I’ve been banging on a bit about how the new(ish) Reserve Bank Governor has been enthusiastically talking about everything under the sun (mostly modish left-wing causes) in speeches and interviews, but six months into his term of office we still haven’t had a considered speech from him on any of the things he is, by law, exclusively responsible for, notably monetary policy and banking and insurance prudential regulation. It is quite an extraordinary omission. It is almost as if he isn’t overly interested in monetary policy and financial stability, which can be pretty dry but need to be done well and accounted for rigorously, preferring to use the pulpit his office provides to pursue personal political and policy agendas. The appearance of that is bad enough, let alone the reality. And then, of course, there are his meanders after the forest gods.
I stumbled yesterday on an example of what is lacking around monetary policy when a reader in the financial markets pointed out this line in a Bloomberg interview done by one of Orr’s senior managers, chief economist John McDermott, just after the last Monetary Policy Statement in August.
In current circumstances, the bank would need to see core inflation above 2 percent before it considered raising rates, he said.
I’d seen the interview when it was first published, but somehow overlooked this line. As far as I’m aware, it didn’t get much – or any – attention anywhere else either, although who knows whether in the private briefings the Bank provides to select market economists they may have explained themselves.
As it stands, it looks like – but perhaps isn’t – quite a change in the way the Bank thinks about monetary policy, but with no explanation and no elaboration.
Under the previous Governor – on whose watch, and in agreement with the Minister, the 2 per cent target midpoint was explicitly made the focus of monetary policy – the Bank’s approach would have been described as something like the following: adjust the OCR so that, allowing for the lags, a couple of years ahead (core) inflation would be around 2 per cent.
It was a forecast-based approach, and of course forecasts are often wrong. Over the last decades, forecast errors were mostly one-sided, so that core inflation ended up consistently undershooting the target midpoint. The approach recognised that the midpoint could never be achieved with 100 per cent certainty, but envisaged departures from it arising only by (less or more) inevitable accident.
The approach the chief economist is reported as articulating in that interview seems quite different on two counts:
- it isn’t forecast-based (they would need to actually see core inflation above 2 per cent before moving – bearing in mind that the lags from policy to core inflation outcomes are probably 18-24 months), and
- they would be relaxed about seeing inflation settle above the target midpoint, and not just by accident.
If that is the Bank’s new approach to policy, I would have considerable sympathy with it (although many probably wouldn’t). I’ve argued for some time that, given the limited scope to cut the OCR in the next recession, it would have been desirable to get inflation up, perhaps even a bit beyond 2 per cent, and with it inflation expectations. That, in turn, would have supported higher nominal interest rates, and provided more room to move in the next serious downturn. Given the evident difficulties of forecasting, I’ve also argued that for the time being the Bank should put relatively greater weight on what they can see now – actual core inflation outcomes – not on quite distant forecasts. Doing so would seem a rational response to the evident uncertainty about the model (how the economy and inflation process are working).
(I’d have “considerable sympathy” if this were the new policy reaction function, but would have even more sympathy if such an approach had been reflected in the Policy Targets Agreement, ie with explicit ministerial support.)
But is this really the Bank’s policy approach? We don’t know. McDermott seems set to become a member of the new statutory Monetary Policy Committee next year, but for now he is just an adviser to the Governor, and only the Governor’s view finally matters. There was no hint of such a policy approach in the last Monetary Policy Statement, or in the OCR announcement this week. And, of course, the Governor talks about everything under the sun, but has provided no sustained analysis of how he thinks about the monetary policy process.
We don’t know, and that knowledge gap matters to anyone trying to make sense of how the Reserve Bank might respond to incoming information. If core inflation now is at, say, 1.7 per cent rising gradually on current policy to 2 per cent over the next 18 to 24 months, any upside economic surprise should be expected to take the Bank close to tightening, on the old forecast-based approach focused on the 2 per cent midpoint. But if it takes actual core inflation to be above 2 per cent before they think about moving, near-term surprises would have to be very large – with direct and immediate core inflation implications – to make much difference at all to policy judgements.
If the new Governor has made such a change of approach, he’d have my full support – for the little that matters. But whatever his actual approach, we are well overdue receiving a proper explanation from him as to how he – in whom so much power is vested by law – is thinking about monetary policy and the appropriate reaction function.
As part of that, we are overdue a good sustained explanation about how he is thinking about handling, and preparing for, the next serious downturn (beyond rather complacent, even glib, answers about there being lots of tools at his disposal).
It might all interest the Governor less than climate change, the (alleged) failures of capitalism, or idly lecturing people on the insufficiently long-term perspective they take to this, that or the other issues. But it is the job he has taken on, and the Bank has liked to boast (not very credibly or convincingly) about how transparent it is. A clear statement about how he thinks about monetary policy, not just as this or that particular OCR review, but in general, and in the context of the longer-term risks around the next downturn, would actually rather nicely fit with his emphasis on more long-term thinking. Or is that lecture just for other people?