Reviewing Covid monetary policy – Part 1

After last week’s posts on the Reserve Bank’s handling of monetary policy, I thought it might be worthwhile to stand back and attempt a series of posts this week on how the Reserve Bank has handled things (mainly monetary policy) over the two and half years since, in late January 2020, Covid became an economic issue for New Zealand. In today’s post, I will look at the Bank’s preparedness and their responses over the first three months or so. In a second post, probably tomorrow, I will look at their handling of policy over the following year or so, and a third post will look at the more recent period. If it seems worthwhile, I might attempt a final post bringing it all together.

It is hardly a secret that I do not have a high regard for the Governor, but in this series I will be seeking to offer both brickbats and bouquets as fairly as I can, and to distinguish as far as possible between perspectives that were reasonably open to an informed observer at the time and those which benefit from hindsight. Both have their place. Even though every country’s circumstances differ, what was going on in other countries and central banks is not irrelevant to a fair assessment of the Reserve Bank’s handling of things. People with more time and resources are better placed to assess the variety of responses in other advanced countries, but I will draw on comparisons where I can and where I think it would be helpful. Finally, while my focus is on the people who mattered – the Bank and the MPC – I’m always conscious that I wrote a lot in real-time about how monetary policy was being and should be handled. Inevitably I’ve had to reflect on what I got right and wrong, and why.

One area in which the Bank does not score well throughout is transparency. The Bank often likes to boast about being very open and transparent – the Governor was at it again in his press release last week reacting last week to the Wheeler-Wilkinson paper – but it is anything but, and the gaps were more evident than usual over the Covid period. The Bank has been less willing than the government generally to release relevant background documents, nothing at all has been heard from most members of the MPC (despite it being one of the most difficult times for monetary policy in a decades), and there have been few serious and relevant speeches and little or no published research. In challenging and uncertain times when no one has any sort of monopoly on wisdom the stance the Governor has chosen to take – echoing the biases of successive Governors – is a poor reflection on the Bank. We are told that Bank staff are beavering away on their own review, but the Bank will not even commit to having that material available to the public before their consultation on the five-yearly review of the monetary policy Remit closes (and there is no sign, for example, of any sort of ongoing engagement with alternative views going on). Here it is always worth bearing in mind that the Reserve Bank has far more resources available to it (including the largest team of macroeconomists in the country) than any other relevant party in New Zealand. We should expect better. And the Governor’s assertion a couple of months back to Parliament’s Finance and Expenditure Committee that he regrets nothing is neither true to the limitations of human knowledge/understanding, nor exactly reassuring that we are dealing here with an open and learning organisation.

Preparedness

When the first news of Covid cases emerged from China at the very end of 2019, the OCR was 1 per cent and the Bank had been struggling for some years to get (core) inflation up to the 2 per cent that successive governments had told them to focus on. By the end of 2019, they were not far away, but equally the economy was pretty full employed, the growth phase had run for 8 or 9 years, and prudent central bankers needed to be thinking about how they’d cope with the next recession. The effective lower bound on the nominal OCR really wasn’t that far away and in typical recessions perhaps 500 basis points of interest rate cuts had been required.

In a couple of respects, the Bank doesn’t score too badly:

  • as long ago as 2012, then outgoing Governor Alan Bollard had set up a working group (I chaired it) to think about how we would handle the next serious downturn. That group recommended, and there was no dissent from senior management, that steps be taken to ensure that the Bank’s systems and those of the banks could cope with modestly negative interest rates (which had already become a thing abroad),
  • in 2018, shortly after Orr took office, the Bank published a survey of options for what they referred to as “unconventional monetary policy”, citing the need to have thought through the issues in case the need arose in New Zealand (I discussed the article here).
  • well into 2019 the Governor gave a substantive interview in which he expressed his view that a negative OCR was preferable to using large-scale asset purchases in a future serious downturn. They seemed to have been thinking about the issue quite a bit.

The problem was that it didn’t seem to have occurred to them until very late in the piece to check if their preferred option was workable. Documents released under the OIA confirm that it wasn’t until December 2019/January 2020 that they thought to check, and pretty quickly the feedback from banks told them that – for many if not all banks – there were systems problems (both computer systems and documentation) that meant negative interest rates could not be implemented in short order.

(To be honest, I am still mystified on two counts: the first is how the Bank never checked over all those years, but the second is how the banks – often part of banking groups with operations in countries/markets that had dealt with negative rates elsewhere over the previous decade – were sufficiently remiss as not to have prepared either. How insuperable these obstacles really were in still hard to tell, but what matters is that the Reserve Bank and the MPC treated them as so, and were foreced into last minute changes of plan.)

The Bank was pretty slow off the mark to recognise the potential severity of Covid. By late January, some New Zealand exporters of luxury food products to China (notably crayfish) were reporting real problems. At the very end of January, New Zealand temporarily closed the border to arrivals from China (China have already restricted outflows from China), threatening both tourism and foreign students, and lockdowns were a thing in one of the world’s largest economies. But through February, the Bank took a fairly relaxed approach (which, in fairness to them, seems to have reflected a fairly relaxed approach across much of government – the Secretary to the Treasury sits on the MPC, and there is no sign that she injected any great sense of urgency to the deliberations on the February MPS, and published papers reveal no urgent whole of government effort to get ready for what might be coming). I was among those calling for a precautionary (Covid) OCR cut in February – at the time, there was no doubt that the Covid effects we were experiencing were, from a New Zealand perspective, pure adverse demand shocks. The Bank didn’t act, but what surprised me more was a couple of weeks later when they took to social media to talk up economic prospects for 2020 (an OIA request revealed that this wasn’t some rogue social media person, but was initiated/cleared by the Bank’s chief economist).

The global situation deteriorated into March, and not much was seen or heard of the Bank. But then on 10 March the Governor delivered a speech to an invited audience on monetary policy at very low interest rates. The Governor was keen to stress that this was all in abstract, there were no immediate plans to use any of them, but also

There was an indication that they would shortly be publishing background technical papers on each option (papers which, if they existed, never actually were published).

Note the preferred order. Note the date.

A couple of days later the Herald briefly reported some comments by the chief economist also downplaying the potential of asset purchase options.

On Monday 16 March, the deteriorating situation (virus, markets, economic dislocations), finally prompted the Bank to act. The centrepiece of the day’s announcements was that the OCR was cut by 75 basis points immediately (other central banks were making similar moves). But there were other elements to the day’s announcements, notably:

  • a year’s delay in the commencement of the higher bank capital requirements,
  • a move to pay the OCR interest rate on all settlement cash balances (previously each bank had a quota – linked loosely to daily interbank settlement requirements – above which only below market rates were paid).

Both moves made sense.

The Bank also indicated that it had discovered – 6 days on? – that banks could not operationally cope with a negative OCR, and issued a pledge that seemed strange and inappropriate at the time and seemed only more odd later: no matter what happened, the OCR would not be changed for the coming year. It simply made no sense. On the one hand, even if a negative OCR wasn’t really technically feasible, there didn’t seem to be any obstacle to an OCR of zero (or 1 or 10 basis points). And in an environment that was moving so fast and was so uncertain (that, for example, emergency unscheduled MPC announcements were needed) how could anyone pretend to the level of confidence in the economic and inflation outlook implied by a pledge that, come what may, the OCR would not be changed – up or down – for the coming year? Since the Bank won’t release the relevant documents and has never really engaged on the issue, it is hard to know what was going on in their minds, or what issues/risks they were thinking about (or not).

All that said, on the day the broad thrust of the moves was fairly widely welcomed (as just one example, here is the “Whatever it takes” (and “more will be necessary”) press release from the NZ Initiative. This was the day before the government’s own first significant Covid fiscal package (which I described at the time as, at best, good in parts).

The Covid situation deteriorated rapidly over the following week, with New Zealand’s “lockdown” (not envisaged in either fiscal or monetary announcements the previous week) announced and implemented. Economic activity was clearly weakening, as (eg) domestic travel dried up. Global equity markets were very weak and pressures spilled over into bond markets, initially in the US, but increasingly globally. Cash was king and bonds could be sold.

And on 23 March, the Bank announced that they had lurched to launching a $30bn large-scale asset purchase programme. Read the statement and it is clear that there were two separate considerations: one about the immediate pressures in the government bond market (yields were rising) and the second – more important – about the deteriorating economic situation. In their words

The negative economic implications of the coronavirus outbreak have continued to intensify. The Committee agreed that further monetary stimulus is needed to meet its inflation and employment objectives.

The following day – the “lockdown” having been announced by then – the Reserve Bank, the government and the retail banks had a further announcement (not primarily about monetary policy) : a six month mortgage holiday for those with severe Covid income disruptions, an (ill-fated) Business Finance Guarantee Scheme, and (from the RB, and with monetary policy implications) an easing in the core funding ratio requirement on banks.

There were various other announcements over the following days/weeks, but perhaps the last in the initial wave (and I’d forgotten it came a month later) was a 21 April announcement that the Bank was planning to remove LVR restrictions for 12 months.

It seems to me that the Bank’s broad approach over the period from mid-March to late April 2020 was consistent with a pretty widely held view of severe downside risks to both economic activity and inflation – widely held among informed observers in New Zealand and those overseas (looking at their own economies). Of course everyone recognised that (for example) ordering people to stay at home for weeks on end represented a reduction in the economy’s capacity to supply (good and services) and that the liberal wage subsidies would maintain immediate purchasing power (at least for wage and salary earners), but that there were good reasons to suppose that adverse demand effects would outweigh supply reductions. If so, downside risks to inflation and inflation expectations were very real (risks to expectations soon became apparent in survey measures) and, well, inflation and inflation expectations were what we wanted the monetary policy arm of the Reserve Bank to focus on.

What sort of demand effects might we see? Examples included:

  • schools and universities unable to receive foreign students (significant export industry), and uncertain when those restrictions might ease,
  • tourism itself was a net export earner for New Zealand,
  • the borders being closed meant few if any new migrants could arrive (the demand effects of new migrants typically outweigh supply effects over the short-term horizons relevant to monetary policy,
  • the previous recession had seen a material fall in nominal house prices (despite much larger interest rate reductions) and between (a) reduced immigration, (b) limited interest rate cuts, and (c) significant reductions in business income (not protected by wage subsidies) house price falls and consequent reductions in building activity seemed likely (for those fond of wealth effects, them too)
  • big fiscal outlays upfront meant higher taxes later. That, together with lost GDP, meant we were actually/prospectively poorer, and might less keen on future spend-ups
  • huge additional risk and uncertainty had been added to the economic environment ( no one knew when normality would return, what it would look like, how many disruptions – or deaths – there would be in the intervening months/years. A standard prediction would be that heightened perceptions of risk and real inescapable uncertainty would mean firms and households would respond by deferring spending, and particularly (very cyclical) investment spending,
  • and if all this happened globally then our export commodity prices could be expected to fall (even as headline inflation was lowered by oil prices briefly approaching zero).

I held many/most of those sorts of views. So did many/most forecasters in those early days. A fairly aggressive macro policy response was warranted on those sorts of scenarios. If inflation and inflation expectations were to fall sharply it could prove very hard to get them back up again. against that sort of troubled economic backdrop. I am not aware of many (if any) mainstream commentators or forecasters taking a drastically different view in those early days (even as everyone recognised the huge uncertainty).

That doesn’t mean an automatic tick for everything the Bank did. For me

  • the big OCR cut, if a little late coming, was quite the right thing to do (including against a backdrop of significant fiscal income support and some other stimulus)
  • making available additional liquidity if required also made sense,
  • as did the easing of the core funding ratio, which helped enable lower term deposit rates relative to the OCR,
  • but the pledge not to change the OCR further for a year made no sense then, and makes no sense now.  The Bank knew it was entering a climate of extreme uncertainty, it knew it might need all the monetary support it could get. No one else anywhere in the economy had any certainty at all about anything, and yet the Bank pretended to.  
  • the move to pay the OCR on all settlement cash balances made little sense if the Bank was really serious about delivering as much stimulus as it could (that floor stopped market rates drifting lower) [UPDATE: altho it did support a more precise control of very short-ter market rates at/near the OCR itself, that might have been impaired otherwise if the Bank was injecting more liquidity.  This was probably the intention, althoguh a little later in ended up impairing one channel through which the LSAP might have worked].

My focus is on the remaining two strands of the package.

Perhaps one can mount a decent case for a week or two of stabilising intervention in the government bond market in late March 2020.   The pressures would have sorted themselves out anyway (after Fed intervention) but if the RB wanted to do its little bit that in isolation probably did little harm (if reinforcing future moral hazard risks).   But the case for the sustained LSAP itself (initially $30bn) was never, and has never compellingly, been made.  The Bank was right, just a few weeks earlier, to be wary of what the LSAP could offer outside the white-heat of financial crisis.  It seemed to have been too readily swayed by some mix of a need to be seen doing stuff (having ruled out more on the OCR), and false parallels with choices some other central banks had made over the previous decade.  The Bank rushed into the LSAP mainly purchasing long-term government bonds with ever, it seems, addressing either the fact that very little borrowing in New Zealand occurs at long-term fixed rates (so even if they affected those rates a bit, so what?) and with no serious financial risk analysis at all (if any such document existed it would surely have been released by now).   This latter failure has cost the taxpayer very dearly, and any serious risk analyst (in the Bank or The Treasury –  who seem quite culpable here, as advisers to the Minister on the indemnity)) would have identified those downside risk scenarios.   It was a failure of controls that, in a private bank, would rightly alarm a supervisor.     (While my view on the LSAP still seems to be something of a minority view in New Zealand, it is quite consistent with that of Professor Charles Goodhart, a UK monetary economist that the Bank has drawn on over the years, writing –  in a Foreword to a book on QE completed just prior to Covid “the direct effect on the real economy via interest rates, whether actual or expected, and on portfolio balance, was of second order importance. QE2, QE3 and QE Infinity are relatively toothless”).  I absolve the Bank of claims that the LSAP was later to do much to influence asset prices or the CPI, but that was on grounds that it was a gigantic speculative punt in the bond market, at taxpayers’ risk, for an expected economic return that was always derisorily small. 

If I have a minority view on the LSAP –  simply was not appropriate even at the time as a monetary policy tool –  I may also have on the LVR restrictions.  I see numerous people commenting, including on my Twitter feed, that “well, maybe the Bank had to do something with monetary policy in March 2020, but why do they do anything with LVRs-  that really was inexcusable”.

And on that I simply disagree.  I have never been a fan on LVR restrictions and in that sense would always –  including now –  welcome their removal, but even on the Bank’s own terms suspension of the restrictions was the sensible thing to do back then (ideally a few weeks earlier).  LVR restrictions were intended to lean against reckless lending against rapidly rising collateral values, and in discussions inside the Bank in the early days on LVRs the mentality was that sensibly controls would be lifted if asset prices were to be falling, or otherwise the controls would exacerbate falls and potential illiquidity in the market, while doing little/nothing for financial stability.  In this particular (Covid) crisis there was a further factor, cited by the Bank in its announcement: a six month mortgage holiday for those severely affected by Covid could have run smack hard into LVR restrictions had the latter been left in place [UPDATE: since interest deferrals in particular would have amounted to an extension of further credit to the borrower, at a time when collateral values –  which in principle would need to be reassessed at any fresh credit extension – appeared to be (and were expected to be) falling.]   One might quibble that the mortgage holidays really did pose increasing financial stability (loan loss) risks down the track, but the banks were already amply capitalised.  Between early indications that house prices would fall –  as they did for the first couple of months –  and tightening bank credit standards anyway (something the Governor regularly inveighed against) suspending the LVR restrictions was definitely the right call with the information, and the (widely shared) economic outlook the Bank had at the time.

This has, almost inevitably been a long post. I’m going to stop here, with just one final brief observation.  When, as is often done, people now talk about high inflation being a problem almost everywhere, it is sometimes (and fairly) pointed out that it isn’t quite all (advanced) countries: Japan and Switzerland being two examples of countries with much more moderate inflation.  They were also two countries that didn’t do anything much with monetary policy in 2020.  However, that doesn’t really tell as anything about what was right to do, with the information at the time, in early 2020.  After all, both Japan and Switzerland went into Covid with policy rates already negative, and unable to do very much more with monetary policy.  Had they been able to do more perhaps they would have done so. Or perhaps not.  But we have no easy way of knowing.  In early 2020 countries (central banks) like NZ, Australia and the US were openly quite glad to have the leeway they did, to take the steps they did, in a climate in which many argued “just do whatever it takes”.

Next stage in Covid monetary policy tomorrow.

 

4 thoughts on “Reviewing Covid monetary policy – Part 1

  1. Not my field but a reasonable length history that as far as I remember is consistent with articles you wrote at that time. Has anyone attempted a similar review of the political decisions related to Covid? What the medical experts were saying and how the politicians were reacting with lockdowns and quarantine? Our memories fade.

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