Virtue signalling, with your money

I haven’t written about the New Zealand Superannuation Fund (NZSF) for a while, and a well-informed reader has been encouraging me to get back to the economics of the Fund (and some of the important issues raised in a recent review paper).  I will, but for now I remain of the view that the Fund is serving no useful purpose and should be wound up.

But while we have it, it needs to be run well.

One of the annoying aspects of the Fund is the way in which the Board and management get to take your tax money and mine, and invest (or not) in causes which they happen to find appealing.    Of course, the Act isn’t written that way, but that is what it boils down to.   I’m not too keen on my money being invested in abortion providers or private prison operators –  just to span the ideological spectrum –  but obviously Adrian Orr and his Board don’t have a problem with such exposures.   They, on the other hand, object to tobacco companies and whaling, which don’t greatly bother me.

But the other day, they announced a big new policy shift that has substantially reduced the carbon exposure of the Fund (somewhat puzzlingly, I saw no mention in any of their documents of methane exposures, and as we know in New Zealand at least methane exposures make up a very large chunk of greenhouse gases).

To their credit, NZSF pro-actively released several background and Board papers relevant to this move, as well as several pages of question and answer material (all at the link in the previous paragraph).

This shift is dressed up as a simple matter of economic and financial management.  Indeed, they are at pains to assert that ethical (or presumably political) considerations played no part in the shift.  But, on the material they have presented it just doesn’t ring very true.

For example, they released a presentation to the Board from a few months ago.  In it, the chief investment officer and the “head of responsible investment” told the Board that

We believe climate change is a material long-term risk for which the Fund will not be rewarded.

What they appear to mean is the market prices of shares with (adverse) exposure to climate change and any associated policy responses do not adequately reflect those risks.

It is an arguable proposition, for which you might expect that evidence would be marshalled.  But the Board appears to have been presented with no evidence whatever, just assertions, and questionable economic reasoning.  Thus, on the next page

Climate change is a market and policy failure: markets are producing too many emissions and are over-invested in fossil fuels. We believe carbon risk is under-priced partly because the time horizon over which the effects will manifest is too long for most market analysts – but it is relevant to the time horizon that matters for the Fund.

This is a hodge-podge paragraph. For a start, climate change itself isn’t a market failure, but may well arise from market failures (costs aren’t properly internalised etc).   But the fact of climate change –  whatever role past policy or market failures may have played – tells one nothing about whether shares in companies exposed to carbon are now fairly priced or not.  They are just two completely different things.

And there is still no evidence presented for the proposition (“belief”) that markets have overpriced these companies (such that expected future risk-adjusted returns on them won’t match those available elsewhere).  Other market participants know as much (or as little) as NZSF staff know.

There was a more detailed Board paper in April containing the final recommendations.   It has more text, but no more analysis of the risks or of why the Board (or we) should believe that NZSF is better placed than the market to appropriately value climate change related risk.    Instead, we get a repeat of the same assertions,

NZSF quote

followed by a sentence which is best summarised as “but we really don’t know”.

There are repeated references to lines such as “ignoring Climate Change presents an undue risk”, but that isn’t even remotely the issue.  The issue is whether (a) the market on average is mispricing that risk, and (b) whether NZSF staff, management, and Board are better placed to evaluate the complex mix of scientific, economic, technological, and political factors that determine how things will play out (and thus what fair value pricing will prove to have been).     Thus, it is quite likely that the market on average has the appropriate pricing of these risks wrong, because much of what is relevant is inherently unknowable.  But if it is likely that the market is wrong, there is no particular reason to be confident which side the error lies on.   And it isn’t obvious why it is easier for NZSF to be confident it is right about this, than about any of the other very long-term risks embedded in many sectors, or in the market as a whole.

There are also hints that really this has little to do with a careful evaluation of financial investment risk and a lot more about politics and “good causes” –  virtue signalling.

NZSF 2

Consistent with this political focus, the very first item in the proposed communications strategy reads

“Recommend engaging with the Greens to explain to them the approach we have taken”

(And, sure enough, they were lauded by the Greens – although not for the quality of their financial analysis –  when the new policy was finally announced the other day.)

NZSF’s detailed public story is contained in the Q&A document they released.  This is text that they will have had months to refine, the Board having made this decision in April.

But again, there is no analysis presented or summarised to indicate why the Board is confident the market has it wrong. Instead they seem reduced to lines like this

We believe that now is the right time to act. Even if there remains some uncertainty about global policy, its general direction is consistent with meaningful carbon reductions.

This is the basis for a major strategic investment choice by the Board managing taxpayers’ money??   “General directions” are one thing, assessing market pricing and demonstrating with a high degree of confidence that market prices are wrong is quite another.

Or lines like this

The Mercer climate change study that we participated in during 2015 found that the biggest risk to investors from climate change was to be on the wrong side of strengthening global policy and/or technological disruption. Mercer found that investors who got ahead of the curve could mitigate the potential downside.

Well, of course.  If you read markets well, and judge policy correctly, there is plenty of money to be made.  But doing so is hard…..very hard, and NZSF provides no evidence that they are able to beat the market uniquely well is this particular area of their global exposures.

There is further evidence that this move is about politics and virtue signalling, rather than robust financial analysis.

Will your active managers be allowed to hold stocks that have been sold from the passive portfolio on the Fund’s behalf?
Our active NZ equity managers (who may also from time to time invest in Australia) will not invest in these stocks.

If this were just a strategic view that markets were systematically mispricing this risk, there would be no reason to bar active managers from holding such stocks from time to time (after all, even if one average the market is mispricing this risks, it doesn’t mean there won’t occasionally be opportunities in individual stocks that are exposed to such risks.)

There is very strong sense that NZSF decided to reduce its climate change exposures, and then back-filled the (rather weak) argumentation in support of that.  As it is put early on in the April Board paper, setting the scene for the recommendation.

“a reduction of climate-change related risks for the Fund is a key goal of the CCIS [Climate Change Investment Strategy]”

Perhaps there is some other economic and financial analysis, that they haven’t yet released, to support that strategic preference (I’ve lodged an OIA request to that end) but at the moment it looks like a political choice not a financial one.

The NZSF has implemented this strategic choice by the Board and management by altering their so-called Reference Portfolio benchmark.   They have long argued that the reference portfolio is what their performance should be benchmarked against  (the numbers scream out at one, in large type, when one goes onto their website).  I’ve long argued that is the wrong benchmark for citizens and taxpayers to focus on (useful as it might be for the Board to judge staff active management choices against).  In this case, the Board itself has taken what amounts to a punt (an active call) that the market is underpricing risk in a particular sector.  They need to be evaluated on the results of that call over time, not avoid accountability by burying the implications of their policy decision in what looks like a passive benchmark that is beyond their control.

Perhaps the NZSF choice will be widely popular.  But that isn’t their job.  In fact, it has always been one of the dangers of the Fund.    It isn’t their job to be playing politics by tilting the portfolio towards trendy causes.  If anything, long-term investors (the advantage they constantly assert) might be better positioned to take somewhat contrarian stances, leaning against the tide of opinion at times (but only when backed up with sound analysis).    And if they really believed that the market was underpricing climate change risk, why not be rather more open about the resulting investment choices  –  leave the reference portfolio unchanged, and implement the market call through active management positions?

And you do have to wonder how, in a country where policy is still aimed at opening up further oil and gas deposits, a New Zealand government agency now has an official ban on buying shares in companies that might be developing those resources.  Will an NZSF ban on dairy exposures be next?

We have elections to choose the people who will make policy decisions.  If the public want to ban dairying, or oil and gas exploration, then elect the politicians to make those calls, and hold them to account.   But lets not have bureaucrats and unaccountable Board members pursuing personal agendas (even popular ones) with our money.  If the economic and financial case is really there –  and remember that active management calls of this sort don’t have a great track record globally –  then lay it out for us to see.  On what they’ve released to date, this look much more like a virtue-signalling call than one consistent with the NZSF’s statutory mandate, or with the sort of professional expertise we should hope for from well-remunerated investment managers.

 

 

 

 

LVR restrictions

The successive waves of LVR controls that the Reserve Bank Governor has imposed on banks’ housing lending in recent years are back in the headlines, with comments from both the Prime Minister and the Leader of the Opposition (here and here).

As readers know, I’m no defender of LVR restrictions.  The other day I summarised my position this way

I never favoured putting the successive waves of LVR restrictions on in the first place.  They are discrimatory –  across classes of borrowers, classes of borrowing, and classes of lending institutions –  they aren’t based on any robust analysis, as a tool to protect the financial system they are inferior to higher capital requirements, they penalise the marginal in favour of the established (or lucky), and generally undermine an efficient and well-functioning housing finance market, for little evident end.  Oh, and among types of housing lending, they deliberately carve-out an unrestricted space for the most risky class of housing lending –  that on new builds.

You’d never know, from listening to the Governor or reading the Bank’s material, that New Zealand banks – like those in most other floating exchange rate countries –  appear to have done quite a good job over the decades in providing housing finance and managing the associated credit risks.   We had a huge credit boom last decade, followed by a nasty recession, and our banks’ housing loan book –  and those in other similar countries –  came through just fine.

The Bank’s statutory mandate is to promote the soundness and efficiency of the financial system.  On soundness, successive (very demanding) stress tests suggest that there is no credible threat to soundness, while the efficiency of the system is compromised at almost every turn by these controls.

At a more micro level, this comment (from my post yesterday) about the Bank’s debt to income limit proposals is just as relevant to the actual LVR controls they’ve put on in successive waves.

Much of the case the Reserve Bank seeks to make for having the ability to use a debt to income limit rests on the assumption that banks don’t do risk management and credit assessment well and that, inevitably crude, central bank interventions will do better.  The Bank’s consultation paper makes little or no effort to engage on that point at all.  It provides no evidence, for example, that the Reserve Bank has looked carefully at banks’ loan origination and management standards, and identified specific –  empirically validated –  failings in those standards.  Neither has it attempted to demonstrate that over time it and its staff have an –  empirically validated –  superior ability to identify and manage risks appropriately.

For all that, in partial defence of the LVR controls right now, many of those who are calling for the controls to be lifted or eased seem to be giving all the credit (or blame) for the current pause in housing market activity to the LVR controls.   That seems unlikely.  Other factors that are probably relevant include rising interest rates, self-chosen tightening in banks’ credit standards, pressure from Australian regulators on the Australian banking groups’ housing lending, a marked slowdown in Chinese capital outflows, and perhaps some election uncertainty (Labour is proposing various tax changes affecting housing).  I don’t know how much of the current slowdown is explained by each factor, but then neither do those focusing on the LVR controls.   Neither does the Reserve Bank.

And the backdrop remains one in which house price problems haven’t been caused mostly by credit conditions, but by the toxic brew of continuing tight land use restrictions (and associated infrastructure issues) and continuing rapid population growth.     Those two factors haven’t changed, so neither has the medium-term outlook for house and land prices.  Political parties talk about improving affordability, but neither main party leader will openly commit to a goal of falling house prices, and neither main party’s policies will make much sustained difference to the population pressures.   A brave person might bet on  some combination of (a) a recovering Australian economy easing population pressure, and (b) talk of abolishing limits around Auckland actually translating into action and much more readily useable land.  It’s a possibility, but so is the alternative –  continued cyclical swings around a persistently uptrend in the price of an artificially scarce asset.

And thus, in a sense, the Reserve Bank has a tiger by the tail.  House prices are primarily a reflection of serious structural and regulatory failures, and the problem won’t just be fixed by cutting off access to credit for some, or even by just buying a few months breathing space until a few more houses are built (before even more people need even more houses).   This isn’t a “bubble”, it is a regulatorily-induced severely distorted market.

So I strongly agree with the Prime Minister that, having repeatedly sold the LVR controls as temporary, the Reserve Bank Governor really needs to lay down clear and explicit markers that would see the controls be wound back and, eventually, removed completely.     And yet how can the Governor do that in any sensible way?   After all, the underlying problem wasn’t credit standards, or even overall credit growth.  It appeared to be simply that the Governor thought that he should “do something” to try and have some influence on house prices, even though he (a) had no good model of house prices in the first place, and (b) his tool didn’t address causes at all, and bore no relationship to those causes –  it was simply a rather arbitrary symptom-suppression tool.  And the Reserve Bank knew that all along –  they never claimed LVR controls would do much to house prices for long.

Because the interventions weren’t well-designed, any easing or removal of the controls will inevitably be rather arbitrary, with a considerable element of luck around how the removal would go.   What sort of criteria might they lay out?

  • a pause in house prices for a couple of years?  Well, perhaps, but as everyone knows no one is good at forecasting cyclical fluctuations in immigration.  Take off the LVR controls and, for unrelated reasons, house price pressures could still return very quickly,
  • housing credit growth down to, say, the rate of growth of nominal GDP for a couple of years.  But there isn’t much information in such a measure, as the stock of housing credit is mostly endogenous to house prices (high house prices require a higher stock of credit).

The latest set of restrictions seemed to be motivated as much by a distaste for investor buyers as by any sort of credit or systemic risk analysis, so it isn’t clear what indicators they could use to provide markers for winding back the investor-lending controls.  And since the Bank has never documented the specific concerns about banks’ lending standards that might have motivated the controls in the first place, it isn’t obvious that they could easily lay out markers in that area either.  Since the controls were never well-aligned with the underlying issues or risks, it seems likely that any easing won’t be able to be much better grounded –  almost inevitably it will be as much about “whim” and “taste” as anything robust.  Unless, that is, the incoming Governor simply decides they are the wrong tool for the job, and decides to (gradually) lift them as a matter of policy.   Doing so would put the responsibility for the house price debacle where it belongs: with politicians and bureaucrats who keep land artificially scarce, and at the same time keep driving up the population.

Some have also taken the Prime Minister’s comments as ruling out any chance of the Reserve Bank’s debt to income tool getting approval from the government.  I didn’t read it that way at all.

But he [English] explicitly ruled out giving the bank the added tool of DTIs, which it had requested earlier in the year.

“We don’t see the need for the further tools, Those are being examined. If there was a need for it then we’re open to it, but we don’t see the need at the moment. We won’t be looking at it before the election.”

As even the Governor isn’t seeking to use a DTI limit at present (only add it to the approved tool kit), and as submissions on the Bank’s proposal haven’t yet closed, of course the government won’t be looking at it before the election (little more than a month away).  It will take at least that long for the Reserve Bank to review submissions and go through its own internal processes.  In fact, at his press conference last week Graeme Wheeler was explicitly asked about the DTI proposal, and responded that it would be a matter for his (acting) successor and the new Minister of Finance to look at after the election.    Perhaps the Prime Minister isn’t keen, but his actual comments yesterday were much less clear cut on the DTI proposal than they might have looked.

In many ways, the thing that interested me most in yesterday’s comments was the way both the Prime Minister and the Leader of the Opposition seemed to treat decisions on direct interventions like LVR or DTI controls as naturally a matter for the Reserve Bank to decide.

The Prime Minister’s stance was described by interest.co.nz as

However, he again reiterated that relaxing LVR restrictions was a matter for the Reserve Bank. “I’m not here to tell them what to do.” English said government was not going to make the decision for them and that he did not want to give the public the impression that politicians could decide to remove them. “The Reserve Bank decides that.”

The Leader of Opposition similarly

“But we’ve not proposed removing their ability to set those…use those tools,” Ardern said. “We’re not taking away their discretion and independence.”

Both of them accurately describe the law as it stands.  The Reserve Bank –  well, the Governor personally –  has the power to impose such controls.    But there isn’t any particularly good reason why the Reserve Bank Act should be written that way.

The case for central bank independence mostly relates to monetary policy.  In monetary policy, there is a pretty clearly specified objective set by the politicians, for which (at least in principle) the Governor can be held to account.  In our legislation, the Governor can only use indirect instruments (eg the OCR) to influence things –  he has not direct regulatory powers that he is able to use.

Banking regulation and supervision are quite different matters.  I think there is a clear-cut argument for keeping politicians out of banking supervision as it relates to any individual bank –  we don’t want politicians favouring one bank over another, and we want whatever rules are in place applied without fear and favour.  In the same way, we don’t want politicians making decisions that person x gets a welfare benefit and person y doesn’t.  But the rules of the welfare system itself are rightly a matter for Parliamant and for ministers.

There isn’t compelling reason why things should be different for banking controls (and, in fact, things aren’t different for non-bank controls, where the Governor does not have the same freedom).  As my former colleague Kirdan Lees pointed out on Morning Report this morning, when it comes to financial stability and efficiency, there are no well-articulated specific statutory goals the Reserve Bank Governor is charged with pursuing.  That gives the holder of that office a huge amount of policy discretion –  a lot more so than is typical for public sector agencies and their chief executives – and very little effective accountability.    So when Ms Ardern says that she doesn’t propose to take away the Bank’s discretion or independence, the appropriate response really should be “why not?”.

We need expert advisers in these areas, and we need expert people implementing the controls and ensuring that different banks are treated equitably, but policy is (or should be) a matter for politicians.  It is why we have elections.  We get to choose, and toss out, those who make the rules.  It is how the system is supposed to work –  just not, apparently, when it comes to the housing finance market.

I’ve welcomed the broad direction of the Labour Party’s proposal to shift to a committee-based decisionmaking model for monetary policy.   But, as I noted at the time of the release, their proposals were too timid, involved too much deference to the Governor (whoever he or she may be), and simply didn’t even address this financial stability and regulatory aspects of the Bank’s powers.      There is a useful place for experts but –  especially where the goals are vague, and the associated controls bear heavily on ordinary citizens –  it should be in advising and implementing, not in making policy.   Decisions to impose, or lift, LVR controls or DTI controls should –  if we must have them at all – be made by politicians whom we’ve elected, not by a single official who faces almost no effective accountability.

 

 

Some praise for the Reserve Bank

Last week I bemoaned the fact that the Reserve Bank had dropped various questions from its Survey of (business and professional) Expectations, and although it had added some new questions (in some cases more or less directly replacing the ones they had dropped) they had withheld the survey results for those new questions.  Presumably their logic was to build up a time series of responses before making the information available outside the Bank.

That wasn’t very satisfactory. It gave them information the rest of us didn’t have, and meant that  –  in particular –  we had suddenly lost any survey-based measures of what the Bank was expected to be doing with monetary policy.  Thus, they’d deleted a 90 day bill rate question and added a question about OCR expectations, but weren’t planning to tell us the results for some (unknown) time.

I wasn’t too happy about that stance, and thought it probably wouldn’t stand up to an Official Information Act request –  it is, after all, official information, and couldn’t possibly be withheld on the usual grounds the Bank likes to invoke (eg free and frank advice).  So I lodged a request for the answers to the new questions.

That request was lodged on 7 August.  This afternoon their reply turned up, providing everything I’d asked for.

expecs 1.png

expecs 2

They also indicated that future summary responses to these questions will be released with the regular Survey of Expectations releases.

Of course, it is new data so there is only a limited amount one can take from this first set of numbers.  But I was interested that respondents have a mean expectation for inflation 10 years ahead of 2.13 per cent –  quite a bit higher than is probably implicit in the gap between indexed and nominal bonds (my own response to that question was 1.4 per cent).

Respondents (in a survey in late July) put a pretty high probability on the Reserve Bank having raised the OCR by next June, and respondents also seem to be of the view that the worst of the house price inflation is over for now –  rather than, say, what we are seeing at present being just a brief pause.

In time, these new questions will enrich the Survey of Expectations.  The Bank could (and should) have gone further – eg a question about the OCR five years hence (a proxy for expectations of the neutral rate) and a question or two about expected net immigration flows.   But at least we now have some new data.

I don’t often praise the Bank, but I am impressed at the quick change of mind, and helpful and full response I got today.

 

Misconceived and deeply flawed

Later this week submissions close on the Reserve Bank Governor’s attempt to get the some sort of debt to income restriction added to the list of possible direct controls on banks upon which the government has bestowed its favour.  (I write it in that slightly awkward way because, by law, the Governor does not need the Minister’s permission at all –  Parliament, somewhat recklessly, appears to have given all those powers to the Governor personally, but a few years ago the Governor committed to only using restrictive tools that the government had approved of.)

This would be the latest in the series of direct interventions by which the Reserve Bank has been undermining the effectiveness and efficiency of the housing finance market.  For now, the (outgoing) Governor says he wouldn’t apply a debt to income restriction even if he had the Minister’s imprimatur.  But all it will need will be another rebound in the property market and Wheeler would no doubt be keen.  Whether his permanent successor next year shares that enthusiasm is, I would hope, something the Board and the (next) Minister turn their minds to in considering possible candidates for Governor.

I probably will put in a submission, but if so it will overlap in many areas with the paper just published by my former colleague (now Tailrisk Economics) Ian Harrison.    Ian spent many years in the prudential supervisory wing of the Reserve Bank and led the work on risk modelling that has underpinned the Bank’s positions on capital, risk weights etc.  He has previously written and published his critical analysis on the Reserve Bank’s decision to treat residential mortgage loans owed by investors as riskier than the same loan on the same security when owed by owner-occupiers.  It was published under the somewhat provocative title House of Cards – and I wrote about it here.

His new paper on the proposal to have a debt to income instrument available doesn’t have a provocative title.   But it is no less forceful in its conclusions.  Here is the bulk of Ian’s press release

A report by Tailrisk Economics on the Reserve Bank’s justifications for possibly imposing debt to income (DTI) limits on housing lending, shows that that they are deeply flawed.

The main problem is that the DTI is a crude tool that does not adequately assess borrowers’ debt servicing capacities, and which will perversely target better quality loans.

“The Reserve Bank has presented no substantive evidence that higher DTI loans are ‘excessively’ risky, or that a DTI ratio of 5 is a sensible cut-off,” said Ian Harrison, Principal of Tailrisk Economics, “but there is significant evidence that DTIs do not predict loan defaults, or reduce the likelihood or severity of crises”. The European Systemic Risk Board found, in a recent assessment of GFC performance, that DTI levels did not have any “relevant effect either on the prediction of the crisis or on the depth of the crisis” .

The application of the DTI limit to investor loans, which are the primary focus of the policy, is particularly misconceived, because DTI limits are only intended to apply to owner occupier borrowers. The DTI measure assumes that when investor purchases a new property their living expenses increase. “This simply does not make sense”, Harrison commented.

The effect of the policy could be to impose an effective LVR limit as low as 30 percent on professional investors.  No other country has imposed DTI restrictions on investor loans.

“Higher future interest rates do not pose a material systemic risk, providing the conduct of monetary policy is competent”  Harrison added. “Further, the Bank’s assessment that the restrictions would have a net welfare benefit, is very optimistic. Our assessment is that they will have  a welfare cost, like most misconceived quantitative interventions.”

Much of the case the Reserve Bank seeks to make for having the ability to use a debt to income limit rests on the assumption that banks don’t do risk management and credit assessment well and that, inevitably crude, central bank interventions will do better.  The Bank’s consultation paper makes little or no effort to engage on that point at all.  It provides no evidence, for example, that the Reserve Bank has looked carefully at banks’ loan origination and management standards, and identified specific –  empirically validated –  failings in those standards.  Neither has it attempted to demonstrate that over time it and its staff have an –  empirically validated –  superior ability to identify and manage risks appropriately.

One of the Reserve Bank’s bugbears is that while the current lending practices may look broadly okay at current interest rates, those same loans will look rather less sound if interest rates rise considerably.  Of course, banks already take into account the resilience of each borrower, including their ability to cope with unexpected changes in servicing costs.    I wrote about this in my post on the most recent FSR.

… there was something a little odd in the box the Bank included on “Vulnerability of owner-occupiers to higher mortgage rates“, clearly softening us up for the consultation paper on debt to income ratios.  They argue that

New Zealand is particularly vulnerable to a sharp rise in mortgage rates as the banking system funds a large proportion of its mortgage credit from offshore wholesale markets. The cost of this funding can increase sharply if there is an unexpected increase in global interest rates or a change in investor risk appetite, and banks are likely to pass on the higher funding costs to customers through higher mortgage rates.

But mostly this is just untrue.  The Reserve Bank sets the OCR in New Zealand based on overall inflation pressures in New Zealand.  If funding spreads rise –  as they did in 2008/09 –  and domestic inflation pressures don’t the Reserve Bank can easily offset most or all of the potential impact on retail interest rates by lowering the OCR.    That is what happened in 2008/09.

Of course, retail interest rates can rise, quite materially.  As the Bank points out, new floating mortgages rose from “around 7 per cent to over 10 per cent between early 2004 and 2007”.  Of course, as we used to stress at the time, fixed mortgage rates rose nowhere near that much.  But, more importantly, interest rates here didn’t rise because foreign rates were rising, but because the economy was cyclically strong, unemployment was low and falling, and wage and price inflation were increasing.  Wages rose roughly 20 per cent in that period.

It is fine and good for the Reserve Bank to do these sorts of stress-testing exercises, looking at what happens if interest rates rise to 7 per cent, or 9 per cent.  But in any realistic assessment, those sorts of substantial increases are only remotely likely if the economy is doing really cyclically well.  If jobs are readily available and wages are rising, not many people will be under that much stress even if interest rates rise quite a lot.  And those that are should quite readily be able to sell their house and move on.  It might be painful for them, but it simply isn’t a financial stability event.

Ian makes many of the same points, including

Financial  stability  will  only  be  threatened  if  there  is  a  large  number  of  borrowers   who  can  not  service  their  loans,  and  if  there  is  a  material  fall  in  house  prices.      If   house  prices  hold  up  through  the  interest  rate  cycle  then  borrowers  who  come   under  servicing  pressure  will  generally  be  able  to  resolve  their  problem  by  selling  the   house.  A  systemic  problem  only  starts  to  arises  if  the  interest  rate  increases  cause  a   large  fall  in  house  prices.    However,  if  this  did  occur  then  RBNZ  could  readily  respond   by  reducing  the  OCR.  It  is  almost  inconceivable  that  a  large  house  price  shock  would   not  feed  through  into  broader  economic  activity,  and  into  the  inflation  rate,  which   would  naturally  require  a  monetary  policy  response.    Mortgage  interest  rate  would   fall  and  the  pressure  on  borrowers’  servicing  capacity  would  be  relieved.

He also rightly highlights how unusual it is to propose including investor loans in a debt to income limit.  The Reserve Bank likes to highlight the debt to income limits adopted by the United Kingdom and Ireland, but simply hasn’t engaged with the fact that neither country includes investor loans in its limits.   Of the Bank of England Ian notes

The  Bank  of   England  has  the  legal  capacity  to  apply  DTI  limits  to  investor  lending,  but  has  not  done  so,   because  the  retail  DTI  limits  do  not  readily  translate  to  investor  lending.  Instead  the  Bank   requires  banks  to  meet  minimum  qualitative  standards  in  their  affordability  assessments.  In   addition,  banks  are  required  to  apply  a  2  percentage  point  stress  test  to  the  interest  cost   assessment,  and  the  test  rate  must  be  at  least  5.5  percent.  Where  buy-­‐to-­‐let  borrowers  rely   on  other  income  to  support  the  loan,  account  must  be  taken  of  taxation  and  living  costs.  This   is  basically  the  methodology  that  New  Zealand  banks  apply  to  retail  investment  lending.   There  are  no  further  quantitative  restrictions  such  as  times  interest  cover.  This  is  left  to   individual  bank’s  assessments.

In its assessment of submissions, the Reserve Bank should really be expected to provide rather more justification for the inclusion of investment loans than it has done to date.

Ian concludes his press release this way

“There are simpler, and less distortionary, ways of targeting ‘excessive’ house price rises, which appears to be the Bank’s primary motivation for DTI restrictions,” Harrison said. “Banks could be required to apply a prescribed higher test interest rate to affordibilty assessments.  This would provide the Reserve Bank with an interest rate policy tool that can be directed to imbalances in the housing market.”

His is a pragmatic response.   Mine is perhaps more hardnosed –  and perhaps less “realistic”.  It is no business of the Reserve Bank to be targeting house prices, targeting whether investors or owner-occupiers are buying, or even targeting levels of household debt.  Apart from anything else, they have no robust model of the housing market, or of the incidence of financial crises, and without those all they appear to have is gubernatorial whim, or the shifting winds of political preferences.  That is no basis for sound public policy.     The Bank –  and its political masters –  needs to be reminded of its mandate in this area: to promote the soundness and the efficiency of the financial system.  Direct controls that apply to one set of lenders and not others, to one set of loans and not others, to one class of borrowers but not others, are quite simply inferior on both limbs of that mandate to reliance on indirect instrument, such as capital standards, stress tests, and a deeply informed understanding of how banks are measuring, monitoring and managing risk.   To their credit, banks in countries like ours appear to have done a good job in recent decades of managing housing loan books.  It is a shame that the same cannot be said of the central and local government politicians and officials who have regulated urban land markets to the point where a house purchase is an increasingly impossible dream for too many of our fellow citizens.    How did we allow such disastrous outcomes?

Anyway, for anyone interested in the DTI proposal I’d commend Ian’s paper.  I don’t agree with everything in it, but is a detailed review of many of the relevant issues, and of the “evidence” the Reserve Bank seeks to rely on.  I hope that, for example, the Treasury will pay careful attention when they formulate their advice on the Reserve Bank inevitable (regardless of this “consultative process”) bid for approval to add debt to income limits to their toolkit of direct controls.

 

Doomed to repeat history…..or not

Last week marked 10 years since the pressures that were to culminate in the so-called “global financial crisis” burst into the headlines .

Local economist Shamubeel Eaqub marked the anniversary in his Sunday Star-Times column yesterday.  It grabbed my attention with the headlines Ten years on from the GFC” and “We appear dooomed to repeat history” .  

Frankly, it all seemed a bit overwrought.

It seems inevitable that there will be yet another crisis in the global financial system in the coming decade.

There have been few lessons from the GFC. There is more debt now than ever before and asset prices are super expensive. The next crisis will hopefully lead to much tighter regulation of the financial sector, that will force it to change from its current cancerous form, to one that does what it’s meant to.

The first half of the column is about the rest of the world.  But what really caught my attention was the second half, where he excoriates both the Reserve Bank and the government for their handling of the last decade or so.    This time, I’m defending both institutions.

There are some weird claims.

We were well into a recession when the GFC hit. So, when global money supplies dried up, it didn’t matter too much, because there was so little demand to borrow money in New Zealand anyway.

Here he can’t make his mind as to whether he wants to date the crisis to, say, August 2007 (10 years ago, when liquidity pressures started to flare up) or to the really intense phase from, say, September 2008 to early 2009.

Our recession dates from the March quarter of 2008 (while the US recession is dated from December 2007), but quite where he gets the idea that when funding markets froze it didn’t matter here, I do not know.  Banks had big balance sheets that needed to be continuously funded, whether or not they were still expecting any growth in those balance sheets. And they had a great deal of short-term foreign funding.  Frozen foreign funding markets, which made it difficult for banks to rollover any such funding for more than extremely short terms, made a huge impression on local banks.  For months I was in the thick of our (Treasury and Reserve Bank) efforts to use Crown guarantees to enable banks to re-enter term wholesale funding markets.  Banks were telling us that their boards wouldn’t allow them to maintain outstanding credit if they were simply reliant on temporary Reserve Bank liquidity as a form of life support.

Despite what he says I doubt Eaqub really believes the global liquidity crunch was irrelevant to New Zealand, because his next argument is that the Reserve Bank mishandled the crisis.

The GFC highlighted that our central bank is slow to recognise big international challenges. They were too slow to cut rates aggressively. They were not part of the large economies that clubbed together to co-ordinate rate cuts and share understanding of the crisis.

I have a little bit of sympathy here –  but only a little.  I well remember through late 2007 and the first half of 2008 our international economics people patting me on the head and telling me to go away whenever I suggested that perhaps events in the US might lead to something very bad (and I’m not claiming any great foresight into just how bad things would actually get).  And I still have a copy of an email from (incoming acting Governor) Grant Spencer in August 2007 suggesting that it was very unlikely the international events would come to much and that contingency planning wasn’t worth investing in.

And, with hindsight, of course every central bank should have cut harder and earlier.  I recall going to an international central banking meeting in June 2007 when a very senior Fed official commented along the lines of “some in the market are talking about the prospect of rate cuts, but if anything we are thinking we might have to tighten again”.

As for international coordination, well the Reserve Bank was part of the BIS –  something initiated in Alan Bollard’s term.  Then again, we were tiny.   So it was hardly likely than when various central banks did coordinate a cut in October 2008 they would invite New Zealand to join in.  Of its own accord, the Reserve Bank of New Zealand cut by 100 basis points only two weeks later (having already cut a few weeks earlier).

But what did the Reserve Bank of New Zealand actually do, and how did it compare with other advanced country central banks?

The OECD has data on (a proxy for) policy rates for 19 OECD countries/regions with their own currencies, and a few other major emerging markets.   Here is the change in the policy rates between August 2007 (when the liquidity pressures first became very evident) and August 2008, just before the Lehmans/AIG/ agencies dramatic intensification of the crisis.

policy rate to aug 08

The Reserve Bank had cut only once by this time.  But most of these countries had done nothing to ease monetary policy.  It wasn’t enough, but it wasn’t exactly at the back of the field, especially when one recalls that at the time core inflation was outside the top of the target range, and oil prices had recently been hitting new record highs.

That was the record to the brink of the intense phase of the crisis.  Here is the same chart showing the total interest rate adjustment between August 2007 and August 2009 –  a few months after the crisis phase had ended.

policy rate to aug 09

Only Iceland (having had its own crisis, and increased interest rates, in the midst of this all) and Turkey cut policy rates more than our Reserve Bank did.   In many cases, the other central banks might like to have cut by more but they got to around the zero bound.  Nonetheless, the Reserve Bank cut very aggressively, to the credit of the then Governor.  It was hardly as if by then the Reserve Bank was sitting to one side oblivious.

Obviously I’m not going to defend the Reserve Bank when, as Eaqub does, he criticises them for the mistaken 2010 and 2014 tightening cycles.  And the overall Reserve Bank record over several decades isn’t that good (as I touched on in a post on Friday), but their monetary policy performance during the crisis itself doesn’t look out of the international mainstream.   Neither, for that matter, did their handling of domestic liquidity issues during that period.

Eaqub also takes the government to task

The government bizarrely embarked on two terms of fiscal contraction. This contraction was at a time of historically low cost of money, and a long list of worthy infrastructure projects in housing and transport.

Projects that would have created long term economic growth and made our future economy much more productive, tax revenue higher, and debt position better.

Our fiscal policy is economically illiterate: choosing fiscal tightening at a time when the economy needed spending and that spending made financially made sense.

To which I’d make several points in response:

  • our interest rates, while historically low, remain very high relative to those in other countries,
  • in fact, our real interest rates remain materially higher than our rate of productivity growth (ie no productivity growth in the last four or five years),
  • we had a very large fiscal stimulus in place at the time the 2008/09 recession hit, and
  • we had another material fiscal stimulus resulting from the Canterbury earthquakes.

Actually, I’d agree with Eaqub that the economy needed more spending (per capita) over most of the last decade –  the best indicator of that is the lingering high unemployment rate – but monetary policy is the natural, and typical, tool for cyclical management.

And, in any case, here is what has happened to gross government debt as a share of GDP over the last 20 years.

gross govt debt

Not a trivial increase in the government’s debt.   Not necessarily an inappropriate response either, given the combination of shocks, but it is a bit hard to see why it counts as “economically illiterate”.  Much appears to rest on Eaqub’s confidence that there are lots of thing governments could have spent money on that would have returned more than the cost of government capital.  In some respects I’d like to share his confidence.  But I don’t.   Not far from here, for example, one of the bigger infrastructure projects is being built –  Transmission Gully –  for which the expected returns are very poor.

Eaqub isn’t just concerned about how the Reserve Bank handled the crisis period.

Our central bank needs to own up to regulate our banks much better: they have allowed mortgage borrowing to reach new and more dangerous highs.

I’d certainly agree they could do better –  taking off LVR controls for a start.  But bank capital requirements, and liquidity requirements, are materially more onerous than they were a decade ago.  And our banking system came through the last global crisis largely unscathed –  a serious liquidity scare, but no material or system-threatening credit losses.  Their own stress tests suggest the system is resilient today.  If Eaqub disagrees, that is fine but surely there is some onus on him to advance some arguments or evidence as to why our system is now in such a perilous position.

Macro-based crisis prediction models seem to have gone rather out of fashion since the last crisis.  In a way, that isn’t so surprising as those models didn’t do very well.     Countries with big increases in credit (as a share of GDP), big increases in asset prices, and big increases in the real exchange rate were supposed to be particularly vulnerable.  Countries like New Zealand.   The intuitive logic behind those models remained sound, but many countries had those sorts of experiences and had banks that proved able to make decent credit decisions.  And we know that historically loan losses on housing mortgage books have rarely been a key part in any subsequent crisis.     Thus, the domestic loan books of countries like New Zealand, Australia, Canada, the UK, Norway and Sweden all came through the last boom, and subsequent recession, pretty much unscathed.

One of the key indicators that used to worry people (it was the centrepiece of BIS concerns) was the ratio of credit to GDP.  Here is private sector credit as a per cent of GDP, annually, back to when the Reserve Bank data start in 1988.

psc to gdp

Private sector credit to GDP was trending up over the two decades leading up to the 2008/09 recession.   There was a particularly sharp increase from around 2002 to 2008 –  I recall once getting someone to dig out the numbers suggesting that over this period credit to GDP had increased more in New Zealand than it had increased in the late 1980s in Japan.  It wasn’t just housing credit.  Dairy debt was increasing even more rapidly, and business credit was also growing strongly.   There was good reason for analysts and central bankers to be a bit concerned during that period.  But what actually happened?  Loan losses picked up, especially in dairy, but despite this huge increase in credit –  to levels not seen as a share of GDP since the 1920s and 30s – there was nothing that represented a systemic threat.

And what has happened since?  Private sector credit to GDP has barely changed from the 2008 peak.  In other words, overall credit to the private sector has increased at around the same rate as nominal GDP itself.  It doesn’t look very concerning on the face of it.  Of course, total credit in the economy has increased as a share of GDP, but that reflects the growth in government debt (see earlier chart), and Eaqub apparently thinks that debt stock should have been increased even more rapidly.

It is certainly true that household debt, taken in isolation, has increased a little relative to household income.  But even there (a) the increase has been mild compared to the run-up in the years prior to 2008, and (b) higher house prices –  driven by the interaction of population pressure and regulatory land scarcity – typically require more gross credit (if “young” people are to purchase houses from “old” people).

If anything, what is striking is how little new net indebtedness there has been in the New Zealand economy in recent years.  Despite unexpectedly rapid population growth and despite big earthquake shocks, our net indebtedness to the rest of the world has been shrinking (as a share of GDP) not increasing.  Again, big increases in the adverse NIIP position has often been associated with the build up of risks that culminated in a crisis –  see Spain, Ireland, Greece, and to some extent even the US.   I can’t readily think of cases where crisis risk has been associated with flat or falling net indebtedness to the rest of the world.

There is plenty wrong with the performance of the New Zealand economy, issues that warrant debate and intense scrutiny leading up to next month’s election.  In his previous week’s column, Eaqub foreshadowed the possibility of a domestic recession here in the next year or two: that seems a real possibility and our policymakers don’t seem remotely well-positioned to cope with such a downturn.     But there seems little basis for “GFC redux” concerns, especially here:

  • for a start, we didn’t have a domestic financial crisis last time round, even at the culmination of two decades of rapid credit expansion,
  • private sector credit as a share of GDP has been roughly flat for a decade,
  • our net indebtedness to the rest of the world has been flat or falling for a decade,
  • there is little sign of much domestic financial innovation such that risks are ending up in strange and unrecognised places, and
  • whereas misplaced and over-optimistic investment plans are often at the heart of brutal economic and financial adjustments, investment here has been pretty subdued (especially once one looks at capital stock growth per capita).

In other words, we have almost none of the makings of any sort of financial crisis, “GFC” like, or otherwise.

House prices are a disgrace. We seem to have no politicians willing to call for, or commit to, seeking lower house prices.  But markets distorted by flawed regulation can stay out of line with more structural fundamentals for decades.  If house prices are distorted that way, it means a need for lots of gross credit.  But it tells you nothing about the risks of financial crisis, or the ability of banks to manage and price the associated risks.

LVRs, interest rates and so on

I was recording an interview earlier this afternoon, in which the focus of the questioning was the Real Estate Institute’s call for some easing in the Reserve Bank’s LVR restrictions.

Of course, I never favoured putting the successive waves of LVR restrictions on in the first place.  They are discrimatory –  across classes of borrowers, classes of borrowing, and classes of lending institutions –  they aren’t based on any robust analysis, as a tool to protect the financial system they are inferior to higher capital requirements, they penalise the marginal in favour of the established (or lucky), and generally undermine an efficient and well-functioning housing finance market, for little evident end.  Oh, and among types of housing lending, they deliberately carve-out an unrestricted space for the most risky class of housing lending –  that on new builds.

That doesn’t mean I think it is remotely likely that the Reserve Bank will be easing the restrictions any time soon –  apart from anything else, it would leave their consultation paper on debt to income ratio restrictions looking a little silly.   Of course, it would be good if the Reserve Bank did lay out some specific criteria for lifting these ostensibly temporary restrictions, but with the toxic brew of rapid population growth and continuing land use restrictions in place, if I saw the world as they seem to, I wouldn’t be in a hurry to lift the restrictions either.

In any case, it isn’t that clear quite how large a role the LVR restrictions are playing in the reduction in sales volumes.   They must be playing a part, but so too will higher interest rates, and the apparent increase in banks’ own lending standards, and pressure through the parents from APRA (on the lending standards across the whole of Australian banking groups).  Which, of course, is also why it isn’t clear quite how much difference any easing back in the New Zealand LVR controls might make.  Some presumably, but even the Reserve Bank has never claimed that LVR controls would have a very large impact on house prices, or housing market activity, for very long.   And while I noticed an article this morning about negative equity, it is worth bearing in mind that, on the REINZ index (not using median prices), house prices have risen 65 per cent in the last five years, and are currently 0.6 per cent off their peak.

But what of interest rates?  A year ago, the OCR was 2.25 per cent, and today it is 1.75 per cent.  Thus, the Reserve Bank talks of having eased monetary policy.   Here are mortgage rates though.

mortgage ratesI don’t suppose anyone is taking out four or five year fixed rate mortgages, but across the entire curve, interest rates are higher not lower.   Or we could go back another year or so, to just prior to when the Reserve Bank began cutting the OCR.   The OCR has been cut by 175 basis points since then.   Even at the shortish end of the mortgage curve, rates are down only 50-70 basis points.

Having been reflecting this morning on Graeme Wheeler’s performance over his term, I had a look back at where interest rates were when Wheeler took office in September 2012.

mortgage rates sept 12Barely lower, even though core inflation –  on their own favoured measure – is as low today as it was then (and has been consistently low throughout his term).

I wondered if there were offsetting factors but:

  • Two year ahead inflation expectations are about 25 basis points lower than they were then (largely offsetting any reductions in nominal mortgage rates, to leave real rates little changed)
  • the TWI measure of the exchange rate is a bit higher than it was then,
  • the ANZ commodity price index, in inflation-adjusted world price terms, is hardly changed from what it was then.

Of course, the unemployment rate has fallen since September 2012, but there hasn’t been any sign of a pick-up in the best indicator of labour scarcity –  real wage inflation.

So, overall, it is a bit of a puzzle how the Governor expected to get core inflation back to fluctuating around the target midpoint without actually easing monetary conditions.  I don’t happen to agree with him on this one, but he keeps talking about how the huge migration inflows have reduced net inflation pressures (supply effects outweighing the demand effects).  If he really believes that it is even more puzzling that monetary conditions haven’t been eased.

I’m not sure how he’d respond.  But perhaps he could explain that too in the forthcoming speech.

 

Three Governors and monetary policy

Graeme Wheeler indicated yesterday that he will shortly be giving a speech offering some reflections on his time as Governor.    It is a good idea, at least in principle.  Wrapping up his 10 years as RBA Governor last year, Glenn Stevens gave a thoughtful speech along those lines (which I had intended to write about, but never got round to).   Wrapping up his 10 years as Governor of the Reserve Bank, Alan Bollard did an interesting interview with one of the editors of the Bulletin – he even acknowledged having made a mistake early in his term.

It is hard to be very optimistic about the forthcoming Wheeler speech, but ….. perhaps……this time.  Someone emailed me last night, after my comments on yesterday’s news conference, suggesting that

surely at heart you would have been more disappointed if Wheeler had finally answered questions in a meaningful way.  Would have made the past 5 years of communication even more painful.

I’d have been astonished certainly, but I have a naively optimistic streak and I’d like to  be pleasantly surprised, even this late in the game.  When he was appointed, I had had high hopes for the Governor.

But the promise of a forthcoming review speech, and an exchange with someone yesterday about the relative performance of the three Governors who have operated in the inflation-targeting era (in which I found myself defending Graeme), got me reflecting on how one might do those comparisons, at least in respect of monetary policy.

One could simply look at deviations of inflation from target.   Using headline CPI inflation wouldn’t help much there –  the CPI in the 1990s was constructed materially differently than it is now.  And when Don Brash took office there wasn’t an inflation target at all.  But the Bank is fond of its sectoral factor model measure of core inflation.  That measure has only been around for the last five years or so, but the Bank has calculated the series back to September 1993.   And as it happens, the first inflation target that last long enough for performance to be measured against it was the one adopted by the incoming National government in December 1990 –  inflation was to be 0 to 2 per cent by December 1993.

So here is the sectoral factor model measure graphed against the midpoint of the successive target ranges.

targets and outcomes

There are several things to notice:

  • this measure of core inflation has been much more stable in the Wheeler years than in any previous five year period,
  • none of the three Governors kept sectoral core inflation (or any other measure) close to the midpoint of the target range, and
  • the biggest deviations were in the last years of the previous boom, when this measure of core inflation was actually outside the target range.

In terms of average deviations

Brash 0.5
Bollard 0.5
Wheeler 0.6

But the Bollard decade was a tale of two halves: far above the target midpoint for his first six years or so, and then increasingly below the midpoint by the end of the period.

All this said, I wouldn’t want to put too much weight on those numbers, for various reasons including:

  • monetary policy works with a lag.  One can’t blame Graeme Wheeler for the first 12-18 months’ outcomes during his term.  Then again, the last three or four years’ numbers aren’t much different from those early in his term,
  • this measure didn’t exist, and certainly wasn’t being used, in the Brash or Bollard years (that said, no one disputes that inflation ran above the target midpoint during their terms, for various –  different –  reasons),
  • only since Wheeler took office has the target midpoint had any formal status.  In practice, Don Brash did aim for the midpoint, and often referred to it in public communications.  Alan Bollard didn’t regard the midpoint as being particularly important, and thought (and talked) in terms only of being comfortably inside the target range (thus at times we published projections with inflation settling back to around 2.5 per cent).

The fact that inflation averaged well above the target midpoints during the Brash years often surprises people.  Don had a reputation as an inflation-hating hardliner (an “inflation nutter”), which was –  at least in some respects –  well-warranted (he could also, at times, be a political pragmatist, to the dismay of the real hardliners).   He took the targets, and the midpoints, seriously.  So why was inflation averaging persistently above target?  My story is that he – we –  never quite realised how much higher than international interest rates New Zealand interest rates needed to be to keep inflation here in check.  In today’s terms, we underestimated the neutral interest rate.  In a way that wasn’t surprising.  After the great disinflation, we expected our interest rates to converge to those of the rest of the world –  and international visitors encouraged us in that view (I well recall the day a visiting senior Australian sat in my office trying to argue that we must have policy wrong because interest rates were still so much higher than those in Australia).    That convergence has simply never proved possible –  I argue because of the interaction of high immigration and low savings, but the “why” is a topic for another day.  Everyone realises that now, but we didn’t in the 1990s.   It led us to forecast lower inflation rates than we ended up achieving, and because – in effect – we believed our model we kept making what amounted to the same mistake.

Alan Bollard’s “mistake” was different.  He came into office with a sense that Don –  and those around him –  had been too hardline, and that if only we “gave growth a chance” we could get better outcomes all round.  I suspect he really did care about unemployment. He certainly cared a lot about the tradables sector, and the rising and high exchange rate quickly became quite a constraint on what he was willing to do with the OCR  (it was something of a political constraint too).  He was probably less willing to tighten than the median of the staff advice would have been, but actually staff advice also had something of the wrong model.  People just didn’t realise how much momentum there was behind the boom, or how structural (to the interaction of population and land use regulation) the lift in house prices was.   Because of the exchange rate, Alan was unwilling for too long to contemplate taking the OCR anywhere near the (real) peaks of the 1990s, even though by most measures –  whether unemployment or capacity utilisation –  the pressure on resources was much greater.

All three Governors made what would now be generally recognised as mistakes.  Some lasted shorter than others.  We held off adopting an OCR for years too long.  In 1991 we made the now-incomprehensible mistake (I strongly supported it at the time) of trying to hold up interest rates even as the economy was falling away rapidly into a recession, on some misguided view around the interpretation of the yield curve slope.  That lasted only a matter of months.  Then there was the MCI debacle in 1997 and 1998.  And scarred by that experience, we were too quick to cut the OCR in 2001 –  responding to a US recession that never much affected us.

Alan Bollard later openly acknowledged that his interest rates cuts in 2003 had been a mistake (at the time I’d thought at least the first one was appropriate).  And in 2010 the Bank was too quick to start raising interest rates, and had to reverse itself quite quickly.

As for the (single) Wheeler term, it was dominated by the mistake of promising to raise the OCR a lot, actually raising it by 100 basis points, and then the Bank only slowly and reluctantly having to more than fully reverse itself.     Perhaps more seriously still, there has been no apparent effort to position New Zealand for the next recession, when the OCR won’t be starting at 8.25 per cent.

Some of the mistakes the Reserve Bank has made have been in company (other central banks doing similar things).  Most haven’t.  In some cases, it has been a clear example of the Governor imposing his will on the organisation –  those 2003 OCR cuts were over the advice of a majority of OCRAG –  but most haven’t.  Then again, chief executives shape organisations, recruit people they are comfortable with, and sometimes don’t really welcome the airing of alternative views.  I don’t think, with hindsight, the institution’s record has been particularly good –  and I say that as someone who was heavily involved, at times at very senior levels, for a long time.  Sadly, it doesn’t seem to be improving.

I’m reluctant to try to reach a view on whether, overall, Wheeler has been worse than his two predecessors.     After all, the circumstances the three men faced were very different:

  • Don Brash was in charge during what we liked to think of as the “heroic” phase, slaying the inflation beast that ravaged New Zealand for the previous 25 years.  But, beyond that, he –  and we –  were learning what it meant to run monetary policy in a low inflation environment.  We had few effective yardsticks –  although we were probably more reluctant than we should have been to have consulted other countries’ practices and experiences.
  • On the other hand, Don presided over monetary policy through probably the most stable period ever in New Zealand’s terms of trade.
  • Alan Bollard presided during the most dramatic financial crisis the world had seen for decades –  perhaps since 1914.  I didn’t agree with all his stances in that time –  some he himself changed quite quickly –  but in many ways that 18 months or so was his finest hour: the willingness to improvise liquidity policies and to cut the OCR again and again, in large dollops.
  • Recessions: Bollard and Brash had to cope with them (ie externally sourced ones –  1991, the Asian crisis, the dot-com bust, and 2008/09). and Wheeler simply hasn’t.
  • Different shocks: Brash presided over the period of wrenching fiscal and structural adjustment, which made much of the data harder to read.  Bollard presided during a whole new period of persistent and unexpected strength in the terms of trade (we hadn’t paid them much attention until to then) and the Canterbury earthquakes.  All three Governors have had to grapple with the toxic mix of population growth and land use regulation spilling into rising trend house prices –  but it was the Bollard years that saw the largest, and most widespread, increase in debt/GDP ratios and private sector lending more generally.
  • In his early years, Brash had to deal with a severe domestic financial crisis and the aftermath of a very damaging credit, equity and commercial property boom.  Neither Bollard (despite the finance companies) nor Wheeler had to face something similar.

But, in many ways, I’d argue that Graeme Wheeler, and the Bank he presides over, have had it relatively easy.    Over his period there has been:

  • no international recession,
  • no major overseas financial crisis (the euro crisis transitioned into chronic state around the time Wheeler took office),
  • no deeply dislocative domestic shocks,
  • a stable backdrop of global inflation,

And unlike many of his international peers, he has always had total flexibility to adjust the OCR as required (the near-zero bound simply wasn’t an issue) and there were no looming fiscal crises in the background either.

You might be surprised by the comment about stable global inflation. But here is the OECD’s measure of G7 core inflation (ie CPI ex food and energy).

CPI ex G7

Pretty stable for almost 20 years now.  Of course, within that some countries have done better than others.  And the interest rates that have been consistent with keeping inflation around these levels have fallen a long way.  But there aren’t huge inflationary or deflationary shocks from other advanced economies.  Contrast this chart with the New Zealand core inflation chart above.    And recall that, unlike New Zealand, most of the G7 countries were pushed to the absolute limits of conventional monetary policy.

It is fair to acknowledge that the recent swings in the terms of trade have been quite large –  so I’m not trying to suggest that getting monetary policy just right was easy (if it were that easy, we wouldn’t be paying a lot of people a lot of money to get it right).    But broadly speaking, a lot of things have been working in the Reserve Bank’s favour in recent years, that their peers in other countries haven’t had:

  • as already mentioned, the Reserve Bank had full OCR flexibility, and
  • an unemployment rate persistently above their own estimates of the NAIRU (a basic pointer to a demand shortfall, something conventional monetary policy can remedy),
  • high terms of trade (on average), supporting demand overall,
  • the effects of Canterbury earthquakes were quite disruptive late in Bollard’s term, but ever since Wheeler took office, they’ve been a consistent source of demand growth [NB I’m not suggesting earthquakes make us richer, but the reconstruction is a significant source of demand –  helpful if demand is otherwise scarce.] and
  • really rapid population growth (hard to forecast, but persistently surprising on the upside throughout Wheeler’s term –  the last quarter of net outflows, seasonally adjusted, ended a few days after he took office), and
  • although fiscal policy was net contractionary at the start of his term, even that has swung round to neutral or mildly expansionary more recently.

There is no reason to think it has been any harder to get things right –  forecasts and reality – than in the earlier years, and some reasons why it should have been easier to keep inflation up near target.

Non-tradables inflation, the bit the Reserve Bank has most medium-term influence over, should have been relatively easy to get up to levels more consistent with meeting the overall inflation target.  And yet, the Bank’s sectoral factor model measure of non-tradables inflation is no higher now than it was when the Governor took office.

Arguments about technological change, structural changes in labour demand, or whatever simply aren’t relevant to this conclusion.  They provide opportunities for faster growth without unduly fast inflation –  surely, broadly speaking, the goal of economic policy?  They provide the oppportunity to run the labour market a bit harder and get more people –  often people who find life a bit difficult – into employment.   In such a world, one does well –  getting inflation back to target –  by doing good.    Instead, all too often it has come to seem as though the Wheeler Reserve Bank is more concerned about house prices –  especially in Auckland – than it is about inflation or unemployment, even though –  when pushed –  they will acknowledge that monetary policy can’t do much about house prices.  And all this with no good model of house prices, and the failures of land use regulation.

So, yes, we’ve had stable (core) inflation in the Wheeler years, but stable at too low a level –  in his own words, an “unnecessarily” low levels.  He agreed to deliver it higher, and had a lot of things working in his favour to get it higher.  He wasn’t faced with rapid productivity growth –  driving prices down  –  rather the contrary.  And he was never faced with a fully employed labour market.    He simply didn’t do his job, when he easily could have.  He seemed to allow himself too readily to believe that somehow he faced the same challenges some of his peers bemoaned at BIS meetings –  when the preconditions for rapid (per capita) demand growth, a strong labour market, and inflation around target were much different here.

Would another Governor faced with the same circumstances have done differently in recent years?  We can’t really know.  There have always been some economists and commentators running a different tack but (a) as far as we can tell, most of the rest of the Reserve Bank senior officials have supported the Governor’s approach, and (b) most domestic market economists have done so most of the time as well.     It was the sort of defence we used in the Bollard and Brash years –  few ever consistently argued for tougher policy.  But it isn’t that persuasive an argument –  we charge the Reserve Bank Governor, resource him, and pay him well, to do better.

Where I suspect we can conclude that a different Governor would have done better is in perhaps the more peripheral aspects of monetary policy:

  • it is hard to believe that any other Governor would have been so reluctant to acknowledge a mistake.  Even if reluctant to accept the fact, most would have found more effective, appealing, lines to use,
  • Most possible Governors would have been much more willing to open themselves up to serious scrutiny, especially when questions around performance started arising.  Good ones would prove their competence and capability in part by their ability to engage with and deal with alternative perspectives.
  • Surely no other possible Governor would have taken the pursuit of Stephen Toplis to quite such lengths.  We know other Governors have at times expressed irritation with particular views, but that is very different from deploying your entire senior management team to attempt to close a critic down, and then when that failed  writing to Toplis’s employer – an institution the Bank actively regulates – to attempt to have him censored,
  • (oh, and other possible Governors probably wouldn’t have attempted to tar publically, in the cool light of day, someone who highlighted a serious weakness in the Bank’s systems).

It is hard not to think that a different Governor wouldn’t have produced stronger speeches – more akin to the quality one finds from Governors in other advanced countries –  or demanded, and received, more consistent depth and excellence in the quality of the analytical work underpinning the advice on monetary policy.

I’m not going to conclude that Wheeler did monetary policy worse than his predecessors –  and I will be interested to see his own arguments in his forthcoming speech –  but even considered in isolation it doesn’t look to have been a creditable record, whether on substance or on style.   That is something the Bank’s Board –  and whoever might shortly be Minister of Finance –  need to reflect on seriously, not just in identifying a specific successor, but in strengthening the institution as a whole.