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.
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.