Immigration the source of Australia’s prosperity?

Late last year, veteran Australia journalist and author George Megalogenis’s new book Australia’s Second Chance was published.  Despite the single economic market, it is often hard to become aware of new Australian books, and not always easy to get hold of them either.  Somehow I stumbled on a reference to this book and read it a few weeks ago.

Megalogenis appears to be highly-regarded by the liberal-left in Australia, at least judging from the reviews of his previous book (which was launched by Prime Minister Julia Gillard) that are quoted on the inside cover of this one.   Wikipedia says he once was once married to the woman who is now Labour premier of Queensland and, whether because of that or despite it, he appears to have it in for Queensland –  not helped, it seems, by the large number of New Zealanders living there.

It is a well-written easily-read book, and for those who don’t know too many details of Australian history since 1788 it is full of interesting facts.  It is just a shame that the thesis that shapes the book is almost certainly almost totally wrong.

Megalogenis argues that immigration is what has made Australia rich, and is what will make it richer still in future –  if only the naysayers, sceptics, racists etc just get out of the way, and let Australia fulfil its manifest destiny.

You may think I am over-egging his story, but here are some lines from the last page of the book

Australia matters more than most nations because it remains a settlement with potential.  Our unique strengths…..come with a burden.  The rest of the world expects Australia to succeed, given our small population and resource endowment.  Our previous eras of poor performance were punished so severely because the world believed we had let it down.  This is the pragmatic argument for openness, because history tells us the alternative is an isolated belittled Australia.  A globally minded Australia will continue to thrive, because the world will project its best self on us.

and a page or two earlier, concludes that Australia’s

standard of living depends on the migrant

The test for Australia now, we are told, is “to keep them coming”.

It is really a very odd argument.

As one person I mentioned the book’s thesis to noted, in one sense it is clearly true.  Had there been no immigration to Australia since 1788, it seems most unlikely that per capita incomes of Australians would anything like as high as they are today.  They aren’t in, say, Botswana or Mongolia.

Then again, as far as we can tell from the historical estimates that are available, Australia’s per capita incomes were the highest in the world in about 1890.  Australia has not matched that performance in the 125 years since.

According to Megalogenis, Australia’s success has rested on repeated waves of immigrants, and when the flow slowed times were not typically good for Australians.  Mostly, it is a story that seems to reverse cause and effect.    Migrants are attracted to economic success and opportunities.  In the 19th  century it was hugely expensive to immigrate to Australia (or New Zealand) and people did so in large numbers either when someone else paid them to do (assisted migration) or when really good new opportunities (large expected income gains) opened up.

Early European Australia was a penal colony, hugely heavily subsidized by Britain, with few export opportunities and not particularly attractive as a place to relocate to (the total European population in 1820 was 33000).  The first big natural resource shock was the discovery of the natural pasturelands in western New South Wales in the 1820s.  In 1830, Australian wool accounted for 8 per cent of British wool imports (German states had been the dominant supplier), but by 1850 Australia accounted for more than half of a fast-growing market.  The associated income growth markedly boosted both the Australian colonies ability to support themselves, and to support a much larger population at the sort of living standards (or better) they might have been used to at home.

The gold rushes of the 1850s (and sustained high gold production for several subsequent decades) had a similar effect.   Whole new incomes could be generated in Australia, supporting high living standards (and associated imports) for a larger population.  Immigrants flooded in  –  as they did later to New Zealand in our gold rushes. Australian exports as a share of GDP rose to around 40 per cent –  a level never achieved since.  But there is nothing in the economic histories to suggest that the immigrants created the prosperity. Rather, the prosperity made Australia (and especially Victoria) attractive to immigrants.  Since the typical immigrants was a single male, content with a pretty rough standard of accommodation – so there weren’t huge initial capital stock requirements –  the standard result in Australian economic histories is that the huge inflow of immigrants dampened wages in Australia (relative to a counterfactual in which the gold discoveries had to be exploited only by people already there).

After a final gold rush in Western Australia in the 1890s, there were no great natural resource discoveries in Australia for decades.  Agricultural productivity gains continued to lift farm output –  and refrigerated shipping and new dairy technologies assisted Australia, although to a lesser extent than New Zealand –  but the best land was already taken.  Perhaps unsurprisingly, these weren’t great decades for remote Australia.  By global standards, it remained a rich and successful country, but no longer at the forefront-  indeed, on some of best measures around there wasn’t much per capita growth from 1890 until World War Two. Perhaps unsurprisingly, the rate of population growth wasn’t as rapid – European migrants weren’t quite so keen on coming as they had been (and, as in other settler countries, Asian migration was severely restricted).  For the first half of the 20th century, Australia was much like New Zealand –  an agricultural exporter, primarily to the United Kingdom.  Overall, the two countries generated rather similar living standards  –  and still had some of the faster rates of population increase anywhere in the advanced world.

Minerals began to come back to prominence in Australia from the 1960s.  Australia stopped doing stupid stuff to itself-  bans on iron ore exports were lifted, prospecting rights were improved etc –  and some combination of new discoveries and new opportunities (the rise of Asia) provided a whole new, increasingly large, income stream for Australia.  New foreign income opportunities support higher consumption demands from an existing population, and can sustain a higher population.  Mineral exports from Australia had been 1 per cent of total exports in 1951.  They were 18 per cent in 1974, 28 per cent in 1989, and 55 per cent in 2009.  And exports as a share of GDP were materially higher than they had been in the 1950s and 1960s.  New Zealand, of course, has had nothing similar (some argue that there is plenty of mineral potential, but if laws make it difficult or impossible to exploit, it doesn’t matter much whether the enthusiasts are right or wrong).

But, contrary to Megalogenis’s thesis, there is just nothing in the data to support the idea that the rapid (immigration-fuelled) population growth has been the basis for strong per capita income growth (over decades).  Rather it is the rapid total income growth –  particularly associated with mineral developments over the last 40 to 50 years –  that has enabled Australia to support pretty good incomes for a growing number of people.  Again, we in New Zealand had nothing similar on the income side, and so overall returns (eg GDP per hour worked) available to the growing number of people have continued to languish.

Now, to be clear, this is not some crude story in which physical resources inevitably make a country rich.  There are so many counter-examples I’m not going even going to attempt to list them.  But new physical resource discoveries, when combined with capable people, and strong institutions, have proved able to generate high per capita incomes for people in places where one might not otherwise have expected such good outcomes.  Norway is one example –  balancing all three components of that mix..  With more emphasis on the resources than the human capital or institutions, Brunei or Kuwait are other examples (or Equatorial Guinea and Gabon).   Australia is closer to the Norwegian end of the story –  the same North European combination of people and institutions, that have made for the most prosperous settled societies in history, augmented abundant natural resources (but spread over considerably more people than Norway).  Australia doesn’t seem like the sort of location that, natural resources apart, would easily generate top tier incomes –  never in its history has it looked like developing seriously internationally competitive manufacturing or services industries based in Australia.

Readers may be skeptical of the story I’ve been telling.  But don’t take my word for it.  Most of it (and most of the data I’ve quoted) is based on one of my favourite economics books Why Australia Prospered,  published in the prestigious Princeton Economic History of the Western World series, and written by the recently-retired leading Australian economic historian Ian McLean.  The value of the book is partly that he explicitly considers Australia through a comparative lens, looking at other settler economoies, including New Zealand.   I reread it after I’d read Megalogenis, and his story is essentially the one outlined in the previous paragraph.  There is no sense, anywhere in the entire book, that anytime in the entire modern history of Australia immigration has been an enabler –  allowing Australia to lift its per capita income above what it would otherwise have been.

And what of that bastion of careful economic analysis, the Australian Productivity Commission?  They produced a big report 10 years ago, that concluded that there were probably few or no benefits to Australians from modern immigration inflows.  And late last year, in response to another government request for a report on immigration, they produced another lengthy draft report.  I’d seen a few media reports suggesting that they had reached a positive conclusion on the benefits from immigration, but when I dug into the chapter on the economywide impacts of immigration (from p 263), I found that in their baseline scenario productivity growth and wages were lower in the scenario in which current immigration levels continued than in a scenario without immigration.  The differences are very small, and my only point here is that there is little or no support for the sort immigration-boosterism reflected in a book like Megalogenis’s.  The Productivity Commission do run an alternative more positive scenario – but essentially it amounts to “what if we just assume that skilled immigration materially boosts productivity growth”.  If one assumes gains going into the analysis, one gets gains out the other end.

Over the broad sweep of modern history Australia and New Zealand have had pretty similar approaches to immigration. And they’ve had similar institutions, and similar sorts of capable people.   In neither case is there any evidence that continued high rates of immigration have done anything to lift either country’s longer-term economic performance.  Rather successful economies successfully absorbed more people at little cost to their own people.  The big difference between the two countries in the last 100 years has been the discovery and exploitation of the vast mineral resources in Australia. That has enabled Australia to continue to offer fairly high incomes to a lot more people –  including many New Zealanders.  Without the new opportunities, products or markets, New Zealand has struggled to cope with its population growth, and continues to drift further behind the rest of the advanced world –  putting more people into a place with few natural advantages.

I described Australian incomes as “fairly high”.   And yet for all its huge natural resources, Australia’s real GDP per hour worked –  while a lot better than New Zealand’s – is no higher than the median of advanced countries.  For decades it fell relative to other advanced countries, and even over the last 20 years has done little better than hold its own.

aus real gdp phw relative

As a topic for another day,  might its people also have been better off without such rapid immigration-fuelled population growth?



New Zealand and Norway: a real exchange rate that hasn’t moved

On average, over time, one would expect the real exchange rate of a more poorly-performing country to depreciate against that of a better-performing country.

There is a whole variety of strands to a possible story about why one might expect to see such a relationship, and for why it would be helpful for the more poorly-performing country for such a depreciation to occur.  A less well-performing country will typically have found its firms less well able to compete in international markets (than those of the better performing country).  That, in turn might reflect a less attractive tax and regulatory environment, less real productivity growth, or changing demand patterns so that the world wants more of what the more successful country produces and less of what the less successful country produces.  Or it might even be about natural resource discoveries –  a country that discovers major new resources (eg oil and gas) just has more stuff that the rest of the world wants, and with good institutions such a country will tend to outperform other countries for a (perhaps quite prolonged) period.  And the citizens of a faster-growing country will rationally anticipate strong future income gains, increasing their consumption demand relative to the trajectory of consumption demand in the less well-performing economy.

I’ve illustrated previously that one of the striking stylized facts about New Zealand is that although our economic performance over the last 60 or even 100 years has been pretty disappointing by global standards, there has been no depreciation in our real exchange rate relative to those of other advanced economies.  No wonder our tradables sector has struggled.

This post is really just about illustrating the point by reference to one other particular small commodity exporting country, Norway.

For the first 100 years or more of modern New Zealand, no one doubted that per capita incomes in New Zealand were much higher than those in Norway.  New Zealand was one of the great economic success stories, while Norway struggled, and exported a lot of people, especially to the United States.  On the Maddison numbers, GDP per capita in New Zealand in 1870 was more than twice that in Norway.  By 1910, when New Zealand GDP per capita is estimated to have been the highest in the world, the margin was even more in our favour.

These days, GDP per capita in New Zealand is not much more than half that in Norway  (and the NNI per capita gap is even larger).  New Zealanders work long hours per capita, and our real GDP per hour worked is estimated to be only about 45 per cent of that in Norway.  Over the last few years, we’ve done a bit better than Norway, but the multi-decade trend has been strongly downwards.

Here, using the OECD database which has estimates back to 1970, is New Zealand GDP per capita relative to Norway’s (in current prices, using current PPP exchange rates).  These are really large declines.  Back in the early 1970s we had incomes about the same as those of Norwegians.

gdp pc nz and norway

Norway began to pull away from other OECD countries when its large oil and reserves began to move into production in the 1970s.  We, on the other hand, suffered in the 1970s from a deep decline in the terms of trade, and new access restrictions on our major export products.

And yet here is a chart showing New Zealand’s real exchange rate relative to that of Norway since 1970.  I’ve shown two, very similar, series –  one is the OECD’s relative consumer prices index, and the other is the BIS’s narrow real exchange rate measure.

rer nz norway

Our real exchange rate (in particular) has been quite variable –  Norway’s has mostly been materially more stable –   but over the whole period there has been no trend whatever in the ratio of our real exchange rate to theirs (and in the last few years, Norway’s real exchange rate has risen a lot relative to ours).

Using the OECD’s relative unit labour cost measure produces a slightly more encouraging picture for New Zealand –  but if there has been a trend decline at all, it has been quite small, compared with the magnitude of the deterioration in New Zealand’s economic performance (productivity, GDP per capita, usuable natural resource endowments).

Why has it happened?  Well, it is Saturday and I’m not planning to write an extended essay.  But my thesis is that it is a combination of things Norway has done, and things we have done.

On the Norwegian side, wisely or otherwise, much of the oil and gas revenues –  mostly accruing to the Crown – were diverted into the Petroleum Fund, and saved for a later day.   Norway has net government financial assets of around 250 per cent of GDP –  a figure that was less than 50 per cent only 20 years ago.  And there hasn’t been a large private sector offset   Norway’s positive net international investment position is now some 200 per cent of GDP.

What that has meant is that quite a large proportion of the new income earned in recent decades has not been spent.  And income not spent does not put upward pressure on the prices of non-tradables goods and services relative to those of tradables (another definition of the real exchange rate).  Norway has experienced some of that pressure –  Oslo is an expensive city – but a lot less than they would have without the huge savings rates.

Since the early 1970s, our government debt position hasn’t changed much –  it has gone up and down –  but was pretty low at the start of the period, and is pretty low now.  Our NIIP position has gone in the opposite direction of Norway’s, even though they were earning lots of (initially unexpected) income, and we were experiencing repeated disappointment.  On best estimates, our NIIP position was around -10 per cent of GDP in the early 1970s, and has been fluctuating around -70 to -80 per cent of GDP for the last couple of decades.

The Norwegians haven’t spent a larger share of their income even as their growth prospects improved, and we haven’t saved a larger share of ours even as our growth prospects deteriorated.  Neither choice is necessarily better than the other, but their choice tended to weaken their real exchange rate (all else equal) keeping more non-oil tradables firms competitive, and our choices tended to strengthen our real exchange rate, making it hard for the tradables sector to grow much.  For us, it tends to reinforce our decline.

And then there are population choices.  When migration works well, it usually complements economic success that was already underway.  Rapid population growth, all else equal, tends to put upward pressure on a country’s real exchange rate –  it involves a high demand for non-tradables, putting upward pressure on non-tradables prices relative to those of tradables (set globally).  Norway’s population growth rate has increased quite a bit in the last decade, but over the full period since 1970, here is the chart showing the ratio of New Zealand’s population to that of Norway.

population nz norway

Our population –  in a country that has had one of the worst performances of any advanced country –  has grown materially faster than that of Norway, one of the most successful countries in the advanced world.  Not usually a recipe for success – in a family, or at a national level.

I don’t believe in population policy –  people should be free to have as many, or as few, kids as they can afford, and it should be no concern of governments –  but immigration policy is a different matter.  Our population has grown faster than that of Norway almost entirely because successive National and Labour governments have chosen to bring so many non-New Zealanders into the country (more than offsetting the upsurge in those leaving, mainly for Australia).  Doing so has helped impede the sort of the sustained downward adjustment in the real exchange rate one would have expected if governments had simply stayed out of the way.  It has made even harder for New Zealand to turn around the decades of economic decline.

It just looks like a wrongheaded policy, foisted on us –  at our expense, without seeking our endorsement –  by a succession of bureaucratic and political elites (different party labels or none, but similar ideologies and mindsets) who can offer barely a shred of evidence in support of the success of their strategy.

We can’t change the fact that Norway got oil or gas, and nor would we  wish to, or begrudge them their good fortune.  But it is pretty extraordinary that over 35 years when they’ve done so well and we’ve done so badly, there has been no change in our real exchange rate relative to theirs.  At our end of that relationship, it is as if governments have set out to stop the adjustment happening.   It wasn’t their conscious intent, but after this long lack of conscious intent makes them no less culpable.




Monetary policy is bust….

Or so Vernon Small, the Dominion-Post’s political columnist would have us believe.  His article appeared yesterday under the heading “Reserve Bank rules need major rethink”, and then online as “Monetary policy is bust, so why are we still banking on it”.

I reckon he has rather overstated his case.  “Reserve Bank ‘rules’ need following” might be a more accurate assessment.

Start with the odd line that Small got from the Minister of Finance, claiming that “no one ever thought it [the inflation targeting framework] would be used to try to lift inflation”.  I’m not sure where the Minister got that idea from, but as a reminder New Zealand is the classical case where it has been used, successfully, that way.  In 1996, the National-New Zealand First government raised the target midpoint from 1 per cent to 1.5 per cent.  And in 2002 the Labour government raised the target midpoint to 2 per cent (the then Prime Minister wanted to raise it further, to match Australia, and to Alan Bollard’s credit he resisted).  As I’ve noted previously, right through to the2008/09 recession the Reserve Bank delivered inflation rates averaging higher than the successive (and increased) target midpoints.

Small does have some nice lines that had me nodding in approval

….Governor Graeme Wheeler’s rejection of a “mechanistic” approach that would see low inflation immediately trigger a cut to interest rate, currently at 2.5 per cent. It is hard to find any sophisticated analysts in the area who has made such a “mechanistic” call, but hey! Straw men have no say over what goes into their stuffing.

But he can’t quite seem to make up his mind whether, as he says, “the prime tool of monetary policy, cuts to the official cash rate, cannot achieve the target”. [my emphasis added] or whether it is more a matter that “the Reserve Bank appears reluctant to try”.

No one has advanced any evidence that, or even a strong argument why, New Zealand’s inflation rate could not have been raised, or could not now be raised.  And I’m quite sure the Reserve Bank doesn’t believe such a story.  In my post the other day, I set out a list of factors that suggested that keeping inflation up around target should be less hard here than in most advanced countries.  And we know, for example, that another small advanced commodity exporter, Norway, has managed.

In a New Zealand context, no one seriously doubts that –  all else equal –  if the Reserve Bank were to come out with significant OCR cuts and a convincing statement of their determination to do whatever it takes to get and keep inflation near 2 per cent, that the exchange rate would fall.  Prices of tradables would rise to some extent, and returns to tradables production in New Zealand would also rise.  That combination of factors would lift the inflation rate –  and, over time, the latter would be the more important channel.

New Zealand isn’t a surplus country –  so we don’t find capital flooding home to our safe haven when international fears rise.  We are a small remote net-borrowing country, whose currency foreigners mostly hold because of the yield advantages it typically offers.  All else equal, when those yield advantages narrow or disappear so does a lot of the interest in holding New Zealand dollar assets.   Stories about what, on occasion, may have happened to exchange rates in Japan or Switzerland or the United States just aren’t particularly relevant here.

For a long time, I don’t even think it was a case of the Reserve Bank being “reluctant to try” to get inflation back to target. At least while I was still closely involved there was a quite genuine and quite widely-shared belief in the Bank that there would be sufficiently strong economic growth that the inflation rate would soon lift back to around 2 per cent, and would have gone beyond that midpoint if interest rates were not raised.  They were persistently wrong –  and, over time, that should involve some effective accountability for the relevant decisionmakers and advisers –  but it was a quite genuine belief. 

But over the last 18 months, it increasingly seems as though “reluctant to try” has been a more apt description of the Bank’s approach.   This has been exemplified in some of the rather shaky arguments they have begun to run.  Last year, for example, we were repeatedly told that headline inflation would rise because the exchange rate had fallen, but there was hardly any emphasis on the underlying or core inflation trends that they should have been focusing on.  More recently, we’ve had a convenient fixation on a single measure of core inflation, which just happens to be the highest around, when previously they had told us what most other central banks say –  there is no one ideal measure, and one needs the information from a range of series to interpret what is going on. Oh, and claims that it is “all about oil” when the data clearly don’t reflect that.  And attacking straw men  – claiming that those who advocate further OCR cuts are just inappropriately focused on headline inflation.

I don’t even think it is a case of the Bank looking for inflation under ever stone. Rather strangely, they have changed their view on the short-term demand effects of immigration –  in a way that supports the dovish side of the story –  and yet even though it was a major feature of the last MPS they can’t, or won’t, tell us why or show us their research or analysis in support of their story.

Perhaps the 2.5 per cent “barrier” has been a factor.  The OCR has never been taken lower than 2.5 per cent, and there might be a psychological/mental barrier for the Governor and his advisers to taking it lower.  If so, it shouldn’t be.  Prior to 2008 the OCR had never been lower than 4.5 per cent, but Alan Bollard rightly blasted through that floor, lowering the OCR to 2.5 per cent in late April 2009 (by when the worst of the financial crisis itself had passed).  There were debates in the Bank at the time as to whether it would be safe to go any lower –  at Treasury at the time we found that rather frustrating  –  but that was seven years ago.  Since then not only have we seen many countries with official interest rates near zero for long periods, but an increasing number tentatively experimenting with negative rates.  Historical reference points are an obstacle to good policy at present, rather than being a useful anchor. If anything, they make people doubt that central banks will do enough, soon enough.  In the end I’m sure the Bank will cut further, but once again they’ll have been behind the game, when they could have got ahead of it and helped recreate a climate in which people believe that, whatever was going on abroad, inflation would average around 2 per cent in New Zealand.

Were they reluctant to try?  Well, probably latterly.  Certainly the evidence is that they haven’t tried.  There has been a lot of focus on last year’s OCR cuts, but recall that they only reversed the previous year’s unnecessary increases.  Here is a chart of the real (inflation adjusted) OCR.

real ocr I’ve shown two versions.  One, which I prefer, deflating the OCR by the two year ahead inflation expectations from the Bank’s survey, and the second using the implied long-term expectations from the indexed bond market.  Whichever measures one uses, real interest rates have been rising not falling in New Zealand over the last few years.  In a climate of such persistently low inflation, that shouldn’t have happened.

It all adds up to a story of a central bank that has been poorly led and managed, and which has not managed monetary policy well.  It hasn’t been held to account well either.

But that doesn’t say the “rules” are wrong, it simply says they haven’t been followed well.  Perhaps we should try operating within the “rules” rather than rush to conclude that there is something wrong with the system itself.    There is no sign that delivering inflation near 2 per cent is impossible, or that it is undesirable, or that doing so would lead to otherwise weird outcomes. Protracted debates now about whether the framework is right is a distraction from the real, immediate, and easily remediable issues: even under the current framework, monetary policy has been, and is, simply too tight.

None of which is to say that we should not from time to time review the rules under which the Reserve Bank works.  I’ve been championing far-reaching governance reforms, to bring the Bank more into line with international best practice, and the way other government agencies in New Zealand are run.  And the Policy Targets Agreement itself expires with the Governor’s term in September next year (which creates timing problems I’ve noted earlier).  I’ve argued here previously that it would be a good idea to follow the lead of Canada, and announce now a joint (and open) work programme, involving the Reserve Bank and Treasury, and outside researchers and commentators, to review the issues around the best design and contents of the PTA.  The last PTA, and those before it, were done largely in secret –  even though the PTA is the main document governing short-term macroeconomic management in New Zealand –  and even now, three years on, the Bank refuses to release any material background papers relevant to that PTA.

We should advance work on both fronts –  governance reform, and open review of the PTA issues in advance of the next renegotiation.  I’m not convinced of the case for material change in the PTA –  or that eg nominal GDP targeting, or wage targeting, or adding an external balance consideration –  would make much practical difference anyway (points I’ve covered in earlier posts).  But the research should be done, and debated, openly, to test and explore the arguments and alternatives.

But the problem at present is not that inflation targeting is being followed too closely, let alone “mechanistically”, or that it is proving overly and inappropriately restrictive.  It is that isn’t being taken seriously by those – the Bank –  with a legal responsibility to do so.



Memo to the Minister: our low inflation is not a good thing

An interview with the Minister of Finance on inflation, monetary policy, and the Reserve Bank was reported in NBR (for those with subscriptions) yesterday.  The story is headed “English drops heavy hint to Reserve Bank” (to cut the OCR).  That may, or may not, have been the Minister’s intention – I suspect it was probably more about getting coverage on the right side of the issue, now that opinion among local economists has started to shift again.  The reporter, Rob Hosking, has appeared to be on the “hawkish” side of the argument until recently, and even in yesterday’s article seems to want to play down how well-established the fall in inflation expectations has become. (The breadth and extent of the falls are illustrated in this post of mine, and in a very good piece put out yesterday by the Westpac economics team.)

But my eye lit on some other comments by the Minister. Perhaps playing distraction, he observed

“While there are these discussions about Reserve Bank performance, you need to think through what the problems and the benefits of persistently low inflation are.  I think it would be worthwhile if the economists articulated those pluses and minuses a bit better.”

In between devoting too much of the last day or so to complying with new regulatory imposts of this supposedly red-tape cutting government (see the Financial Markets Conduct Act), I’ve been pondering the Minister’s question/suggestion and jotting down some notes.  I’m sure he has advisers in The Treasury who can articulate all these points for him, but in case not, here are my perspectives.

Why do we want low inflation?  Because economies work better that way, when (in Alan Greenspan’s words) people don’t have to think too much about inflation in the ordinary course of life and business.  And the tax system assumes inflation away, so high inflation can lead to some really nasty tax effects.

Why do we want stable inflation?  Again, as a predictable backdrop against which people can proceed, negotiating contracts, saving and investing etc.

Why don’t we set the target inflation rate at zero (or even half a per cent to allow for index number biases)?

Two main reasons. The first is a recognition that wages and some prices can be “sticky downwards” so that a modern economy might function less well if we insisted on targeting inflation near zero.  And the second is the lower bound on nominal interest rates.  It isn’t zero, but for the time being it isn’t far below.  With a very low target average inflation rate, average nominal interest rates will also be very low.  If so, when bad things happen (eg the next recession), the central bank might have limited leeway to do much about it.  This argument is less compelling when productivity growth is strong –  since equilibrium real interest rates will be higher –  and more so when productivity growth is weak.

There is a third “reason” in a New Zealand context.  We started out with a target centred on an annual inflation rate of 1 per cent per annum.  Under significant political pressure, successive governments  – including one of which Mr English was himself a junior minister – revised the target upwards in two stages.  It is now centred on 2 per cent –  very similar to the targets in most advanced countries.

All that is by way of prelude.  But it is also to remind the Minister that he has (now twice) signed Policy Targets Agreements in which the Reserve Bank’s target is centred on 2 per cent.  He has statutory responsibilities to assess the Governor’s performance in pursuing the target.  But he also has other powers.  If he so chose, he could invite the Governor to renegotiate the PTA and lower the target range.  Or he could use the section 12 powers of the Act to override the current target and temporarily impose a lower one.  Thus far, he has done neither of those.

When might one be comfortable with inflation being materially below 2 per cent?  One set of circumstances might be those the PTA itself talks of.

For a variety of reasons, the actual annual rate of CPI inflation will vary around the medium-term trend of inflation, which is the focus of the policy target. Amongst these reasons, there is a range of events whose impact would normally be temporary. Such events include, for example, shifts in the aggregate price level as a result of exceptional movements in the prices of commodities traded in world markets, changes in indirect taxes, significant government policy changes that directly affect prices, or a natural disaster affecting a major part of the economy.

When oil prices fall sharply that temporarily lowers the headline inflation rate.  When government taxes and charges are cut that temporarily lowers the headline inflation rate.  In both cases, good economic analysis and the PTA tell the Bank to be content to see headline inflation temporarily dropping away?  Why?  Because these aren’t persistent medium-term pressures, and it is those medium term pressures the PTA rightly focuses on (the stable environment for firms and households).    We deal with these sorts of one-offs with core inflation measures.  There is no one ideal measure but at present, when headline inflation in the most recent year was 0.1 per cent, the median of the various possible core measures is probably not much above 1 per cent.

No one is criticising the Reserve Bank for not reacting to those one-offs (even though the Governor has suggested otherwise).  The debate is about how the Bank should (or should have) responded to low core inflation.

Are there any benefits from having core inflation around 1 per cent at present?  I can’t think of any.

Could there be circumstances in which there would be benefits?  I can think of some.  If, for example, New Zealand (and perhaps the world) was experiencing a period of extremely rapid productivity growth then, all else equal, that would tend to drive down inflation rates everywhere.    Rapid productivity growth would underpin strong investment growth, and support a high level of neutral real interest rates (the marginal product of capital and the real interest rate should be related).  In such a climate one might also envisage a buoyant economy and a low unemployment rate –  plenty of jobs to take advantage of the newly productive opportunities.  In such a world, the Reserve Bank could adjust monetary policy to get inflation back up to around 2 per cent.   But society might reasonably say “why bother”, and consider changing the Bank’s target.    After all, there is no obvious excess capacity or unemployed resources lying round in this example –  the unemployment rate in this fortunate economy might already be below estimates of the NAIRU, and wage inflation would be likely to be strong, supported by the high productivity growth.   Turbo-charging a booming economy might seem rather risky and the arguments for a target centred on, say, 1 per cent rather than 2 per cent might seem reasonably good.  In the same vein, deflation driven by really fast productivity growth is a lot less concerning than deflation simply resulting from weak demand (the latter was the Great Depression story).

But the scenario I discussed in the previous paragraph bears not the slightest resemblance to New Zealand’s current situation (or, as far as I can tell, to that of the rest of the advanced world).

Do we have high, and stronger than normal, trend productivity growth?  No, like almost all advanced countries we’ve seen a marked slowing in productivity growth (labour productivity and TFP) in the last decade or so.

Do we have abnormally low unemployment rates?  Again no, even at 5.3 per cent –  which the respondents in the Reserve Bank’s recent survey don’t expect to be sustained –  the unemployment rate is well above most estimates of NAIRU.  Consistent with the excess capacity and low productivity growth, wage inflation is low and is expected to fall further.

We are also adjusting to a significant adverse terms of trade shock.  For all the talk of cheaper goods and services from abroad, the terms of trade have been falling.  When the terms of trade are falling we would normally expect to see the exchange rate falling, and domestic prices rising as a result. Core inflation measures never manage to capture all that effect, so that if anything in a weak terms of trade environment one might expect to see inflation running temporarily a bit higher than target.  Our exchange rate has not fallen very much (see the comparison with Norway), but that is partly because the Reserve Bank has presided over rising real interest rates over the last couple of years,  rather than cuts.

And, although it is becoming less of an issue now, the exogenous large boost to demand and activity resulting from the Canterbury earthquakes is yet another reason why one might have been more comfortable with inflation a bit above target, rather than well below, over the past few years.  Lots of resources needed to be diverted to the repair and rebuild process, and changes in relative prices are typically part of getting those resources in place.  Changes in relative prices need not boost the overall price level –  monetary policy can simply act to counteract them.  But, within limits, it generally isn’t sensible to do so.  We wanted the economy pushed as hard as was prudent, to get the repairs done and as much other stuff still  happening as possible. That probably implied a one-off lift in the price level –  of the sort suggested by the PTA itself (see references to natural disasters in the quote above).

Recall that the New Zealand recovery in the last few years has been the weakest and most anaemic in modern history.  Had it been the other way  – really unusually strong sustained growth –  again one might have been content to have monetary policy lean a little against the boom.  But it has been nothing of the sort –  instead we’ve had weak per capita growth, weak productivity, lingering unemployment, all in the face of a huge exogenous demand shock.

Those are sorts of combinations of circumstances in which discretionary monetary policy should be doing its utmost, not looking for excuses to justify repeat inflation outcomes well below the agreed target.

What about house prices?  I’m sure that in some minds, high house prices –  and the risk of them rising further –  is a consideration in opposing OCR cuts.  I might even sympathise with that logic if there had been broad-based large increases in real house prices and rapid supply-led growth in credit.  But again, that isn’t the story. In most of the country, real house prices are no higher, or materially lower, than those at the peak of the last boom.  Credit to GDP or credit to disposable income ratios have not risen in almost a decade, and most housing credit growth appears to be an endogenous response to higher house prices themselves.  There are real and substantial affordability problems in Auckland, but there is no real mystery about what has gone on there: the government runs an immigration policy that channels tens of thousands of people into a city, and then does not have a legislative framework in place the allows the physical size of the city to grow commensurately with the rapid population growth.  That just isn’t a consideration that monetary policy should be driven by – it is a relative price change, and the cost to the rest of the underperforming economy of using monetary policy is just too high.  Past Reserve Bank research has shown, quite plausibly, that it takes potentially hundreds of points of OCR changes to have any material impact on aggregate house prices.

We have a 2 per cent inflation target.  There is simply no good reason for us (or the Minister) to be content for the Reserve Bank not to meet that target (in core or underlying terms).   As I noted yesterday, the shocks and pre-conditions New Zealand faced should have made it easier to have meet the target here than other countries may have found it.  And none of the circumstances that might make one relaxed about a persistent undershooting of the target are present here now. We’ve simply been the victims of a poorly run monetary policy.  Under the New Zealand legislation, the Minister is the public’s agent who is supposed to sort out that underperformance.

Finally, in case anyone doubts the slow productivity growth story here is chart of TFP, based at the point when the Conference Board’s data start in 1989.  I’ve shown here the median of the West European, North American, and Oceania advanced economies (a group for which there is data all the way back), and the line for New Zealand.

tfp conf board

New Zealand’s performance has been pretty dire for a long time, but we’ve shared in the marked deterioration evident across the advanced world in recent years.  This is simply not a climate in which the wonders of human ingenuity are driving productivity strongly upward and driving prices more strongly down than usual. It is a climate in which monetary policy should do what it can, when it can. In New Zealand there are no material constraints, and neither we –  nor the Minister –  should be content with what has been being delivered.

Keeping inflation near target: easier here than for most

Some of the discussion around New Zealand’s low inflation rate, and the question of what the Reserve Bank should do (or have done) about it, has a strong element of “it has been awfully hard to keep inflation up near target, not just here but everywhere in the advanced world”.  In other words, we shouldn’t be too critical of the Reserve Bank because they have just been struggling with the same problems everyone else has faced.  Everyone, perhaps, except Norway?

Inflation is, ultimately, a monetary phenomenon.  But monetary policy works and responds within a wider economic climate, where there can be all sort of other pressures at any one time.  Sometimes those other pressures work in the same direction as monetary policy, and sometimes in the opposite direction –  in those cases we might say it is (respectively) a bit easier or a bit harder than usual to deliver on inflation goals.  People have advanced various stories about these sorts of pressures to help explain both the rise in inflation in the advanced world in the 1960s and 70s, and the subsequent sharp decline.  Changed attitudes of monetary policy decision-makers contributed in both cases, but those attitudes weren’t the only factors.

Today I don’t want to try to illustrate that point over history, but rather to look at the pressure/shocks/pre-conditions that might have made it a little easier, or a little harder, for monetary policymakers in OECD countries over the period since just prior to the 2008/09 recession.

What about the pre-conditions?

Many advanced countries have been, or felt they were, constrained in doing more with monetary policy by the near-zero lower bound on nominal interest rates.  Thus, going into a period with lots of downward pressure on the inflation rate it helped, all else equal, to have high nominal interest rates. High nominal interest rates leave plenty of room to cut.  Going into the 2008/09 recession and aftermath, New Zealand had the third highest interest rates in the OECD –  only Iceland and Turkey had rates higher than New Zealand.  That wasn’t just a reflection of some last minute RBNZ madness in driving interest rates sky high.  Our interest rates have been above those in most of the rest of the OECD for a long time.

And going into the period of the recession and beyond, we had also had quite high inflation.  I’m not going to attempt to reconstruct the chart here, but work done at the Reserve Bank showed that among inflation targeting countries New Zealand was quite unusual in that our inflation outcomes had typically run above the midpoint of our (successive) target ranges.  Other countries had historically averaged nearer the midpoint.  Going into the recession, the Reserve Bank’s favoured measure of core inflation was actually above the 3 per cent top of the target range, and as this Reserve Bank chart I reproduced the other day illustrates, core measures had all typically been well above the target midpoint in the years leading up to 2008.

core inflation measures

So we had higher inflation to start with (and inflation expectations fairly consistent with that high inflation) and more room to cut policy rates should that be required.  Oh, and unlike half the OECD countries –  members of, or pegged to, the euro – we had a floating exchange rate.  Floating exchange rates increase a country’s ability to achieve its own inflation target whatever is going on elsewhere.

What about the fiscal pre-conditions?   If government finances are in such bad shape that there is little effective choice but to run severely contractionary fiscal policy, it can make it a little harder for monetary authorities if those authorities are trying to keep inflation up, especially if the near-zero lower bound is in view.

One way of looking at the fiscal situation is to look at the cyclically-adjusted balances prior to the recession.  Using the OECD’s measure, New Zealand’s average surplus over the years 2006 to 2008 was higher than those in almost every other OECD country.

fiscal surplus 06 ot 08Using data on the general government sector’s net debt, New Zealand’s position wasn’t quite as strong. But in 2007, we were one of the 12 countries where the government sector has less debt than financial assets, still one of the stronger positions among OECD countries.

So the pre-conditions looked pretty favourable for New Zealand to be able to keep inflation near target.  If anyone was going to be able to do so, in a strongly disinflationary environment, our high starting inflation, high starting interest rates, and strong fiscal position meant New Zealand was well-positioned to do so.

Pre-conditions are one thing.  But what about the shocks that each country faced?

Financial sector crises didn’t occur to same extent in all countries.  I’ve shown this table before, classifying advanced countries by the extent of the increase in non-performing loans since 2007. Real wealth losses –  whether borne by the government in bailouts, or by private creditors –  make it harder to keep inflation up, all else equal.   New Zealand is among the group of countries to the left of the table with the smallest increase in losses.

&Non-performing loans since 2007
Source: World Bank.

It is never clear how to think about the impact of house price falls  –   how much of it is a real wealth loss, given that we go on living in the same house and consuming the same flow of housing services?  New Zealand did experience falling house prices during the recession, but as this chart I ran a few months ago illustrates, those aggregate losses have been fully recovered and, if anything, real house prices here have been a little stronger than those in the median OECD country.

house prices since 2007

How about the terms of trade?  For a country like New Zealand, the terms of trade are largely exogenous.  A strong terms of trade boosts national incomes, supporting domestic demand (consumption and investment) whatever else is going on in the rest of the world. All else equal, if central banks are struggling to keep inflation up near target, they would prefer strong income gains, rather than the alternative, to support the efforts of monetary policy.

As this chart shows, New Zealand was among the handful of countries with the strongest terms of trade.  Even now the terms of trade are around 10 per cent higher than they were over the years prior to the recession.  That gave us an edge, all else equal, in keeping inflation up.

tot crosscountry

What about exogenous demand shocks?  It is often hard to think of examples of these, but the repair and rebuild process associated with the Canterbury earthquakes is one.  Other OECD countries have had to repair and rebuild after natural disasters – Chile and Japan both suffered from serious earthquakes.   But the damage in Japan, as a share of GDP, was much smaller than the damage in New Zealand and Chile (in both cases up towards 20 per cent of annual GDP).  And, as this table in recent Reserve Bank article highlighted again, what really marked New Zealand out was the extent of the insurance coverage of the losses –  most of that, in turn, covered by foreign reinsurers, rather than by domestic institutions.

insured losses

Earthquakes are awful, and often expensive, phenomena.   But the activity associated with the repair and rebuild processes can be a substantial near-term boost to demand and activity.  That is so even if all the losses are borne domestically – since people need a new house (or functioning water pipes) now, and might pay for it through higher savings over 40 years –  but it is much more obviously so when foreign reinsurers bear the bulk of the cost.  Activity needs to occur now, and someone external is paying for it.  That provides a lot of support for demand.  It could be quite troublesome if there was already a lot of inflation pressure, but –  much as one would wish the earthquakes never occurred –  it provides a lot of  potentially helpful support for demand (reinforcing monetary policy) when other inflation pressures are weak.

Looking through the list of OECD countries, I can’t see any countries that have had anything like that sort of large exogenous demand shock in the last decade or so.  Perhaps I’m missing some, and if so please feel to mention those case in the comments.

In general, declining population growth rates tend to be associated with relatively weak demand pressures.  That can be helpful when other demand and inflation pressures are strong, but more troublesome if other inflation pressures are weak –  as they have been, across the advanced world, in recent years.   But as it happens, New Zealand has had one of the faster population growth rates among OECD countries in the last decade or so, and in the last couple of years has had the fastest population growth we’ve experienced for 40 years.

Bringing it all together, thinking about things that have made it easier or harder for monetary policy to do its job and keep inflation up around target in recent years, relative to the situation in other advanced countries, we’ve had:

Favourable pre-conditions (things already in place in 2008):

  • high starting inflation (relative to target)
  • high starting interest rates
  • a floating exchange rate
  • low net public debt
  • a strong flow fiscal position

And favourable idiosyncratic shocks (or shocks avoided that others faced):

  • few direct financial crisis costs
  • no large sustained fall in house prices
  • a strong terms of trade
  • a large exogenous demand shock (earthquake repair process) largely externally-financed
  • continued strong population growth

None of this is to deny that the global environment  –  eg the declining productivity and population growth I highlighted yesterday, and global oversupply in various markets reflecting past excess investment associated with China –  might have made it more difficult, perhaps materially more difficult, generally for central banks to keep inflation up to around their respective targets.

But among advanced countries, it is difficult to think of any where it should have been easier to have kept inflation up near target than New Zealand.  Almost everything was going our way, and yet the Reserve Bank has consistently failed.

In any reasonable evaluation of the performance of an independent agency pursuing a target it does not control directly, one has to look at all the circumstances, not just at the bottom line, important as that bottom line often is.    One could easily envisage an alternative New Zealand in which many of the factors in the list above might have been reversed.  In such an environment, whatever else was going on in the rest of the world, one might not have been inclined to be very harsh in evaluating our own Governor had he persistently failed to keep inflation around the target.  But in the environment the Governor and his advisers have actually faced in the last few years, it is difficult to acquit the Reserve Bank of responsibility for failing to achieve its primary goal. It was easier for them than for almost all their overseas peers, and yet they’ve failed.  And no forecast I’ve seen suggests that situation is about to reverse rapidly.

The Reserve Bank published an article late last year on “Evaluating Monetary Policy”.  I discussed it here, and included a link to another earlier article they had published on a similar topic.  From the earlier article I highlighted a list of things the Reserve Bank’s Board (or the Minister) might want to take into account in evaluating the Governor’s performance, and perhaps considering any reappointment.

Some of the items the Reserve Bank’s Board might be expected to concern themselves with in fulfilling the monetary policy monitoring role include:

  • The processes the Governor uses to gather and interpret economic information.
  • The choices the Governor makes in allocating resources areas of the organisation relevant to monetary policy (including judgements he makes on whether to seek more, or fewer, resources, when the five-yearly funding agreement is negotiated)
  • The means the Governor uses to ensure that he is exposed to alternative perspectives.
  • The quality of the people the Governor appoints to advise him on policy choices.
  • The way in which the Governor applies section 3 and 4 of the PTA (dealing with deviations from the target range, and the avoidance of unnecessary instability).
  • The way in which the Governor thinks about and responds to the uncertainties around monetary policy.
  • The ability of the Governor to articulate the reasons for his policy choices, and his ability to convince others of his case.
  • The processes the Governor uses to assess past policy and learn from experience.
  • The stability through time in the Governor’s policy choices.

I’d now add to the list “the shocks and pre-conditions” the Governor faced over his or her term.  On this occasion, it doesn’t really seem to help his case.

Some Great Depression comparisons

Back in the early days of this blog, I illustrated how for advanced countries as a group cumulative growth in real GDP per capita in the period since the peak of the last cycle (2007) to 2014 had been no better than that in a comparable seven year period from 1929, during the Great Depression.

Here is an updated version of the chart I ran then for all the OECD countries

real pc gdp growth 07 to 14

The median growth rate –  o.22 per cent in total over seven years –  is so small as to be almost invisible on the chart.

And here is the comparable chart, using the Maddison database of historical estimates, for the years 1929 to 1936

1929 to 1936b

I wouldn’t want to make much of the differences in the median growth rates –  given the imprecision of many of the historical estimates, and the likelihood of revisions to the more recent ones.  I was more struck by the lack of any material real GDP growth per capita in either period.

The Great Depression is seared in historical memory –  and whole generations of politicians came afterwards telling themselves and voters “never again”.  It is too soon to know whether the most recent period achieves the same permanent imprint on historical memories.  Perhaps in part it will depend what comes next.    But I’ll be a bit surprised if this episode has quite the same impact.  The Great Depression hit popular consciousness particularly hard because unemployment rates in so many countries rose very high, and stayed high for a long time, and in an age when government income support for those unemployed was typically less generous than it is today.

There aren’t (at least that I’m aware of) any consistent cross-country estimates of the unemployment rates in the 1930s.  But in most countries, the increases in the unemployment rates were very substantial (in the US, the unemployment rate is estimated to have peaked well above 20 per cent, and remained high for years).

By contrast, here is what has happened to advanced country unemployment rates in the last decade or so.

oecd U since 04

Whether one takes the median OECD country or, say, the total for the G7 countries, there was an increase in the unemployment rate of around 2.5 percentage points, which has been substantially reversed over the subsequent years. Unemployment rates are typically around where they were in 2006.  There are still awful cases –  Spain and Greece still have unemployment rates in excess of 20 per cent –  but the defining character of the last few years has not been very stubbornly high unemployment rates.

What really marks out the last decade  –  and contrasts it with the 1930s – is how poor the productivity growth has been. Without productivity growth, one can still end up with plenty of jobs, but they tend not to offer much in way of wage increases.

I’ve drawn attention previously to the work of US economic historian Alexander Field, who devoted a book to illustrating the very strong productivity gains (TFP) that the US had achieved in the 1930s.  A few weeks ago, I saw a nice summary of a new study by some other economic historians.   On the basis of their new work, they no longer see the 1930s as the period of fastest TFP growth in US history, but it was still very strong –  reflecting rapid technological and managerial innovations.  Here is the key chart.

Figure 1. TFP growth in the private domestic economy, US, 1899-2007 (% per year)

crafts us productivity

By contrast, here is a picture that uses John Fernald’s (FRBSF) business sector TFP estimates for the US over the last 25 years.


Business sector TFP growth is typically faster than for the entire economy, but for the last 10 years Fernald estimates average annual growth of  just over 1 per cent, dramatically slower than the 7 per cent average growth over the previous 10 years.

The slowdown in productivity growth isn’t unique to the US –  indeed on some measures, the US has done better than most –  and was becoming apparent in the data (again, not just this dataset), if not in the public consciousness, before the great recession of 2008/09 and its aftermath.

The contrast with the 1930s is striking.  That was, overwhelmingly, a failure of demand and of the global monetary system, and as those constraints were removed, the underlying lift in productivity supported a recovery in investment.  For the US, for example, post-war per capita GDP is on the same growth path as it had been pre-1929: output wasn’t permanently lower.

What about the current situation?  Taken together, falling rates of population growth and falling rates of TFP growth materially reduce the volume of investment that is likely to be required, and profitable, at any given interest rate.  Add in apparently high desired savings rates around the world, and it is hardly surprising that real interest rates have fallen away so much.  Add declines in inflation expectations to the mix, and it has reinforced the decline in nominal interest rates.  The problems are mostly structural in nature, but they have been amplified by the reluctance of central banks to do what is required to keep inflation (or other nominal measures) up around target, in turn driven by a constant focus on a desire for “normalization” and a focus on some sense of where real interest rates “must” (in some sense) be in the very long term.  The reality, and perceptions, of the near-zero lower bound haven’t helped in many countries.

I’m pretty confident that in the longer-term real interest rates around the advanced world will be positive –  land is still fertile, as is the human imagination (so there will be a flow of new innovations and opportunities.  But there is no guarantee of such positive real interest rates in any particular decade (any more, in a New Zealand context, than there is a guarantee that our real interest rates will converge with those of “the world” in any particular decade).  It seems likely that some mix of lower global savings rate, higher birth rates, and structural reforms that create a better climate for productivity growth and investment are likely to be required to put the world economy on a better path –  one that, inter alia, might put us back on a path that supported more “normal” levels of nominal and real interest rates.  But those interest rates will be an outcome of a successful overall policy mix, not an intermediate target in their own right.  Monetary policy –  here and abroad –  in recent years has come too close to treating them as an intermediate target, rather than focusing on, and responding to, the data flow.



Perspectives from the Christchurch economy

As New Zealand readers won’t be able to avoid knowing from the blanket media coverage, today is the fifth anniversary of the most destructive of the thousands of earthquakes that have hit Christchurch and its neighbouring areas since September 2010.

Christchurch is “home” to me. I haven’t lived there for decades, and don’t suppose I will again. But almost all my wider family live there, and my ancestors for 150 years or more have lived in and around Christchurch.   Many of my family were, and are, badly affected by the 22 February quake: my elderly parents managed to get down the damaged stairs of their multi-storey apartment block, but never even got inside the building again.  The church where they had been raised, and married, and where several generations had been buried from, lay in ruins.


On Friday, presumably to mark the anniversary, the Reserve Bank released an issue of the Bulletin looking at how the economy of Christchurch and the Canterbury region has fared in the years since the worst of the quakes  (it is billed as “The Canterbury rebuild five years on”, but is mostly about economic activity in Canterbury, of which of course the rebuild is a significant, if temporary, new part).  The article builds on an earlier one along much the same lines published in September 2012.

There is a range of interesting material in the article, as well as a few things that read oddly.  For example, the authors note on several occasions that “the bulk of commercial building reconstructions has yet to start”, which seems to defy the evidence of the senses (there has been a lot of building going on in and around the central city in the last year, public and private, and a lot of “for lease” signs on the new buildings), unless the Bank is much more optimistic than most people seem to be on just how large a CBD Christchurch is likely to have in the next decade or two.    And the authors include this chart, using SNZ data, suggesting that retail sales in Christchurch have been much stronger than in the rest of the country

chch retail sales

Which seems a little odd, since population growth has lagged behind that in the rest of the country.  Using the SNZ subnational population estimates, between June 2010 and June 2015 populations are estimated to have grown as follows:

New Zealand 5.60%
Canterbury regional council 3.30%
Christchurch city -2.30%
Christchurch city + Selwyn and Waimakariri 2.60%

Even allowing for the lower unemployment rate in Canterbury than in the rest of the country, it would seem surprising if retail sales per capita had grown so much more strongly than in the rest of the country (estimated retail sales 6 per cent faster –  see chart –  and population growth perhaps 2 to 3 percentage points slower.

But in commenting today, I didn’t want to focus on the fine details of a useful article.  Instead I wanted to comment briefly on three thoughts that struck me as I read.

First, in an article written by officials in a government agency, the authors are quite constrained in what they will have felt able to say about the rebuild process and the role of central government in it.  It is perhaps useful to read the Bank’s article alongside, say, the article in this week’s Listener.  And the Bank’s primary focus is, of course, on resource pressure issues, not the effectiveness or otherwise of the rebuild process.  But silence on some of these matters risks being read as endorsement.  I’ve noted already the comment about the commercial rebuild process, but if the authors are right that there is a lot more to come, perhaps it is worth pondering what role central government has played in  slowing down the process.  For example, the use of compulsory land acquisition powers, in pursuit of some official vision of what the city centre “should look like”, which will have contributed to much higher than necessary land prices in the central area.  Or the uncertainty which central government has created by promoting (almost certainly uneconomic) so-called anchor projects, and then making almost no progress on them –  leaving private investors considering projects that would sensibly locate close to the “anchor projects” in limbo.

Second, a couple of charts in the article prompt a “what might have been” thought about the entire economy.    Some have argued that the New Zealand economy would have performed much more poorly over recent years without the repair and rebuild process.  If anything, I think the opposite is true.  Right from the early days following the earthquakes, the Reserve Bank was focused on the size of the rebuild expenditure, and associated pressure on resources, that was to come over the following few years.  As probably the largest investment programme in New Zealand (share of GDP) since the Think Big projects in the early 1980s, and with a very domestic spending component to it, it was quite right for the Bank to focus on those issues and risks.  But, with the benefit of hindsight, I think that doing so helped leave the Bank more reluctant than it should have been to have cut the OCR as the record of persistently low inflation kept building up.  The sentiment was often along the lines of “it might be low right now, but it can’t last –  look at all those resources pressures to come in Christchurch in the next few years”.

If the economy had been fully employed, the repair and rebuild process would inevitably have had to “crowd out” some other economic activity –  most probably from the tradables sector.  In fact, we’ve had an underemployed economy throughout the last five years and could, with hindsight, have done with more demand, which would have generated more economy activity, less unemployment and a bit more wage and price inflation.  Without the spectre of the rebuild programme, there might have been more chance of it being allowed to happen.

Part of what I’m talking about is captured in these two charts from the Bank’s article.

chch Uchch particThe labour market in Canterbury has been materially stronger than in the rest of New Zealand.  Even pre-quake, the participation rates were higher and the unemployment rates were lower (probably partly reflecting different demographics), but both gaps widened further in Canterbury’s favour as the demand/activity associated with the rebuild really got underway from 2013.

With a lower OCR over the last few years, and the associated lower exchange rate, the whole of New Zealand could have enjoyed a milder version of this sort of buoyant labour market.  The intense focused nature of the rebuild “shock” probably always meant that the Canterbury market, at peak, would be tighter than that in the rest of the country, but the rest of the country simply could have done materially better.  Demand makes a difference, and monetary policy can either hold back or stimulate demand.

Had the demand been there in the rest of the country to generate stronger labour market outcomes, there would have been inflation consequences. But that would have been a good thing, not a bad one.  Recall that inflation has been well below target for years.    And as the Bank notes

 In real terms, wages in Canterbury have increased by about 8 percent since the earthquakes, whereas wages outside of Canterbury have increased about 6 percent in real terms.

Hardly of a magnitude – 2 percentage points different in total over five years –  that, repeated nationwide, would have been sufficient to have blown the inflation rate back through the upper end of the target range.

One can’t simply mechanistically translate one region’s experience into that for a whole country,  but the simple comparisons outlined here point in the direction of what went wrong with monetary policy management in New Zealand in the last few years.  With a huge non-tradables demand shock (which, in macro terms, is what the rebuild represents) New Zealand should not have had any great difficulty keeping inflation up around target in recent years –  indeed, one could, if so inclined, have mounted an argument for it to have been a little higher for a few years, reflecting the intense one-off nature of the shock).

My final set of thoughts, rather more speculative, is around the longer-term health of the Christchurch economy.  The Bank repeatedly describes the Canterbury economy as being “resilient” (including in its press release) , but if anything I came away from the article more sobered and worried about the future of Christchurch than I had been.  In internal debates in the immediate wake of the earthquake, I was always one of those who pushed back against the idea that there would be a wholesale exodus from Christchurch, from which the city would never recover etc.  Apart from any other arguments, between risks of tsunamis, volcanoes, earthquakes, and floods where in New Zealand was really much safer in the longer-term?   And there hasn’t been such an exodus –  indeed, the population of greater Christchurch is higher it was in 2010.

But there always was Professor Ilan Noy’s work suggesting permanent adverse effects (population and economic activity) from past overseas natural disasters.  Noy is now at Victoria University and is listed as a co-author of the Reserve Bank’s article.

The Christchurch economy has historically drawn strength from a number of areas.  There was a large manufacturing sector, with a significant high-tech and export orientation.  That sector hasn’t been materially affected by the earthquake and subsequent rebuild process – but then the overall manufacturing sector (especially outside the construction-related bits) has been performing poorly (per capita manufacturing value-added is now only around 80 per cent of what it was in the early 2000s).   Christchurch has also built on the large rural hinterland –  which is still there, and probably more intensive than ever as vineyards (to the north) and dairy displace sheep.

But Christchurch has also become a reasonably significant location for export education (one of the worst sets of fatalities was a English language school for foreign students) and some combination of tourist destination and gateway to the picturesque South Island. I’ve never been entirely confident that tourism is a robust basis for long-term high advanced country living standards (it isn’t tourism –  much more of it than New Zealand has – that makes France or the UK prosperous), but some of the charts in the article were sobering.

Guest nights

guest nightsInternational numbers are recovering, but there is a very long way to go.  Perhaps not too surprisingly (cause and effect) hotel capacity in Canterbury is only about 60 per cent of what it was.

Or international student numbers, where there has been no recovery at all (although I gather the picture for graduate students is a little more encouraging).

chch studentsThe chart for foreign fee-paying school students is even weaker.

The Bank ends its article noting

 In particular, activity in the tourism and education sectors remains markedly below pre-quake levels. Without increased activity in other sectors, the labour market in the region could see a reversal of the improvement that has occurred in recent years, leading to reduced participation, higher unemployment and outward migration.

No doubt activity in some of those tradable services sectors will recover further at some point, but how far and how quickly?  In some way’s Christchurch’s tradables sector plight probably isn’t a million miles out of line with the experience of much of the rest of provincial New Zealand, which has struggled to cope with the effects of a persistently high exchange rate, out of line with the longer-term real economic fundamentals.  In aggregate, economic activity in Christchurch has been held up by the repair and rebuild spending, but that won’t last for ever, and is no longer an impetus for growth (the volume of activity having now levelled off).  “Buoyant” might have been a better description than “resilient”.

Like many places in New Zealand, Christchurch is a nice place to live, but as the rebuild phase passes, there must be doubts about the ability of economic activity in the area to support high incomes for a growing population.  It is a concrete illustration of the more general need for a reorientation of policy in directions that would generate a lower real exchange rate –  a stronger competitive foundation –  for at least a decade, to help unwind the adverse effects of the last decade: successive non-tradables shocks, exacerbated by policy mistakes, resulting in an exchange rate too high, it appears, to support, much growth in the tradables sector.

As I noted, the Reserve Bank authors will have been constrained in what they could say.  The same constraints don’t apply to Professor Noy. Perhaps a journalist could consider approaching him, and inviting him to elaborate on his thoughts on the Canterbury economy and the apparent fragility of its rebuild-fuelled activity?

Justice Scalia on charging for OIA requests

The late Justice Antonin Scalia was something of a hero to thoughtful Christian conservatives, and no doubt to others who thought that the US Constitution should be read as it was written, not as a contemporary committee of ex-lawyers wished it had been written.

Over the last few days since Scalia’s death I’ve been reading various obituaries and appreciations, and taking the opportunity to read various articles and opinions he had written, mostly from before his time on the Supreme Court.    In doing so, I stumbled on all sorts of things –  including commentary on a 19th century case in which the US Supreme Court was called upon to determine the validity of a curious law which (in the great era of trans-Atlantic migration) forbade the offer of employment in the United States to someone still resident abroad.  Taking what Scalia considered was creative license with the Constitution, the Court struck down that law, allowing a New York church to recruit a vicar from the United Kingdom.

In clicking on various links I stumbled on this 1982 article in Regulation magazine, a journal that Scalia then edited.  The article ran under the heading “The Freedom of Information Act Has No Clothes”.  Much of his critical commentary is specific to the details of the American Freedom of Information Act, and particularly a bunch of extension enacted in 1974 when the presidency was at its weakest, just after the resignation of Richard Nixon.

Having been pushing the cause of easy access to official information  – the principle enshrined in our Official Information Act –  and lamenting the Reserve Bank move to charge for access to information, I was slightly disconcerted to find Scalia all in favour of charging for Freedom of Information Act requests.  The 1974 amendments had significantly liberalized the charging provisions

The question, of course, is whether this public expense is worth it, bearing in mind that the FOIA requester is not required to have any particular “need to know.” The inquiry that creates this expense-perhaps for hundreds of thousands of documents-may be motivated by no more than idle curiosity. The “free lunch” aspect of the FOIA is significant not only because it takes money from the Treasury that could be better spent elsewhere, but also because it brings into the system requests that are not really important enough to be there, crowding the genuinely desirable ones to the end of the line. In the absence of any “need to know” requirement, price is the only device available for rationing these governmental service

He raises a number of other concerns with the priority the statute gives to freedom of information cases (including the requirement to respond with a specified time –  10 working days in the US at the time), noting that

The foregoing defects (and others could be added) might not be defects in the best of all possible worlds. They are foolish extravagances only because we do not have an unlimited amount of federal money to spend, an unlimited number of agency employees to assign, an unlimited number of judges to hear and decide cases. We must, alas, set some priorities-and unless the world is mad the usual Freedom of Information Act request should not be high on the list.

Of the FOIA he writes

It is the Taj Mahal of the Doctrine of Unanticipated Consequences, the Sistine Chapel of Cost-Benefit Analysis Ignored

And he concludes

The defects of the Freedom of Information Act cannot be cured as long as we are dominated by the obsession that gave them birth that the first line of defense against an arbitrary executive is do-it-yourself oversight by the public and its surrogate, the press. On that assumption, the FOIA’s excesses are not defects at all, but merely the necessary price for our freedoms. It is a romantic notion, but the facts simply do not bear it out. The major exposes of recent times, from CIA mail openings to Watergate to the FBI COINTELPRO operations, owe virtually nothing to the FOIA but are primarily the product of the institutionalized checks and balances within our system of representative democracy. This is not to say that public access to government information has no useful role-only that it is not the ultimate guarantee of responsible government, justifying the sweeping aside of all other public and private interests at the mere invocation of the magical words “freedom of information.”

I wasn’t ultimately persuaded.  But it is always worth reflecting on arguments one disagrees with, perhaps especially when they are made by someone whose arguments one usually finds persuasive.  Perhaps it is partly a matter of the passage of time: society seems to put a greater weight on open government now than was perhaps the case 35 years ago.   Perhaps it is partly that, in the New Zealand context at least, there is little evidence of an overweening burden being placed on the public purse by Official Information Act requests.  And perhaps too our “institutionalized checks and balances” are weaker than those in the United States –  no powerful, and well-resourced, congressional committees, for example.   The economic argument, which Scalia alludes to, that products that are unpriced will attract a very high level of demand, rings less true when, say, an organization as large and powerful as the Reserve Bank attracts perhaps 70 requests, of all types and across all issues, in a busy year.

Another Scalia piece I enjoyed, from a few years later by when he was a judge on the US Court of Appeals, was headed On the Merits of the Frying Pan, presented as part of a Cato Institute conference on Economic Liberties and the Judiciary.

Scalia discusses the question of whether substantive economic freedoms (as distinct from protection of procedural due process) should be built into the Constitution.    He warns both (a) be careful what you wish for, and (b) more generally, reminds his readers and listeners that constitutions should really reflect matters on which there is already a deep social consensus.  There wasn’t one –  and probably isn’t –  for economic freedom, in the US or here.

First, be careful what you wish for

Many believe- and among those many are some of the same people who urge an expansion of economic due process rights-that our system already suffers from relatively recent constitutionalizing, and thus judicializing, of social judgments that ought better be left to the democratic process. The courts, they feel, have come to be regarded as an alternate legislature, whose charge differs from that of the ordinary legislature in the respect that while the latter may enact into law good ideas, the former may enact into law only unquestionably good ideas, which, since they are so unquestionably good, must be part of the Constitution. I would not adopt such an extravagant description of the problem. But I do believe that every era raises its own peculiar threat to constitutional democracy, and that the attitude of mind thus caricatured represents the distinctive threat of our times. And I therefore believe that whatever reinforces rather than challenges that attitude is to that extent undesirable. It seems to me that the reversal of a half-century of judicial restraint in the economic realm comes within that category. In the long run, and perhaps even in the short run, the reinforcement of mistaken and unconstitutional perceptions of the role of the courts in our system far outweighs whatever evils may have accrued from undue judicial abstention in the economic field.

And then on constitutions

The most important, enduring, and stable portions of the Constitution represent such a deep social consensus that one suspects that if they were entirely eliminated, very little would change. And the converse is also true. A guarantee may appear in the words of the Constitution, but when the society ceases to possess an abiding belief in it, it has no living effect.

I do not suggest that constitutionalization has no effect in helping the society to preserve allegiance to its fundamental principles. That is the whole purpose of a constitution. But the allegiance comes first and the preservation afterwards.

Unless I have been on the bench so long that I no longer have any feel for popular sentiment, I do not detect the sort of national commitment to most of the economic liberties generally discussed that would enable even an activist court to constitutionalize them. That lack of sentiment may be regrettable, but to seek to develop it by enshrining the unaccepted principles in the Constitution is to place the cart before the horse.

If you are interested in economic liberties, then, the first step is to recall the society to that belief in their importance which (I have no doubt) the founders of the republic shared. That may be no simple task, because the roots of the problem extend as deeply into modern theology as into modern social thought. I remember a conversation with Irving Kristol some years ago, in which he expressed gratitude that his half of the Judeo-Christian heritage had never thought it a sin to be rich. In fact my half never thought it so either. Voluntary poverty, like voluntary celibacy, was a counsel of perfection–but it was not thought that either wealth or marriage was inherently evil, or a condition that the just society should seek to stamp out. But that subtle distinction has assuredly been forgotten, and we live in an age in which many Christians are predisposed to believe that John D. Rockef eller, for all his piety (he founded the University of Chicago as a Baptist institution), is likely to be damned and Che Guevara, for all his nonbelief, is likely to be among the elect. This suggests that the task of creating what I might call a constitutional ethos of economic liberty is no easy one. But it is the first task.

As even those with an alterative judicial approach have noted this week, Scalia brought a combination of energy and intellect to his work that constantly improved even the judicial reasoning advanced for decisions with which, as a matter of legal interpretation, he profoundly disagreed.

Meeting the inflation target in one OECD country

There is a small OECD country whose export commodity prices surged prior to the 2008/09 recession, and again in the years after that recession.  It has grappled with high and rapidly rising house prices –  some of highest ratios in the world – and high and rising levels of household debt.  It wasn’t New Zealand I had in mind, but Norway.

There has been a lot of talk from those opposing further OCR cuts of how countries everywhere are struggling to get inflation up, as if meeting New Zealand’s inflation target was either (a) a lost cause, or (b) not something we should be bothered about anyway.

So I found Norway’s experience interesting.

The Norwegian government has set an inflation target for the central bank:

The operational target of monetary policy shall be annual consumer price inflation of close to 2.5 per cent over time

They have all the usual ‘outs’

In general, direct effects on consumer prices resulting from changes in interest rates, taxes, excise duties and extraordinary temporary disturbances shall not be taken into account.

So far, so conventional.  The precise words are a bit different, but the gist is no different from New Zealand’s Policy Targets Agreement –  ours focused on 2 per cent inflation, and theirs on 2.5 per cent.

And, much as the Reserve Bank used to, the Norges Bank recognizes that there is no one foolproof indicator of underlying inflation

There is no one indicator that provides a precise picture of underlying inflationary pressures in all situations. Different measures of underlying inflation are discussed in Monetary Policy Report.

In fact, they include on their website a nice summary table of four different measures

And here is how they’ve been doing.

Inflation indicators

CPI CPI-ATE CPIXE Trimmed mean 1) Weighted median 1)
Jan.16 3.0 3.0 2.6 ND ND
Dec.15 2.3 3.0 2.6 2.3 2.2
Nov.15 2.8 3.1 2.8 2.5 2.4
Oct.15 2.5 3.0 2.8 2.4 2.3
Sep.15 2.1 3.1 2.9 2.4 2.3
Aug.15 2.0 2.9 2.7 2.3 2.4
Jul.15 1.8 2.6 2.5 2.1 2.4
Jun.15 2.6 3.2 3.1 2.3 2.4
May.15 2.1 2.4 2.4 2.1 2.3
Apr.15 2.0 2.1 2.1 2.1 2.5
Mar.15 2.0 2.3 2.3 1.9 2.4
Feb.15 1.9 2.4 2.3 2.0 2.3
Jan.15 2.0 2.4 2.4 2.0 2.1

1) Owing to Statistics Norway’s changes to the statistical structure at a detailed level, estimates for January 2016 are temporarily unavailable.

ATE excludes tax changes and energy products

XE excludes tax changes and (estimated?) temporary changes in energy prices.

The target is 2.5 per cent inflation, and the average of the last observations of the four underlying measures is 2.5 per cent.

Inflation in Norway had been below target, but they cut official interest rates further  –  currently, the Key Policy Rate is 0.75 per cent, down from 1.5 per cent a couple of years ago.  The central bank reports that inflation expectations have been fairly stable, so that the whole of the cut in the nominal policy rate has also been a fall in the real policy rate.

As you might expect, economic conditions in Norway haven’t been great in the last year or so, since oil prices plummeted –  even though most of the direct effects of fluctuating oil revenues are sterilised in the Petroleum Fund.  The unemployment rate –  while still one of the lowest in the OECD at around 4.6 per cent –  has increased by around a full percentage point, and is as high as it has been at any time in the last fifteen years.

But, nonetheless, the inflation rate has increased and core measures suggest it is around the target midpoint.    That hasn’t been the New Zealand picture. What is the difference?

A key proximate part of the story is the behaviour of the respective exchange rates.  Here are the BIS broad exchange rate indices for the two countries.  Norway’s exchange rate is the lowest it has been for decades, while ours –  off the 2014 peaks for sure  –  hangs around the average level of the last decade or so.

bis exch rate norway and nz

People could fairly respond that oil and gas are far more important to Norway than, say, dairy is to New Zealand, and oil prices have fallen even more steeply than dairy prices.  All of which is true.  Then again, all fluctuations in dairy prices flow straight through to private domestic incomes –  unlike Norwegian oil revenues.

My point isn’t to draw exact parallels, but just to highlight a case of an advanced economy, with a severe adverse terms of trade shock, which has managed to keep inflation near the target –  they’ve been willing to do what was needed, and in parallel the exchange rate response has been large.

The direct effects of higher import prices have helped to boost Norway’s inflation rate.  That shows up in that the exclusion measures (ATE and XE) have been a little above target, while the central tendency measures (trimmed mean and median) are still a touch below.

Here is a chart from the Norges Bank’s (excellent) recent Monetary Policy Report.

norway inflation

The inflation rate for imported consumer goods has increased quite substantially, while that for domestically produced goods and services is  estimated to be holding comfortably around the 2.5 per cent target rate.  Outcomes like these are mutually reinforcing with the inflation expectations measures  – expectations consistent with the target make it easier to keep meeting the target, and outcomes around target help validate the prior expectations.

There might still be questions about what happens when the exchange rate stabilises and imported inflation drops, especially if the unemployment rate is then still high (by Norwegian standards).  Alert to the risks, the Norges Bank has flagged the possibility of further cuts in the Key Policy Rate.  But again, my point is not that the Norwegians have solved their problems for all time, but that they are now meeting their inflation target once again. Our central bank isn’t.

As a reminder, in Norway (relative to the position a couple of years ago) real interest rates have fallen. In New Zealand they have risen.  Ponder a counterfactual in which our real interest rates were 100 or 150 basis point lower than they are now –  and that is about the magnitude of the change in the gap between the two countries’ real interest rates over the last couple of years.  I think it is hard to dispute that we would have (a) a materially lower exchange rate, and hence higher tradables inflation, and (b) somewhat more domestic and net external demand and hence more upward pressure on non-tradables inflation.  There would be few doubts in anyone’s mind of the Governor’s commitment to delivering on the 2 per cent target he signed up to a few years ago.  Oh, and we’d have the good fortune to have an unemployment rate that would probably have a 4 in front of it, and probably be near the NAIRU.

Perhaps New Zealand doesn’t yet need real interest rates quite that much lower –  I’ve been arguing for some time for an OCR of around 1.5 to 1.75 per cent. The point really is just to illustrate what has been done in Norway – a small commodity-dependent country, with serious house price issues –  and what could have been, and perhaps could still be, achieved here.

Thoughts prompted by the expectations survey

The Reserve Bank’s quarterly survey of expectations results were released the other day.  As a reminder, it is a survey  of business people, sector leaders, and quite a few economists.  The vision has always been that the survey should capture some mix of informed people and people who might influence actual behavior – whether through their own business transactions, or through their commentary or advice to others.    There is a sample pool of about 100 potential respondents, and they typically seem to get about 65 or 70 replies each quarter.  Some criticize the survey for its small sample, but for what it is trying to do, in a small country, it has never seemed too bad to me.  It is, after all, asking for numerical answers to quite a bunch of macroeconomic questions.  I know that when I fill it in, I sometimes have to go back to the data to check what the latest reported numbers were –  not carrying QES wage inflation data in my head.

For inflation expectations specifically there are other surveys with larger samples.  ANZ provide their long-running Business Outlook survey, and their newer survey of household expectations, and the Reserve Bank will release its  latest survey of household expectations next week.  At the other extreme is the (inaccessible to the general public) AON survey, designed primarily to provide inputs for actuaries evaluating pension funds.  They ask about, inter alia, longer-term inflation expectations, but they ask only a handful (perhaps 7) economists.

I’ve never been quite sure what to make of inflation expectations measures.  Inflation expectations play  a significant, and quite plausible, role in conventional macroeconomic models.  The difficulties come with mapping the data we have available with the concepts in the models.  For a start, what horizon matters?  In principle, 10 or 20 year ahead expectations sounds interesting, abstracting from all the short-term noise, whether around taxes and government charges, petrol prices, or even swings in the exchange rate.  Then again, how many people sign up to 10 year nominal contracts?   No one sets wages or selling prices that far ahead.  And while plenty of bonds are issued with long maturities, when corporates issue them they typically seem to swap back to floating rates.  So 10 year ahead expectations probably provide some useful information about how confident people are that, say, the framework will hold or be delivered on, over 10 years, but I doubt they make very much difference at all to this year’s inflation rate, or the challenges a central bank faces in meeting its inflation target over the next couple of years.  I don’t know much about the politics of the next 20 years, but if forced to write down a number for average inflation over the next 20 years I might still write down 2 per cent.  But with huge error bounds….and grateful that nothing rests on it and that my pension is inflation indexed.

Shorter-term expectations matter more. But not too short.  Quarter or year-ahead expectations are influenced by specific stuff people know about –  relative price changes and administered taxes and charges.  In trying to make sense of inflation expectations, analysts are typically trying to look through those effects, to get a sense of the “norms” people have in mind when they set selling prices, negotiate wages, and make decisions to borrow or save.  If firms have in mind a benchmark inflation rate of, say, 1 per cent, then when they come to review their pricing schedules –  perhaps every six or twelve months –  pricing adjustments are likely to be different (lower) than if firms had in mind a benchmark or normal inflation rate of 2.5 per cent.  Same goes for wage negotiations.  And for how potential borrowers react to any particular nominal interest rate.   When those norms are above the inflation target, it can be hard to get actual inflation down to target –  more interest rate pressure is needed, than otherwise, to deliver the desired inflation rate.  And vice versa.  Two year ahead expectations have often been seen as a reasonable horizon to focus on for these purposes –  far enough that it gets beyond most (but not all) of the immediate noise, but close enough that it is more or less within the planning horizons of many.  In the latest RB survey, for example, the actual question asked in early February 2016 was about the annual inflation rate for the year to December 2017.  Halfway through that year respondents are asked to focus on is only 16 months away.   (Similarly, it was pleasing that when the ANZ launched a household expectations survey they asked about two year ahead expectations).

If, in principle, measures of two year ahead inflation might usually give one a steer on the “pricing norms” that firms and households are operating on (at least implicitly), there is still the matter of whether the answers to survey questions actually give us the information we really need.  As I’ve noted before, for example, the ANZBO survey and the Reserve Bank household survey measures have consistently, over decades, been materially above actual average inflation.    In the 20 years the RB household survey has been running, mean expectations have been just over 1 per cent higher than the average inflation outcome.  Does it mean households really didn’t believe the Reserve Bank would do it job?  Does it mean those are the inflation rates people implicitly contract on?  We simply don’t know (at least without a lot more formal research).  There is no incentive for people to invest any time or effort in responding to one question in a substantial telephone survey –  whereas they might well be when they ponder taking out a mortgage, or negotiating a pay increase.

All of which is a roundabout way of getting to the point that historically the Reserve Bank has put most weight on the two year ahead inflation expectations measure from the Survey of Expectations.  And it has done so because (a) there is now a good long time series (back to 1987), (b) it fits the prior that, typically, it will be horizons just beyond the immediate noise that matter, given that most contracts reprice at least every year or two, and (c)  because historically  it had a mean which seemed to align quite well over time with actual inflation.  One way to see this is to compare the two year ahead expectation with the Bank’s preferred sectoral factor model indicator of core inflation (remember what I said yesterday –  whatever the potential problems, for historical periods it is probably as reasonable as any measure, effectively smoothing through the noise in headline inflation).

infl expecs and core inflation

So what actually happened in the most recent survey?  Two year ahead expectations fell by 0.22 percentage points to 1.63 per cent [1].  Relative to the midpoint of the inflation target, that is the lowest in the history of the survey.  That isn’t all a bad thing –  despite the rhetoric suggesting we were crazed mechanistic inflation zealots, actually under both Don Brash and Alan Bollard inflation had averaged higher than the successive target midpoints, and expectations (in this survey) seemed more or less consistent with that.  But we don’t have a price level target, and if expectations start undershooting the target that is pretty undesirable as well.

infl expecs and target

The size of the fall in inflation expectations wasn’t unprecedented, but it was pretty large for this (not overly noisy) series.  In the period since low inflation became the norm (say since 1992) the only materially larger quarterly falls were (a) in the depths of the 2008/09 recession, and (b) in March 2012, when (post GST) the headline inflation rate had just fallen, in a single quarter, from 4.6 per cent to 1.8 per cent.

So this fall will have got the attention of the Reserve Bank, its analysts and forecasters.  It can’t really have been expected  – only 2 weeks ago the Governor told us explicitly that “survey measures of inflation…are now consistent with inflation settling at 2 per cent in the medium term”.  That was arguable, at best, previously.  It doesn’t really wash at 1.63 per cent –  and the prospect of further falls from here.

In the internal debate in the Bank, some will try to dismiss the latest fall as “just about petrol prices”.  Inflation expectations measures do respond, to some extent, to headline inflation, some seem “excessively” responsive to petrol prices, and even this two year measure (of informed respondents) is a bit sensitive to headline movements.  But, as I have pointed out on several occasions, the latest annual CPI inflation rate excluding petrol was only 0.5 per cent.  The more internationally conventional ex food and energy measure of inflation was only 0.9 per cent.  So if headline inflation is influencing two year ahead expectations (a) that seems quite reasonable –  it looks as though there is some information in trends in the headline rate, and (b) nobody much seems to expect headline inflation (including or excluding petrol) to pick up soon.  It looks as though respondents are just gradually giving up on the Reserve Bank’s story that inflation is heading back to 2 per cent any time soon.    It should be doubly sobering for the Bank that this comes in a survey in which responses to the other questions are not uniformly bleak: large falls in inflation expectations have usually gone hand in hand with more pessimistic GDP growth expectations, but in this survey those expectations have actually risen a little.

If people more generally –  not just these respondents –  are giving up on the Reserve Bank story, that will make it materially harder to get inflation back to target.

In one sense, it often seems wrong and excessively “mechanistic” to put too much weight on a single survey, and of 65 people –  it often did to me, when I sat around contemplating the survey results and wondering what OCR advice to offer successive Governors.  And in isolation that would be fine.  But it isn’t the only information we have –  rather, if anything, it is somewhat belated confirmation that the persistent undershoots of the inflation target have changed how people are thinking about prospects for inflation in New Zealand.   I suspect the Reserve Bank, perhaps rather grudgingly, will come to the same conclusion.

Recall what Mario Draghi, head of the ECB, said in the speech I discussed the other day

… in a context of prolonged low inflation, monetary policy cannot be relaxed about a succession of supply shocks. Adopting a wait-and-see attitude and extending the policy horizon brings with it risks: namely a lasting de-anchoring of expectations leading to persistently weaker inflation. And if that were to happen, we would need a much more accommodative monetary policy to reverse it. Seen from that perspective, the risks of acting too late outweigh the risks of acting too early.

And it is not as if New Zealand monetary policy has somehow already got ahead of the problem.  If the two year ahead measure is a reasonable proxy for the inflation norms now abroad in New Zealand –  and it may yet prove too high – real interest rates have actually risen over the last couple of years.

The Reserve Bank lists three lending rates on its main retail rates page: a business lending rate, an SME rate, and new customer floating mortgage rate.  In nominal terms, all are almost exactly now where they were at the start of 2014 (just before the OCR tightening cycle began). Inflation expectations, by contrast, are 70 points lower than they were then.  With an unemployment rate above any measure of NAIRU, and inflation persistently below target, rising real interest rates  have not obviously been something this economy needed. Retail deposit rates are lower than they were two years ago – by even they are no lower in real terms.  And as funding spreads are rising –  as they appear to have been recently, reflecting market unease about banks internationally  –  all else equal, the pressure on retail rates over the period ahead will be upwards not downwards.

And all this is before we focus on the continuing high exchange rate, the continuing weak commodity prices, and the growing stress persistently weak dairy returns are going to be placing on demand and activity (even if they aren’t necessarily a threat to the soundness of our banks).  Let alone the worsening global situation.

And, of course, there are market measures of implicit inflation expectations (from the difference between indexed and conventional bond yields).  These are weakening everywhere, but a chart someone sent me yesterday highlighted that the fall has been particularly sharp in New Zealand.  As of yesterday, a 10 year conventional bond had a yield of 3.06 per cent, and a 2025 inflation indexed bond was yielding 2.12 per cent.  That gap is now less than 1 per cent (and look how far it has fallen this year so far).

infl expecs indexed bonds

These aren’t perfect proxies, and bond investors’ expectations don’t directly affect (CPI goods and services) pricing now, but I don’t think central banks –  ours in particular –  can afford to be indifferent to message from bond markets: people with money on the line are no longer acting as if they think inflation is going to be near target on average over the next decade.  They might be wrong, but why would central banks be so confident that those investors are wrong –  especially when central banks, ours foremost among them, have themselves been persistently surprised by how weak inflation has been.  In part, in turn, that  has been because central banks –  ours among them –  have been persistently focused not on doing “whatever it takes” to create confidence that inflation targets will be delivered, but on doing as little as they can away with, perennially focused on “normalization” and some long-term benchmarks of where, surely, interest rates have to get back to one day.

There is a story abroad  – I saw it in a commentary from one of the local banks yesterday –  that low inflation is good and inevitable.  It certainly isn’t inevitable here –  looser monetary policy would, for example, lower our exchange rate generating additional resource pressure over time.  And it isn’t good either.  The story seems to go that structural features are driving price levels down.  But remember that productivity growth rates globally have been falling, not rising.  And stories about global overcapacity tell you mostly about demand having failed to keep up with supply capacity:  discretionary monetary policy exists to influence demand.  The indifference to what is going on is hauntingly reminiscent of some of the discussion and debate during the Great Depression –  when there was excess supply capacity (reflecting, eg, past heavy investment in agriculture), even amid rapid ongoing productivity gains –  and a sense in too many circles, for too long, that nothing very much should be done about monetary policy and the monetary system.

[1]  For what it is worth, when I completed the survey I did not lower my two year ahead expectation from the one I recorded in the November survey. On both occasions, I wrote down 1.4 per cent.