Reading the MPS

Read the first page of the Reserve Bank’s Monetary Policy Statement yesterday (the press release) and it is hard to find anything to quibble with. It was a strong statement, backing up another large OCR increase, and referencing a further increase in inflation pressures (and thus a revision up in the forecast track). One might wish they had gotten this serious back in November/December when the issues were already becoming stark and the upside risks high, instead of doing one 25 point increase in November and then heading off for a very long summer recess. But if they have got serious, and a bit worried, now, then better late than never.

And given where we are now – which is not a good place – if they manage to deliver core inflation next year at 2.6 per cent (as in the projections) I’d probably count that as quite a reasonable outcome: still some way from the 2 per cent they are required to focus on, but at least comfortably back within the target range. It would be much more acceptable than the persistently high inflation forecast track The Treasury published last week (but finalised two months ago).

But then the questions etc started.

Notably, given that all the core inflation measures the Bank lists are currently 3.9 per cent or above, what is it is in the forecast track that brings about so much lower core inflation (and forecasts that far ahead can be treated pretty much as core inflation)? The Bank no longer publishes a quarterly track for the output gap – their assessment of excess (or surplus) capacity pressures – but in the table of annual forecasts the output gap average for the year just ended (to March 2022) is shown as 2.1 per cent, and for the 22/23 year ending next March it is also shown averaging 2.1 per cent. It is lower the following year – averaging 0.6 per cent in 23/24, and finally goes slightly negative (-0.4 per cent) in 24/25. But on standard models (a) inflation lags behind output gap developments, and (b) a lower but still positive output gap should slow the rate of increase in inflation, but should not lower the inflation rate itself (it takes a negative output gap to do that).

The situation isn’t much clearer if one looks at their unemployment rate forecasts. They have the unemployment rate rising to 3.8 per cent by the March quarter of 2023 (materially higher than Treasury expects), and then increasing a little more to reach 4.7 per cent by March 2025. They don’t publish a NAIRU estimate but in their forecast description they say

“employment gradually returns towards its maximum sustainable level over the medium term ….this is in line with the unemployment rate increasing from a low of 3.1 per cent in the June 2022 quarter to 4.8 per cent by the end of the forecast horizon [June 2025]”

There is no hint in that description that they think a negative unemployment gap will have opened up either – and certainly not in time to produce sharply lower core inflation next year.

I don’t know how they are generating so much lower core inflation, and so quickly.

One of the startling gaps in the document is any discussion of history – past successful substantial reductions in core inflation. Surely with all those economists on staff they would have been well-placed to have provided us with some thoughtful insights on lessons/experiences? But I guess that might have involved acknowledging that it is very rare – almost unknown – to see significant reductions in core inflation without also experiencing a recession (often quite a nasty one). A recessionn isn’t strictly necessary. but perhaps the MPC could have enlightened us on why they think one will be avoided this time. As it is, search the entire document and you will not once find the word “recession” – not as a risk, not as a phantom the Bank thinks will be avoided, nothing. It seems quite a gap (and in fairness when the Governor was asked at FEC about the possibility of recession, he did note the wide margins of uncertainty, even if he tended to focus all the risk discussion on the big world out there, not on New Zealand.

But all that was a little odd too because as the Governor noted a lot of countries are grappling with similar inflation and excess demand pressures to those in New Zealand. But on the forecasts/assumptions the Bank is using their inflation largely goes away again, and GDP growth just settles back to something pretty normal. Sure, some of the one-offs around food and energy etc will probably settle down, but the Bank seems to be assuming the ultimate in global soft landings. Quite why isn’t clear.

But if the Bank assumes the world settles back to normal quite easily, the New Zealand medium-term story seems quite a lot bleaker.

Well beyond when inflation is back in the target range, annual GDP growth seems to settle at annual rates of 1.1 and 1.2 per cent per annum. The working age population is forecast to be growing at 1.2 per cent per annum towards the end of the forecast period. In other words, no growth in per capita GDP at all (and probably almost no productivity growth). Even if there is no recession it is a pretty bleak picture.

And for those inclined to worry about the current account deficit – I don’t, but it fluctuations are often pointers to imbalances – the Bank expects the current account deficit to average about 6.5 per cent per annum throughout the forecast horizon. I’m not sure quite what to make of these numbers, but they are hardly a reflection of buoyant business investment: on the Bank’s forecast business investment three years from now is no higher than it is estimated to have reached in the March quarter this year.

Overall, I don’t find the picture very persuasive at all. I’m a bit sceptical that the OCR will need to rise as much as the Bank thinks (3.9 per cent) but if it does get that high it would be astonishing – and I’m sure without precedent – were there not to be a recession here. Especially when, as Orr rightly reminds us, a lot of other countries are now tightening quite aggressively as well, and there is open talk abroad about recession risks more widely. And – to hark about to the point earlier – the Bank does not project a negative output or employment gap (at best until well after inflation has fallen a lot), so how does the Bank think (core) inflation is going to fall so much. It may not be wishful thinking – the risks of recession in the next 12-18 months are already quite high, and such a recession would open negative output gaps and lower inflation, especially in parallel with similar corrections abroad – but it does look like poor forecasting and – more importantly – worse storytelling. I guess official agencies never forecast recessions until we are already in them, but how else does the Bank really expect to lower core inflation that quickly, that much?

The Bank’s fiscal forecasts never get much attention. There is good reason for that. The Bank does not take its own view on fiscal policy parameters, but uses the government’s own announced parameters and then slots that information into its own macro outlook. But having highlighted in a couple of posts earlier in the week that it seemed pretty irresponsible to be running an operating balance deficit in such an overheated economy, it is perhaps worth noting that the Bank’s picture is even worse than Treasury’s with the same output gap in 22/23 they expect an even bigger deficit, and don’t see a surplus on the horizon, not even in 24/25 (the Minister’s latest promise).

I did a thread on Twitter yesterday making the case (using NZIER Shadow Board views) that, really poor as inflation outcomes have been, it is also hard to realistically think that an alternative MPC would have produced much less bad outcomes either now or any time very soon. That isn’t to say that things could not and should not have been done much better, just that it was hard to identify a realistically different committee which would have got it right (their peers abroad are, after all, often doing at least as poorly – and those Committees often have much deeper pools of expertise, and more commitment to open debate and contest of views). It doesn’t absolve the Governor and MPC of blame – they each put up their hands to take the job, and need to be held accountable for failure – but you might have least hoped that their new MPS would be rich in self-scrutiny, in signs of learning from past mistakes, and in compelling analysis of their current story (if only to open that to challenge scrutiny). As it is, the MPS had none of that.

There was also, of course, no mention of the massive losses the MPC has run up with their huge speculative punt on the bond market, otherwise known as the LSAP. $8billion of losses and counting – $8000 per family of five – is just extraordinary, all supported by probably as little analysis as Nick Leeson deployed in playing the Japanese equity futures markets, but with much much less effective accountability.

A 2 per cent OCR is probably the right call for now, although even then much better if they’d had it their six months ago. But that is about all the good that can be said for the MPS. The Governor told FEC a few weeks back that he had no regrets, and in this document not only is there no sign of any regret, any contrition, there is no sign of even a determination to learn from how we got into this mess. And, of course, no compelling story for how Orr and his MPC plan to get out it. Most likely, even though there medium-term picture is pretty grim across the board, the reality facing the New Zealand economy over the next 12-18 months is likely to be much worse still. Once allowed – even by mistake – to develop, inflationary excess has to be worked off, and that is rarely an easy or smooth process, perhaps all the more so when so many other countries are grappling with much the same problems.

I would normally include some mention of the Bank’s FEC appearance. Orr was in very good form this morning, clear and crisp (if perhaps a little defensive in emphasising all the things the Bank wasn’t responsible for – things he has often felt free to comment on in the past) but the noteworthy thing was just how lacking in serious scrutiny and challenge the questioning from MPs was. It was as if some middling test batsman took guard and the opposition team wheeled about a club bowler. It allowed the Governor to perform at his best, at a cost of no serious scrutiny of the policy failures and massive losses.

2022 vs 2008

When the National-led government took office in late 2008, the government’s books were in something of a mess. The Treasury’s projections were for operating deficits of 2 to 3 per cent of GDP each year over the forecast horizon. Since the mid 1990s, under governments led successively by National and by Labour, there had been 14 years in succession of OBEGAL surpluses (a very very small one in the June 1999 year). After all those surpluses there was, of course, not much debt (the Decenber 2008 HYEFU shows net Crown debt for the just-completed year at 0.0% of GDP). It certainly wasn’t, in any substantive economic sense, a fiscal “crisis”, but it was pretty substantially unsettling, both politically and at The Treasury (where I was working at the time).

There was a great deal of rhetoric about Michael Cullen, Minister of Finance in the outgoing government, having squandered the fruits of the boom years, and bequeathed a “decade of deficits” (some contemporary political stuff is here).

Over the years I have defended Cullen in a couple of posts (here and here), particularly centred on the 2008 Budget delivered on 21 May 2008. There is no doubt it was an(other) expansionary Budget. As a share of GDP, core Crown expenses were projected to increase from 31.8 per cent of GDP in 2007/08 to 33.4 per cent in 2008/09. The operating balance was projected to drop from a surplus of 2.9 per cent of GDP to one of 0.7 per cent of GDP (dropping away further to tiny surpluses later in the four-year forecast horizon). Against a backdrop of above-target core inflation, it is wasn’t exactly helpful in terms of macroeconomic balance, but in purely fiscal terms it was hard to argue against it very strongly. Recall that in the New Zealand system, ministers set fiscal policy (tax and spending choices), but the Secretary to the Treasury has independent personal responsibility for the fiscal and economic forecasts. The best professional advice the then-government had was that their fiscal policy was consistent with continuing to avoid deficits over the forecast horizon. And the initial level of public debt was untroublingly low.

It was, of course, election year. After 8.5 years in office, Labour was by then running well behind in the polls. One might expect taxpayers’ money to be thrown around with a bit more abandon than usual, but – in purely fiscal management terms – The Treasury assessment told them it was okay.

What were the projections like? By most reckonings it was an overheated economy. The latest unemployment rate available when the numbers were being finalised was 3.4 per cent (lowest of that cycle, lowest for a generation). Core inflation was running above target. Output gap estimates were typically positive. And the terms of trade – boosting nominal GDP and tax revenue – were at fresh record highs.

Treasury expected the economy to slow down. GDP growth over the 12 months to March 2009 was forecast to slow to about 1.5 per cent and over the following couple of years the unemployment rate was expected to rise back to about 4.5 per cent. With a Governor who wasn’t very focused on the midpoint of the inflation target, inflation was expected to remain right near the top of the target range, but ministers (and the public) were told there was likely to be room for the OCR to fall somewhat over the forecast horizon.

It was the sort of environment in which standard fiscal policy advice would be that it was appropriate to be running an operating surplus – not necessarily a large one, but a surplus. And Treasury advised that the government’s tax and spending plans were consistent with continuing to deliver surplus (headline and in cyclically-adjusted terms).

They were, of course, bad forecasts – bad economic forecasts translating into badly-wrong fiscal forecasts. The economic forecasts were completed using data up to 15 April 2008, but by then the financial system stresses abroad had been headline material for months, and oil prices were rocketing upwards towards their peak – higher even in nominal terms than anything we’ve seen this year – reached in July 2008. But if we don’t always expect ministers to agree with Treasury advice or even Treasury forecasts, the published fiscal projection numbers rely on exactly those forecasts (and there is no sign at the time that ministers had a wildly different view). It is fair to note that opinion shifted fast that year – the Reserve Bank’s June Monetary Policy Statement forecasts were finalised on 26 May 2008 (just a few days after the Budget was delivered): they saw the unemployment rate climbing back to 6 per cent over their forecast horizon, but even they – taking fiscal policy as given, but applying their own economic outlook – didn’t see looming fiscal problems.

My point re 2008 is that you can criticise that Budget if you want, but really – given the combination of economic forecasts from The Treasury, and the government’s polling plight – it still looks quite impressively restrained, in some ways a testimony to the 15-year record built up by then of a presumption towards a balanced operating budget (at least) or a surplus. Of course, the more left-wing among Labour’s supporters didn’t much like that presumption – they’d talk about missing out on opportunities etc – but (inaccurate as they were to be) looking through those June 2008 Reserve Bank forecasts, at the time they saw the policy and economic environment as consistent with 2 per cent annum productivity growth.

Against that benchmark of avoiding deficits – at least outside crises – Labour in 2008 might have done something close to “spending it all” (Muldoon’s claim of his 1972 pre-election Budget), but if Labour was going to lose that year, they thought they would still be bequeathing a small surplus. After 14 successive years of surpluses. Debt was projected to rise a bit – lots of capex planned – but, four years out, was forecast to be about 6 per cent of GDP. That 2008 Budget continued the track record, under both governments, of not projecting an operating deficit.

The contrast between Clark/Cullen that year and Ardern/Robertson this year is striking.

Now, in part, the climate has changed. We have become accustomed to deficits once again. Of the last 14 fiscal years, there have been operating deficits in eight of them. Some of that is to have been expected. In the 14 years from 1994 to the 2008 Budget, there had been only a single mild recession in New Zealand and no great natural disasters. By contrast, since 2008 we have had a serious (double-dip) recession in 2008/09/10, the big fiscal cost of the Canterbury earthquakes, and most recently the pandemic and associated severe disruptions to economic activity.

But what hadn’t changed – at least until now – was that governments projected to run balanced budgets or surpluses at times when The Treasury estimated that the economy was pretty full-employed, or even overheated. Now, you might push back that the sample is pretty small – on most metrics, there was excess capacity in the economy (negative output gap, lingering high unemployment, sluggish core inflation) for most of the decade after 2008.

But how about Robertson’s second Budget, in 2019? For the 2019/20 year, then just about to start, Treasury projected a small positive output gap (0.3 per cent of GDP), an unemployment rate (4.0 per cent) evidently a little below their view of the sustainable rate, and inflation was projected to be bang on the target midpoint. The government’s fiscal policy choices led Treasury then to project an operating surplus of 0.4 per cent of GDP. Tiny, but still positive. Focusing only on the macroeconomics, one couldn’t really complain. It all looked pretty prudent.

That was the, just three years ago. This is now – same Minister of Finance, same Prime Minister. The macroeconomic environment – at least per the Treasury’s estimates and projections, which the government showed no sign last week of questioning or disowning – has changed, but in ways that materially improve the government’s expected fiscal position. The output gap, for example, is estimated at 2.1 per cent of GDP in 2022/23. The unemployment rate is expected to average about the current 3.2 per cent (evidently well below The Treasury’s view of sustainable), we’ve had a huge upside surprise on inflation, and if the terms of trade are not making new record highs, in 2022/23 they were expected to hang around the very high level of recent years (see chart above).

Not a month ago the Minister of Finance announced his new fiscal rules. The first of them was this

  • Surpluses will be kept within a band of zero to two percent of GDP to ensure new day‑to‑day spending is not adding to debt.

It was, on paper, good stuff. Except that it doesn’t apply now, only in some future era beyond the next election. Because this Budget (for 22/23) projects an operating deficit of 1.7 per cent of GDP, despite all those (projected) overheating economy indicators. In cyclically-adjusted terms, it is probably a deficit of getting on for 3 per cent of GDP – just miles away from the Minister’s own good-stewardship benchmark. Brings to mind St Augustine: “Give me chastity and temperance—but not yet”.

It isn’t as if there is some Covid excuse for these big projected cyclically-adjusted deficits. No more lockdowns (and wage subsidies or equivalent) are planned, MIQ is all-but gone and…….if the sectoral pattern of activity is still different (not many foreign tourists yet, and Treasury projections in which foreign trade remains lower as a share of GDP) the economy is (more than) fully-employed. And on Treasury’s view, inflation remains above target for several years to come.

It is just cavalier – political management rather than responsible economic or fiscal management. And it isn’t even election year yet. When Muldoon in 1972 talked of “having spent it all”, and Cullen in 2008 acted in ways that one might reasonably suggest were much the same, they both probably thought the political odds were against them, that any problems would most likely fall to the opposite party soon to take office (and even if not, there would be three years to sort things out), this time it looks a lot like Robertson and Ardern have done it to themselves, and that fiscal chickens could come home to roost just a few months out from next year’s election. Unless, that is, they are really just giving up on the notion of a balanced operating budget – an idea which shouldn’t be that controversial (see the Minister’s own embrace of the principle).

Take a couple of other contrasts with 2008. By then, for example, the OCR was widely believed to have peaked already (at 8.25 per cent reached in June 2007) and attention was beginning to turn to when, and to what extent, the OCR might eventually be cut. And, to the extent the economy was overheated it was the culmination of a build-up of pressures over years – a fairly long and sustained economic expansion. Oh, and public debt had been steadily falling every year since 1992. Depending on your precise measure, it was basically zero (a little lower even than at the time of the 1972 Budget).

By contrast, Treasury now tells the government to expect lots more OCR increases (so looser fiscal policy is directly working against monetary policy), public debt – while still low by international standards- has risen a lot in the last couple of years, and the overheated economy at present, while real, was sudden, is ill-understood, and could have some distinctly evanescent aspects to it. You might not think it was time for savage structural fiscal tightenings – and I would probably agree – but it certainly isn’t time for choosing to move deeper into cyclically-adjusted deficits. And the precedent it sets for future governments is not exactly welcome – perhaps they too will commit to surpluses only beyond their own electoral horizons.

All the discussion of this year has been premised on The Treasury’s economic forecasts. They were what ministers had in front of them, and they were not disowned by Robertson in delivering his Budget last week. But they have a distinctly rosy tinge to them – I doubt if The Treasury was finalising them now they would be as upbeat – and it is very easy to envisage a much-worse outlook, not just for the medium-term but from now through to the election. Significant core inflation problems have very rarely if ever been resolved without a recession – and such recessions are rarely of the nature of two quarters of -0.1% growth. It isn’t “necessary” – soft landings are hypothetical possibilities, but achieving a fabled soft-landing assumes a state of knowledge (and ability to fine-tune tools) that is evidently rarely – and perhaps especially unlikely at present, since if governments and central banks had the level of knowledge required we should not have been in this overheated inflationary mess in the first place. That isn’t a criticism of any individual or agency, but an observation about the evidence of our eyes – here and abroad – over the last couple of years.

There was a famous line from the US 1988 vice-presidential debate. Senator Dan Quayle, the Republican nominee, had noted that he had as much congressional experience as Kennedy had had when he ran for President. But the memorable line of the night was Senator Lloyd Bentsen’s response

“Senator, I served with Jack Kennedy. I knew Jack Kennedy. Jack Kennedy was a friend of mine. Senator, you’re no Jack Kennedy.

It came to mind when thinking about the contrast between Michael Cullen and Grant Robertson. One, miles behind in the polls, nonetheless projected surpluses (on best professional macro forecasts) in his last Budget. The other, on projections (valid or not) of an even more overheated economy, with more severe inflation problems, having already overseen (somewhat inevitable) increases in public debt) drops into significant projected deficits – complete with gimmicky handouts. And it isn’t even election year yet.

Cavalier policy and disconcerting projections

From a macroeconomic point of view, that title for this post really sums things up nicely.

Take policy first. The government has brought down a Budget that projects an operating deficit (excluding gains and losses) of 1.7 per cent of GDP for the 2022/23 year that starts a few weeks from now. Perhaps that deficit might not sound much to the typical voter but operating deficits always need to be considered against the backdrop of the economy.

Over the last couple of years we had huge economic disruptions on account of Covid, lockdowns etc, and fiscal deficits were a sensible part of handling those disruptions (eg paying people to stay at home and reduce the societal spread of the virus). Whatever the merits of some individual items of spending over that period, hardly anyone is going to quibble with the fact of deficits.

But where are we now (or, more specifically, where were we when Treasury did the economic forecasts that underpin yesterday’s numbers, and which Cabinet had when it made final Budget decisions)? Treasury has the terms of trade still near record highs, it has the unemployment rate falling a bit further below levels the Reserve Bank has already suggested are unsustainable, and over 22/23 it expects an economywide output gap (activity running ahead of “potential”) of about 2 per cent of GDP. In short, on the Treasury numbers the economy is overheated. And when economies are overheated revenue floods in. Surprise inflations – of the sort we’ve seen – do even more favours to the government accounts in the near-term: debt was issued when lenders thought inflation would be low, and although the revenue floods in (GST and income and company tax), it takes a while for (notably) public sector wages to catch up. On this macro outlook, the government should have been making fiscal policy choices that led to projected surpluses in 22/23 (perhaps 1-2 per cent of GDP), consistent with the idea – not really an right vs left issue – that operating balances, cyclically-adjusted – should not be in deficit. Big government or small govt, on average across the cycle operating spending should be paid for tax (and other) revenue.

Instead in an economy that is grossly overheated (on the Treasury projections) the government chooses to run material operating deficits. It is the first time in many decades a New Zealand government (National or Labour) has done such a thing, and should not be encouraged. It risks representing slippage from 30 years of prudent fiscal management by both parties, and once one party breaches those disciplines the incentives aren’t great for the other once it takes office.

And this indiscipline isn’t even occurring in election year (and already I’m getting an election bribe). It is fine to talk up projections of smaller deficits next year, but slotting a number in a spreadsheet is a rather different than making the harder spending or revenue decisions to fit within those constraints. Perhaps they’ll do it. Who knows. The political incentives may be even more intense by then. And the economic environment could be (probably will be) quite different.. What any government should be directly accountable for is their plans for the immediately-upon-us fiscal year.

You will hear people suggest that fiscal policy isn’t anything to worry about. Some like to quote The Treasury’s fiscal impulse measure/chart. But it just isn’t a particularly useful or meaningful measure at present (at least unless you line up against it a Covid “impulse” chart). But even if you want to believe that the overall direction of fiscal policy wasn’t too bad – and my comments on the HYEFU/BPS were not inconsistent with such an interpretation – the real impulse we should be focused on is how near-term fiscal policy has changed since December.

In December, the operating deficit for 2022/23 was projected at 0.2 per cent of GDP (allow for some margins of uncertainty and you could call it balanced). Now the projected deficit is 1.7 per cent of GDP, in an economy projected to be even more overheated that was projected in December.

What about spending? Well, here are the projections for core Crown spending. Back in December the government planned that spending in 22/23 would be a lot lower than in 21/22 (which made sense since no more expensive lockdowns were being planned for). Yesterday’s projections for 22/23 are $6.8bn higher than what was projected only six months ago – and only about a billion less than last year’s heavy Covid-driven spending.

Some of it is inflation, but whereas in December Treasury projected that spending would be 30.5 per cent of GDP, now it is projected to be 31.6 per cent of GDP. It is a lot more spending and, all else equal, a lot more pressure on the economy and inflation. In case you are wondering, in both sets of projections tax revenue is projected to be 28.9 per cent of GDP.

Perhaps there is a really robust case for all this extra spending, making it so much more valuable and important than the private spending that will have to be squeezed out. But the evidence for any such claim is slight to non-existent, and the general presumption should be that if you want to spend a lot more you do the honest thing and make the case for higher tax rates. Instead, the Cabinet has chosen operating deficits amid a seriously overheated economy. It is cavalier and irresponsible.

That is policy, things ministers are directly accountable for. But there is also a full set of economic projections, amid which there are some quite disconcerting numbers. Now, before proceeding, it is worth stressing that these economic projections were finalised a long time ago, on 24 March in fact. If anything, that only makes things more concerning.

Here are The Treasury’s inflation forecasts

You will recall that the government has given the Reserve Bank an inflation target range of 1-3 per cent per annum but with an explicit instruction to focus on the midpoint of that range, 2 per cent annual CPI inflation. You should be aware that monetary policy doesn’t work instantly, with the full effects on inflation of monetary policy choices today not being seen for perhaps 18 months or even a bit longer. You should also be aware that The Treasury (and other forecasters) generally don’t include future supply etc shocks in their forecasts, because they are basically unknowable (and could go either way). So (a) any annual inflation forecasts more a few quarters ahead will be wholly a reflection of fundamentals (expectations, capacity pressures, and perhaps some small exchange rate effects), and (b) any forecast annual inflation rate 18 months or more ahead is almost wholly a policy choice. Actions could be taken now to get/keep inflation around the midpoint of the target range.

But Treasury forecasts inflation for calendar 2023 at 4.1 per cent – as it happens reasonably similar to many estimates of core inflation right now – and 3.1 per cent for calendar 2024 (December 2024 was the best part of 3 years ahead when Treasury finished the forecasts). Only at the very end of the forecasts – four years away – is inflation back to 2.2 per cent, close enough to the target midpoint that we might reasonably be content. It is a choice to forecast that the Reserve Bank’s MPC will simply not be serious in showing any urgency in getting inflation down, and seems barely to engage with the risk of entrenching expectations of higher future inflation. If one takes the annual numbers on the summary table, it is still a couple of years before they even expect the Reserve Bank to be delivering an OCR that is positive in inflation-adjusted (real) terms.

Now, The Treasury does not set the OCR, the Reserve Bank does that. But the Secretary to the Treasury is a non-voting member of the MPC, The Treasury is the government’s chief adviser on macroeconomic policy including monetary policy targets and performance. And they finished these projections two months ago, and will have shared them with the Minister of Finance and with the Reserve Bank. At very least, there should have been a “please explain” from the Minister to the Governor/MPC. Treasury might have been quite wrong, but if so the Bank should have had a compelling response. But it doesn’t seem likely that anything of the sort happened, and you may recall that when the Bank last reviewed the OCR they explicitly said they weren’t seeing any more inflation than they’d projected in February.

The Treasury numbers are doubly disconcerting because – finished in March – they are persistently higher than the expectations (late April) of the Reserve Bank’s semi-expert panel in the quarterly survey. For the year to March 2024, the survey of expectations reported expected inflation of 3.3 per cent, but The Treasury projects 3.8 per cent inflation.

Now, maybe this will all be overtaken by events. The forecasts were completed in late March, and since then the economic mood – here and abroad – has deteriorated quite markedly, with a growing focus on the likelihood of a recession (almost everywhere significant reductions in core inflation have involved recessions). Quite possibly, if the projections were being done today they would be weaker than those published yesterday (and the RB’s will be finalised about now) But I hope journalists and MPs are getting ready to compare and contrast the RB and Treasury forecasts and to ask hard questions about the differences.

Soft-landings rarely ever happen once core inflation has risen quite a bit (as it clearly has this time). That doesn’t stop forecasters forecasting them, but if forecasters knew the true model well enough we probably wouldn’t have had the inflation breakout in the first place. I was, however, particularly struck by The Treasury’s quarterly GDP growth forecasts, which ever so narrowly avoid a negative quarter in Q3 next year (as the election campaign is likely to be getting into full swing). I’m not suggesting Treasury overtly politicised the forecasts, but had they assumed a monetary policy reaction more consistent with returning inflation to target quickly (say, under 3 per cent for 2023, which seems a reasonable interim goal at this point), the headlines might have been rather different.

I’m going to end with two charts that have little or nothing to do with short-run macroeconomic policy management.

This one shows The Treasury’s projections for (nominal) exports and imports as a share of GDP.

Of course, with closed borders for the last couple of years we saw a sharp dip in both exports and imports as a share of GDP. But the end point for these projections is four years ahead. For both imports and exports, the shares settle materially below pre-Covid levels, in series that have been going backwards for decades. No doubt the Greens would prefer we all stopped flying, but successful economies have tended to feature – as one aspect of their success – rising import and export shares of GDP.

The Budget talked of a focus on creating a “high wage economy”. Sadly, all I could see in the documents that might warrant that claim was the expectation of continued high inflation – which will raise nominal wages a lot, but do nothing for actual material living standards.

One of the striking features of the last decade was how relatively weak business investment as a share of GDP had been. Firms invest in response to opportunities, and the absence of much investment is usually a reflection on the wider economic and policy environment (much as bureaucrats like to think they know better, few firms just leave profitable opportunities sitting unexploited). For what is worth – and all the corporate welfare notwithstanding – The Treasury doesn’t see the outlook for business investment any better this decade than last.

And so in time will pass yet another New Zealand government that has done nothing to reverse decades of productivity growth underperformance. If that is depressing enough, this government seems to be in the process of unravelling the foundations of what had been a fairly enviable reputation for fiscal discipline and overall macroeconomic management. The situation can be recovered, but there is no sign in this Budget that the government much cares. And it isn’t even election year yet.

What if (2)

Last week I wrote a post suggesting that a rational Minister of Finance – one not unconcerned with macro stability but not particularly focused on price stability itself, one averse to severe recessions, one keen to be re-elected – might now seriously consider raising the inflation target. Such a Minister of Finance could find support among the economists abroad – quite serious and well-regarded figures among them – who have at times over the last decade or more championed a higher target to minimise the risks associated with the (current) effective lower bound on nominal interest rates.

To repeat myself, I would not favour such a move, and would quite deeply regret it were it to happen (here or in other advanced inflation-targeting countries – the UK for example). But interacting with a few commenters over the last week and reflecting further on the issue myself, I’m increasingly unsure why such politicians – and here I am talking about countries like New Zealand and the UK where the Minister of Finance has direct responsibility for setting the operational target of the central bank – would choose not to make a change. That is perhaps especially so in New Zealand, which has a history of politician-driven increases in the inflation target – changes that weren’t generally favoured by Reserve Bank staff or senior management, but which it has to be said have done little or no observable economic damage. Perhaps our Minister of Finance thinks he couldn’t fend off the tough forensic critiques that would come from the National Party? Perhaps he just thinks he can fob off any responsibility for the depth of the coming recession with handwaving about the rest of the world? Perhaps he would conclude it was already too late to get much benefit this term (not impossible)?

There isn’t yet much discussion (I’ve seen) of the possibility, whether here or abroad, although I did see last night a tweet from a former senior Bank of England researcher (and academic) championing just such a change. Of course, the most important two central banks are the ECB and the Fed, and in neither is there any provision for politicians to set operating targets, and the Bank of Japan is not yet grappling with high inflation. But it isn’t as if there is no discussion either: in this piece from late last year, by two former senior Fed officials, the case is made – or purely analytical/economics grounds – for exactly the sort of change I suggest a rational Minister of Finance might now consider. Among other things, the authors explicitly refer to the past New Zealand experience with raising inflation targets.

What disconcerts me is that, much as I would oppose an increase in the inflation target, I don’t think the case against will be particularly compelling to most people. I can highlight the distortions to the tax system, and thus to behaviour, that result from positive expected inflation, but that would be a more compelling argument were we starting from a target centred on true price stability rather than something centred already on 2 per cent inflation. I can, and do, make a strong argument for addressing the lower bound issues directly – easy enough to do as a technical matter, if only authorities would get on with doing so. There is a risk that materially raising inflation targets will lead to the public and markets being much less willing in future to take on trust the commitment of authorities to any (inflation) target they’ve announced (and one could note that the last New Zealand target change was 20 years ago – in the scheme of things still relatively early in the inflation targeting era).

So why would I oppose such a change? It isn’t impossible that some of it is just the reaction of someone who was present at the creation of (and actively engaged in forming) the current system and past inflation target. But I like to think it is more than that, and that many of the same arguments that persuaded me of the case for price stability 30-35 years ago still hold today. In the end I think it is largely almost a moral issue, and that – as we don’t tinker with our weights and measures, and look very askance on those who seek to fiddle them – there is something wrong about actively setting up a policy regime designed, as a matter of explicit policy, to debase the purchasing power of the currency each and every year.

Might it be different if – posing a hypothetical – nothing could be done about the current effective lower bound? Perhaps (although despite my advocacy for action on that front I’ve long been intrigued by the relative success of Japan in keeping cyclical unemployment low) but plenty can be done, as numerous economists have argued now for years. One can overstate the advantages of long-term price stability (there are very few long-term nominal contracts, and mostly that would be quite rationally so even if the inflation target was centred on “true” zero – ie allowing for the known modest biases in most CPIs) but it is like some gruesome triumph of the technocrats to be systematically destroying the value of people’s money by quite a bit each and every year on some proposition that doing so might produce slightly better cyclical economic outcomes, and even then only because politicians and technocrats wouldn’t address the problems at source. Sure, unexpected inflation is in many ways more troublesome than expected (targeted) inflation, but people shouldn’t have to take precautions against governments systematically eroding the value of their money.

Anyway, I would continue to be interested in alternative perspectives – either why the incentives on politicians aren’t as they appear to me to be, or why the economics-based case for pushing back strongly against increasing the target is stronger than it appears to me. Or, of course, why raising the target might just be good, on balance, economic advice.

Those comments got a bit longer than I intended. I’d really intended this post to be mainly some simple charts: given the (annual) inflation targets we’ve had, how have the cumulative increases in the price level over the decades compared with what might have been implied by the targets. I’ve seen a few charts around (for NZ and other countries) and did a quick one myself a few weeks ago on Twitter.

There are some caveats right from the start:

  • neither New Zealand nor any other country has been operating a price level target system.  In the New Zealand system, bygones are supposed to be treated as bygones –  eg a period in which inflation has overshot the target (for whatever reason) is not supposed to be followed by targeting a period of undershooting.  There are good reasons to prefer the “bygones be bygones” approach (even if some still contest it),
  • the charts below will focus on the midpoint of successive target ranges.  Since 2012 the Reserve Bank has been explicitly required to focus policy on the midpoint of the target range, but that was not so previously (and whereas Don Brash had quite an attachment to the idea of the midpoint, Alan Bollard did not particularly).  The targets have always been formally expressed as ranges.
  • while the targets have typically been expressed in terms of increases in the headline CPI, the Policy Targets Agreements (more recently the Remits) have explicitly recognised that there are circumstances in which CPI inflation not only will but should be outside the target range (a GST increase is only the most obvious, least controversial example).
  • the targets have been changed several times, but policy works with a lag.  In all these charts, I simply change the target when that change was formally made (even though if one were measuring annual performance –  not the issue here) one could not rationally hold a Governor to account for outcomes relative to a new target even six to twelve months after the target was changed).

With all that as background, here is a chart comparing the CPI itself with the successive targets, beginning in 1991Q4 (because the first formal inflation target was for the year to December 1992).  To December 1996 the midpoint of the inflation target was 1 per cent annum, rising to 1.5 per cent per annum to September 2002, and 2 per cent per annum since then.

CPI since 1991

Cumulative CPI increases have run a bit ahead of what a (very simple) reading of the successive inflation targets might have implied. It is a different picture than one would see for many other inflation targeting countries, but reflected the fact that until the 2008/09 recession (and despite lots of anti-Bank rhetoric about “inflation nutters”) we tended to produce inflation outcomes consistently quite a bit higher than successive target midpoints.

As I noted above, the Bank has only been formally been required to focus on the midpoint since September 2012 when Graeme Wheeler took office. Here is the same chart for the period since then.

CPI since 2012

Despite the newly-explicit focus on the midpoint, the annual undershoots during the Wheeler years cumulated to quite a large gap.

What about core inflation? The Bank’s (generally preferred) sectoral factor model has been taken back only as far as the year to September 1993. However, the Bank also publishes a factor model which goes back a couple more years (and which, although noisier year to year, has had exactly the same average inflation as the sectoral factor model in the decades since 1993).

This comparison surprised me a little. If you’d asked me I’d have guessed that over the decades the CPI might have increased perhaps 5 per cent more than a core measure (things like GST increases) but the actual difference is not much more than 1 per cent (the sort of difference best treated as zero given the end-point issues – chances of revisions – with such models).

CPI and fac model since 1991

Finally, although the Bank has never been charged with anything relating to the GDP deflator, I was curious. How would the cumulative path of the GDP deflator compare with that for the CPI? I didn’t have any priors, but was still surprised to find over 30 years the two series had increased in total by almost identical percentages.

CPI and GDP deflator since 1991

Inflation in the GDP deflator is a lot more volatile (mostly on account of fluctuations in export prices), so not at all suitable for targeting, but still interesting that over the long haul the total increases have been so similar.

To end, I should stress that I am not attempting to draw any fresh policy lessons, or offer either fresh bouquets or brickbats to the Reserve Bank (past or present). I was just curious.

What if?

When inflation becomes established and pervasive – not just direct price effects of this or that supply shock or tax increase (or combination of them) – it generally doesn’t come down all by itself.

Expressed in terms of conventional monetary policy, it usually takes a period in which policy interest rates are raised to, and maintained at, a level above the (not directly observable) then-neutral rate. Of course, sometimes an adverse external demand shock – eg an external recession – comes along, which can do a big part of the job. But that isn’t usually much more pleasant. Either way, domestic demand growth typically needs to be held below growth in the economy’s productive capacity for long enough to lower inflation. And, among other things, that will typically mean a rise in the unemployment rate, to (for a time) levels beyond (not directly observable) then-neutral (sustainable, non-inflationary) rate.

In principle, it can all happen very smoothly and gradually (the vaunted “soft landings”, often talked of, rarely observed). Such “soft landings” are almost always forecast (not just by central bankers), at least until the alternative is unavoidably obvious. Of course, “soft landings” are generally preferable, but (except as a matter of luck) they assume a degree of understanding of what is going on, how economies are unfolding, that isn’t often present. If forecasters (central bank and otherwise) really had a good handle on how economies were behaving at present, we probably wouldn’t have landed in quite the current inflation mess in the first place.

Since the New Zealand economy and financial system were substantially liberalised after 1984, we’ve had two episodes in which pervasive (“core”) inflation has been lowered. Both fit the story. As it happens, in both cases, we had a period of quite-tight domestic monetary policy and an international economic downturn. Actually, in 1990/91 we had a fair amount of discretionary fiscal tightening as well.

Inflation had still been very badly entrenched in the late 80s. Core inflation was probably around 5-6 per cent, and hadn’t been lower for a long time. It took 90 day bill rates at 13-14 per cent for a couple of years. We didn’t have a concept of “neutral rates” then, but no one would have seriously doubted things were tighter than neutral: that was the point. The unemployment rate peaked at about 11 per cent (there were other structural changes going on at the same time) to get inflation down into the target 0-2 per cent range. It was a nasty recession, quite similar to one in Australia and no doubt with contributions from the US recession at much the same time.

Fifteen years later, core inflation had been rising for several years. On best estimates, it peaked at about 3.5 per cent, some way from the midpoint (2 per cent) of the revised target range. The OCR had been raised to 8.25 per cent to counter this inflation (at the time, from memory, the Bank thought of the neutral rate as being somewhere not much above 6 per cent). Core inflation, of course, came down, through some combination of the tight domestic monetary policy and a nasty global recession. The New Zealand unemployment rate, unsustainably low at the pre-recession trough (about 3.5 per cent), rose to about 6.5 per cent. Core inflation fell back to the target midpoint (and then overshot when monetary policy was kept too tight for years too long – but that is another story).

At present, of course, core inflation is probably a bit over 4 per cent (looking across the range of core measures). That is a long way below headline inflation (as was the case in 2007/08). The unemployment rate is 3.2 per cent, and even the Reserve Bank has been moved to observe that the labour market is unsustainably tight.

Core inflation can be brought down again, but it isn’t going to happen by magic. Most likely it will take a period of sustained weakness in demand growth, a period of a negative output gap, and – as part of that – a period when the unemployment is above the medium-term sustainable level. The Reserve Bank thought the neutral OCR was about 2 per cent pre-Covid: if so, then the subsequent lift in inflation expectations would suggest at least 3 per cent now. Getting above that is a long way from the current 1.5 per cent.

The situation isn’t much different in a bunch of other advanced economies, even if each have their own idiosyncrasies.

Most likely – here and abroad – getting core inflation back down again will take recessions.

Voters may not be altogether keen on recessions. That is understandable at the best of times, but right now it is only two years since the last dramatic dislocation and temporary loss of output and employment.

And so I’ve been wondering recently if, before too long, some government and/or central bank (probably the two together) might not just decide it is all too hard. Why put people through another recession? Perhaps especially if the government concerned is already not looking too good in the polls.

But, you say, wouldn’t that just be seen as feckless. “giving up” in the face of a “cost of living crisis”? How could serious people possibly defend such a stance?

Actually, quite easily.

Long-term readers of this blog will recall that for many years I banged on about the effective lower bound risks, and how difficult monetary policy would prove in the next recession. With hindsight, I (and the many others internationally who were raising such concerns) should have rephrased that “the next demand-led recession”. Covid proved to have been different, in ways little appreciated in March 2020. But the issue has not gone away. And not a single central bank has yet done anything much to ease the effective floor on nominal policy rates (at probably around -0.75 per cent, beyond which the incentives to convert to physical cash – neutering monetary policy – become increasingly strong). Nasty demand-driven recessions will come again.

Since the 08/09 global recession, several prominent macroeconomists abroad (including Ken Rogoff and Olivier Blanchard) had been suggesting raising inflation target, perhaps to something centred around 4 per cent) to grapple with exactly that lower-bound risk. I was not convinced then – including because these same central banks were failing to deliver even on their existing inflation targets (too low inflation was the story of the decade), and it was difficult to see how stated intentions of delivering even higher inflation were going to be given much credence.

To be clear, I still do not support such a policy change now. Economies function a bit less effectively at higher inflation rates (even stable ones), and the lower bound issues can be – and should be, as a matter of some priority – be addressed directly.

But the context has changed, a lot. Now, it wouldn’t be idle talk from ivory towers in the abstract about lifting inflation. Inflation is already high, and the question may soon be about willingness to pay the price to get it back down again. Few people are very fond of recessions. So why isn’t it quite possible – even likely – that some set of authorities somewhere, backed perhaps by some eminent economists focused on those lower-bound issues, as well as more-immediate political imperatives would suggest (initiate) a change. A 3-5 per cent inflation target range perhaps?

There would be pushback from some quarters of course. Do it once and won’t everyone believe you’ll do it again any time the pressure comes on? It is the sort of argument that sounded good 30 years ago, but actually New Zealand twice raised its inflation target – when the political pressure came on – and although I’m still not a big fan of those changes, it is hard for any honest observer to conclude that they were terribly damaging. Bond holders won’t necessarily like it, but many of the indebted would. Those on the margins of the labour market – the sorts of people most likely to lose their jobs, or find it harder to get one – might be responsive too. Realistically, in the face of such a change most forecasters would revise their numbers and project a little more output in the short-term (no long-term tradeoffs, but the costs of getting inflation back down are real).

There are quite a few places that aren’t likely to lead the way on any such change. The ECB, for example, sets its own specific inflation target, faces no election, and has a price stability focus embedded by treaty.

But there are other places where it could happen, and in particular any place where (as should happen) the elected government sets the inflation target.

New Zealand might be one of them. After all, the government is slipping in the polls, the likelihood of a recession between now and the election is steadily rising, and whatever merits the current Cabinet have, none of them seem like hard money people (to many of their voters that is probably a good thing). The current policy target Remit still has 21 months to run, but the Governor’s term expires in March, a new Board takes office in July, and so on. The Governor has already told us the Bank has analytical and research work underway – consistent with the provisions of the amended RB Act – for the next Remit review. Mightn’t it seem brave and pioneering, prioritising employment (immediate and in that next demand-led recession), to carve a new path and revise up the target (all perhaps flanked by distinguished experts).

To be clear, I do not (and would not) support such a change. Moreover, there is nothing in the public record to suggest that our government or central bank are looking at such a change. My point in writing the post is that, when one thinks about incentives, it isn’t obvious why some government or other mightn’t adopt exactly such an approach before too long. And it isn’t obvious why it wouldn’t be the New Zealand government. Just think of it, the ultimate product differentiation from Roger Douglas (the main consideration that seems to have driven Grant Robertson in the overhaul of the RB Act in recent years).

Of course, even if core inflation was to be stabilised at around 4 per cent, it seems almost certain that the unemployment rate will rise from here: that is the implication of the Reserve Bank’s observation that the labour market is unsustainably overheated. But there is quite a difference between settling at 4.0 to 4.5 per cent, and a couple of years at (say) 5.5 per cent. Shrewd political advisers will recognise this. They will also recognise that if most other advanced countries are heading for recessions we won’t fully escape the effects, but they might think that easing up on our target now might better position us for the (near-certainly) tough times on the horizon. Were I Ardern or Robertson – and I am very thankful I am neither – I might be tempted.

Perhaps the analysis here is all wrong. If so, I’d be really interested in reactions or alternative perspectives.