s Annual Report.

And when they get to monetary policy

In the last year, we have considered the Bank’s decisions to hold the OCR at a record low of 2.5 percent for an unprecedented three-year period, and to increase the OCR four times from March to July 2014.

The level of disclosure in monetary policy was very high. We considered that the Bank’s policy decisions were appropriate, initially taking into account the need to provide support for the economic recovery after the disruptions of recession and earthquakes, and lately the need to ensure that the recovery is sustainable, by restraining emerging inflationary pressure.

This was a “formal review”? I still find it astounding that, less than a year ago, the Bank’s Board – the independent agency responsible for scrutinising the Bank – made no mention at all of the continued undershooting of the inflation target. I’m not suggesting they should have read the data better than the Governor – they are paid as ex-post monitors, not as monetary policy decision makers – but there is little sign of any serious scrutiny at all. It reinforces my view that the governance model is inappropriate in a wide variety of dimensions, and that the Board in particular plays little useful or effective role as agent for either the Minister or the public. By construction, it is simply too close to the Bank, and thus is more prone to act as defensive cover for the Governor, than as a source of serious scrutiny and challenge in the public interest. At very least, we should expect something much more substantive from the Board in its next Annual Report.

The Minister of Finance has commented a couple of times recently about the Bank undershooting the inflation target midpoint (which was added explicitly to the PTA by him in 2012). Such “shots across the bow” seem both understandable, and quite appropriate. The Minister initiates the inflation target, but has no say in individual OCR decisions. But he is responsible to the public (and Parliament) for having the target met by the Governor. Whether with hindsight or foresight, monetary policy has been too tight for probably five years. Partly as a result, New Zealand’s economic recovery has been anaemic – much more muted than in a usual recovery, despite the huge boost to demand provided by the Canterbury repair and rebuild process. The unemployed pay a particularly severe price for that, but they aren’t the only ones.

The real question is whether the Minister is willing to do more than talk. My impression is that his instincts are often in the right direction, but there is often a reluctance to follow through (one could think of housing supply issues as a prime example).

I’ve touched previously on some of the options the Minister has to show that he takes these issues seriously. In May I noted:

The Minister could seek a report from The Treasury on their view of how well the Governor was doing consistent with the Policy Targets Agreement, could let it be known such work was underway, and could arrange for such a report to be published. The New Zealand Treasury offers independent professional advice to the Minister of Finance and would have to take seriously such an exercise. It might be expected to consult externally (but confidentially) to canvass opinion. At present, for example, most financial market economists – not the only relevant observers but not unimportant either – in New Zealand seem quite comfortable with the Governor’s handling of monetary policy.
The Minister could also seek formal advice from the Bank’s Board, and let it be known that he was doing so. This would be a totally orthodox approach – the Board exists as a monitoring agent for the Minister – and it was, for example, the approach taken in the mid-1990s when inflation first went outside the target range. The Board has a number of able people on it, but as an effective agent for accountability risks being too close to management. The Governor sits on the Board, the Board meets on Bank premises, it has no independent resources, and it has been chaired exclusively by former senior managers of the Reserve Bank. It was striking that last year’s Board Annual Report (which is just embedded in the Bank’s Annual Report document) had nothing substantive on the deviation of inflation from the policy target.

Those are both still serious options. I suspect that it might be timely to exercise both of them.

Longer-term, it is now only just over two years until the Governor’s term expires. There must be real questions as to whether Graeme Wheeler could credibly be reappointed (recommended by the Board or accepted by the Minister) after his succession of overconfident monetary policy misjudgements, and in light of the poor quality analysis he has used to support his over-reaching policy initiatives in the regulatory areas. Perhaps Graeme will make it easy and conclude that, at his age, one term is enough?

The mistakes of the last few years don’t result primarily from the governance model, but the governance model – with too few checks on the Governor, as decision-maker and chief executive responsible for all the supporting analysis – is likely to have contributed. The mistakes –  an exaggerated version of those made in various other countries – highlight the material weaknesses in our most unusual system. The start of a new gubernatorial term is a good opportunity for the Minister to take the lead in reforming the Reserve Bank Act to bring governance of this powerful agency more into line with international practice and with governance standards in the rest of the New Zealand public sector. Treasury recommended doing something in 2012, and the Minister refused. He should take the lead this time. If he did, I suspect he would find pretty widespread support – from other political parties and from market economists. Perhaps even from the Reserve Bank itself.

PS.  Following on from earlier commentary, SNZ has altered how it is doing seasonal adjustment of the non-tradables inflation series.  The cost of doing so, is quite a short series, but for what it is worth, seasonally adjusted quarterly non-tradables inflation last quarter (0.3 per cent) was about half what it had been each quarter for the last 2-3 years.

8 thoughts on “A severe commentary

  1. Michael

    When I was at Treasury I wrote an internal piece on the Baumol disease using the unpublished Input-Output table data, which Stat NZ circulated in 2013. I am not sure whether they published the table. I calculated prices by sector and found that prices have actually been lower than published price data. I had no explanation whatsoever. When consulted Stat I did not get a satisfactory response. If you like to see my note please let me know how I send them to you. My email is razzakww@gmail.com


  2. Michael… so who would be a good Governor to replace Mr Wheeler….. Adrian Orr maybe? or do you not want to go into that discussion?

    Only reason I suggest Adrian is he has RB experience, as well as banking experience in the NZ market and from his comments in the media appears pragmatic and not ideologically driven…


  3. Dave

    I think I’ll stay clear of the specifics of that sort of discussion for now. I can think of a variety of potentially plausible candidates, but no one who stands out as the “must have” candidate. To me, the priority should be getting someone with a commitment to reforming the governance model – but that requires the Minister (in particular) to have recognised the importance of the issue. A new one-term Governor with a vision to oversee the transition (and resulting reorientation of the Bank internally) to a new system, in which his own power would be much less than what Brash/Bollard/Wheeler have had, would probably be my preference.



  4. Hi Michael

    As the OCR seems destined to go into the 2% range soon, and given that NZ, as a small, geographically isolated country tends to have higher interest rates relative to the ROW, and also given the immutable law of diminishing returns, just what is your estimate of the effective zero lower bound for our economy?

    I hope that’s not too tough a question.


  5. Luc

    I don’t think our interest rates are high because we are small/isolated, but rather because on average the pressure on resources here (desired investment less desired savings) is greater than in most other countries.

    That means we are less likely to get to the ZLB than most countries (most advanced countries got there 6 or 7 years ago), but the chances are still non-trivial. I led some work at the RB a few years ago on this, and it is clear that the OCR could be taken somewhat negative. Once one got below -50bps – or maybe 75bps – I think we’d pretty much have reached the limits. Odds are that we won’t reach those limits, even if there was new recession in the next few years, but central banks shouldn’t even have to contemplate ‘running out of ammunition”. For NZ, one thing that really helps is that if our OCR ever got to 0, let alone -50bps, there would be no yield advantage over other countries. Yield advantage is the main reason offshore investors hold NZd assets, and once that disappeared I’d expect the NZd and TWI would at least revisit the lows we saw in 2000 (when the yield differential to the US last disappeared).


  6. Tarek Hassan “Country Size, Currency Unions, and International Asset Returns,” The Journal of
    Finance, forthcoming, is a paper that explains the point. Luc is right and I find this paper to be an excellent explanation to high interest rate in New Zealand. Size matters. This young professor at Chicago wrote his PhD thesis with the top economists in this field. He provides a careful empirical evidence.


  7. Thanks Weshah. It is certainly one argument, but not one that I find persuasive as an explanation of the overall NZ story (or indeed of the global distribution of interest rates)


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