Making it up

And by that title, I don’t mean to imply the semi-positive tone associated –  in a crisis –  with “making it up as they go along”, but just making it up: things that fundamentally are not so, and telling Parliament’s select committee those things.

The Governor of the Reserve Bank and two of his deputies turned up yesterday to Parliament’s Epidemic Response Committee.    There were things I was pleased to hear (including that the numbers in next MPS are likely to be primarily in the form of scenarios, rather than central views) and things I fairly strongly agreed with.

Among the latter there were obvious points such as that monetary policy can’t prevent or offset the current economic losses (many of which are discretionary policy choices anyway) but it can act to soften the blow.  And there were important points including that the financial soundness of our banks is not in any sort of immediate jeopardy and that it would take several years of unemployment well into double digits, and substantial sustained falls in asset prices, for that outlook to change (although that assumes banks aren’t pressured to take on too much more low quality new debt now).  I welcomed the observation that the IMF’s view on the economic situation is probably too rosy (but then that is almost always so in downturns).   I was sympathetic to the Governor’s view that, after any immediate rebounds in activity, a full recovery –  here and abroad – is likely to be a long and slow process, where domestic demand globally will tend to pretty subdued (I thought I heard the Governor suggest that the recovery might be even more sluggish than after the last recession –  if so, that is really bleak given that, as I noted the other day, it took five years for New Zealand’s unemployment rate then to drop by a mere two percentage points.  And I welcomed the Governor’s mention that this shock is/was a significant deflationary risk.

(There, probably more things than you’ve ever previously heard me agreeing with the Governor on in a single paragraph.)

Of course, any decent analyst could easily say many of the same things. But we don’t primarily hire Orr and his offsiders as analysts but as policymakers (and policy advisers).    And on that count, their lines yesterday came up a long way short.

Thus, when Orr began by talking about monetary policy being an “important support player” in the overall economic response, he attempted to illustrate the point by claiming that they had taken steps that ensured that “interest rates are as low as they can possibly go” and that “the exchange rate was low and competitive”.

At least some of this claim was not allowed to go unchallenged.  In particular, National’s finance spokesperson Paul Goldsmith asked the Governor about negative interest rates, including noting that even if the OCR was near zero, most retail interest rates were still materially positive.  He also asked about the pledge the MPC had made not to cut the OCR any further, referencing the Bank’s claim that “some banks” did not have systems that could cope with negative interest rates, and asking – for example –  when the Bank first became aware of this (mentioning that the Bank had repeatedly over the last couple of years talked about the possibility of negative rates).  If I say so myself, they were good questions.  Shame about the answers then.

First, the Governor claimed that they had not ruled out negative interest rates.  Of course, his own press release said they had been ruled out for at least a year –  and probably most of us would hope that the worst of this economic crisis will have passed in a year’s time.  Oh no, he said, they hadn’t ruled out negative interest rates, they had just decided to use large-scale asset purchases (government bonds) first, not having wanted to bother the banks when they were very very busy on other matters.  (Note that he never actually answered Goldsmith’s question about when the Bank first learned of the systems issues, let alone how widespread they actually are.)  Moreover, claimed the Governor, the asset purchase programme had achieved the same effective level of easing as OCR cuts might have, and that interest rates were “down significantly across the board”.    He claimed that a “shadow short rate” –  of the sort developed by their former researcher Leo Krippner and discussed in a post here –  was already “significantly negative”.   (On which note, he stated that the Bank will have a “range of new indicators” to illustrate this in next month’s MPS – which is welcome.)

It is fair to say that Paul Goldsmith did not seem persuaded by the Governor’s grand claims about the asset purchases programme was doing all that needed to be done.  He pointed out to the Governor that in typical New Zealand recessions (well, US and other ones too) short-term rates had typically fallen by perhaps 500 basis points or more (575 basis points in 2008/09) and that, on the face of it, what we’d seen so far this time was nothing remotely comparable to that.

The Governor, as is he way, pushed back boldly, claiming that he reckoned the measures they had taken to date were the equivalent of “half to two-thirds of that”.   Roughly speaking, he seemed to be claiming that what they had done to date was the equivalent of a 300 basis point cut in the OCR.   His offsider Hawkesby is a bit less given to overreach, but he claimed that “international research” suggested that an asset purchase programme of the size the Bank had announced was equivalent to 150 basis points of OCR cuts.  Even if so, that would be a total of 225 basis points……in the face of a much bigger slump, and negative output gap, than in any of the previous downturns (the 500 basis points numbers came from).

The Governor was getting a bit defensive at this point, and tried to claim that “negative rates aren’t off the table”, but fortunately wasn’t allowed to get away with that claim as one of the MPs pointed out that they had, in fact, explicitly ruled it out for a year.  In fairness, I suppose the MPC could change its mind.

(Having given credit to Goldsmith for this line of questioning, I should note that a little later a government MP –  a peripheral member of the Executive no less –  Fletcher Tabuteau also weighed in suggesting that actual negative interest rates would be much better for business right now.)

I think there is little doubt that the Reserve Bank’s large-scale asset purchase programme –  which, mostly, I support –  has acted to bring government bond yields back down again (and with them some other interest rates).  In that sense, there is probably quite a large effect in those markets.  But what that has done is to reverse a tightening in monetary conditions that got underway as assets were being liquidated globally; it is not any sort of easing relative to where conditions stood three months or so ago.

The best way to look at actual monetary conditions facing firms and households is to look at the financial prices they are actually facing.  At a retail level, the Bank publishes two monthly series that are readily updatable with public information: a six month term deposit rate and a floating first mortgage rate.

In December, before anyone in New Zealand had even heard of the new coronavirus, those interest rates were 2.63 and 5.26 per cent respectively.  As of this morning, using the data on current rates on, the big banks are offering between 2.3 and 2.45 per cent for six month terms deposits (shall we call it 2.38 per cent), and offering between 4.44 and 4.59 per cent for floating rate mortgage (call it 4.5 per cent).   In nominal terms these deposit rates have come down by 0.25 percentage points and 0.75 percentage points.  It is harder to replicate the Bank’s “SME new overdraft rate”, but by March it had come down by 0.59 percentage points.

Here, by way of comparison, is how much those three series fell from December 2007 to April 2009:

Six month term deposit rate:     -4.6 percentage points

Floating first mortgage rate:      -4.1 percentage points

SME new overdraft rate:             -2.4 percentage points

So nominal lending rates have come down to some extent.  Unfortunately, but fairly predictably, so have inflation expectations.  I often highlight the implied expectations from the government bond market, and they are now about 40 basis points lower than they were at the end of last year.  The Reserve Bank tries to avoid engaging with that series, but here is the ANZ Business Outlook survey of year-ahead inflation expectations

ANZBO infl expecs

and they are also down about 40 points since late last year.

In other words, real retail interest rates have barely changed –  those on term deposits are actually up a little, and those for loans down a little (and there have been indications that bank wholesale funding has got more expensive –  consistent with term deposit rates holding up –  suggesting banks may now be regretting passing through the full OCR cut to floating mortgage rates.

These are simply tiny effects/adjustments really to the scale of the economic slump, and the scale of the recovery challenge –  shortfalls of demand –  the Governor rightly talked about.

Or here is the secondary market yield for the last year for the government inflation-indexed bond maturing in September 2025.

IIB sept 2025

You can see the impact of the bond purchase announcement (even though that programme does not yet directly encompass indexed bonds), but the current yields are still well within the range this bond traded in over the six months from, say, August to February. Big falls back last year, but really rather tiny changes now –  in face of the biggest economic slump on record.

What about a wider range of interest rates?

Basis point change since 31 Dec
90 day bank bill -87
1 yr govt bond -85
5 yr govt bond -78
10 yr govt bond -65
1 yr interest rate swap -85
2 yr swap -85
5 yr swap -87
10 yr swap -81
15 yr swap -80

Pretty consistent across the board, but nothing like the 300 points of total easing the Governor was suggesting or the 225 points of easing Hawkesby was suggesting.  In fact, it looks a lot like what might expect if the OCR had been cut by 75 basis points and people expected it would remain low for a very long time.

By contrast, for example, 10 year government bond rates fell almost 200 basis points over the 2008/09 recession –  at a time when belief in a fairly quick snap back was still common – 5 year government bond rates fell by about 320 basis points, and 90 day bank bill rates……well, they fell by about 550 basis points.

And that episode, bad as it was, was mild by comparison to what we are confronting now.

So where is this great easing that the Governor and his offsiders tried to persuade the Committee of?  Well, as noted above, the Governor mentioned the exchange rate.  It has certainly come down, but here is a chart of the TWI for the last 20 years or so, with the last observation being yesterday’s reading on the TWI.

twi corona

The scale of the fall in the exchange rate in recent months doesn’t begin to compare with (a) the slippage in 2015, (b) the fall in early 2006, or (c) the fall to the lows in 99/00 –  each rather minor economic slowdowns in New Zealand –  let alone with the fall during the last real recession in 2008/09.    Now, sure, commodity prices are holding up for now. On the other hand, one of our major export earners has just gone to zero, and another –  export education –  is looking quite severely impaired.

The Governor is just making stuff up.  The measures the Bank has taken have led to some slight easing in monetary conditions –  real interest rates down just a little, the exchange rate down a bit too – and, importantly, have successfully prevented a temporary sharp rise in longer-term interest rates.    But there is just no way that the cumulative effect of all that has given us monetary conditions much easier than they were three months ago –  when market thoughts (and RB ones) were beginning to contemplate the next tightening.  And they’ve produced nothing like the extent of effective easing that is customary in New Zealand recessions, all of which previous ones have been materially milder than we are experiencing now.

Does it matter?  Absolutely it does. Not only should powerful government officials not be trying to spin in front of MPs, but this stuff has real consequences.  As I noted, I agree with the Governor that (a) this shock is seriously deflationary in nature, and (b) that the full recovery is likely to be slow and difficult, with demand hard to find.    But part of the reason why the full recovery is likely to be so sluggish is because central banks –  having stopped the tightening –  are now sitting on their hands doing nothing, when historically monetary policy has played a key role in bringing forward demand, and assisting the process of getting back to full employment.  In the good old days –  just a few weeks ago really –  it used to be a theme of the Governor’s, championing his spin on the new statutory mandate.

In their remarks yesterday, Bank officials indicated that their view of the relevant economic scenarios were pretty consistent with those The Treasury had published earlier this week.   But as I noted in my post on them, those scenarios have very weak inflation outcomes – and, typically, lingering excess capacity.  The Governor (rightly) confirmed yesterday that monetary policy is focused on keeping inflation moderately positive, consistent with the target (centred on 2 per cent).   But the scenarios were inconsistent with that target, and they assumed that nothing more was coming from monetary policy.  Nothing the Governor said yesterday suggested the Bank takes a different view.  The risk then is that inflation expectations continue to fall, real interest rates tend to rise, and it becomes harder and harder to engineer anything like a timely return to full employment.  That should really worry policymakers, especially the Minister of Finance who is responsible for the Bank.

I’ve highlighted previously the disconcerting parallels with monetary policy in the Great Depression.  When the Depression first hit, it wasn’t as if central bankers did nothing.  In  fact, in the US notably monetary policy was eased, within the limits of the technology and institutions as they were seen at the time.  In New Zealand –  then without a central bank – the exchange rate was allowed to depreciate a bit.  But the problem was that it took years for governments and central banks to get to the point of recognising that the needed to break the “golden fetters” (the title of Eichengreen’s classic book) and allow a much more expansionary monetary policy.  The countries that did so first –  the UK notably –  had the least bad experiences and recovered soonest.  In New Zealand it took more than three years –  and the resignation of the Minister of Finance –  before the government finally substantially devalued. It took a similar length of time before the US devalued against gold, and in the process give a decisive start to lifting the restarting demand and lifting the price level.

As the Governor noted yesterday, the Reserve Bank here is doing much the same as its peers abroad. That isn’t quite true, since several of them already have moderately negative policy rates (and negative government bond yield curves) but for these purposes it is true enough.  None of them has been willing to break the entirely self-imposed paper chains that prevent interest rates being taken deeply negative.  Unless and until they do, recovery is likely to be quite muted at best, and the risks of the advanced world becoming locked into even lower inflation will rise by the month.   Conventional wisdoms can be hard to break, but in the right crisis doing so really can make all the difference.  (Recall, here, that interest rates are simply the price the reconcilies desired savings and desired investment: desired investment having collapsed for now, and desired private savings almost certainly having risen, a negative real interest rate facing firms and households looks like a natural and inevitable balancing price in the current context –  once immediate lockdowns are past we don’t want macro policy encouraging savings for the next few years, and we do want every signal to encourage firms to consider new investments.  Hand in hand with whatever government fiscal policy can do  –  which will be limited – it is how economies get back to full employment as soon as possible.

Incidentally, in the course of yesterdays’s presentation the Bank gave its estimates of how much the GDP losses might be (relative to normal) for each level in the government’s four alert level framework.  The Treasury published their estimates earlier in the week.

Loss of GDP (%) while restrictions in place
Treasury Reserve Bank
Level 4 40% 35%
Level 3 25% 20-25%
Level 2 10-15% 10%
Level 1 5-10% 5%

The numbers are similar, although the Bank seems to be a bit more optimistic (wrongly so, in my view).

The table is probably outdated now since the new “Level 3” outlined yesterday is more akin to “Level 4-“.  But what really interested me was the gap between the Level 4 and Level 1 estimates, which are really the difference between the situation if all domestic controls now in place were removed in full, but the borders remain closed.    On these numbers, even if we went to what they are calling “level 2” now and had those sort of controls in place for the rest of this year, we’d be giving up perhaps 6 per cent of GDP  (30 per cent loss for the level 4 month, or 2.5 per cent of a year’s output, and a 5 per cent loss for the remaining eight months or 3.3 per cent of a year’s output.    In the New Zealand Initiative’s paper last week, using the Otago modelling framework, they suggested 6.1 per cent of GDP might be a price worth paying to save 33000 lives.  Ian Harrison’s paper yesterday (and John Gibson’s as well) raised serious questions about the number of lives that could have been saved only by these level restrictions.  Personally, I think all the numbers in the table above are insufficiently negative, and perhaps the slope –  from level 1 to level 4 –  is insufficiently steeep. But it is the numbers in the table that are those the government’s chief economic advisers appear to be using.