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.