The Shadow Board on the OCR

Some months ago I wrote about the NZIER’s Shadow Board, a panel of expert and informed observers who are each asked prior to each OCR review to provide a probability distribution as to what OCR is “appropriate for the economy”.  It isn’t quite the same job as the Reserve Bank has –  the Bank has to follow the PTA, and in principle the panel members might, say, agree with the two NZIER economists who recently argued for nominal GDP targeting.

There isn’t usually much information in the results of the Shadow Board exercise.  They usually track remarkably closely with the Governor’s own choice about the OCR, so they are right or wrong about as often as the Governor is.

That pattern continues this month.  The mean expectation across the respondents has dropped a little, from 2.70 per cent in October to 2.67 per cent  this time.  Whichever way the Governor goes tomorrow the Shadow Board will have been close.

shadow board tracking RB

I’ve been more struck by the lack of much diversity in the views (across panel members) and the high degree of confidence with which each panel members appears to hold his view.  This time the lower quartile expectation is 2.5 per cent and the upper quartile is 2.75 per cent.  According to these respondents there is only a 12 per cent chance that something other than 2.5 or 2.75 is the right OCR for the economy.

I don’t really understand how anyone can be that certain, given the uncertainties about the current state of the economy, the future, and about the connections between real activity and inflation (or other nominal variables monetary policy can target).

I told an interviewer this morning that I thought the economy would be better off with the OCR at 1.75 per cent than at 2.75 per cent.  I hadn’t distributed my probabilities then, but I’ve put them in the chart below (and compared them to those of the Shadow Board).  My numbers effectively say that I think there is roughly a 30 per cent chance that the consensus view is correct.

shadow board and me

It would be interesting to know the probabilities the Governor and his chief advisers would assign.  We’ll know the mean tomorrow, but almost certainly will learn little or nothing about the distribution.  Having information of that sort –  whether as a table like the Shadow Board provides, or as fan charts  –  would provide useful information on how these senior officials think about the economy.


What should the Governor do?

Tempting as it is to write about the Ombudsman’s weak report on the OIA, or to carry on looking at the Wellington airport proposal (taxpayer subsidies for long haul holidays for Wellingtonians, the return of a Think Big mentality, as Brian Easton suggested here), it is time to get back to macro.

Tomorrow is the final Reserve Bank Monetary Policy Statement for the year.  The focus, of course, is on whether or not the Governor chooses to cut the OCR, but it is worth briefly looking at what Parliament requires from the Reserve Bank in its MPSs.  That is set out in section 15(2) of the Reserve Bank Act.

The policy statement shall be signed by the Governor and shall—

(a) specify the policies and means by which the Bank intends to achieve the policy targets fixed under section 9:

(b) state the reasons for adopting those policies and means:

(c) contain a statement of how the Bank proposes monetary policy might be formulated and implemented during the next 5 years:

(d) contain a review and assessment of the implementation by the Bank of monetary policy during the period to which the preceding policy statement relates.


As I’ve noted previously, this bit of the legislation needs updating.  But it is the law, and it isn’t typically followed very closely by the Bank.  MPSs tend to be full of data analysis –  important and sometimes interesting –  but light on policy.  There is never much, for example, on the reasons why the Reserve Bank is adopting one particular approach to policy rather than another.   And when there is such discussion it is never very serious –  it is almost always a caricatured or straw man alternative  Scrutiny and accountability involves, in part, the ability to assure ourselves that powerful policy officials have thought seriously about the alternatives.  For example, at the start of last year, the alternative of not raising the OCR.

MPSs never look five years ahead, but then there isn’t much they can usefully say about such a horizon.  Whenever core inflation gets back to target they should envisage keeping it there, absent the unforeseen and unforeseeable shocks.  As I said, the legislation needs amending.

And MPSs don’t often contain much in the way of serious review and self-critical assessment of past policy.  In one respect that is understandable.  Bureaucratic incentives don’t encourage open self-scrutiny. But that is precisely why Parliament puts such provisions in legislation, to lean against the natural self-protective tendencies of powerful agencies.  We’ve heard defensive lines from the Governor –  “of course I was right” –  but little to give us (public, Board, FEC) much confidence that the Bank has really thought hard about its monetary policy performance in the last few years.   Given the target Parliament set for the Governor, it looks as though mistakes have been made.  Contra Donal Curtin, it isn’t a “gotcha culture” to suggest as much, simply a recognition of the difficulty of doing monetary policy consistently well.

But what of tomorrow?    Most economists apparently expect the Governor to cut the OCR, even if market pricing is less certain.  I don’t claim any insight into what he will do, but I am clear that the OCR should be cut.  And that the likelihood of further cuts next year should be foreshadowed.

Liam Dann had a piece in the Herald the other day looking at the pros and cons of cutting now.  I was a bit surprised to see him listing the prospect of a drought this summer as a reason to cut now.  I disagree.  Apart from anything else, it is too late to make any material difference: the biggest impact of further OCR cuts now will be seen next summer, and I doubt anyone has any particular insights on what the weather will be like then (or even on what the after-effects, eg on pasture or stock condition, of this year’s drought might be).

But also, even if a drought were to temporarily knock real GDP, it is not clear it would make much difference to incomes (nominal GDP) –  Reserve Bank research done at the time of the last drought found, somewhat surprisingly, that New Zealand droughts tend to raise world diary prices.  If so,. some people will be worse off, but some will probably be better off.  Monetary policy can’t usefully deal with distributional issues.

And, of course, the fall in real GDP associated with a drought is also a temporary reduction in the supply capacity of the New Zealand economy, so it doesn’t have very obvious implications for the level of excess capacity or of inflation pressures.

Droughts can be nasty things for rural producers, but mostly they are best looked through by monetary policy makers.

I was also a bit surprised by one of the items on Dann’s lists of reasons to hold.  This was the suggestion that the economy had been doing quite well, in maintaining real GDP growth of around 2 per cent, perhaps even picking up to around 3 per cent next year.  I highlight this not to pick on Dann, but because it is such a common line.  People seem to lose sight of the fact that Statistics New Zealand estimates that New Zealand’s population grew by 1.95 per cent in the year to September, faster than almost any advanced country.  In other words, 2 per cent real GDP growth would represent no per capita growth at all. Perhaps we are living in an age of diminished expectations, but since when was almost zero per capita growth a mark of a reasonably well-performing economy?

As a reminder, the unemployment rate has risen back to 6 per cent this year.  With inflation as low as it has been, monetary policy should have been set looser.  If it had been not only would inflation have been a bit higher, but the economy would have been growing rather faster.  That would have been a good thing, not a bad one.  Over the 17 years 1992 to 2008, real GDP growth averaged 0.8 per cent per quarter.  Since then it has averaged 0.5 per cent.    Monetary policy can’t materially influence the longer-term structural performance of the economy, but when inflation is so low we should be expecting to see growth rates materially above potential.  Monetary policy choices have meant that hasn’t happened.

Here is another way of looking at the disappointing performance of the economy in the last few years. The trend line is the path the economy would have followed if it had sustained the average growth rates of 1992 to 2008, and the red line is the actual path.  The gap between the two is now equivalent to around 15 per cent missing GDP.

real gdp pc trend and actual

There is also the argument that the OCR should not be cut because of property price inflation in Auckland (perhaps Hamilton and Tauranga too).  Reasonable people can debate the merits of whether house prices (or perhaps credit growth) should be part of the goal for monetary policy.  But they are not at present.  And the job of the Governor is to implement policy in accordance with the Policy Targets Agreement.

My view is that house prices should generally not be part of what monetary policy is targeting.  High house prices, particularly in a single city (even the largest) are largely a real relative price phenomenon –  in this case, the interaction of supply restrictions and policy-induced population growth.  Monetary policy is singularly badly suited to trying to deal with uncomfortable relative price movements –  doing so involves throwing the whole rest of the economy round to make up for some other microeconomic policy failures.  We should always be vigilant about the possibility of emerging financial stability threats, while being modest about how much we (or the Reserve Bank) really know about those risks.  But if policy responses are needed to contain those risks, there are perfectly good conventional options open to the Reserve Bank –  increasing the risk weights on housing loans and/or increasing overall capital requirements.  Such approaches are effective in limiting the potential damage to the financial system if things go wrong, while imposing minimum distortionary effects on the rest of the economy now.   And, of course, while its gets boring to say so, monetary policy works in part by lifting the demand for, and price of, long-lived assets.

A final line I’ve seen repeated several times in recent days is the suggestion that in any case monetary policy can’t do much to raise inflation.  I’ve not seen any very serious analysis or argumentation in support of that view, and it seems to simply to reflect the fact that inflation is low relative to target in much of the advanced world.  But in most of the advanced world, the scope of conventional monetary policy to do more has been long since exhausted –  interest rates have been at or near zero for years.  Neither we, nor Australia, are in that position.  We can cut the official interest rate.  And even if some are sceptical that lower domestic interest rates will do much to boost domestic demand, lower interest rates would almost certainly lower the exchange rate.  A lower exchange rate will, all else equal, boost domestic prices to some extent. And, more importantly, it will over time encourage more investment, production and employment in the tradables sector of the economy.  There is no reason to believe that something closer to full employment of domestic resources would not tend to lift core inflation.

As I’ve noted repeatedly, core inflation has been below the target midpoint –  the number explicitly highlighted in the PTA –  for several years.  There is no sign that anyone really fully understands quite why or (hence) that the Reserve Bank has been able to adequately correct its models and forecasts to avoid a repetition of this outcome in the future.   Given that, it would be prudent for the Reserve Bank to be acting now in a way that it believes would actually deliver core inflation in the upper part of the target range.  Act on the basis of forecasts that you think will deliver, say, 2.5 per cent core inflation 18 months hence.  If the Bank did that, they might be right and core inflation might end up higher than the midpoint.    If so, as it became more certain that was the case, there would be plenty of time to tighten gradually.  But if the forecasting  (or understanding) errors of the last six years continue, it is likely that core inflation would end up somewhere near 2 per cent.  The latter would be an unambiguously good outcome –  good in its own terms, and also good for the unnecessarily unemployed.

At present, by contrast, and unless the MPS tomorrow reveals some startling new analysis, we have simply to take on faith the Bank’s view that the current approach to policy and forecasting  is enough to get back to 2 per cent, even though it has not been enough for years now.  With the zero-bound no longer that far away, and with nothing in the domestic or global environment suggested any sustained acceleration in growth or inflation pressures any time soon, it is an approach that should have been seriously considered.  And if it isn’t adopted, perhaps in scrutinising the MPS tomorrow, FEC members might ask the Governor about the reasons he has chosen to adopt one policy approach over the other.