The Governor has form

If one had simply been handed the Governor’s speech this morning, with no other knowledge of the New Zealand data, or of the Governor’s stewardship of monetary policy in his four years in office, it might have seemed quite reasonable.  And a person who had a good track record in making sense of inflation pressures and adjusting the OCR to keep inflation fluctuating around the target would have built a store of reputation and credibility.  Backed by all the analytical resources at his command, one might be inclined to be influenced by such a person’s analysis and storytelling.

But Graeme Wheeler is not that sort of person. Instead, he –  and his advisers –  badly misread inflation pressures, and after champing at the bit to raise interest rates, he launched an ill-judged, unnecessary, and ill-fated tightening cycle.  He set out on his quest talking up a coming 200 basis points of OCR increases, before finally bowing to reality after 100 basis points, and has only, and mostly very grudgingly, lowered the OCR since then.  In real terms, the OCR today is no lower than it was before that tightening cycle began.    And so core inflation lingers well below the midpoint of the target –  a focus he and the Minister had explicitly added to the PTA in 2012 –  and the unemployment rate is now into an eighth year materially above anyone’s estimates of the NAIRU.

Of course, forecasting and policy mistakes are, to an extent, inevitable.  No one is granted the gift of perfect foresight –  and if anyone had, they’d be better employed somewhere other than a central bank.  But what has compounded the problem –  the reasons not to take too seriously what the Governor says –  is his continued failure to even acknowledge mistakes, let alone express any contrition.  It is hard to have any confidence that someone has learned from their mistakes if they won’t even own up to having made obvious ones.  And while no individual speech can cover everything, it is striking how totally absent any treatment of the Bank’s conduct of monetary policy over the last four years was from this one.

Since my wife will be ticking me off for overdoing it and not resting if I write too much, I wanted to pick up on just two points in the speech.

The first was the Governor’s apparent model of inflation.

low inflation in some countries is linked to demographic change, especially in countries with a declining workforce and rapidly ageing population. Low inflation is also due to technological change around information flows and energy production, and to the global over-supply of commodities and manufactured goods;

Which sounded depressingly like the excuses and alternative explanations that were touted, in reverse, in the 1960s and 1970s.  At that stage people talked about the role of union power, occasionally even about demographics, about oil prices and resource scarcity and so on.  Each of those phenomena were real –  as those in the Governor’s list are –  but to cite them as explanations for persistently high, or persistently low, inflation is some mix of cop-out and analytical failure.

Persistent inflation –  or the absence of persistent inflation – is always and everywhere a monetary phenomenon.  By that, I don’t mean printing banknotes, and I don’t mean particular levels or growth rates for things central banks call “monetary aggregates”.   I mean simply that monetary policy can, if it chooses (or is permitted to) counter the impact of the sorts of factors the Governor listed and deliver an inflation rate that averages around target.  If they no longer believe that, the Reserve Bank should hand back its remit.

Sometimes, the job of monetary policy is harder than normal, and sometimes easier.  In the 1960s and 70s, with overfull employment in many countries, lots of union power, and lots of demand pressure associated with a rapidly growing workforce, it took a lot of effort to get and keep inflation under control.  Some countries did pretty well.  Others –  and New Zealand and the UK were two prime examples –  did poorly.  In the current climate, there seem to be a variety of ill-understood factors dampening inflation pressures globally.  Some countries have done well in countering them –  Norway is an example, and on Stan Fischer’s reckoning the US might be too.  Others less so.  But last year, on IMF numbers, around 90 countries had inflation in excess of 2 per cent, and almost 70 had inflation in excess of 4 per cent

Of course, the current effective lower bound on nominal interest rates, a bit below zero, does constrain many countries’ freedom of action.  But it doesn’t change the fact that inflation is a monetary phenomenon –  it is just that regulatory and administrative practices hamstring the ability to use monetary policy to the full in those countries.  Low inflation in other countries doesn’t make the Reserve Bank of New Zealand’s job harder. although common global factors –  affecting us as much as other countries –  may do.

Before turning to the second main aspect of the speech I wanted to comment on, I would note that there was plenty in the speech that I agreed with.  My differences with the Bank have never been about how the inflation target is specified and I agree that the government should not be considering lowering the target when the next PTA is signed next year. There might be a case for considering raising the target –  to minimize the risk that the near-zero bound becomes a problem –  but that is a topic for another day.   As the Governor notes, no other governments in other countries have changed the inflation targets their central banks work to, or abandoned inflation targeting.

The second area I wanted to focus on was the section devoted to explaining why the Governor disagrees with people like me, who think that interest rates should be cut further now.  Here is what the Governor has to say.

This view advocates bringing inflation quickly back to the mid-point of the inflation band by rapidly cutting the OCR. Driving interest rates down quickly would lower the exchange rate, contributing to increased traded goods inflation and stronger traded goods sector activity. The ensuing increase in house price inflation is not seen as a consideration for monetary policy, even though there would be an increased risk of a large correction in the housing market and associated deterioration in economic growth.

There would be considerable risks in this strategy. An aggressive monetary policy that is seen as exacerbating imbalances in the economy would not be regarded as sustainable and would not generate the exchange rate relief being sought.

With the economy currently growing at around 2½ – 3 percent and with annual growth projected to increase to around 3½ percent, rapid and ongoing decreases in interest rates would likely result in an unsustainable surge in growth, capacity bottlenecks, and further inflame an already seriously overheating property market. It would use up much of the Bank’s capacity to respond to the likely boom/bust situation that would follow and would place the Reserve Bank in a situation similar to many other central banks of having limited room to respond to future economic or financial shocks.

Such consequences suggest that a strategy of rapid policy easing to extremely low rates would be counter to the provisions in the PTA that require the Bank to “seek to avoid unnecessary instability in output, interest rates and the exchange rate” and to “have regard to the soundness of the financial system”.

Do note the rather loaded language throughout this section.

Note too, as context, the chart of the real OCR

real ocr to aug 16

To this point, far from having seen “rapid” OCR cuts, the OCR in real terms hasn’t yet got back down to where it was before the ill-judged tightening cycle began.  Context matters: if the Governor were making these sorts of arguments when the real OCR was already 100 bps below previous record lows, with the labour market overheating and inflation rapidly heading back to 2 per cent, they might sound more plausible

As it is, I’m not  quite sure what to make of the comments.  On the one hand, in the first paragraph he accepts that such a strategy would work by lowering the exchange rate. But then in the next paragraph he appears to suggested that unexpectedly rapid OCR cuts would not in fact lower the exchange rate.  We all know that foreign exchange markets can be fickle things, but I’m pretty confident that if he’d come out this morning and said “you know, on reflection it does look as though interest rates will need to be quite a bit lower than we had thought.  We’ll do whatever it takes to get inflation fluctuating back around 2 per cent, and at present it looks as though that might mean the OCR has to head towards 1 per cent” that the exchange rate would be quite a lot lower.

And what of GDP growth?  Recall, that the Bank has persistently overestimated how rapidly spare capacity has been used up.  Their forecasts currently have GDP growth accelerating to 3.5 per cent. But the expectations survey they run  –  and apparently now want to gut – suggests informed observers don’t agree: latest expectations among that group were for growth of 2.5 per cent and 2.4 per cent in each of the next two years.   On that basis, those observers don’t expect the substantial excess capacity in the labour market to be absorbed any time soon.  And as a reminder to the Bank, to absorb an overhang of unemployed people the economy has to have a period of faster-than-sustainable growth.  To get core inflation back to target typically involves much the same sort of pressures.

In fact, most of this is –  as always with this Governor –  about house prices.  In his description of the “further cuts” view, the Governor notes that for those running this view

The ensuing increase in house price inflation is not seen as a consideration for monetary policy

That is because it is not, under the current Act and PTA, a relevant consideration for monetary policy.  The target is medium-term CPI inflation.  House prices don’t figure in that index and –  unless they have had a major recent change of view –  the Bank doesn’t think they should.  Monetary policy has one instrument and can really only successfully pursue one target.  The Minister of Finance and the Governor agreed that target would be medium-term CPI inflation.

But perhaps my biggest concern is that the Governor is now falling back, quite openly and formally, on the spurious argument that if he cut more now, he would only increase the chances of running into the near-zero lower bound at some future date.   His logic here is totally wrong, and his approach is only increasing the risk of lower-bound problems becoming an issue for the Reserve Bank of New Zealand.

With hindsight that is pretty clear. Remember that I’ve pointed out that we’d have been better off if the Governor had done nothing at all on monetary policy in his four years in office.  Actual inflation would be a bit higher –  since average interest rates would have been lower, and no doubt the average exchange rate –  and, on the Bank’s own reckoning (they point out that expectations appear to have become more backward looking) inflation expectations would have been higher.  Higher inflation expectation would, in turn, have supported higher nominal interest rates now (for the same real interest rates).    But the same analysis applies looking ahead.  If the OCR were cut further and faster than the Bank currently plans then, on their forecasts, inflation and inflation expectations would rise, helping to underpin higher nominal interest rates in future.  The risk of the current strategy –  especially given the Bank’s asymmetric track record –  is that actual inflation continues to undershoot, excess capacity lingers, and in response inflation expectations drift ever further downwards.  If that happens, the nominal OCR will have to be lowered just to stop real interest rates rising.

The lesson from a wide variety of advanced countries over the last decade is surely that, with hindsight, they didn’t cut their official interest rates hard enough and far enough early enough.  I stress the “with hindsight” –  there was little good basis for knowing that in 2009, but there is much less excuse for central banks, like the RBNZ and RBA, that still have conventional policy capacity.

On which point, two other observations:

  • there was still no reference in the speech to New Zealand doing anything about making the near-zero lower bound less binding.  There is simply no excuse for the New Zealand authorities to have done nothing pre-emptive to ensure that the ability to use monetary policy aggressively in the next downturn is not constrained by artificial constraints around the price of physical banknotes.
  • in his alarmist rhetoric about “further inflaming” the housing market, the Governor appears to have forgotten completely the line the Bank used when LVR restrictions were first imposed.  Asked then why not use monetary policy instead, the (correct) response was that our modelling suggesting that it would take 200 basis points of OCR increases to have the same impact on the housing market as the (quite limited) estimated impact of LVR controls.  No one –  not even me –  is suggesting that the OCR should be cut by 200 basis points now.  And if the Bank is concerned about banking system risks from high house prices, it has capital requirements that it could adjust.

Once again, this is a speech that reflects a key aspect of the Governor’s underlying “model” –  his fear that inflation might be just about to break out, all while taking little or no responsibility for the fact that it repeatedly fails to do so.  I’m caricaturing a little bit, but not a lot. Go back and read what he was saying leading into the 2014 tightening cycle, and then read those paragraphs from today’s speech that I included above –  written from a point where the real OCR is still slightly higher than it was before the tightening cycle.  That mindset clearly shapes how he thinks about policy and his asymmetric view of risks.  Past performance might not be a good predictor of future performance in investment management, but in senior managers and key decisionmakers it often is. It is hard to self-correct unrecognized biases –  perhaps especially if the decisionmaker thinks those biases are actually strengths.   The Governor has form. Unfortunately, it is has mostly been poor form.  It is not clear why that bad run is about to break.

In passing, it is just worth noting one of the Governor’s final observations

Central banks do not have special powers of market foresight or a franchise on wisdom. But they do have significant research and analytical capacity that can deliver valuable insights, and this is being applied to challenges associated with the current global economic and financial developments.

And yet, neither in the text of the speech nor in any of the 11 footnotes, is there any reference to any Reserve Bank research at all.