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

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.

Monetary policy matters.

Other things matter more of course.  Even in the economic area, the long-term prosperity of a country and its people is affected very little by the quality of the country’s monetary policy. But the short to medium term matters too.  And monetary policy can make quite a difference to how the economy performs, and the employment opportunities open to its people over horizons of typically a couple of years, but potentially stretching out to five years.

So it is encouraging to find various people weighing in on how monetary policy should be conducted –  partly on the questions of where the OCR should be right now (about which there will always be quite a bit of uncertainty even if everyone agreed on what target monetary policy should be pursuing), but more importantly on what target monetary policy should be aimed at.  In this post, I’m going to disagree with several recent contributions to the debate, but differences of view are vital if there is going to be debate at all.

Of course, many of these issues are addressed and dealt with –  passively or actively –  in the design of the Policy Targets Agreement.   Those documents matter, a lot.  In the PTA, the Minister of Finance constrains the otherwise unchecked power Parliament gives to a single unelected individual (a person in turn chosen by faceless company directors with no democratic mandate or public accountability) to run monetary policy as s/he chooses.  The process behind agreeing the PTA is clothed in secrecy –  even years afterwards the Reserve Bank refuses to release the relevant papers.  It needn’t (and shouldn’t) be so.  This isn’t just a bureaucratic piece of paper, but the design of the policy “rule” that will govern New Zealand’s short-term stabilization policy for the following five years.

I’ve noted previously the much better approach taken in Canada –  where the Bank of Canada had an open process of research and reflection in advance of the next review of its equivalent of the PTA.  There is no reason at all why New Zealand shouldn’t do that, and more.  Instead of relying on occasional passing comments from the Minister of Finance or the Secretary to the Treasury about their views on the (absence of a) case for substantive change to the PTA, the Treasury and the Reserve Bank, supported by the Minister of Finance, should be promoting an open research programme, inviting outside submissions, and looking to host a conference/workshop early next year where interested parties could engage and offer advice to the Minister and whomever the Board determines will be next Governor.  Among the many issues such a work programme might look at is how best to design the policy rule to cope with the risk that New Zealand hits the near-zero lower bound in the next five years (as an illustrative piece  –  see Fig 1 – by a senior Treasury economist highlights, it is hardly a trivial risk).  It might seem uncomfortable for the Bank –  once upon a time, as an insider, I’d probably have pushed back too.  But it is what open government should actually look like.  In practice, we all know that ex post accountability for monetary policy judgements means little in practice (perhaps inevitably so).  Getting the “rules” right at the start  –  and appointing good people, which probably includes shifting towards a committee decision-making model for monetary p0licy – probably matters more.    (For avoidance of doubt, I’m not championing any particular changes to the PTA, although there are a few matters that could usefully be tidied up.)

But to come back to the various contributions to the debate that I’ve seen over the last few days.

In their weekly commentary, the ANZ economics team says they will offer some more detailed opinions on the framework “down the track”, but for now they offer two suggestions:

It’s arguable whether CPI inflation is the right target. It might be better to include a basket of various price indices. Some back-casting to see whether policy and economic outcomes would have been improved under different targets or a basket would also be useful

We need a better framework for driving more co-ordination between fiscal and monetary policy.   …there are limits to what monetary policy can do. It is now widely appreciated that fiscal policy and structural reform need to do more heavy lifting to generate better growth outcomes globally. But that is easy for many to say when there are no mandates or requirements to follow through. Monetary policy needs mates

On fiscal policy, I offered some skeptical responses to the ANZ’s thoughts in this area last year.  I remain skeptical.  If they are arguing for a more expansionary fiscal policy at present (as they were last year) it is a recipe for a higher exchange rate, and no higher  growth (other than around the near-zero lower bound, monetary policy offsets the demand effects of fiscal policy).  I’m not opposed in principle to greater coordination of fiscal and monetary policy –  and as we near the lower bound on interest rates it may become more important – but now hardly seems the time for more spending.  Our debt isn’t that low, and that borrowing capacity could yet be very important.  If “monetary policy needs mates” in the current context, some mix of more extensive land use deregulation and reduced medium-term immigration targets look more appropriate.  But both would make sense on their own terms, whether or not monetary policy faced particular challenges.

But perhaps the more interesting question is whether the CPI itself is the “right” target.   There is no compelling theoretical reason to prefer CPI inflation over any other of the range of possible nominal targets (individually or in combination).  One could think of using various wage indices, the private consumption deflator, nominal GDP, a differently constructed CPI, or perhaps even the exchange rate itself.  One could target levels instead of rates of change.  One could, to be deliberately absurd, consider anchoring to the price of tomatoes, or the prices of houses or –  oh, we’ve been there before –  the price of gold.     Plausible arguments could be mounted for most of those options.   We ended up, 25 years ago, settling on the CPI (more or less) because it was prominent measure, somewhat understood by the public.  There wasn’t a huge amount of analysis behind the choice at the time –  and we knew the CPI had its pitfalls, more so then than now – but it has stood the test of time.  Almost all the countries that have adopted inflation targeting, use CPI-centred targets.  The important exception, the US, uses the private consumption deflator.

Having said that, it is also important to recognize that monetary policy has never just been driven off the CPI inflation rate.  First, there are all manner of exclusions and adjustments to get to a sense of where some “core” or “underlying” measure of CPI inflation is right now. Few people, for example, are particularly bothered by the fact that annual headline CPI inflation is currently 0.4 per cent.  What bothers them more is the interpretation of that data –  hence the range of estimates suggesting “core” CPI inflation is probably somewhere in a range of 1 to 1.5 per cent.  And, as importantly, policy has never targeted current inflation.  No matter what the Reserve Bank did it couldn’t make any material difference to inflation for the September quarter of 2016.  So policy looks ahead to forecasts of (CPI) inflation.  But when it looks ahead a couple of years, the precise index the Bank is using doesn’t matter very much.  Their forecasting models embed assumed relatively stable relationships among the various elements of the economy –  and if they think the economy is going to evolve in a way that will lift pressure on resources over the next few years, that will show through typically in whatever variable they are forecasting –  whether it is the CPI, private consumption deflator, wages or whatever.   Some of those series might be more volatile than others, and so if one did shift to using them as the basis for the PTA target, one could have to take that into account in the design of the PTA.  One can’t simply assume that all the rest of the parameters of the PTA could sensibly be left unchanged if one replaced CPI with some other price/wage/income index as the centerpiece of policy.  The LCI, for example, is much less variable than the CPI –  so small movements in it tend to matter more.

I’m not, at all, opposed to further work being done on evaluating alternative rules.  But my prior is that most of the alternatives would make little difference (when evaluated using forecast data).  The bigger issues –  and disputes –  have not really been about what index the Reserve Bank might be targeting but about (a) their overall read on the outlook for resource pressures, and (b) which risks they choose to tolerate.  Neither seems likely to have been much different if they’d been handed a different index (and a suitable target for that index) some years ago.  They –  and most of the market economists –  thought inflation (however defined) would pick up quite strongly (hence the presumed need for such large interest rates increases).  They were wrong, but a different target wouldn’t have changed their model of how they thought the economy was working.

Shamubeel Eaqub’s latest weekly column has thoughts along similar lines to the ANZ’s. but he is a bit more specific, arguing (if I read him rightly) that the Reserve Bank should be charged with targeting an index that includes house prices.

There is nothing sacrosanct about how our CPI treats housing (actual rents, and the cost of constructing a new house, but not the land price).  It isn’t an uncommon approach –  and is used in Australia for example.  One could easily argue for an alternative approach – the one used in the US (and in our private consumption deflator) –  in which actual and imputed rents (the latter in respect of owner-occupied houses) were used, but not construction costs.    That latter approach was long the preferred option of the Reserve Bank, and I still have a hankering for it.  In fact, for a few years in the early days of inflation targeting, for accountability purposes the target was expressed not in terms of the CPI, but of an alternative index that used the imputed rents approach.  But for the last 20 years, the Reserve Bank has been content with, and positively endorsed, the current “acquisitions” approach.

Eaqub argues that if land prices had been included in the CPI – I’m not sure what weight he envisages –  inflation on that measure would have been “2.5 per cent or more for the last three years”.  Perhaps so, but we’d also have switched to using an index that was much more variable than the CPI, and that greater variability would need to be taken into account in writing the PTA.  Moreover, given that the combination of land regulation and immigration policy (or tax policy problems, as Eaqub might argue) have imparted a very strong upward bias to real land prices over several decades, that would also need to taken into account in setting the appropriate target range.  It seems to be an argument that would have led to higher real interest rates over history.  But, if so, it is worth reflecting that we’ve already had the highest interest rates in the advanced world for the last 25 years, and a mostly overvalued real exchange rate to match. I’m not sure how exacerbating those imbalances looks preferable to what we’ve had.  Add to the mix of challenges that monetary policy runs off forecasts, and no one has good forecasting models for urban land price fluctuations. and at best I think such a suggestion would require a lot more in-depth evaluation.    Or we could just fix up the structural distortions that mess up our urban land market –  but not, say, those of Houston, Atlanta, or Nashville.

The final contribution to the monetary policy debate that I wanted to touch on today was a thoughtful column by my former Reserve Bank colleague (now apparently the chief investment officer for a funds manager) Aaron Drew.  Aaron believes that  interest rate cuts are doing more harm than good (globally and in New Zealand).  In taking that view, he isn’t alone.  The BIS in particular has at times argued that the world would be better off if only central banks got on and lifted policy rates back to some more-normal level.  I’ve thought there was a germ of an insight there in that monetary policy can’t make much difference to the long-term structural prospects of the economy –  and the biggest challenges many countries face are the widespread decline in productivity growth.

Beyond that, I think the argument is just wrong.    After all, we’ve already twice tried the experiment of raising interest rates in the years since the 2008/09 recession.  Both prove rather short-lived experiments.  Aaron cites two arguments in support:

Two key arguments are made as to why cutting rates may be making things worse rather than better. The first is essentially a confidence argument. Cutting rates to very low levels, and in the extreme case to negative levels, signals that things are very wrong with the economy. Households and firms react to this by pulling-back spending.

The second key argument is that cutting interest rates to very low depresses, rather than boosts, household spending because the negative impact it can have on savers and the retired outweighs positive impacts elsewhere.

On the first of these arguments, I’d question just where the evidence anywhere is to support it.  It is certainly true that whatever forces have led central banks to adopt such low (or negative interest rates) are extraordinary –  out of our range of historical experience.  And the associated weakening of income growth prospects should have led people to become quite a bit more cautious –  prospects now just aren’t as good as they seemed 10 years ago.  But if central banks simply pretended those pressures weren’t there, it doesn’t suddenly make them go away.  But whatever the arguments about negative interest rates, that isn’t an issue New Zealand currently faces –  our OCR is still higher than the US’s policy rate has been at any time in the last seven years or more.

The second is an empirical matter. Aaron argues that, in contrast to the usual experience, in the current climate lower interest rates are dampening demand and inflation, not contributing to raising them.  It could be so, but it isn’t obvious why it should be.  He emphasizes the adverse impact of low interest rates on those –  the retired –  consuming from the earnings of fixed income assets, as well as on those saving for retirement.  But the flipside of that approach is the lower servicing costs of debt –  especially for the people who already had debt outstanding before the latest surge up in house prices.  And real interest rates have been falling for 25 years now.

But even if the income effects in New Zealand did work in Aaron’s direction, the substitution effects don’t.  All else equal, lower interest rates make it more worthwhile to do a project today than it would have been without that interest rate cut.  And, perhaps more importantly, for all the fuss around exchange rate movements on the day of MPS announcements, I don’t know anyone who thinks that if New Zealand had kept interest rates much higher –  and Drew is quite open that he was arguing against cuts (and still thinks he was right to do so) even a year ago –  we would not have a higher real exchange rate today.  That was the certainly the view the Governor took last week, and I agree with him.

There are some nasty distributional implications of what has gone in the last decade. Many of the old are unexpectedly much worse off (but most aren’t because most are largely reliant on NZS).  The implications for other age groups are much less clear.  But distributional consequences are an almost inevitable part of unexpected real economic changes. If there aren’t the high-returning projects to generate lots of new investment, the value of (returns to) savings will fall.  Central banks can’t alter that, and any slight difference they can make will be marginal at best.   As I noted yesterday, it is not as if central banks are holding policy rates down while long-term bond rates linger high.  Rising house prices are , of course, a big burden on the young –  but, at least technically, that effect is easily mitigated, by reforms to land use regulation and/or changes to immigration policy.  And recall that in real terms, nationwide house prices today are little different than they were in 2007 –  when interest rates were much much higher.

Aaron claims he doesn’t want to abandon inflation targeting, but I’m not sure what his alternative would practically look like.   He thought the OCR was already too low last year when it was 3 per cent.  Perhaps he is right that raising the OCR back to, say, 3.5 per cent would lift business and household spending and raise inflation.   But the evidence to back such a strategy seems slender at best.  To adopt such an approach would involve the Reserve Bank going out on such a limb –  adopting an approach so different to every other advanced country central bank –  that we would have to impose quite a burden of proof on anyone advocating such a strategy.

This post has got longer than I expected.  Apologies for that.  There are important issues and debates to be had.  We should be encouraging the debates, and associated research programmes, not assuming that the answers are already all in.