Still reluctant to lower interest rates

I was a little late to the Monetary Policy Statement. The actual OCR cut yesterday was very well foreshadowed, and I wasn’t expecting much else.  And in fact there weren’t many surprises in the document.  But that is shame, because the Reserve Bank still seems trapped in much the same mindset that has delivered inflation below the midpoint of the target range (the explicit required focus of policy since 2012) for the last five years or so.  And it isn’t just headline inflation –  thrown around by petrol prices, tobacco taxes, ACC levies etc –  but whichever one or more core inflation measures one cares to focus on.  At present, the median of half a dozen core inflation measures is around 1.2 per cent.

And despite the rather self-congratulatory tone of the document, and particularly of yesterday’s press conference with the Governor and Assistant Governor, even on the Bank’s latest projections it is still another two years until inflation is expected to be back around 2 per cent.  And, of course, we’ve heard that line before, repeatedly.  As everyone knows, a lot can happen in two years, and it is most unlikely that things will unfold as the Bank (or any other forecaster expects) but there is nothing –  not a word, sentence, or paragraph –  in the latest MPS to explain why it is more likely today that inflation will now track back to settle around 2 per cent than it has been for the last five years.   Why should we be comfortable that the Bank has it right this time?

The Governor continues to repeat the line favoured by the government, emphasising recent annual GDP growth of around 3.5 per cent.  He does so in a way that suggests that all is pretty rosy, and my goodness if we were to do anything more there would be real risks of nasty overheating and intense volatility.  But like the government, the Governor rarely bothers to mention per capita growth.  Here is the chart of annual average growth in real per capita GDP (using the average of expenditure and production GDP).


At its brief best, several years ago, real per capita GDP growth never got anywhere near the rates of previous recoveries.  At something around 1 per cent now (1.5 per cent of an apc basis) it not anything to be encouraged by.  Sure, some of the weaker growth reflects the deteriorating productivity growth trend –  which the Governor can’t do much about –  but not all of it by any means.  With 2 per cent population growth, we probably should be getting a bit uneasy if over GDP growth were at 6 per cent –  and the unemployment rate was falling quickly below the NAIRU –  but that just isn’t the way things have been in New Zealand in the Wheeler years.  And the disconcerting thing is the Graeme seems to think that is a good thing.  Monetary policy could have done more, but consistently and consciously chooses not to do so.

Instead he repeats, over and over again, the point that tradables inflation has been negative for several years, making his life oh so hard (hard to get overall inflation back to 2 per cent).  From a New Zealand consumer’s perspective, low tradables is a good thing.  And from a New Zealand producers’ perspective it is typically should be quite a good thing as well.  Persistently weak tradables inflation creates room for the Reserve Bank to cut New Zealand interest rates further, in turn lowering the exchange rate (relative to the counterfactual).  A lower exchange rate would raise tradables inflation a bit, but also increase domestic economic activity and raise returns to our own tradables sector producers.    The headline inflation rate would rise as, over time, would core measures.

It is one of aspects of Graeme Wheeler’s stewardship that I don’t purport to adequately understand.  In almost every statement he repeats the plaintive line “a decline in the exchange rate is needed” but isn’t willing to do much about the one thing in his control that really makes some difference: lowering interest rates.

You might think that is a little unfair.  After all, the OCR has been cut by 175 basis points in the last 16 months.  But then it was unnecessarily raised  by 100 basis points over 2014.  Overall, the nominal policy interest rate has fallen over the last three years, but once one takes account of the fall in inflation expectations, there has been hardly any fall in the real OCR at all.  And that despite three more years of inflation persistently undershooting the target (and three more years of an unemployment rate above the NAIRU).

And they aren’t even providing much to boost domestic demand and activity.  The Bank ran this chart in yesterday’s MPS


It isn’t that easy to read, but just focus on the top and bottom lines. The top line is an estimate of the weighted average cost of new bank funding (retail, wholesale, onshore, offshore).  The bottom line is the OCR.  That marginal funding costs measure hasn’t fallen much at all this year, despite the continuing falls in the OCR.  Over the last three years taken together, the fall in marginal funding costs has not even quite kept up with the fall in inflation expectations.  Is it any wonder that core inflation has stayed low, and if there is any sign of some lift in inflation, it is at a very sluggish rate?

The Governor devoted a paragraph in  his main policy chapter to a discussion of the helpful things (in terms of lifting resource pressure and inflation) lower interest rates are doing.  There was a striking omission: frustrated as he no doubt is with the level of the TWI, it is almost certainly lower today than if the Bank had not cut the OCR.  But no mention of the exchange rate connection at all, even though it is probably one of the most important monetary policy transmission mechanisms in New Zealand.

But I was also struck by one of the observations the Governor did make.  He noted that low interest rates “are encouraging businesses to undertake investment they may not have done otherwise”.  So far, so conventional, and I wouldn’t disagree at all.  But here is a chart of investment (excluding residential investment) going back almost 30 years.


Investment in things other than building new houses is certainly off the recessionary lows, but it is still a considerable way below the typical share of GDP seen in the mid-late 1990s and the pre-recessionary 2000s.  And that is (a) with some considerable activity related simply to rebuilding in Christchurch following the earthquakes, and (b) the most rapid population growth rate we’ve had for decades.  Many more people should mean a lot more investment (simply to maintain the capital stock per person).  With current rates of population growth, and the Christchurch effects, perhaps we might be a little uneasy, concerned about overshooting, if the investment share (ex housing) was much above say 18 per cent (around the pre-recession peak). But it isn’t, and there is a little sign of business investment accelerating.

Monetary policy doesn’t make that much difference to an economy in the long run.  But in the short to medium term it can make quite a difference.   If a central bank is reluctant to cut policy rates further when

  • core inflation is well below the target focus (and has been for years),
  • when the unemployment rate is falling only slowly and is still well above the NAIRU,
  • when per capita GDP growth remains modest at best,
  • when the exchange rate is well above appropriate long-run levels, despite a languishing exports/GDP picture,
  • and when business investment itself is pretty modest, especially given the unexpectedly rapid population growth

it is leaving New Zealanders poorer, and more of them unemployed, than is necessary, or desirable.

Perhaps the bit of yesterday’s press conference that frustrated me most was the response by John McDermott, the Bank’s chief economist and Assistant Governor to a question.  The questioner asked about whether the Bank had given any thought to the idea Janet Yellen had openly toyed with, of deliberately aiming for a period of above-target inflation –  whether to in some sense “make up” for the period of below-target inflation and cement in slightly higher inflation expectations, or just to “give growth a chance”, including the chance that additional demand growth might stimulate new supply and productivity growth.   As the next recession –  and the next need to cut rates –  can’t be that many years away –  whether by accident, exhaustion or unintended trade war – the “overshoot” approach might just be prudent risk management in the current circumstances.

There are a number of problems with the idea.  In a US context, I don’t find that argument that weak demand has held back productivity growth that convincing –  and they managed very rapid productivity growth during the Great Depression –  and there are questions as to whether a central bank could credibly commit to overshoot its target for a time (aren’t the incentives to renege as soon as inflation actually starts getting near the target?).  And in the US, the unemployment rate is already back to around pre-recession lows.

But the Bank’s chief economist simply didn’t address the question.  Perhaps he didn’t hear it clearly, or misinterpreted what was being asked, but he simply gave the rather self-satisfied response that if one looked at the Bank’s projections, inflation was heading back towards target, and that “sounds like the plan being implemented”.

It is nothing of the sort.  What the Bank is doing is pretty mainstream inflation targeting, on the assumption that their forecasting models and understanding of the economy is roughly correct.  And it is surely exactly the same approach they’d take if the target was, say, centred on 5 per cent, and core inflation measures were around 4.2 per cent.

It is also exactly the approach they’ve taken throughout the Wheeler term, when they have proved to be consistently wrong.  Inflation has simply kept on undershooting.

The approach that was asked about, at least as I heard it, was whether the Bank should not cut more aggressively now, actively aiming to get (core) inflation up to perhaps around 2.5 per cent for a time.  If the Bank’s forecasting models are still wrong –  and they’ve given us no basis to believe something has changed and they now have it right –  perhaps actual core inflation would turn out around 2 per cent.    But if the models are right, we’d have a few years where inflation was a bit above target.  There would be few obvious downsides to that.  The next recession –  whenever it is –  would be likely to see inflation fall again.  But we’d see inflation expectations pick up –  from the current 1.6 to 1.7 per cent – to something more like 2 per cent, and we’d see a phase of stronger real GDP growth (per capita), stronger business investment, and the unemployment rate might finally –  eight years on from the recession –  get back to something like the NAIRU.  Indeed, perhaps it might undershoot the NAIRU for a year or two, likely a welcome outcome for the people concerned.

And then there is the looming issue of the near-zero lower bound on nominal interest rates. The Bank has just cut the OCR to a new record low of 1.75 per cent, and projects that it will remain at that level for the next three years.  They think the economy already has a small positive output gap.  So if the next recession comes in the next few years, there will be only around 250 basis points of leeway to cut the OCR if required.  In past cycles, the Bank has often needed twice that capacity.  And yet the Bank has shown no sign of having any preparations in train to make the lower bound less binding.

Far better to take a more aggressive path now.  Actually push real interest rates well below where they were in the years when inflation has consistently undershoot.  Get inflation up sooner, and perhaps even overshoot for a time.  Get growth in real GDP per capita up, and drive unemployment down.  And in the process, get inflation expectations –  what people treat as normal –  up again. The best way to preserve capacity for the next recession is to get inflation expectations up –  at or above target midpoint –  now, while there is still discretionary capacity.

There are counter-arguments to this sort of approach –  no doubt, many would mention house prices –  but the Bank simply ignored the quite reasonable question.  It is as if they really just don’t care.  Not, I’d have thought, ever an appropriate response from a body given such great delegated power, but perhaps less so than ever in a week when voter rebellion against the elites, perceived not to have the interests of ordinary people at hear, hog the headlines.

As a final thought, while I welcomed the move to publish the interest rate projections in terms of the OCR (rather than the 90 day bill rate), given that the Bank adjusts the OCR in increments that are multiples of 25 basis points, it is rather odd to give the interest rate projection to only one decimal place.   Over the next few months, the OCR will either be 1.5 per cent, 1.75 per cent (as presumably the Bank thinks), or 2 per cent.  It won’t be 1.8 per cent or 1.7 per cent.  The Governor seemed to suggest yesterday that 1.7 per cent was implying a 20 per cent chance of a further OCR cut.  But, even if so, how do we know whether 1.8 per cent is simply 1.75 per cent rounded, or is intended as a 20 per cent chance of an OCR increase?  The move to using the OCR was designed to improve clarity.  They could do a little more in that direction (and in ways that might reduce the temptation to micro manage market expectations).