Massive losses, for nothing

All sorts of items of public spending have attracted attention since March 2020 when the Covid-related spending really began. Some of the things money has been spent on – the wage subsidy for example – were large but necessary and appropriate. Some things, often quite small in scale, were pure waste. Others were dressed up under a Covid label but were really just poor-quality (but quite large scale) spending.

One of the items that has had almost no attention is the huge losses that have resulted from the Reserve Bank’s Large Scale Asset Purchase (LSAP) programme. I guess it is a bit harder to report on, since neither the Bank nor the government puts out press releases boasting of losing $4bn or so.

The government has, with no parliamentary authorisation or scrutiny, agreed to idemnify the Reserve Bank for any losses it incurs on the LSAP. That, at least, has the merit of encouraging/requiring some transparency. On the Reserve Bank’s balance sheet there are two line items, show in this chart

LSAP indemnity claims

To be honest, I’m not quite sure what the orange line is, since as I read the indemnity the liability is one-way only (Crown pays Bank if Bank loses) but it looks like it may reflect periods early on when the LSAP bonds were valued at more than they had been purchased at (lower yields than is). In any case, it is irrelevant now as the remaining number is tiny. The blue line – the Bank’s claim on the Crown – is where the focus should be. That claim was almost $4 billion at the end of September, and nominal yields have risen further this month.

Since the Bank discloses all its purchases, in principle someone could go through and identify the losses on each and every purchase undertaken over the period (more than a year) that purchases were undertaken. But for our purposes here, suffice to say that government bond yields are a lot higher than they were. Here are few medium-long term government bond yields

govt bond yields

Recalling that bond prices move inversely with yields, September/October last year would have been a great time to have been selling bonds (top of the market and all that). But the Reserve Bank went right on buying more bonds (albeit at a slower pace), all of which will now be valued at less than the Bank paid for them. They were still buying (lossmaking) government bonds right through the June quarter – when core inflation was already above the target midpoint, and unemployment was back at pre-Covid levels – not finally stopping the purchases until mid-July.

Accounting for the LSAP isn’t simple. In some quarters, there is a tendency to say “well, since the bonds are (almost) all government bonds and the Bank is owned by the government it is all a wash, and nobody is any the worse off”. That is simply wrong, as I will demonstrate shortly.

But it is also wrong to simply look at the indemnity claim (blue line in the first chart above). If all the bonds were held to maturity – in some cases 19.5 years from now – the indemnity claim would come back closer towards zero (since, whatever the market value of a bond now, eventually it will pay the full face value). But it would also be quite wrong to deduce from that correct observation that if only the bonds are held long enough no one is any worse off. Bottom-drawing doesn’t address the issue. (It is worth noting that a few of the bonds the Bank purchased have already matured).

Instead, we need to think about what difference has been made to the overall Crown finances as a result of the independent choices of the Reserve Bank and its Monetary Policy Committee. Assume the rest of the government would have made exactly the same choices they did – spending, taxes, bond and Treasury bill issuance- and assess the marginal financial impact of the Bank’s choices and actions.

The government, of course, did quite a lot of spending and quite a lot of borrowing through the course of the Covid crisis. The Reserve Bank publishes tables of the monthly influences on settlement cash (deposits banks hold at the Reserve Bank). There is a weirdly long lag (for data which really should be available next day), but for illustrative purposes between March 2020 and August this year the government issued domestic debt (bonds and bills) on market, net of maturities, that raised $73.2 billion of cash. Over the same period, its cash outgoings exceeded cash revenue by $33.6 billion. In other words, the government issued a great deal more debt than the net spending it needed to fund. As a result, the balance in the government’s account at the Reserve Bank went up sharply. The balance used to be kept just modestly positive, but this is how things have unfolded since the start of last year.

CSA balance

Mostly the government issued so much debt because it expected to need the cash. Tax revenue came in a lot stronger than the fiscal forecasts had allowed, as the economy rebounded more strongly than forecast (and inflation came in stronger than forecast). But the debt issuance plans were about fiscal policy. As it happens, the Crown ended up issuing a lot of debt earlier than it needed to, at yields that were mostly attractive. The gain to the taxpayer arises from the fact that the bonds were issued last year at, say, 0.5 per cent rather than this year (or next year?) at 2 per cent.

But as far as the Reserve Bank was concerned, all that was a given.

And, incidentally, it is also why a large part of the huge increase in the size of the Reserve Bank’s balance sheet since Covid began is also a given, largely outside the Bank’s control.

When the government overfunds (raises more than its net outgoings) all else equals that reduces the balances commercial banks hold at the Reserve Bank. The net of tax payments, settlement of bond purchases, and government disbursements results in money flowing from the private sector (who bank with commercial banks) to the Crown.

But when Covid began, aggregate settlement cash balances held by commercial banks were about $7 billion, and had been so for some years. A net $40 billion drain to the Crown (see numbers above) needed to be funded somehow.

In normal times, if there were to be a persistent drain it would typically be countered by (funded by) a large buildup in the stock of short-term Reserve Bank loans to the financial system (typically fx swaps or repurchase agreements. Those loans would be rolled over quite often, until the underlying imbalance (government borrowing more than it needed to) was remedied. Doing so would have been pretty much of a wash all round: the Bank would be paying something like the OCR on the Crown Settlement Account, and earning something close to the OCR on its short-term collateralised loans. There would have been little or no market risk or credit risk (the loans would have been well-collateralised) and short-term interest rates would have been kept near the OCR. Most likely, the Bank would have made a small profit (monopoly provider of settlement cash is a position of some strength).

But nothing like this happened.

Instead, we had the LSAP. Now, to be clear, the LSAP was not launched with the intention of filling a hole in system settlement cash. No doubt at the time the Bank assumed that the government would, more or less, be borrowing as required to fund its own deficit, and that if anything, borrowing might be a bit less than the deficit at least while the programme was scaled up (recalling the global bond market illiquidity pressures in March 2020). The Bank’s primary intention – this isn’t a matter of dispute – was simply to lower market interest rates, buying bonds and driving (as they expected) a long way up aggregate system settlement cash balances. Had the government more or less funded just what it was spending over the last 18-20 months, then all else equal settlement cash balances now would be a lot higher than the $37 billion they were last Friday. Recall too that the Bank changed its policy in March 2020 such that all settlement cash balances – without limit – now earn the OCR (previously there was a quota system in which the Bank really only fully remunerated banks for the balances they “needed” to hold for interbank settlement to operate smoothly).

The intent of the policy was to take a big punt on interest rates (that is why they sought and obtained a Crown indemnity). The intent was to buy tens of billions of dollars of long-term fixed rate bonds to which the counterpart would be tens of billions of floating rate settlement account deposits. The Bank initially expected that all those deposits would be held by banks, but because the government overfunded the real counterpart is now in the much-increased balance in the Crown settlement account. But it was a large scale asset swap, which would turn very costly if bond yields went up rather than down. It represented a staggering amount of market risk, assumed by unelected (and not very accountable officials) on a scale with no precedent in New Zealand central banking history.

Views will differ on whether the LSAP made (or is still making) any material sustained difference to (mainly) long-term government bonds rates, and whether even if so that made (or is making) any material difference to New Zealand macroeconomic outcomes. I’ve been consistently somewhat ambivalent on the former, although my reading of the international experience with QE leaves me fairly sceptical. But since long-term interest rates do not matter in the transmission mechanism here in a way they do in (in particular) the United States – since very few fix mortgages for more than a couple of years, and most corporate borrowing is swapped back to floating – I’ve been consistently sceptical that the bond-buying programme (heavily focused at the long end) was making any material macro difference (the more so once the Bank decided to pay OCR on all settlement cash balances, actively preventing one possible transmission mechanism from working). Even if I did – which I do not concede at all – that usefulness ended long ago now (given what we know of the subsequent inflation outcomes and the push to raise the OCR quite aggressively now).

Whatever useful macro impact the Bank might sought last year – simply exploring the hypothetical – could as readily have been achieved by cutting the OCR further, including into modestly negative territory. And using that mechanism would not have involved big financial risks for the taxpayer

And instead now they are stuck with tens of billions of dollars of bonds, many with very long-term maturities, sitting on the Bank’s balance sheet, while the cost of funding (the counterpart liability) looks set to rise quite rapidly further.

In the end, what the MPC has done in effect is to neutralise or reverse the gains the Crown would otherwise have made through the good luck (mostly) of issuing so heavily last year when interest rates were so low, over and above what they were spending then. The Crown will borrow less in the next (more expensive) couple of years and the CSA balance wil no doubt over time be returned to more normal levels. Because more than all the excess bond issuance was, in substance, reversed through the Reserve Bank’s action, bringing tens of billions of long-term bonds back onto the wider Crown balance sheet. If they were to sell the bonds now (or in a scheduled programme over the next couple of years) the loss would be crystallised. That might be a good thing, to help sharpen debate and accountability. But whether the bonds are sold back now or held to maturity, the loss has already occurred. (This is not to say that rates might not go lower – perhaps even much lower – again in future, but that is just another bet at the expense of taxpayers, and no more likely than that bond yields rise further from here, deepening our (taxpayers’) losses.

But it as well to keep the choices by two parts of government separate, reflecting the different sets of decisionmakers. In borrowing as it did (and probably largely by luck re the revenue rebound) the government’s overfunding programme saved taxpayers a lot of money (for which there is no line item in the government accounts). By contrast, the Reserve Bank’s choices — quite conscious and deliberate ones – have cost the taxpayer a great deal of money.

The LSAP simply was not necessary, and it clearly was not well thought through. If there was an arguable case for some action in March 2020, that need quickly passed, and any bonds purchased then could relatively easily have been offloaded back to the market – probably at a profit (crisis interventions should generally be profitable) – by late last year. One might blame the Minister of Finance for providing the indemnity, but the main responsibility rests with the (supposed) technical experts at the Bank and on the MPC (albeit appointed by Robertson). It has cost us billions of dollars already – a $4bn loss is $800 per man, woman, and child, and most families could think of better things to do with such money – and the Bank now sits with a huge open market risk position, the value of which fluctuates by the day.

Having outlined my story – on which I will welcome comments – it is worth pondering why this hasn’t been an issue elsewhere or previously. A lot of bonds have been purchased by central banks in the decade after the 2008/09 crisis. Most likely there will have been two reasons. The first may be around transparency. It is great that we have the indemnity claim is reported each month.

But the much bigger factor must surely have been the continuing decline in global bond yields over the decade. This chart shows long-term bond yields for some of the more significant places where central banks reached effective lows on policy interest rates and engaged in large-scale asset purchases.

long bonds

When yields just keep trending downwards, having built up a portfolio of long-term bonds is (a) profitable, and (b) much less likely to be controversial. Who knows how much this was a subconscious backdrop to Reserve Bank (and Treasury/Minister) thinking here.

Finally, throughout this post I have treated government and Reserve Bank choices are separable and assumed both parties would have done what they did pretty much regardless of what the other did (around debt issuance and bond purchases). That seems sound for the most part, although the extent of the Crown overfunding is such that it is conceivable that without the LSAP – pouring huge amounts in settlement accounts – pressure (including from the Bank) might have mounted on the government to wind back the borrowing programme more aggressively than it did. But even if there is something to that argument, it is unlikely it would have become salient for several months – it took quite a while for the extent of the economic rebound to be fully appreciated, and by that time the bulk of the LSAP purchases had already been done.

As for where to from here, the losses from the LSAP have already occurred – the mark to market estimates largely capture that – but that is no excuse for the Bank continuing to maintain a large open position in the bond market. The bonds can’t be offloaded very quickly, but there is no reason not do so in a steady predictable preannounced way over the next year or two (say $2 billion a month). Given the extent of the CSA balance, there could even be merit in considering a partial government repurchase of the LSAP portfolio (say half of it). Doing that would not change the substance, but would put duration choices around the public debt and overall Crown liabilities back more nearly where they belong, with The Treasury and the Minister of Finance.

The Money Illusion

Or to give the book its full title, The Money Illusion: Market Monetarism, the Great Recession and the Future of Monetary Policy.

I was engrossed in the 2008/09 recession – and the associated financial crises – at the time it happened, as an official at the New Zealand Treasury, and it must have been very early in the piece that I started reading Professor Scott Sumner’s then new blog, also The Money Illusion. I’m not a regular reader now, but found much of what Sumner had to say about the conduct of monetary policy – mostly in the US – stimulating and thought-provoking, even (perhaps especially) when I didn’t end up agreeing. So I was keen buyer when his 400 page book appeared.

It is an interesting mixture of a book – partly textbook, partly personal intellectual autobiography, and partly a tract championing a different approach to policy (and history). It would be well worth reading for anyone interested in monetary policy, with a particular focus on the recession of 2008/09 and it aftermath, and possible reforms for the future. Were I an academic teaching a monetary economics class I’d encourage all my students to read it (and have commended it to my economics-student son), not as replacement for a textbook but as a practically-oriented complement to it.

I usually read books of this sort with a pen in hand. But flicking through the book again I see that the pen was hardly deployed at all in the first 60 per cent of the book, which is a really clear and useful introduction to how the monetary system works, through a slightly different lens than most will be used to. If I didn’t agree with it all – and there were a few straw men tackled – people coming to grips with the system and concepts and history will almost inevitably see things more clearly for having read it. It is an achievement in its own right.

The second part of the book is focused much more on the policies adopted, mostly by the Fed, in 2008/09, and on the way ahead (bearing in mind that the big was largely finished before Covid, although I doubt the thrust of Sumner’s arguments would have been much changed by the experience of the last 18 months). And it is there I start to differ (and thus have lots of marginal notes).

It isn’t, I think, that we differ that much on how the economy works (or even how monetary policy works). Like Sumner I’m a champion of the potency of monetary policy. It can’t make countries rich, or solve things like New Zealand’s decades-long productivity failure, but it can – and should – do all it can to keep the economy as fully-employed as (labour market regulation etc makes) possible consistent with keeping inflation in check. It really matters, given the pervasiveness of sticky wages and prices in the economy. Sumner’s previous book, on the US experience of the Great Depression, was a really nice illustration of both the potency of monetary policy, and the way that misguided regulatory interventions (in that case much of the New Deal) can mess up economic performance.

And I’d also endorse two of his specific criticisms of choices the Fed made in 2008.

The first was the failure to cut official interest rates at the FOMC meeting a couple of days after the Lehmans failure. I think everyone – including Bernanke – now recognises that it was a mistake, but it really was an almost incomprehensible one. The justification was that the FOMC saw the risks of higher inflation as balancing the risks of lower growth. Now, as I noted in my post yesterday, headline inflation in September 208 was high – oil price effects mostly – but it is still hard to see how smart people could have reached the conclusion that a cut in the Fed funds rates was more risky than sitting tight. There was, for example, nothing disconcerting about the medium-term inflation outlook revealed in the breakevens in the government bond market (and by this time the Fed had already cut the Fed funds rate by quite a lot over the previous year. This is, of course, consistent with one of Sumner’s themes: central banks really should be taking more of a lead from market-price indications (which embody more wisdom and perspectives than a few dozen economists in any central bank can, and – he hopes – with less risk of (eg) groupthink).

It was a bad call. But in isolation it can’t have mattered much. After all, the FOMC went on to cut over the next couple of months, reaching their (self-identified) floor in December 2008.

The second questionable call was the move to pay interest on excess reserves held at the Fed (“settlement cash” in New Zealand parlance). I’ve written about this move in an earlier post, reviewing a book by George Selgin. This step was taken to stop short-term interest rates falling further…..in the depths of the most serious recession in decades…..by underpinning the demand for (willingness to hold) settlement cash. Selgin argued that this move deepened and extended the US recession – an interpretation I challenged in the earlier post – but it certainly dramatically changed any relationship that had previously existed between money base measures and wider nominal variables (nominal GDP, inflation, or whatever) – one of Sumner’s points – and did nothing to assist in getting inflation and activity back on course. (Our Reserve Bank made a similar decision last March, moving to pay the OCR on all settlement cash balances and thus underpinning short-term rates, at a time when the Bank also thought it needed to do massive bond-purchasing programmes.)

And while Sumner constantly (and rightly) cautions about simplistic reasoning from price changes, one of his other points about this period – and how the Fed was too slow and unaggressive in its approach – is how surprising it was to see real interest rates trending up over much of 2008. Discount the extreme surge if you like – though Sumner will argue that changes in market prices like that (tied in with risk aversion, market illiquidity) probably in any case support monetary easing – but that real yields were higher in January 2009 than in January 2008 does not sit that comfortably with a story of an aggressively-easing Fed.

TIPS 08

(At the time New Zealand had only a single indexed bond, then with about 7 years remaining to maturity. Yields on that bond did not start falling until November 2008, even though the economy had been in recession all year.)

But there is a tension in Sumner’s book. At least early on there is a sense that he thinks the Fed could have avoided the recession together if only they’d done a better job, but the specific failings he explicitly highlights cannot credibly have been large enough in effect to have avoided the recession (and further on in the book he notes that they might only have dampened the severity of the recession, which is a much weaker – and harder to test – claim).

In many ways his starting point is that the responsibility of a central bank is (or should be) to manage nominal spending in ways that avoid big and disruptive fluctuations (which often involve recessions, and sometimes exacerbate periods of banking stress). I have no particular problem with that. I still prefer something like inflation targeting (at least in countries like New Zealand and Australia) as the operational form that responsibility takes, while Sumner now prefers nominal GDP targeting (preferably in levels form, but in growth rates still better than nothing.

His bolder claim seems to be that if there is a recession – and he makes explicit exceptions for one where, as in March 2020, governments temporarily close down economies/societies – it is the fault of the central bank. And that is a step far too far for me. He might be right that in an ideal world no one would ever unconditionally forecast a recession, since they would also forecast that the central bank would take the steps required to forestall it. And so he might be right to say that neither the housing bust nor the associated financial crisis caused the US recession – central bank failure to react in time did – but that seems to me to simply assume away the problem, in a way that there are no easy or quick substantive or technical fixes for.

Here is a chart of US nominal GDP growth (note, as we see it now, not as people first saw it at the time).

us ngdp

Sumner thinks the Fed should aim to keep nominal GDP on a path consistent with about 5 per cent annual growth. Clearly that did not happen in 2008/09. Nominal GDP fell by more than 3 per cent in the worst 12-months and (consistent with then policy) there was never a later overshoot to get back on that 5 per cent annual growth levels track.

Here is a similar chart for New Zealand (from the low inflation era)

nz nom GDP

Our nominal GDP path is a lot noisier than that of the US – commodity price fluctuations are a key reason why NGDP targets are not a good idea for New Zealand (or Australia) – but you can see how much nominal GDP growth fell away in the two recessions (1997/98 and 2008/09) – and actually in the double-dip recession in 2010 too. Broadly speaking that doesn’t count as a successful outcome – but then nor does the real GDP recession, the rise in the unemployment rate, and (the extent of) the sharp fall in the core inflation rate.

But here’s the thing though. Had Alan Bollard – then the sole decisionmaker – been presented with credible forecasts at the start of 2008 that nominal GDP growth was going to go negative over the coming year, I have little doubt that he would have been prepared to cut the OCR sharply (he wasn’t exactly an anti-inflation hardliner). But he wasn’t. Not just from the internal forecasters, but from the wider forecasting community or the financial markets. Inflation breakevens weren’t plummeting, long-term real interest rates weren’t falling, the exchange rate wasn’t falling much (as late as May 2008 it was still higher than it had been at the end of 2006). The share market was falling back but (a) the New Zealand share-market wasn’t very representative of the wider economy, and (b) few if any one in New Zealand has ever put much weight on local share prices as an indicator. The Bank did not cut early or hard enough (and I was one of Bollard’s advisers until August 2008 and although I was one of those more focused on global risks I wasn’t recommending deep early cuts)….but we did not have the information on which to do so. I would argue that no one did. In a sense, it was the point of that period…..for a very long time no one understood quite how bad some of the lending had been, or who was exposed, or what the macro consequences (absent monetary offset) would be.

From all I read or saw of the US at the time, and since, I don’t think anyone in the US did either. It wasn’t as if the Fed was totally blind: they had been taken by surprise in 2007, but actually starting cutting in September (you can see in the chart above, nominal GDP growth was beginning to slow).

Could the Fed or the RB have done better? Almost certainly (some identifiable Fed mistakes above), but it is inconceivable that they could have prevented the recession – not because the techniques weren’t there, but because the information and understanding wasn’t.

One of my criticisms of Sumner’s book is that he largely avoids this issue, and more or less assumes much more was achievable over 2008/09 (the issues re the recovery are different but note that in NZ and in the US markets were often keener on tightenings than either central bank – and Sumner urges paying more attnetion to market prices). An example of what I have in mind is his treatment of Australia.

We are told that

Among all the developed countries, Australia was the one with that sort of devil-may-care attitude, and it breezed through the Great Recession with only minor problems. And yet from a conventional point of view the Aussies did the least aggressive monetary stimulus. Unlike most other developed countries, they did not cut interest rates to zero.

He goes on to present a table showing that average nominal GDP growth in Australia for 2006 to 2013 was much the same as in the previous decade (unlike the US and the euro-area).

And yet….the RBA was still raising interest rates into 2008 (I recall a conversation at a conference in early 2008 at which a very senior RBA figure expressed astonishment at what the Fed thought it was doing keeping on cutting), the RBA ended up cutting by 425 basis points, there was a huge fiscal stimulus, and yet here is the Australian nominal GDP growth chart.

aus nom GDP

And yet look how much nominal GDP growth fell away in that downturn (a bit more than in the US). And it wasn’t as if there were no real consequences, with the unemployment rate rising 2 percentage points.

I’m not saying it was a bad performance…..it might even have been about as good as the authorities could have managed. But that is sort of the point. Limitations of knowledge, understanding etc…..not just in central banks, but much more broadly.

I could go on, exploring some of this points and Sumner’s specific policy prescriptions in more depth. But this post has probably gone on long enough already. He favours targeting a futures contract on nominal GDP, which may be a reasonable idea (at least in the US context), but it isn’t going to change the basic problem around knowledge. In countries like New Zealand (as Sumner notes) something like an aggregate wages series would probably make more macroeconomic sense (but would have its own political problems). I’m all for using monetary policy aggressively, but there are limits to what short-term stabilisation can be hoped for, no matter the indicator, the specific target, the instruments, or the individuals.

(Rather than labour points about nominal GDP targeting, I’ll link to some remarks I made on the topic at a conference a few years back.)

Good books make you think, and think harder. The disagreements are often where the most value lies in forcing one to think harder about one’s own view. This one is worth reading and reflecting on. And I’m going to finish where the book does with a quote I endorse (even if a bit more relevant in the US than here):

In other words, the goal is a world in which policy makers don’t view fiscal stimulus or the bailout of bankrupt firms as a way of “saving jobs”, but rather as a sort of crony capitalism that favors one sector over another.

But there will still be recessions, real and nominal.

Inflation and monetary policy

No posts here for a while as I’ve been bogged down in trying to make sense of some events – little more than one week in history – from 30 years ago, where the uncertainty as to what actually happened (a precondition for making sense of what the events mean) is greatly magnified by really poor documentation and recordkeeping by….the Reserve Bank.

I was planning to return with something a bit more longer-term (perhaps tomorrow) but wasn’t yesterday’s inflation number interesting? It seems to have taken almost everyone – notably the people who do detailed components forecasts, including the Reserve Bank – by surprise to some extent.

Almost all the media focus has been on the headline number – 2.2 per cent increase for the quarter, 4.9 per cent for the year – because (I guess) it makes good headlines. (Excluding the two quarters when the GST rate was increased) it was the largest quarterly increase since June 1987 – an unexpected rise of 3.3 per cent, at a time when the Bank thought inflation was falling away, and when the Bank’s chief economist, Grant Spencer, was interviewed about the number that night he declared himself “flabbergasted”. That one number helped prompt an overhaul of, and marked improvement in, the Bank’s short-term inflation forecasting (not previously much of a priority).

But in annual terms, it is only 13 years since we had an inflation rate about this high. It was 5.1 per cent in the year to September 2008, a rate that may be beaten when the next CPI number is released in January, since last December’s (relatively modest) 0.5 per cent quarterly increase will drop out of the annual rate. Note that in the September 2008 quarter, the Reserve Bank had already (and appropriately) started cutting the OCR.

But my main interest is in core inflation. There are all sorts of different measures, from simple ones (useful for cross-country analysis at least) like the CPI ex food and energy, through varying degrees of complexity (and occasionally even special pleading by the people constructing them). For New Zealand though, my favourite measure – and the one the Bank openly favoured for some years (it is less clear how the current Governor and MPC see things) – is the sectoral factor model measure of core inflation. It was developed a decade or so ago by one of the Bank’s researchers, and initially got little attention even inside the Bank (mostly because the Governor and his advisers on the then Official Cash Rate Advisory Group were not really advised of it). I’ve been something of a lay evangelist for this measure ever since I realised it existed, and had some small role in getting this explanation of the measure published. The gist of what is going on is this

The sectoral factor model estimates a measure of core inflation based on co-movements – the extent to which individual price series move together. It takes a sectoral approach , estimating core inflation based on two sets of prices: prices of
tradable items, which are those either imported or exposed to international competition, and prices of non-tradable items, which are those produced domestically and not facing competition from imports.

Using very disaggregated data, it is an attempt to get at the systematic elements in the annual inflation numbers, recognising that tradables and non-tradables can be influenced by different systematic influences (notably the exchange rate in the case of tradables).

But the best argument for the series has been its usefulness – in some sense it “works”, telling useful stories, not subject to much revision, about what is going on in ways that square with what is going on with other things (notably capacity pressures, but also expectations) that are thought likely to be important influences on the trends in inflation, abstracting from the noise.

And the “noise” can be considerable. Here is annual headline inflation and the annual sectoral factor measure for the period since 1993 (as far back as the sectoral factor measure has been taken).

core oct 21

Big deviations have not been uncommon (although less so in the last decade), and spikes in headline inflation have never (yet) foreshadowed a commensurate increase in core inflation (as,say, stickier prices caught up with more flexible prices). If you did want a prediction of where core would be 12-24 months from now, historically today’s core inflation has been a much less bad (far from perfect of course) predictor than today’s headline inflation.

And so from here on I’m focusing solely on the core inflation measure. There are a few observations worth drawing from simply this chart.

First, the range in which core inflation has moved over 28 years has been 1.1 per cent to 3.5 per cent. And although the inflation target was centred on 1 per cent until the end of 1996 and 1.5 per cent until September 2002, the low in the series wasn’t then, but in late 2014 (a time when, curiously, the then-Governor was raising the OCR).

Second, over the 28 years not much time has been spent very close to the midpoint of the respective target range. In fact, the median gap between the core inflation estimate and the target midpoint has had an absolute value of 0.7 per cent over the history of the series. As it happens, yesterday’s core inflation estimate was 2.7 per cent, 0.7 percentage points above the target midpoint.

Third, for the first 15 years of the series core inflation was almost always at or above the target midpoint, and for the decade until last year it had been consistently below.

Now it is worth pausing here to note that prior to about 2012 the Reserve Bank (a) did not have the sectoral factor measure readily available to policy advisers, and (b) was not explicitly required to focus on the target midpoint. However, neither point really diminishes the usefulness of such comparisons because (a) sectoral core inflation was simply trying to put in a single measure something the Bank had constantly thought and written about since inflation targeting began, and (b) if Alan Bollard was personally disinclined to give much weight to the target midpoint, Don Brash certainly was (and revealed evidence – see those sectoral factor numbers from 2014 – suggests that Graeme Wheeler was more focused on where he thought in principle the OCR should be heading than on the target midpoint.

There are a couple more relevant observations. First, core inflation now (2.7 per cent) is about the same as it was (2.6 per cent) in the last year or so of Don Brash’s term (2001/02), and back then the target midpoint was 1.5 per cent, not the 2 per cent the Bank is now charged with. And, second, core inflation is still well below the 3.4/3.5 per cent seen in late 2006 and throughout 2007.

But perhaps the change in the inflation rate has been unusually sharp.

I put this chart on Twitter yesterday before the Bank published the sectoral core numbers.

core change

On the series now published, the sectoral core inflation rate rose by 0.3 percentage points in the latest quarter (so large but not exceptional). However, this sort of model is prone to end-point revision issues – new data leads the model to, in effect, res-estimate which recent prices moves were systematic and which were not. The previous estimate for sectoral core inflation for the year to March 2021 was 2.2 per cent. But that has now been revised up to 2.4 per cent. I don’t have (but the Bank should really publish) a database of historical real-time estimates, but a change from a previous estimate of 2.2 per cent in the year to March to one of 2.7 per cent for the year to June is likely to have been large by any standards.

What about changes from year to year? Again, I don’t have a real-time database, but here is how the annual rate of core inflation has changed from that a year earlier.

change in core

What we’ve seen so far – on current estimates which are subject to revision – is not exceptional. The rise in the rate of core inflation over the last year has been less than we saw around the turn of the century, and the magnitude of change is less than than the fall seen over 2009. But it isn’t a small change either.

When (last quarter, per the Bank’s published estimates) annual core inflation was estimated at 2.2 per cent, I was prepared to say (and did) that that rate of core inflation was unambiguously a good thing, given the target the government had set. After a decade of core inflation below the target midpoint, it was good to finally see an outcome on the other side, which would help to underpin medium-term expectations near the goal set for the Bank. That was doubly so because 2.2 per cent inflation went hand in hand with an unemployment rate right back down to pre-Covid levels (4 per cent) and probably pretty close to the NAIRU (itself a rate the Bank can’t meaningfully do anything about). I’d not have been uncomfortable with a core inflation rate going a bit higher still – not as a desired outcome, but not something to be too bothered about for a short period (as the MPC raised the OCR, which works with a lag). 2.7 per cent is somewhat less comfortable.

But quite a lot might have depended on where the unemployment rate (or other measures of excess capacity) was going. There have been two previous troughs in the unemployment rate. The first was in the mid 1990s, when the NAIRU appeared to be around 6.2-6.5 per cent. Core inflation reached its cyclical peak then at much the same time unemployment dropped into that range, and showed no signs of going higher. The second was just prior to the 2008/09 recession, when the unemployment rate was in the 3.4-3.9 per cent range. Core inflation had risen as the unemployment rate fell, but core inflation was not going higher in 2007, nor was it forecast to into 2008. In both cases, the Reserve Bank had been raising interest rates (or allowing them to rise) and things stayed more or less contained (before core inflation fell away in the two following recessions).

One of the great unknowns now is how things might have unfolded here without the Delta outbreak and the ongoing restrictions and lockdowns. We will get the HLFS numbers for the September quarter early next month, and the unemployment rate there is unlikely to have been much affected yet by the lockdowns etc. Most likely, the unemployment rate will be lower than 4 per cent, but how much?

But the outbreaks and restrictions did happen, and so even if the unemployment rate for the September quarter was in fact 3.6 or 3.7 per cent, it probably isn’t safe to assume anything of the sort as a December quarter starting point. Yes, most likely economic activity will eventually rebound when controls are finally lifted but (a) there isn’t the fresh policy impetus there was last year, and (b) for those who believe in house prices stories, the worst of this particular house price boom has most likely passed. It isn’t implausible that the unemployment rate for December and March could be back at or above 4 per cent.

What does it all mean for policy? No doubt the MPC is feeling vindicated in having raised the OCR at the last review, even amid the-then extreme Covid uncertainty, and even though the MPC is likely to have been very much taken by surprise by yesterday’s core inflation number. Absent Covid there was a strong case for a robust tightening of monetary conditions – reversing the LSAP bond purchases, ending the funding for lending programme, and getting on with OCR increases – and that case would have been considerably strengthened by yesterday’s outcome.

Perhaps fortunately, the MPC does not need to make another OCR decision until late next month, and that review will come with a full MPS which will allow them space to provide some careful and considered analysis of their own. We might hope that by late next month, something close to normality has returned or is on the brink of returning. There are no guarantees, but if that is the situation, the MPC should be starting to sell off the bonds, and ending the FfL programme (most likely they will do neither), and should probably still be considering seriously a 50 basis points OCR increase (albeit with one eye on the emerging China slowdown). We were told they had considered the option in August. There isn’t a need for panic or headless-chookery about the Bank having lost the monetary policy plot. But a fairly robust response does seem likely to be warranted next month, especially as the MPC has (most unwisely) scheduled decision dates in a way that gives them a long summer holiday with no OCR review at all in December and January.

Finally, I have been highlighting for a long time how the market-based indications of inflation expectations (from the indexed bond market) had consistently undershot the target midpoint for some years. Yesterday’s data seems to have prompted a move to (or above, depending on maturity) 2 per cent for the first time in a long time. That isn’t concerning – rather the contrary – but it will be worth keeping an eye on how those spreads – the breakevens – develop over the period ahead.

Monetary policy, expectations etc

I’ve been reading a few books lately on aspects of monetary policy, and might come back to write about some or all of them. But there has been quite a bit of discussion recently – on economics Twitter, and blogs – about a new working paper from a senior Federal Reserve researcher, Jeremy Rudd.

Judd’s paper runs under the title “Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?)”, which seems like a worthwhile question, especially at the moment when – and especially in the US – debates rages as to how just how transitory (or otherwise) the recent surge in inflation rates will prove. It is common to hear central bankers opining about how much may turn on whether these higher headline rates get into (alter, affect) the expectations about future inflation of firms and households.

If you come at these things from a New Zealand perspective, the most remarkable thing about the paper is probably that it was published at all. How well I recall getting rapped over the knuckles, with severe expressions of disapproval from Alan Bollard, when I used a quiet New Year’s Eve in the office a decade ago to write a short discussion note, circulated in that form only among a dozen or so senior colleagues, in which I had the temerity to suggest that we might consider advancing the case for a legislated Monetary Policy Committee. Not exactly radical stuff, given that it was the way most countries did things (and NZ now does things). When somewhat later word of the paper got out – a Treasury official who had a copy mentioned it in a reference in a paper that was OIAed – the Bank insisted on fighting all the way to the Ombudsman (where the Bank won) to prevent release. Sceptical perspectives on LVR restrictions, before they were put in place, were equally unwelcome, even internally. And when I say “unwelcome”, I don’t mean anything of the sort of “interesting arguments, but I’m not persuaded because of x, y, and z”, but much more of a “back in your box” sort of thing.

And both of those examples are just about internal circulation. I’m pretty sure that no Reserve Bank analyst, economist, researcher or the like has ever published anything that made the hierarchy even slightly uncomfortable in the entire 31.5 year history of the modern (operationally autonomous) Bank. Consistent with that, of course, even though we now have a Monetary Policy Committee with non-executive members, it operates totally under the thumb of the Governor and nothing of a diversity of view is ever heard. The contrast to, say, the Bank of England, Sweden’s Riksbank, or the Federal Reserve is stark.

I don’t want to appear all starry-eyed and naive here. Every institution – every central bank – has its limits, and even the more-open places seem to be quite a bit more open than they were. But it is inconceivable that anything like Rudd’s paper could have been published by the Reserve Bank, even though in many respects it is much less radical than some commentary has tried to suggest, or than the tone Rudd affects on page 1, with his

Economics is replete with ideas that “everyone knows” to be true, but that are actually arrant nonsense.

And

One natural source of concern is if dubious but widely held ideas serve as the basis for consequential policy decisions.2

I have no idea of Mr Rudd’s politics, but like many readers I was intrigued by the footnote to that sentence

2  I leave aside the deeper concern that the primary role of mainstream economics in our society is to provide an apologetics for a criminally oppressive, unsustainable, and unjust social order.

To be honest, I used to edit Reserve Bank research and analytical papers etc for publications and – keen on openness and diversity as I am (see above) – I’d have insisted that sentence come out. Attention-grabbing but quite unrelated to the substance of the paper (or the functions of the Bank) would no doubt have been the gist of my comment.

But what of the substance of the paper? There isn’t really much there that is new. Quite a bit of it is about the limitations of how formal macroeconomic models capture, and ground, a role for inflation expectations. I don’t think any of that will have surprised most readers, or disconcerted anyone who has been associated with the actual conduct of monetary policy in recent decades. Perhaps you might be slightly disconcerted by his point that the models often seem to put more weight on short-term expectations (where surprises/shocks can generate real consequences) but that “one of the few shreds of empirical evidence that we do have suggests that it is long-run expectations that are more relevant for inflation dynamics”.

But even then I’m not sure that you should be disconcerted, in part because nowhere in the entire paper are interest rates mentioned, or financial instruments, and I (at least) have always thought of the role of inflation expectations as potentially most important in the context of a willingness to borrow (in particular) given the prevalence still of long-term nominal debt contracts (particularly so in countries such as the US where long-term fixed rate debt is a large chunk of the market). A 5 per cent mortgage rate is one thing if I’m working with an implicit, perhaps even unconscious, sense that normal inflation is 5 per cent, and quite another if I’m working with 0 per cent inflation as my norm.

There is a school of thought (class of economic rhetoriticians) who will assert, sometimes quite strongly, that in the long-run inflation expectations are the only determinant of inflation. I had a boss for some years who regularly ran that line. And, to be sure, you can set up a model in which it is true, but that model typically won’t be very enlightening at all, since “inflation expectations” (however conceived or measured, and measurement is a real challenge) don’t occur in a vacuum. If we had the data in the early 1980s, New Zealand inflation expectations might well have been about 12 per cent (say), but inflation expectations were that high because of some mix of (a) the government and the Reserve Bank not having done much to get inflation any lower, and (b) the government and the Reserve Bank not being thought likely to do much in future to get inflation much lower. Policy tended to validate the expectations, but it wasn’t the expectations that determined inflation, but the policy itself. When policy stopped validating those high expectations, they came down (albeit often quite slowly, sensibly enough (on the part of those forming the expectations).

Those misperceptions can matter. When we were trying to get inflation down (to something centred on 1 per cent) in the late 80s and early 90s, no one put much weight on the chances of success. Quite probably many of us didn’t either (I recall a conversation with the-then Westpac chief economist in which I suggested that I’d be reluctant to bet on inflation averaging below 3 per cent for the following 20-30 years). That made it harder (and costlier) to get actual inflation down, but – through some mix of good luck, bureaucratic resolution, and close-run-thing political commitment – we did. And indications of expectations about future inflation followed. A 14 per cent bank bill rate by the mid 1990s no longer meant what it had in 1988, when the inflation targeting scheme was first hatched.

On the other hand, it seems likely (but I’m more open on this) that during the period over the last decade when core inflation was persistently low – repeatedly surprising the Reserve Bank, among others – the fact that indicators of inflation expectations mostly tended to hold up nearer the target midpoint may have helped, a little, avoid more of a fall in inflation itself (although even this is arguable since had inflation expectations fallen away more sharply and obviously, the Reserve Bank might well have used policy more aggressively than it did, including getting unemployment down earlier/further).

One of the other limitations of Rudd’s paper is that there is barely any mention of any country’s experience other than that of the United States. Of course, he is American, writing in an American institution for a primary audience that is America, but…..data. In truth, there just is not that much data in any individual country (because no matter how many series and how high-frequency the data, there are only so many genuine cyclical episodes to study). In almost no other country in the world is it conceivable that someone would write such a paper without looking beyond their own borders, and own central bank. Even for the US, it should be more important, since the Fed focused on an index which doesn’t have a great deal of general public visibility, whereas many other inflation targeters will at least start from the CPI.

For me – as someone with (mostly) a policy focus – the most significant part of Rudd’s paper was the last few pages on “Possible practical implications” and “Possible policy implications”. I had a tick beside this paragraph

Another practical implication is rhetorical. By telling policymakers that expected inflation is the ultimate determinant of inflation’s long-run trend, central-bank economists implicitly provide too much assurance that this claim is settled fact. Advice along these lines also naturally biases policymakers toward being overly concerned with expectations management, or toward concluding that survey- or market-based measures of expected inflation provide useful and reliable policy guideposts. And in some cases, the illusion of control is arguably more likely to cause problems than an actual lack of control.

But for all the glib rhetoric that sometimes comes from senior central bankers, I wonder how many – if any – practical central bankers operate as if they really believe that everything (about future inflation) rests on inflation expectations. I’ve had many criticisms of the Reserve Bank of New Zealand over the years, but not even Don Brash acted and operated policy as if that was his view, and certainly none of his successors have.

Perhaps more interesting was this

Related to this last point, an important policy implication would be that it is far more useful to
ensure that inflation remains off of people’s radar screens than it would be to attempt to “re-anchor” expected inflation at some level that policymakers viewed as being more consistent with
their stated inflation goal. In particular, a policy of engineering a rate of price inflation that is
high relative to recent experience in order to effect an increase in trend inflation would seem to
run the risk of being both dangerous and counterproductive inasmuch as it might increase the
probability that people would start to pay more attention to inflation and—if successful—would
lead to a period where trend inflation once again began to respond to changes in economic
conditions.

It harks back a bit to the definition of price stability Alan Greenspan once used to give, that it is when inflation isn’t a consideration for people (firms and households) in the ordinary course of their lives, but also seems to be a bit of dig at the current FOMC policy of aiming to run core inflation above target for a time. I’m probably more sympathetic to that approach than Rudd – including for New Zealand after a decade of undershooting the target – but his comment is a perspective that should be taken seriously.

HIs final main point is this

A related issue is more pragmatic. In some ways, the situation that arises from a focus on
long-term inflation expectations is similar to one in which a policymaker seeks to target a single
indicator of full employment—for instance, the natural rate of unemployment. Like the natural
rate, the long-run expectations that are relevant for wage and price determination cannot be directly measured, but instead need to be inferred from empirical models. Hence, using inflation
expectations as a policy instrument or intermediate target has the result of adding a new unobservable to the mix. And, as Orphanides (2004) has persuasively argued, policies that rely too
heavily on unobservables can often end in tears.

People (including central bankers) fool themselves if they think that survey responses, or implied breakevens from inflation-indexed bond markets, “are” inflation expectations (for the economy as a whole) themselves. They are what they are, and always have to be taken with at least some pinches of salt. In New Zealand, for example, household surveys regularly produce numbers suggesting households expect to average between 3 and 5 per cent over periods 1 to 5 years ahead, but no one has ever taken those absolute numbers seriously (there is little or nothing else anywhere in the economy suggesting that whatever people tell surveytakers they act as if they think inflation will be this high). At best, they are indicators, straws in the wind, and sometimes what look like good relationships then no longer do.

As an example of the latter, the Reserve Bank economics department at times articulated a line that the two-year ahead measure of inflation expectations in the Bank’s survey of informed observers) almost was a measure of core inflation itself.

expecs and core inflation

It held up quite well over the best part of 15 years, until it didn’t. It left the Bank too complacent through the following decade (but the error could equally have run the other way).

I guess my bottom line is that one should rarely put too much weight on any specific indicator, and perhaps especially ones that are hard to observe (or to know what one observes actually means). If we see medium-term inflation expectations – among informed observers – at 5 per cent, we (and central bankers) should be disconcerted, but it is highly unlikely that such an inflation expectations number will have been the first sign of trouble.

Changing tack, what of current monetary policy in New Zealand? There is an OCR review tomorrow. Expectations measures here don’t appear troublesome at all – even the inflation breakevens are getting nearer the target midpoint than we’ve known for some years. But core inflation has been rising, unemployment had fallen quite low, and a lot of indicators pointed to emerging capacity pressures. All that was, of course, before the latest Covid outbreak.

I still think there is a very good case for things the Reserve Bank MPC will not do tomorrow: discontinue the Funding for Lending programme, and start a well-signalled programme of bond sales to reverse the LSAP programme. But what of the OCR itself? I won’t be particularly critical of the MPC if they do raise the OCR by 25 basis points tomorrow, but I think if I was in their shoes I wouldn’t. There is a full forecast round and full MPS at the next review and a lot of uncertainty about the Covid outbreak and is its implications (as well as some emerging downside global risks, notably from China). Yes, monetary policy works with a lag, but the starting point for (core) inflation is not so high that we need to be in a hurry to raise the OCR in such an uncertain and unsettled climate. We will know a great deal more – including about vaccinations, and hopefully about exit pathways – on 24 November than we do now. If all is going really well by then, or if core inflation in the CPI later this month is really troubling, there need be no problem with going 50 basis points then, if the data support such a call. But I wouldn’t be rushing right now.