How about giving inflation a chance

The Governor’s OCR press release this morning held few surprises. Disappointments, yes, but not really any surprises. Given that in the June MPS the Governor had articulated only a fairly modest change of view, and had refused to acknowledge any sort of mistake in how monetary policy had been run last year, it was hardly surprising that, at a review between MPSs, at which he does not have the benefit of a full new set of forecasts, he wasn’t willing to cut by 50 basis points, as some had suggested was likely.  From the tone of the news release, such a cut probably wasn’t even seriously considered.

But if two cuts in six weeks might have broadly kept pace with the deteriorating data over the last couple of months, it does not make any inroads into the overly tight policy put in place when the Governor (and his advisers) misread inflation pressures last year. And that is the bigger problem. The Bank still seems to think it has things broadly right.

Here was my list of some sobering inflation statistics from my post last week in the wake of the CPI

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, by contrast, is the Bank’s take:

Headline inflation is currently below the Bank’s 1 to 3 percent target range, due largely to previous strength in the New Zealand dollar and a large decline in world oil prices.

It just doesn’t wash.  CPI inflation ex-petrol was 0.7 per cent in the year to June.  CPI inflation ex tobacco (large excise increases) was…..actually not inflation, but slight deflation, a fall of 0.1 per cent in the last year.    And what of the exchange rate?  Direct exchange rate effects are not that large these days, but typically pass into consumer prices quite quickly (and one of the fastest routes is through petrol pricing).  The TWI in 2014 was around 4 per cent higher than in 2013, but that increase probably only subtracted around 0.4 percentage points from the annual inflation rate.  And as the TWI peaked in the middle of last year, the effect might have been even smaller by the year to June, the most recent CPI inflation we have.

twi to june 15

Focusing on headline inflation, as the Bank does in the extract above, seems like an effort to distract attention from the surprisingly weak core domestic inflation, whichever indicator of it one prefers to concentrate on.  And that weakness came at the very peak of a major building boom.

I was also a bit disappointed to see this sentence in the statement

While the currency depreciation will provide support to the export and import competing sectors, further depreciation is necessary given the weakness in export commodity prices.

Today would have been a good opportunity to have backed away from commenting on the exchange rate, except as it affects the inflation outlook, in these statements.  What does “necessary” here mean?  I assume it means something about stabilising the NIIP position (as a % of GDP) at a lower level, or improving the long-term growth prospects for New Zealand.    But that has nothing to do with monetary policy.  The nominal exchange rate is not an instrument in the Governor’s toolkit, and the real exchange rate is…well…a real phenomenon.  I happen to agree with the Governor’s unease about the level of the real exchange rate, but it is an endogenous real phenomenon.  Better for the Governor to focus on getting core inflation back to around the target midpoint  –  not just headline, relying on direct price effects of the lower exchange rate.  As it happens, the OCR path consistent with that obligation of the Governor’s would probably lower the exchange rate somewhat further as well.

I’ve made the point  previously, but will state it again.  When the Reserve Bank –  even more than other international central banks –  has misjudged inflation pressures for so long, it would be better for them now to err on the side of running policy a little looser than they really think wise.  Clearly there is something wrong in their mental model of inflation at present (and I’m not suggesting anyone else has a fully persuasive alternative), but after years of such low inflation, it might no bad thing if core inflation ended up a little above the target midpoint for a few quarters a year or two down the track.  I’m not suggesting a price level target, just that the policy reaction function needs to take more, and more aggressive, account of the repeated over-forecasting of inflation, and inflation pressures.  Among others, the 5.8 per cent of the labour force still unemployed might appreciate the chance to get back to work.

How sacrosanct should inflation targeting be?

On Donal Curtin’s blog the other day I noticed a reference to a recent paper published in New Zealand Economic Papers (unusually it appears to be accessible to non-subscribers) that looked at, among other things, whether inflation targeting had reduced the variability of long-term interest rates in New Zealand and Australia.   They conclude that it has.  Donal uses the results to encourage politicians to stay clear of any changes to monetary policy.

There is no doubt that long-term interest rates in New Zealand (and Australia) are much less variable than they were in the early days of liberalisation.  There was an awful lot going on back then.   The authors present the data for two sub-periods, April 1985 to December 1995 (which commences shortly after New Zealand interest rates were liberalised), and January 1996 to August 2008 (a period which ends just prior to the worst of the crisis, and the prevalence of near-zero short-term interest rates in many countries). For the countries they report, here are the data:


In the late 1980s, inflation in Australia and New Zealand was also much higher than in the other countries. Australia’s inflation rate averaged around 8 per cent, and New Zealand’s 10 per cent, while the US had an inflation rate of around 4 per cent.  Sweden’s inflation rate was also still on the high side.

There is little doubt that getting inflation under control (lower and less variable) was part of what helped markedly reduce the variability in nominal interest rates. It did that in all these countries. But how much of that is down to “inflation targeting” per se? I’d suggest very little. After all, as early as 1990q3, just a few months after the first PTA was signed, New Zealand’s annual CPI inflation rate was already the second lowest among the countries these authors look at.   In the UK case, the central bank didn’t even have operational independence until mid-1997, and in the United States anything closely resembling inflation targeting really only dates to the last few years.

I don’t want to get into a debate here as to whether inflation targeting is the best option for advanced economies these days, but to get a better sense of the contribution of inflation targeting we’d really need a country (preferably several) to change their regime. A decade with several countries running NGDP targets, or wage inflation targets, or even price levels targets, in parallel with others still running inflation targets might shed rather more light on the issue. For New Zealand, as I’ve argued elsewhere, inflation targeting was a specific form of articulating a commitment to more stable macro conditions than we’d had previously. It may have provided more discipline (on the Reserve Bank) than operating without an explicit target, but even there one could be reasonably sceptical. Most other advanced countries had already got inflation a long way down –  as had we (see above) before they got very serious about anything like inflation targeting.

There is a variety of good reasons for encouraging Opposition parties not to tamper too much with the essence of the monetary policy targeting framework (and perhaps to focus their energies instead on reforming the Reserve Bank, including its governance framework). Whatever is wrong with New Zealand’s economic performance over the long-term has little or nothing to do with the details of the monetary policy arrangements. But I wouldn’t take much from this NZEP paper on that score. It won’t, for example, shed any light on whether the Labour Party’s proposed restatement of the goal would make things better or worse, or just make no difference.

Here is how Labour last year proposed to amend section 8 of the Reserve Bank Act. The new section would read.

“The primary function of the Bank with respect to monetary policy is to enhance New Zealand’s economic welfare through maintaining stability in the general level of prices in a manner which best assists in achieving a positive external balance over the economic cycle, thereby having the most favourable impact on the stability of economic growth and the level of employment.”

It was clever piece of drafting.  I argued at the time, and still believe, that it would have made no material difference to the conduct of monetary policy. The inclusion of similar sorts of words in the Policy Targets Agreement in 1996 didn’t (but it allowed Winston Peters to tell the world that he had secured changes). I was never sure whether Labour recognised, or not, that the change would make little or no difference. I think their people were smart enough to know, but also to know that, in political positioning product differentiation and branding matter.

Of course, other possible changes might make more difference. Some might (conceivably) be for the better. There is certainly no reason to suppose that inflation targeting will prove to be the last word in how best to conduct monetary policy.