700 years of real interest rates

When I mentioned to my wife this morning that I’d been reading a fascinating post about 700 years of real interest rate data her response was that that was the single most nerdy thing I’d said in the 20 years we’ve known each other (and that there had been quite a lot of competition).   Personally, I probably give higher “nerd” marks to the day she actually asked for an explanation of how interest rate swaps worked.

The post in question was on the Bank of England’s staff blog Bank Underground, written by a visiting Harvard historian, and drawing on a staff working paper the same author has written on  bond bull markets and subsequent reversals.    It looks interesting, although I haven’t yet read it.

Here is the nominal bond rate series Schmelzing constructed back to 1311.

very long term nom int rates

And with a bit more effort, and no doubt some heroic assumptions at times, it leads to this real rate series.

very long-term real rates.png

Loosely speaking, on this measure, the trend decline has been underway for 450 years or so.   It rather puts the 1980s (high real global rates) in some sort of context.

In the blog post the series is described this way

We trace the use of the dominant risk-free [emphasis added] asset over time, starting with sovereign rates in the Italian city states in the 14th and 15th centuries, later switching to long-term rates in Spain, followed by the Province of Holland, since 1703 the UK, subsequently Germany, and finally the US.

In the working paper itself, “risk-free” (rather more correctly) appears in quote marks.  In fact, what he has done is construct a series of government bonds rates from the markets that were the leading financial centres of their days.     That might be a sensible base to work from in comparing returns on different assets –  perhaps constructing historical CAPM estimates –  but if US and West German government debt has been largely considered free of default risk in the last few decades, that certainly wasn’t true of many of the issuers in earlier centuries.  Spain accounts for a fair chunk of the series –  most of the 16th century  – but a recent academic book (very readable) bears the title Lending to the borrower from hell: Debt, taxes, and default in the age of Philip II.  Philip defaulted four times ‘yet he never lost access to capital markets and could borrow again within a year or two of each default’.  Risk was, and presumably is, priced.  Philip was hardly the only sovereign borrower to default.  Or –  which should matter more to the pricing of risk –  to pose a risk of default.

In just the last 100 years, Germany (by hyperinflation), the United Kingdom (on its war loans) and the United States (abrograting the gold convertibility clauses in bonds) have all in effect defaulted – the three most recent countries in the chart.  Perhaps one thing that is different about the last 30 or 40 years is the default has become beyond the conception of lenders.  Perhaps prolonged periods of peace –  or minor conflicts – help produce that sort of confidence, well-founded or not.

I’m not suggesting that real interest rates haven’t fallen.  They clearly have. But very very long-term levels comparisons of the sort in the charts above might well be concealing as much as they are revealing.    They certainly don’t capture –  say –  a centuries-long decline in productivity growth (productivity growth really only picked up from the 19th century) or changing demographics (again, rapid population growth was mostly a 19th and 20th century thing).  And interest rates meant something quite different in an economy where (for example) house mortgages weren’t pervasive –  or even enforceable – than they do today.

As for New Zealand, at the turn of the 20th century our government long-term bonds (30 years) were yielding about 3.5 per cent, in an era when there was no expected inflation.  Yesterday, according to the Reserve Bank, the longest maturity government bond (an inflation-indexed one) was yielding a real return of 2.13 per cent per annum.    Real governments yields have certainly fallen over that 100+ year period, but at the turn of the 20th century New Zealand was one of the most indebted countries on the planet  whereas these days we bask in the warm glow of some of the stronger government accounts anywhere.  Adjusted for changes in credit risk it is a bit surprising how small the compression in real New Zealand yields has been.

The Robertson reviews of the RB Act

When you’ve favoured a reform for the best part of 20 years, and made the case for it –  inside the bureaucracy and out –  for several years, then, even though it was a reform whose time was coming eventually, there is something deeply satisfying about hearing the Minister of Finance confirm that legislative change will happen.    That was my situation yesterday when Grant Robertson released the terms of reference for the review of the Reserve Bank Act, including specific steps that will before long end the single decisionmaker approach to managing monetary policy.   Various Opposition parties had called for change (the Greens for the longest), market economists had favoured change,  The Treasury had tried to interest the previous government in change five or six years ago, before Graeme Wheeler was appointed.  But now the Minister of Finance has confirmed the government’s intention to introduce legislation next year.   The amended legislation won’t be in place before the new Governor takes office, but presumably the policy will be clear enough by then that the new Governor will know what to expect, and what is expected of him or her.  Reform was overdue, but at least it now looks as though it will happen.

There were several aspects to yesterday’s announcement from the Minister of Finance:

  • the new “Policy Targets Agreement”,
  • the two stage process for an overhaul of the Reserve Bank Act, and
  • inaction on the appointment of the new Governor.

In what looks like not much more than a photo opportunity, Grant Robertson got Grant Spencer, current “acting Governor” of the Reserve Bank over to his office and together they signed a “Policy Targets Agreement” that was, in substance, identical to the one Steven Joyce and Grant Spencer had signed in June.

There was no legal need for a new Policy Targets Agreement (even if either of these two documents had legal force, which they don’t), and no incoming Minister of Finance has ever before requested a new PTA (the Minister has to ask, and can’t insist) that is exactly the same as the unexpired one that was already in place.   When National came to power in 2008, they did ask for a new PTA.   The core of the document –  the obligations on the Governor –  weren’t altered, but they did replace clause 1(b), which describes the government’s economic policy and how the pursuit of price stability fits in.  Under Labour that had read

The objective of the Government’s economic policy is to promote sustainable and balanced economic development in order to create full employment, higher real incomes and a more equitable distribution of incomes. Price stability plays an important part in supporting the achievement of wider economic and social objectives.

National replaced that with

The Government’s economic objective is to promote a growing, open and competitive economy as the best means of delivering permanently higher incomes and living standards for New Zealanders. Price stability plays an important part in supporting this objective.

If the new Minister of Finance really thought a new PTA was required to mark his accession to office, surely he could have at least replaced the National government’s policy description with one of his own –  even simply going back to Michael Cullen’s formulation, which actually mentioned full employment.

Apart from the photo op, I’m not sure what yesterday’s re-signing was supposed to achieve.  The Minister presented it as providing certainty to markets, but it does nothing of the sort: we are in the same position now we were a couple of days ago, Robertson had already told us he wouldn’t make substantive changes until the new Governor was appointed and we still have no idea who that person will be, or what the precise mandate for monetary policy only a few months hence will look like.  Nor, presumably, does the Reserve Bank.

And by signing the document, Robertson seems to have bought into Steven Joyce’s “pretty legal” (but almost certainly nothing of the sort) approach to the appointment of an “acting Governor”.    As I’ve noted previously, the Reserve Bank Act does not provide for an acting Governor except when a Governor’s term is unexpectedly interrupted (death, dismissal, resignation or whatever), and –  consistent with this –  there is no provision in the Act for a new Policy Targets Agreement with an acting Governor (since a lawful acting Governor will only be holding the fort during the uncompleted term of a permanent Governor who would already have had a proper and binding PTA in place).    Spencer’s appointment appears to have been unlawful, and Robertson has now made himself complicit in this fast and loose approach to the law.   Consistent with the fast and loose approach, he allowed Spencer to sign yesterday’s Policy Targets Agreement as “Governor”, not as “acting Governor”.  He cannot be Governor, since under the Act any Governor has –  for good reasons around operational independence – to have been appointed for an initial term of five years.  And he isn’t acting Governor, since there is no lawful provision for him to be so in these circumstances.  At best, he is “acting Governor” –  someone purporting to hold that title.

The heart of yesterday’s announcement, however, was the two stage process for reviewing and amending the Reserve Bank Act.

Phase 1:

The review will:
• recommend changes to the Act to provide for requiring monetary policy decision-makers to give due consideration to maximising employment alongside the price stability framework; and

• recommend changes to the Act to provide for a decision-making model for monetary policy decisions, in particular the introduction of a committee approach, including the participation of external experts.

• consider whether changes are required to the role of the Reserve Bank Board as a consequence of the changes to the decision making model.

A Bill to progress the policy elements of the review, including on the details necessary to introduce a potential committee for monetary policy decisions, will be introduced as soon as possible in 2018. This will give greater certainty on the direction of reform in advance of the appointment of the next Reserve Bank Governor, currently scheduled in March 2018.

Phase 1 of the review will be led by the Treasury, on behalf of the Minister of Finance. The Treasury will work closely with the Reserve Bank who will provide expert and technical advice. An Independent Expert Advisory Panel will be appointed by the Minister of Finance to provide input and support to both phases of the Review.

Phase 2:
In line with the Government’s coalition agreement to review and reform the Reserve Bank Act, the Reserve Bank and the Treasury will jointly produce a list of areas where further investigations of the Reserve Bank’s activities are desirable. This list will be produced in consultation with the Independent Expert Advisory Panel.

This list, and the next steps for the review, will be communicated early in 2018. This phase of the review will incorporate the review of the macro-prudential framework that was already scheduled for 2018.

It is clearly intended as a pragmatic approach.  With a new Governor to take office in March, they want to get on with the specific changes Labour campaigned on  so that they come into effect as soon as possible after the new Governor is in office (realistically, it is still hard to envisage the new Monetary Policy Commitee making OCR decisions and publishing Monetary Policy Statements until very late next year –  perhaps the November 2018 MPS – at the earliest.)  It also appears to aim to separate the things on which the government mostly just wants advice on how best to implement changes they’ve promised, from other issues that may need looking at but where the parties in government have not taken a strong position.

But it still leaves me a little uneasy, on a couple of counts.

First, while it would be easy enough, after due consideration, to make limited changes to the Act to give effect to the desire to make explicit a focus on employment/low unemployment without many spillovers into the rest of the Act (I listed here a handful of clauses I think they could amend to do that),  I’m less sure that is true of the monetary policy decisionmaking provisions.    As the terms of reference note, if monetary policy decisions are, in future, to be made by a statutory committee, it raises questions about the role of the Bank’s Board –  whose whole role at present is built around the single decisionmaker (the Governor has personal responsibility for all Bank decisions not just monetary policy ones).

But how can you sensibly make decisions about the future role of the Board without knowing what changes (if any) you might want to make to the Bank’s other functions?  If, in the end, you leave all the other powers in the hands of the Governor personally, something like the current Board structure might still make sense, with some minor changes as regard monetary policy decisions.  But if you concluded that a statutory committee was also appropriate for financial stability issues, and that even the corporate functions should be governed in more conventional ways (Board decides, chief executive implements), there might be no place at all for a Board of the sort (ex post monitoring and review agency) we have now.    Decisions about the governance of an institution need to start by taking account of all the responsibilities of the institution, not just one prominent set of powers.

Second, it may be difficult to maintain momentum for more comprehensive reform once the government’s own immediate priorities have been dealt with.    On paper, it doesn’t look like a problem, but resources are scarce, legislating takes time and energy, implementing new arrangements for monetary policy takes time and energy, and it would be easy for momentum on the second stage to lapse (whether at the bureaucratic level, or getting space on the government’s legislative agenda).    That risk is compounded by an important distinction between phases one and two.    In phase one, the Treasury is clearly taking the lead, on behalf the Minister.  In phase two, we are told, “the Reserve Bank and the Treasury”  (the order is theirs) will “jointly” produce a “list of areas where further investigations of the Reserve Bank’s activities are desirable”.    A joint list raises the possibility of the Bank holding a blocking veto –  not formally, but in practice –  and where the Bank is more interested in (a) blocking other far-reaching changes that might constrain management’s freedoms, and (b) advancing whatever list of minor reforms it might have in mind itself.

Perhaps in the end much will depend on the Minister himself, and on the Independent Expert Advisory Panel he plans to appoint.  But the Minister of Finance will be a very busy man, and up to now he has shown little interest in reforms of the Reserve Bank legislation beyond the first stage ones.

What of the panel?  We’ll know more when we see what sort of people are appointed to it, and how much time they are being asked to give to the issue.

In a set of Q&As released with yesterday’s announcement the Minister indicated of the panel that “they will be individuals with independence and stature in the field of monetary policy, including governance roles”.   That is probably fine for phase one (which is monetary policy focused), but the bulk of the Bank’s legislation, and much of its responsibility, has nothing to do with monetary policy at all.  So if the panel is going to play a substantive role in the planned phase 2, I’d urge the Minister to consider casting his net a bit wider.

As to who might serve on it, there aren’t that many with what look like the right mix of skill, experience, and independence.  It is sobering to reflect that when the (still secret) Rennie review on related issues was done earlier in the year, not a single domestic expert was consulted.  I imagine they will want to draw mainly on people who actually live here.  But if possible, I would urge Treasury and the Minister to consider inviting Lars Svensson to be part of the panel –  as someone who has undertaken a previous review for an earlier Labour government, someone who supports an explicit employment focus, and someone with practical experience as a monetary policy decisionmaker.    David Archer – a New Zealander (and former RB senior manager) who now heads the BIS central banking studies department – might also be worth drawing on.

The third dimension of yesterday’s announcement was the Minister of Finance’s comments about the process for appointing a new Governor.    There I think he is making a mistake.

In his Q&As, the Minister noted that “the process for appointing a new Governor is in the hands of the Board”.

Newsroom reports that, when asked, Robertson noted that

“I’ve met with the chair of the board and he has assured me that process is underway and well under way and going well. I sought an assurance from him that any candidates he was interviewing would be ones who would be able to implement a change to policy along the lines we’re going, he expressed his confidence about that but in the end the process itself lies in his hands.”

Appointing a new Governor of the Reserve Bank is –  or should be –  the most consequential appointment Robertson will make in the next three years.  For a time that person will, single-handedly, wield short-term macro-stabilisation policy (which is what monetary policy is) and –  perhaps indefinitely –  will wield all the regulatory powers of the Bank.  Even if committees end up being established for both main functions, the Governor will have –  and probably should have –  a big influence on how, and how well, macro and financial regulatory policy is conducted over the next five years.

There has been a pretty widespread sense that the Reserve Bank in recent years has not been operating at the sort of level of performance –  on various dimensions –  citizens and other stakeholders should expect.  That isn’t just about substantive decisions, but about supporting analysis, communications, operating style etc.  And yet the Reserve Bank Board –  and chairman Quigley –  have backed the past Governor all the way (whether on minor but egregious issues like the attempts to silence Stephen Toplis, or on the conduct of monetary and regulatory policy).   But the new government claims to want something different.   The issue isn’t whether a potential candidate can, as a technical matter, manage the sort of phase 1 changes the Minister plans.  I’m sure any competent manager could.  The more important issues are around alignment and vision.  Is the Minister content to leave the process to the Board –  all appointed by the previous government – and take a chance on them coming up with someone who represents more than just the status quo?   At this point, it appears so.  Apparently, the selection process will not be reopened, even though the advertising closed months ago and the role of the Bank (and Governor) is to be changed.

It is quite an (ongoing) abdication by the new Minister. In (almost all) other countries, the Governor of the Reserve Bank is appointed directly by political leaders (Minister of Finance, head of government or whoever).   Those leaders no doubt take soundings in various quarters, but the power –  and the responsibility –  rests with the politician.   Here, Grant Robertson just rolls the dice –  relying on a bunch of private sector directors appointed by his predecessors –  without (it seems, from the tone of his comment above) a high degree of confidence in the outcome.  Perhaps he’ll like who the Board comes up with. But if he doesn’t, so much time will have passed that he’ll be stuck. He can reject a Board nomination, but they’ll just come back with the next person on their own list, evaluated according to their own sense of priorities etc.  It isn’t the way appointments to very powerful positions –  the most powerful unelected person in the country for the time being –  should be done.

And two, very brief, final points:

  • now that the government has changed, and the Minister who asked for the Rennie review of Reserve Bank governance issues has gone, surely there can be no good grounds for continuing to withhold Rennie’s report and associated papers?  It is not as if it is playing any role in the current Minister’s thinking.

    Newsroom also asked Robertson if he had seen a review of the bank undertaken by former State Services Commissioner Iain Rennie that was requested by former Finance Minister Steven Joyce.   He said he was yet to see it, but had asked Treasury about it.

  • we are told to expect a new Policy Targets Agreement when the new Governor is appointed.   Presumably, true to past practice, the first the public will know about it is when the document –  guide to macro-management for the next five years –  is released.    It would good if the Minister of Finance would commit now to proper transparency, including pro-active release (once the document is signed) of  relevant documents.  It would be better still if he would think about adopting the considerably more open, and rigorous, Canadian model.

    Less than a year since completing the last review of its inflation-targeting mandate, the Bank of Canada is starting to prepare for the next one in 2021.

    Consultations kick off in Ottawa on Sept. 14 with an invitation-only workshop of economists that will be webcast on the central bank’s website. It’s an early public start to the process, and comes amid a growing sense that a deeper look at the inflation target is needed after almost a decade of poor economic performance.

A more open approach to these issues – as practised in Canada for years – has much to commend it (even if I didn’t always think so when I was a bureaucrat.)