Reflecting on the MPS and the Reserve Bank

There were some aspects of Graeme Wheeler’s comments following the release of the Monetary Policy Statement the other day that I welcomed.

He firmly pointed out that no advanced country central bank –  or, more importantly, government –  had abandoned inflation targeting since the global recession of 2008/09, and that none had lowered (or raised in fact) their inflation targets.  It is always worth keeping an open mind on possible improvements to the regime –  inflation targeting centred on 2 per cent won’t be the end of history –  but for now the Reserve Bank’s job, given to it by the government, is to get and keep inflation outcomes, over the medium-term, around the 2 per cent midpoint of the target range.

And when asked about the impact of a lower OCR on house prices, he succinctly observed “well, that’s just something we’ll have to watch”.  By conscious choice, house prices are not part of the inflation target, either in New Zealand or in most (if not all) inflation targeting countries.  It is one, important, relative price, influenced heavily by a range of other policy considerations.  And if bank supervisors should pay a lot of attention to house prices, and associated credit risks, it is a different matter for monetary policymakers.

And, of course, there was the OCR cut itself. It was the right thing to do, and on this occasion he didn’t allow himself to be locked in by his own previous rhetoric.   Probably one reason why I was less surprised by the move last Thursday than some of my fellow doves is that I’ve seen –  and been part of –  too many episodes in the past when the Reserve Bank has flip-flopped, and when speeches and statements had either backfired or been ill-considered in the first place.

The Reserve Bank now seems to be trying to make out that no one should have been surprised, and that there was nothing wrong with the Governor’s February speech (made only five weeks before the MPS).   Shamubeel Eaqub tells us that

An official told me it was this document that signalled the requirements for a cut in the March meeting

and in a soft-soap interview with the Herald this morning the Governor, clearly on a campaign to improve his image,

“professes surprise at the surprise about the cut”

At one level, this is clearly nonsense.  His markets and economics people will have pointed out to him that few people expected a cut last Thursday, whether or not they thought one was warranted.  He knew he was going to deliver a surprise.

At another, and more important, level it is also nonsense.  Of course, the February speech had the usual lines about risks and the way in which if the outlook changed so would the policy rate path.  Central bank speeches always do.

But (a) the Governor knows very well that his speech (not that of an underling, but of the decision maker himself) was interpreted hawkishly, and (b) that readers who interpreted it that way were quite reasonable to have done so.  After all, if he had thought everyone misinterpreted it on 3 February, it would have been very easy for the Bank to have corrected the perception –  journalists are always keen to talk to the Governor, although only the Herald ever seems so favoured.

Here was what I said about the speech at the time

In many respects it was an elaboration on last week’s brief OCR review statement –  “we might have to cut the OCR, and risks are tilted to the downside, but we don’t really want to”.

…Once again, the Governor simply does not seriously engage with the arguments made by those who suggest that a lower OCR would have been, and would be, preferable.  Instead, he basically makes up an inflation story that simply isn’t supported by the numbers, and attacks straw men.  The defensiveness is disheartening.

There were his assertions that core inflation was just fine, that inflation expectations were just fine (even though he knew key data were coming out shortly which were likely to move lower), that the OCR increases of 2014 had been fully reversed (without so much as a hint of a mention of real interest rates), that the economy was doing well, and house price inflation was concerning, all the time attacking those nameless critics with their “mechanistic approach” suggesting that lower headline inflation warranted a lower OCR.  It just wasn’t a speech that a capable Governor would have given had he thought there was a reasonable chance that he might be cutting the OCR only five weeks later.    Like others, I’ve gone back and read the speech since Thursday, and I stand by that conclusion.   The underlying economic and inflation position just did not change that much in the intervening few weeks.

I didn’t lose money on the episode, or have clients who did, so this isn’t just an articulation of the pain of getting it wrong and hearing from upset clients.  It was simply a(nother) poor performance from the Bank.

I’ve had people ask whether I think it is a case of the Governor not really being up to the job, or of him simply being poorly-advised.   Russian peasants, languishing in their oppression, are said to have reassured themselves “but if only the Tsar knew, if our plight were not kept from him by the venal or incompetent advisers”.

It is easy to adopt the “poorly advised” line, but I don’t think it really washes.  Apart from anything else, the Governor has been in place now for 3.5 years and his senior advisers are appointed, appraised, and rewarded by him.   Part of the chief executive’s role is to have robust advisory processes in place, including people who are willing to stand up and point out the risks in what he is saying or doing.    But, in any case, in my experience at the Bank the Governor treated speeches as very much his own product-  drafted by him, and not really receptive to any suggestions or comments that challenged his own priors.  The February speech felt at the time like the work of an embattled defensive individual, over-reacting under pressure.  Subsequent events tend to confirm it.  The MPS has a very very different tone to it than the speech.  And as I noted the other day there is no sign in it of the staff sharing the Governor’s predilection for the sectoral core factor model as a best single measure of inflation –  indeed, the text and chosen chart almost looked as if they had been placed to undermine any such suggestion.

At one level, perhaps it doesn’t matter very much.  In the end, the speech wasn’t an OCR review, and when it came to reviewing the OCR he did the right thing.  While I don’t think it is desirable to set out to surprise markets, neither do I think that such surprises in and of themselves are the worst thing in the world.

But it is symptomatic of a weak institution.  In one sense, the weakness isn’t new or specific to Graeme Wheeler.  I’d argue that for 20 years the Reserve Bank has been prone to lurches, and has lacked the solidity and consistency of some of better central banks around –  including notably the Reserve Bank of Australia.  Some of the worst examples –  eg (for those with long memories) the MCI  – occurred on the watch of my friend Don Brash.  But things have got materially worse again in the last few years.

In his interview this morning, Liam Dann includes this curious impression

You get a sense Wheeler enjoys lively debate and would love to engage more in the local discussion.

It isn’t an impression anyone else I’m aware of has of him.  While I was still at the Bank he very resistant to any internal debate or to dissenting views –  and from what I hear on the grapevine that hasn’t changed in the last year.  His speeches give no sign of an enthusiasm to engage with alternative perspectives, or even to recognize that such perspectives might have any merit (nameless critics dismissed as “mechanistic”).  And as others have pointed out –  a couple of soft-soap Herald interviews apart –  he does no serious local interviews, and thus eschews the ample opportunity he has to be part of the local discussion.    Curiously, despite being the head of a New Zealand government agency, paid in effect by the people of New Zealand, Wheeler comments to Dann that when he answers media questions his main interest is “economists and investors in the United States or Europe”.  He spent much of his working life in the US and Europe, behind the scenes, and there is nothing to suggest he is remotely comfortable in the glare of public scrutiny back home.

Add in a continued reluctance to ever acknowledge having made mistakes (in an area where mistakes are inevitable, at least for humans), the making up  on the fly of ill-supported stories (eg “it was all about petrol prices” only six weeks ago, a line that has now disappeared again),  a continued failure to get or keep inflation near target, and communications failures like the February speech, and it all adds up to much less than we deserve from such a powerful agency and its chief executive.  He doesn’t seem to have either the really superior personal insights on the economy, or the self-confidence (and recognition of his own limitations) to foster the dialogue and debate internally, that would help deliver consistently good policy, and supporting analysis.

It is good that he cut the OCR on Thursday. It was overdue.  But it is not as if the problems have gone away.  He still seems oblivious to the increases in real interest rates he has overseen, he is still defending the February speech (in the press conference he again asserted that he had to deal with –  nameless –  critics  misinterpreting the PTA), in his press statement (the bit of the MPS he focuses on most) he still asserts the centrality of the sectoral factor model measure when the rest of the document largely ignores it.  And he still forecasts that inflation will get back to target, but offers little substantial analysis to support his claim.  I do believe that he cares about persistently low inflation, but in his role performance is really what matters.  We still aren’t seeing it, and there is nothing in the content or processes to suggest we will avoid a repeat of the last 12 months, heel-dragging and ill-considered communications, in the period ahead.  That has to be a concern.  Under the governance model, the Board’s Annual Report this year should be interesting,  It probably won’t be.

Rod Oram wrote yesterday that

Our Reserve Bank was once a global leader.  It must be again.

When he arrived at the Bank, Graeme Wheeler had the mantra of making the Reserve Bank the best small central bank in the world.  I was never sure that was realistic-  after all, a lot of countries choose to devote a lot more resources to their central bank than we do (even the Governor the other day somewhat surprisingly acknowledged to FEC that it would help if he had more resources).  So, I also don’t think we can expect our central bank to be a “global leader”.

But it really should be doing quite a lot better than it is.

Finally, just a note on one other observation from the Dann interview.  In an unusual disclosure, the Governor tells us that all the 13 people who provided him with written advice on the OCR decision favoured a cut last week, leaving Dann with the impression that “it wasn’t even a line-ball call”.

It is, probably, good to know that officials were unanimous in their advice.  But

  • if those 13 people had seen the draft of the January speech were they all unanimous in being comfortable with that?
  • it is worth bearing in mind that, in my long experience on the Monetary Policy Committee(or its predecessor the OCR Advisory Group), overwhelming majority “votes” are much more common than material divisions of opinion.  It is a climate that does not encourage debate, and certainly does not encourage significant differences of opinion at the recommendation stage.   Indeed, I recall the meeting at which Deputy Governor Geoff Bascand, admittedly then new to the Bank, laid into me for an OCR recommendation which he most certainly disagreed with.  It takes a certain strong-mindedness (or sheer stupidity) to go on dissenting.

It was an unusual disclosure because the Bank has always fought hard to keep secret the advice provided to the Governor on the OCR.  But if the Governor has chosen to disclose the “vote” on this occasion, only a few days after the announcement, it is difficult to see how any of the usual OIA excuses (“free and frank expression of opinion”, “substantial economic damage to the interests of New Zealand”, or “avoiding premature disclosure”)can now be applied in future, especially in respect of decisions from some quarters past.  I have just lodged an OIA request for the voting record (aggregate only, no names, thus mirroring Wheeler’s disclosure) for all OCR decisions since mid-2013 (ie just prior to the ill-fated tightening cycle getting underway).


Labour and the dairy debt

It often isn’t clear quite what the Labour Party means.  Andrew Little is reported as follows:

Little said the banks needed to be “stiff-armed and told we’re not going to see, wholesale, farmers pushed off the land”.

His only argument for this sort of intervention –  whatever it means in practice –  appeared to be that

“We expose more New Zealand farm land to the risk of overseas ownership and I think that is a matter in which there is a national interest the Government should be alert to, and take action on.”

Which all sounds quite dramatic, and yet what follows seems like a rather damp squib.

A summit should be called and dairy cooperative Fonterra should be at the table. Farmers needed to agree on a long term plan for the cooperative to move its products up the value chain, even if that meant taking less cash out once the immediate crisis was over, to allow Fonterra to invest to generate better long term returns.

Government assistance should be provided to get farmers over the crisis, in a similar way to the help offered during drought, but it did not need to be any more than that.

So, apart from more talk, what is Labour actually proposing?

Keen as any individual bank might be to be rid of some of the more questionable exposures in its dairy book, it seems unlikely that banks, as a group, will be that keen on precipitating large scale exits from the dairy industry.  Force one farmer to sell and there won’t be any material impact on the value of dairy farms more generally.  Try to force several thousand to do so, and (a) it will be next to impossible to find buyers in the short-term, and (b) the value of the collateral banks hold could collapse.  The Reserve Bank talked last week of an extreme scenario in which dairy farm prices fell by 40 per cent, but in an illiquid market like that for dairy farms there is no reason why land values should not fall by much more than 40 per cent if serious stresses were to develop.   No one really knows what dairy land is worth in the longer-term (where will oil prices settle, where will the New Zealand real exchange rate settle are just two of the many relevant questions) but it is the sort of market where it is quite easy to envisage a severe overshoot.  I’ve been tantalized for several years by parallels to some of the very illiquid mortgage-backed products in the US –  not the ones that eventually saw huge defaults, but the ones where prices massively overshot in a climate of fear and illiquidity.

If each bank would prefer to be rid of some of its dairy exposures, each of them also knows that farm lending is going to be a major area of credit exposure in New Zealand for decades to come.  It isn’t like lending to, say, a new industry which comes to nothing and goes away.  If some individual farmers will leave the industry, the rural sector will still be around and collective memories can be powerful forces for good or ill.  Banks were scarred by their experiences in the last major rural debt shake-out  in the 1980s, and I doubt they will be eager to burn off goodwill among future potential clients.  That doesn’t mean there won’t be forced sales, but it is hard to envisage the major rural lending banks rushing for the door  (no matter how much unease the risk departments of bank HQs in Sydney or Melbourne or Utrecht might be feeling).

In some ways, a more concerning scenario for banks might be borrower panic.  If enough farmers concluded that they were working for nothing and that there was no prospect of serious relief in the next few years they could, one by one, just choose to (try to) exit the industry.  Of course, they’d still have to find buyers, but in a climate like that collateral values could collapse anyway.  From the perspective of banks, it may be preferable if most farmers doggedly fight to stay on the land, allowing banks to make the calls on who to sell up and when, having regard to the potential impact on the rest of their national dairy portfolios.  No individual farmers cares much about that.

But I still have no idea what, if anything, Labour is proposing the government or the Reserve Bank should do to “stiff arm” the banks, to prevent widespread sales.  I’m pretty sure there are no existing legal powers that could appropriately be used for that purpose.  Of course, behind the scenes all sorts of threats and pressures could be brought to bear, but surely that isn’t how we want to country to be run?    So if Labour’s call means anything much they must be talking of new special legislative provisions.    There was a great deal of resort to such measures in New Zealand during the Great Depression of the 1930s –  allowing writedowns of loans, and of interest rates. Perhaps one could mount an argument for those interventions –  on a basis of a totally unexpected collapse in the entire price level, an issue in macroeconomic mismanagement  –  but what would the case for intervention now be?

It seems pretty clear that any dairy debt losses are not likely to be large enough to threaten the health of the financial system –  especially, as this is a slowly developing situation in which banks have plenty of time to bolster their capital buffers if that is required.   And to bailout individual farmers, or the sector as a whole, would represent a material new source of moral hazard –  a message to borrowers that they need not bear the consequences of their bad choices.  That would only increase future demand for debt –  in an industry that seems likely to continue to face considerable output price fluctuations

Of course, it may be that there is nothing much to Labour’s call at all –  other perhaps than a desire to be heard.  I’m not a fan of government assistance to farmers experiencing drought conditions –  if managing weather risk is not one of the things farmers have to do, I’m not sure what is –  but if Labour is talking of things only on that scale then I probably couldn’t get too excited.  Then again, action on that scale doesn’t seem likely to make the sort of difference that would prevent “wholesale” exits and large scale increases in foreign land ownership.

Perhaps that “foreign land ownership” issue is really at the heart of Labour’s call.   I’m not an absolutist on foreign ownership of land.  After all, to be blunt, large scale English purchases of New Zealand land in the 19th century –  even if mostly, individually, on a willing-buyer/willing-seller basis, did rather dramatically and permanently change the character of the country.    But in the current situation we seem very far from that sort of risk.  And in the shorter-term, the best hope for embattled farmers, and lenders, is the presence of a contested market of keen potential buyers.

And what of the call for a summit?  It seemed like a pretty tired old suggestion, and it isn’t obvious what the role of the government is in such industry issues.  We’ve heard endless talk over the years of “moving up the value chain” and farmers (the Fonterra owners) might reasonably be sceptical of the results to date.   But summits about long-term industry strategy don’t seem that relevant to the issues of the current overhang of farmer debt.

Do I have any sympathy for indebted dairy farmers?  Yes, to some extent.  There are individuals and families involved, and the stresses –  as in any struggling small to medium business –  must be pretty intense and hard to cope with.  It isn’t something those of us who spent our working lives as government officials never face.  Then again, the upsides in the good years are also pretty extreme.  Running a leveraged business is a high-variance operation.

Cyclically, of course, farmers would be somewhat better off if we had a Reserve Bank that was doing its job better.  With core inflation probably around 1 per cent, and real interest rates higher than they were a couple of years ago (and real retail rates probably higher than they were at the start of the year), there is simply no need for the OCR to be anything like as high as it is now.  The OCR isn’t, and shouldn’t be, set with a view to supporting dairy farmers (or people in any other specific sector) but an OCR more consistent with the Bank’s own Policy Targets Agreement would (to a small extent) ease farmers’ financing costs and be likely to result in an exchange rate rather lower than it is now.  We saw the impact of last Thursday’s surprise (itself mostly a timing surprise).  It isn’t obvious that the OCR at present needs to be any higher than 1.5 per cent.  At that level, we’d be likely to see the exchange rate quite a bit lower again, and every cent off the exchange rate raises the prospective payout to diary farmers, materially affecting prospective profitability of people in the industry.  Not many farmers probably did contingency plans in which the TWI would still be above 71 even with WMP prices at current levels.

For the longer-term, if governments want to focus on more structural issues, there is a whole range of policy measures which help and hinder the dairy sector.

The ability to import large numbers of foreign dairy workers acts as a direct subsidy to the industry –  holding down industry-specific wages rates – and has probably largely been capitalized into rural land prices.   Water quality rules have been being tightened, but the ability to pollute, and pollute without paying, is another subsidy to the dairy industry.  Subsidised irrigation schemes go in the same direction.  None seems well-warranted.

And on the other hand, all tradables industries in New Zealand suffer from our very large scale immigration programme.  Whatever monetary policy is doing, the resulting quite rapid growth in the population keeps upward pressure on the real exchange rate, driving up the price of non-tradables relative to the (largely fixed) global price of tradables.  That makes it harder for firms operating here to compete in international markets, and helps explain why the per capita output of the tradables sector as a whole is no higher now than it was 10-15 years ago.    We shouldn’t be reorienting our immigration programme around the short-term needs of particular industries, but the biggest single factor New Zealand has some control over that would help the dairy industry at present would be a lower exchange rate.  A much lower immigration programme would, among other things, achieve that.  It might also allow a more hard-headed longer-term conversation about some of those industry subsidies.