The Reserve Bank and the MPC will tomorrow emerge from their long summer slumber to deliver a Monetary Policy Statement and OCR decision. It is quite extraordinary that in this period, of considerable volatility, uncertainty, and inflation surging above the target range (even on core measures) we’ve heard precisely nothing from any of them (individually or collectively), and had no policy actions, for three months.
But, at last, tomorrow we will hear. As I’ve said repeatedly here over the years, I’m not really in the business of trying to guess what the MPC will do. There are plenty of people with a strong interest in that, and banks have people who nurture every little contact or conversation they can secure with Reserve Bank officials, analysts, or policymakers. As the Bank says little in public, and isn’t that consistent through time in how it acts, all one can say is good luck to those people.
My interest is in what the Reserve Bank should do, given the target set for them by the government (and, of course, the wider but less immediate question of what that target should be). The target is really pretty specific, with a primary focus on keeping the persistent elements of inflation near 2 per cent.
Against the backdrop of the Remit, I think it is pretty clear what the MPC should be doing tomorrow:
- they should be raising the OCR by 50 basis points, and giving a signal that, all else equal, they expect another 50 basis point increase at the next review on 13 April,
- they should be terminating new loans under the Funding for Lending programme, the crisis programme introduced in 2020 which is still at the margin having the effect of holding interest rates lower than otherwise, and
- they should commence a programme of bond sales, designed to liquidate the LSAP bond position within 2 years (or, equivalently, have agreed a programme with The Treasury under which it would sell new bonds on market, buying back on the same day an equivalent amount of the bonds held by the Bank).
I don’t suppose either of the last two items on that list are at all likely. I don’t even think that LSAP sales would make much material difference to monetary conditions (exactly paralleling my argument when they were buying bonds) but (a) every little helps, and (b) we should get this massive taxpayer bet on the bond market closed out ASAP, on principle. And there is no crisis now – the OCR is fully able to be used as desired. Much the same goes for the FLP programme. Closing that now might have some modest useful impact in tightening overall monetary conditions, but it would also align messages – this isn’t the 2020 Covid crisis any more, and the focus of monetary policy now is (or should be) getting core inflation back down fairly expeditiously.
But even if they took both of those steps, the case for a 50 basis point increase tomorrow is strong.
There are a couple of ways I find useful to look at things.
It was in last August’s MPS that the Bank really set out towards some significant OCR increases. They didn’t act that day because they had the misfortune of a (long-scheduled) release a few hours after the Level 4 lockdown was imposed. Back then they envisaged the OCR being 0.9 per cent for the March quarter 2022 (roughly consistent with having been 0.75 per cent moving to 1 per cent now). But back then:
- they thought core inflation was about 2.2 per cent and would go little or no higher (headine inflation forecasts for the second half of this year and beyond were 2.2 per cent, dropping further away)
- they expected the unemployment rate for this quarter to be 3.9 per cent, and to go no lower than that.
- their latest reads on inflation expectations weren’t particularly inconsistent with inflation near the midpoint of the inflation target range (the most recent 2 year ahead measure they had then was 2.3 per cent).
And where are we now?
- the unemployment rate – still probably the best indicator of spare capacity (or lack of it) – had fallen to 3.2 per cent in the December quarter, and there is talk it could go lower yet. No one seems to suppose that the unemployment rate is near the NAIRU.
- the latest headline inflation rate is 5.9 per cent, and may go higher this quarter. Much more importantly, core measures have increased substantially – the best of them, the sectoral core factor model measure, is now 3.2 per cent for the year to December, and
- while there is a wide range of inflation expectations measures, none of them are as low as the Bank was seeing back in August, and the best of them are pretty consistent with people assuming (and acting as if?) inflation will stay outside the target range (and well away from the midpoint) for the next couple of year. Even with the tightening in monetary conditions observed in recent months.
It was really captured quite well in a newspaper article yesterday that reported that all economists talked to thought that the Bank was now “behind the game”. In that sort of environment, when you’ve been repeatedly surprised by the strength of inflation, and outcomes are no longer consistent with target – suggesting that your model of what is going on is not working that well – the appropriate response is not to edge up the OCR ever so gradually and hope. Least regrets – of which we heard quite a lot from the Bank over the last 18 months – calls for something a bit bolder, to get ahead of the rise in (core) inflation and assure watchers (firms, households, markets) that you really are serious, rather than reluctant.
Is there a case in Omicron for holding back (25bps rather than 50bps)? I don’t think so. We can see how other countries have come through the short and intense Omicron waves – which will temporarily disrupt both supply and demand – and there is little sign of what is required from monetary policy being revised down in the wake.
(“Not surprising the market” isn’t a good excuse either. When you say nothing for months, the market has little to go on re the MPC reaction function. If you won’t talk, you have to live with surprises sometimes. The market will cope, although might suggest that a bit more communication than once every few months would make sense.)
The second way of looking at things is to compare where are now to where we were two years ago. Having cut the OCR during 2019 by early 2020 markets, not discouraged by the Bank, were beginning to think in terms of when a first OCR increase might be warranted (still then, it was thought) some time away.
The OCR is early 2020 was 1 per cent. Core inflation was probably just under 2 per cent (having edged up over the previous couple of years towards the target midpoint), and the unemployment was about 4 per cent. Where things are now we’ve already covered above – much more inflation, more capacity pressure, and on any metric you like materially higher inflation expectations.
Any policy and/or monetary conditions?
Well, the OCR today is 0.75 per cent, still below where it was two years ago. A 25 point increase tomorrow will only take it back, in nominal terms, to where things were in February 2020. The nominal exchange rate is also now about where it was two years ago.
But what about the interest rates that firms and households face? We’ve heard a lot about fixed rate mortgage rates have risen from their lows. And that’s true: a two year mortgage rate is now about 170 basis points higher than the low (last April).
But what of comparisons to the start of 2020?
So nominal mortgage rates are perhaps 50 basis points higher than they were two years ago. But inflation is a lot higher than it was then, and so are all indications of inflation expectations. For these purposes, I’ll just use the Reserve Bank’s own survey of two-year ahead inflation expectations: 1.93 per cent in the survey done at the end of January 2020, and 3.27 per cent in the survey done a few weeks ago, an increase of 1.34 percentage points.
Here is the same chart, but expressed in real terms, adjusted for the increase in inflation expectations.
and the same chart for term deposit rates
(Real) monetary conditions have tightened a bit from the lows, but they really needed to. Compared to conditions prevailing two years ago, real mortgage rate, real deposit rates and of course the real OCR are substantially looser than they were. And whereas two years ago inflation looked to be fairly comfortably somewhere near the target midpoint, nothing remotely that optimistic describes the situation now.
Of course there are other influences – things like fiscal policy, the terms of trade, other regulatory restrictions (eg tax or the CCCFA) – but it would very very hard indeed to construct a story that suggested that real monetary conditions as we find them today (or might find them tomorrow) are likely to be consistent with the Bank delivering on its mandate, on the environment as we see it today. In fact, if core inflation becomes established at current rates (3% plus), standard economic analysis would tell us that reductions in core inflation – to the 2% the Bank is supposed to be focused on delivering – are likely to come about only by luck (ill-luck probably – adverse economic events) or by monetary conditions being tightened to above-normal levels of tightness for some time, a process that would (at very least) result in a period of sub-par economic growth, perhaps even a recession.
We’ll see tomorrow what the MPC has decided to do. But whatever the rate adjustment we should be able to expect a serious and rigorous accounting for just what has gone wrong in the last 12-18 months, what the Committee has learned, and a serious analysis of the options and risks in the monetary policy that might be required to get core inflation (and expectations of it) settling back around 2 per cent. Sadly, with this MPC it would probably be a bit of a surprise if we got even the appropriate degree of analysis, self-scrutiny, and accountability.