Why the OCR should be cut substantially

I’ve seen a few people on Twitter, typically not economists, casting doubt on the case for an OCR cut.  Twitter isn’t really a suitable medium for serious engagement on the substance of such issues, so here is a short(ish) post, articulating a case that (I suspect) will seem pretty obvious, on most counts, to most readers.  I almost wrote the title to that post as “why the OCR should have been cut substantially”, but actually, and even though I thought the cut should have come in February, the actual announcement matters less than the confident expectation that the right thing will be done at the next scheduled opportunity.  Markets largely trade on expectations, even if short-term retail rates mostly move on announcements themselves.  Right now, it is the Bank’s talk –  see my last two posts –  that bothers me more than that the OCR is still at 1 per cent.

Why should the OCR be cut substantially?

  • because inflation expectations have already been falling (reflected in the bond market and in the ANZ business survey) leaving short-term real interest rates higher than those at the start of the year.   Faced with the facts of this year in early January, no one would have prescribed higher real interest rates as part of the appropriate policy mix.
  • almost certainly neutral short-term interest rates (consistent with being at the inflation target with full employment) have fallen considerably in recent weeks/months.  A useful way of thinking about monetary policy is that it needs to involve at least keeping pace with changes (estimated only) in the short-term neutral rate.   How large has that change been?  Well, one low-end estimate could be obtained by looking at the inflation-indexed government bond market.  Very long-term interest rates won’t be much influenced by how much markets think the Reserve Bank will do this month or next.  So take the 20 year indexed bond and the 10 year one, and you can back out an implied 10 year real interest rate for the ten years 2030-2040.   Even that yield has fallen by 30 basis points since the end of last year, and most everyone would expect coronavirus no longer to be much of a factor.  For the five years from 2025 to 2030, the implied real yield has also fallen 35 basis points.
  • add these sharp falls in long-term real rates to the drop in inflation expectations, and then bring the next year or two into the mix, and it is pretty easy to mount a case for a 100 basis point cut in the OCR.  (In fact, if we were starting with an inflation target centred on 5 per cent and an OCR of 4 per cent (instead of 2 per cent and 1 per cent) almost certainly that is what would have happened by now.  In periods when there is a very sharp fall-off in activity, or a huge surge in uncertainty, you cut the OCR early and decisively.  I suspect fear –  the limits of conventional monetary policy and a lack of conviction in the limited unconventional instruments –  is probably afflicting more than a few central bankers, not just in New Zealand, making them nervous of the limits being shown up.)  If the OCR was roughly in the right place at the last review pre-coronavirus, it is simply inconceivable it should now be anything like as high as it was then.  And yet it is.
  •  a common argument is that an OCR cut won’t do much to demand now.  And I agree. In fact, in some respects it isn’t even obvious we should want to boost some forms of domestic demand now –  more people going out socialising etc.  The scale of the disruption and dislocation we will face in the next few quarters is almost entirely independent of what monetary policy does (any monetary policy effects will be swamped by the scale of the real shock).  But it will, all else equal, ease debt-servicing burdens for both firms and households –  and you’ll have noticed that binding cashflow constraints is one of the prominent themes under discussion at present.   Consistent with the previous point, time has very little value now (materially less than a few months ago) and, at the margin, people (savers) shouldn’t be rewarded for that time, borrowers (on floating rates) shouldn’t be paying for it.   Will people say that is tough on retired savers?  I’m sure they will.  But, tough.  There is huge income loss underway, and “valid” returns to financial savings are just lower than they were for the time being.  It won’t last for even, but it is some of the loss-sharing that needs to happen.
  • looking ahead, whenever the worst of the crisis is over lower interest rates will do the usual job monetary policy does and support a recovery as fast as feasible.  And we shouldn’t wait and cut then for at least two reasons:
  • the first is the exchange rate.  All else equal a lower OCR will lower our exchange rate (failure to lower the OCR will tend to hold it up).  International trading conditions have become very hostile in aggregate and a lower real exchange rate is a natural and normal part of the buffering process.  And despite Christian Hawkesby’s claim (in his interest.co.nz) that the exchange rate is now low, the extent of the fall so far is small by the standards of typical New Zealand recessions: we aren’t getting any interest rate buffering and we aren’t getting much exchange rate buffering either.
  • the second is about inflation expectations.  Core inflation is likely to fall. Headline inflation is also likely to fall (oil prices).  Inflation expectations have already fallen and are likely to fall further.   When interest rates are getting near the feasible lows, the only prudent thing to do is to act aggressively to leave no doubt in anyone’s mind –  markets or public –  that the authorities are doing everything possible to keep core inflation near 2 per cent.  If they don’t convince people, the road to recovery will be harder and slower.  It was the very argument the Governor was using briefly last year when he noted that the risks were such he’d rather inflation ended up above 2 per cent than risk that downside trap.
  • we can still cut materially.  The ECB can’t do much on that score at all, and several other advanced countries are also very constrained.   But we can.  We need to for ourselves, and we also do our (little) bit for the world.
  • it is what you do with a significant adverse demand shock.  In fact, in a standard Taylor rule guidance, it is even what you do with supply shocks that raise the unemployment rate relative to the NAIRU (as this one certainly is) –  I thank an academic for reminding me of this further hole in the Bank’s reasoning.
  • other countries have.  Not all of them – even those who could –  but the UK, Australia, the US, and Canada have.  Perhaps they are wrong, but they are all experiencing very similar shocks, and it is a bit hard to see why Adrian’s judgement on this would be so much superior to those of his peers.  Wisdom of crowds and all that.
  • there is no conceivable downside to cutting the OCR aggressively now.  We aren’t starting with core inflation even at target, let alone above.  In fact, it hasn’t been at or above for a decade.  So at worst, the lower OCR has no effect at all on anything above (very unlikely, since at very least it will alter servicing burdens in a useful, slightly stabilising way).  Or, it works remarkably and astonishingly well, so much so that core inflation surges above 2 per cent.  After the record of the last decade and the threat to expectations, I can only really accentuate the Governor’s message from late last year and say “if so, bring it on”.
  • OCR cuts are easy to reverse when/if warranted, not relying to anything like the same extent as most temporary fiscal measures do on having a secure view of the period over which support will prove to be needed.  It should barely need saying, we have no idea of that now.

And I haven’t even mentioned tightening credit conditions, rising risk spreads, rising cost of equity capital etc.  It really is one of those times for “all hands to the pump”, even recognising that come what may the economic times ahead are going to be difficult and costly and any macro (or microeconomic) policies are going to make only a limited  – but better than nothing – difference for now.

I was just re-reading the post I wrote on the morning just prior to the last OCR decision, making a quick summary case for a cut then.   Most of it still reads pretty well, even if –  like everyone (well, certainly every economist) then, I was grossly underestimating the severity of just what was –  and is – still unfolding.


Almost literally unbelievable

Our central bank that is.

Except that I had to believe it.  The Governor himself was being quoted again in a Stuff article and the video footage of a full interview with his deputy (on the economics and markets side) Christian Hawkesby was on interest.co.nz.

On Tuesday, as I wrote about in my post yesterday, we had the Governor telling us that monetary policy would have no more than a supporting role –  despite being the main cyclical stabilisation tool – that there would be no “knee-jerk reactions”, that we were in “a good space” and  –  perhaps most incredibly of all –  that “confidence and cashflow will win the day”.  Confidence that had tanked, cashflow that was rapidly becoming a problem for many.  It was –  or one really wished it was –  unreal.

But Orr and Hawkesby –  both statutory officeholders charged with the stabilisation role of monetary policy –  were back at it yesterday.  Clearly, the Governor’s voice is most important –  especially with no deep or authoritative figures elsewhere on the MPC –  so we’ll take his new comments first.

Not all of it was silly.  There was the standard advice to firms to talk to their banks early (I imagine that, where they still can, firms might be well advised to draw down any credit lines early too).  But then we get lines like this

Reserve Bank governor Adrian Orr has advised businesses to focus on things they can influence and banks to consider their “social licence” and play a long game to bridge the gap in activity created by the coronavirus pandemic.

“That is it all it is, just a gap,” he said.

Talk about minimisation.  If a firm takes a deep hit to its revenue for six or nine months, and has fixed commitments it can’t get out of at all, and other semi-fixed commitments, what was a viable business can quickly run through any remaining collateral and not be viable at all (the underlying business might be, but not the existing owners).  So sure it is a “gap”, but it could be a mighty big one, with quite uncertain horizons for anything like normality returning.

Most especially because the Governor –  like the Minister of Finance – gives no hint of recognising that the worst  (probably a lot worse) is yet to come.

(And what about that strange suggestion that firms should focus on what they can influence?    What they can’t, really at all, influence is what is likely to be worrying most, more so by the day.)

But the interview goes on

He said he did not believe there was a perception that the bank had been slow to respond to date.

Instead, there were benefits in the central bank getting more information about how consumer and investor behaviour was unfolding and the response of global governments, he said.

“While some talk about ‘what is your interest rate response?’, at times like this central banks have a much broader and important role which is around financial-market functioning and financial institution stability,” he said.

“There, we certainly aren’t sitting on our hands, watching, worrying and waiting.

“We are on high alert around how the financial markets are operating and our role in the provision of liquidity.”

I guess he isn’t reading much of anything –  unless he now has his media clippings selected only for their favourability to him –  if he really believes that first sentence.  Perhaps the case for an OCR cut at the MPS was borderline, but there were plenty of sceptics even then as to whether their talk was taking things seriously enough.  And I haven’t seen many people who thought has remarks on Tuesday were appropriate, responsible, timely, or whatever.  In the meantime, central banks in Australia, the US, Canada and now the UK have acted.

But it was the rest of that quote that really staggered me –  the claim that the Bank had a “much broader and more important role” in this situation around market functioning and financial institution soundness.  Again, what planet is he on?   No one, but no one, believes the coronavirus shock’s economic effects are primarily a financial stability issue.  Really severe recessions could in time generate significant credit losses, but that is well down the track (for banks of our sort).  In things to do with the Bank this is primarily a severe adverse shock to demand (almost wholly a demand shock for New Zealand so far, something neither Orr nor Hawkesby seem to grasp).  These are the guys who go on and on about their new employment-supporting mandate.  Lots of jobs are being lost right now, and will be over the coming weeks and months.   There may be other things governments can/should do, there may be other stuff other wings of the central bank need to focus on, but monetary policy is their macroeconomic business, the tool that can be deployed quickly and flexibly, and which has been in every past crisis.  But Orr and Hawkesby seem to prefer to sit on their hands and gather more information (of the gathering of information in fast-moving, exponential, crises there is no end).

Before coming back to Orr’s final comments, I add some remarks on Hawkesby’s interview.

Assistant Reserve Bank Governor Christian Hawkesby says the RBNZ’s main focus at this point of the coronavirus crisis is making sure the banking system remains strong.

Echoing comments Governor Adrian Orr made on Tuesday around confidence and cashflow being key, Hawkesby said the RBNZ is looking at how funding markets and banks’ relationships with their coronavirus-affected clients are holding up.

“That’s really our first point of call and our main focus – at least in these initial stages,” he told interest.co.nz.

Much the same themes, but how utterly irresponsible.  No sense of his responsibility as a (statutory) monetary policymaker, explicitly charged with a macrostabilisation role.  Doubly so because, as he goes on to acknowledge (and unlike, say, Italy)

“We have a well-capitalised banking system and a well-funded banking system.”

So try looking under the right lamp-post for issues that need to be addressed.

Hawkesby, like Orr on Tuesday, hosed down expectations of large, if not emergency, Official Cash Rate (OCR) cuts in the immediate future.

He said the government could move with more haste than the RBNZ, targeting those most affected by coronavirus.

He also claimed it was “early days”: early days was a month or six weeks ago, when the Bank was doing its MPS forecasts.  This is now a full-throated downturn –  where even the local banks are now talking, belatedly, of recession.

And what of that nonsense about the government being able to move faster.  Not only is it generally not true –  OCR decisions can be taken and implemented almost instantly –  but on this occasion neither party has actually done anything yet.   In  fairness to Hawkesby when I listened to the interview he seemed to be trying to make a point that sectoral issues are better targeted with sectoral policies, but that doesn’t really help him this time, as he went on to say

Hawkesby said: “What we need to think through is, to what extent is it [coronavirus] a supply-side issue around supply chains; around specific sectors being affected – in which case monetary policy can’t provide direct help.”

He said monetary policy would be useful if there is a spill-over effect and a lack of demand and confidence across the economy.

Perhaps he missed the data release on Tuesday showing that business confidence had fallen to levels last seen in 2009.  And when you are talking about the temporary collapse of one of our largest economic sectors –  overseas tourism –  you are dealing with pervasive effects that really only macro policy can do much to lean against.

It is almost as if these guys think they are running some sort of academic seminar, rather than being alert to real world developments –  here and abroad, including monetary policy responses abroad.  Whatever the explanation –  and no one seems to have a good one, they are just failing to do the basics of their job.  In none of any of that was there any mention of the idea that (at least temporarily) neutral interest rates will have plummeted –  the fall in very long-term bond yields is probably a bare-minimum estimate of how much –  and that much of the job of monetary policy is keeping actual short-term rates in line with shifts in neutral.  These guys would appear to prefer to do nothing, even as real retail interest rates are rising. (I’m sure they will move, perhaps quite a lot, as spiralling global crisis will produce a lot of reality to mug them with in the next couple of weeks.)

Oh, and as in the Governor’s remarks on Tuesday, there was nothing in either interview about the threat to inflation expectations. They are falling around the world, and in New Zealand –  seen in the bond market and in the ANZ business survey.  As I noted towards the end of yesterday’s post, it is a strange omission, because only a few months ago both Orr and Hawkesby were dead-keen on emphasising downside risks to inflation expectations and making the case for pro-active least-regrets monetary policy adjustments.  Good and sensible quotes from both of them are included in this post from late last year.    Not sure what happened to those central bankers.  The threats/risks must be much greater now.  But it all fuels a sense that these guys are just out of their depth, with no consistent mental models or sense of the world (or this event) found especially wanting by a crisis.

By contrast there was good workmanlike speech on coronavirus economic issues yesterday by Guy Debelle, Deputy Governor of the Reserve Bank of Australia, Hawkesby’s direct counterpart.  It was what serious normal central banking looks like.

But I wanted to come back to Orr’s final comment in his Stuff interview.

The coronavirus was a reminder of why policies such as the Reserve Bank’s decision to increase the capital requirements of the major banks and to ensure they could operate on a standalone basis had been pursued, Orr said.

“We try to implement them in peace time, because it is hard to implement them in war time – not that I am saying we are in war time.”   

He probably should get his lines sorted out with his deputy: you’ll recall that Hawkesby quote that, at current levels before any of the increased capital requirements take effect, we have a “well-capitalised” banking system.   Which is what the Bank’s demanding stress tests have always shown, and what numerous serious critics pointed out in the consultation process last year.

But even if we take Orr’s comment in isolation, he seems not to recognise at all that whether his announced higher capital requirements made sense in some long-run steady-state, they will have some adverse effects on the availability of credit, rates of investment etc through the transition period.  Orr confirmed that capital requirements in December and they are to be phased in over seven years.   Unfortunately, the beginning of that transition period – when bank behaviour is already being affected (and we saw this in the last credit conditions survye months ago – the next one, presumably taken this month, will be fascinating) – happens to coincide with the nastiest economic shock we’ve had in a long time.   But, at present, no bank’s capital ratios will be any higher now than they would have been if Orr had seen sense and not proceeded (so there is none of the additional buffer he is implying).   As it happens, reported capital ratios  –  though not of course actual dollar capital – would drop before long, because the change to the rules around aligning minimum risks weights for iRB banks with the standardised rules is being frontloaded.

And while no one could foresee that we’d have a severe pandemic shock this year, Orr was warned of exactly this sort of issue: in a climate with little conventional monetary policy capacity, sharply increasing capital requirements over a period when a new recession was fairly probable at some point would simply compound the real economic and economic policymaking challenges.  This was from my submission

Finally, in this section, there was no discussion at all of the macroeconomic context in which these proposals would take effect.  The proposals involved a transition over five years.  Nine years into an economic recovery, with slowing domestic growth and growing global risks there has to be a fairly significant chance that the next significant recession will occur in the next five years (i.e. during the proposed transition period).  That means a significant risk that regulatory policy would be exacerbating any downturn (through tighter credit constraints, reduced credit appetite, and potential higher pricing), in a downturn in which monetary policy is likely to be hard up against conventional limits (the Bank’s own analysis has suggested the OCR might be able to be cut only to around -0.75 per cent).  Of course, if bank balance sheets were looking shaky it would be prudent to move ahead anyway – better ten years ago, but if not then now – but nothing in the Bank’s published analysis (past FSRs, stress tests, consultation document) nor in the credit ratings of the relevant institutions suggests anything like that sort of vulnerability.  Without it, you will – with a reasonable probability – make economic management over the next few years more difficult (additional upfront potential economic costs), in exchange for the modest probability of making any real difference to (already very low) financial system risks over that period. It isn’t a tradeoff that appears to be worth making – at least not without much more supporting analysis than we have had to date.

I’ve seen no sign Orr or his colleagues ever engaged with this point.

And before passing on, don’t overlook this bit from Orr

“not that I am saying we are in war time”

Relentlessly determined to minimise just what is going on and the extremely challenging period –  of indeterminate length –  we are now entering.

But whatever should have been, the new capital requirements are what they are.

There is some discussion as to whether it might make sense to suspend implementation of the new requirements.  In the UK, the Bank of England last night released their Countercyclical Capital Buffer (an element of their capital requirements).  More generally, people are looking at the merits of some regulatory accommodation.

For now at least, I have to say I’m quite sceptical, at least in New Zealand (and I noticed Hawkesby suggested these were conversations for well down the track).  Sure, capital is there to be used as loan losses mount (which, of course, they haven’t yet).  But it is always worth remembering how important expectations are to behaviour –  for bank/bankers as much as anyone else.  So, sure, Adrian Orr could suspend the implementation of the higher requirements, but why would that materially alter the attitude of banks to taking on additional risk?  After all, the Governor tells us this is just “a gap”, but even when reality finally mugs him, the banks –  and their parents in Australia –  will know that the Governor is still sitting there waiting to resume the steady escalation in capital requirements as soon as some modicum of normality returns.   I’m not going to oppose suggestions of a temporary suspensionm but I doubt there would be much bang for the buck in doing so, at least while Orr is still Governor.

It really has been a reprehensibly bad performance so far in this crisis from the Governor, his monetary policy deputy, and the Monetary Policy Committee as a whole (all of whom must, for now, be presumed to be on board – although will the next OCR decision be the first time someone on MPC is willing to record a dissent?).  Looking to the statutue books, you might have been hoping that the chair of the Bank’s board and/or the Minister of Finance –  both responsible for the Governor and the MPC –  would be demanding something better, but I’m not holding my breath about either of them.

There are, of course, more ultimate statutory provisions.  They won’t be used.  But the case is mounting that the Governor, the Bank, Hawkesby, and (as far we can tell) the external ciphers on the MPC simply are not doing their monetary policy job.  It is an utter failure of leadership, something we are now seeing far too much of at the top levels of government as this crisis deepens.  We are paying for unserious appointments, weakening public institutions, in the quiet times.