Really?

In the Sunday Star-Times yesterday there was a double-page spread in which various moderately prominent people (all apparently “leading speakers” at some “annual University of Waikato economic forum” this week were given 100 to 150 words to tell us “How can NZ build back following a string of serious economic and social setbacks”.

Most of the contributions were pretty underwhelming to say the least. To be fair, 150 words isn’t a lot, but real insight tends to shine through and there wasn’t much on offer in this selection. But then, who really cares much what the chief executive of the Criminal Cases Review Commission or the co-founder of an advertising agency think on such issues.

By contrast, Paul Conway is a statutory office-holder in an economic field. He is the (relatively new) chief economist of the Reserve Bank of New Zealand and in that capacity has been appointed by the Minister of Finance as an internal member of the decision-making Monetary Policy Committee. This was his contribution.

It was pretty bad. It is hard to argue with the first sentence, although the previous decades had not been an unbroken record of success and low inflation (check out core inflation measures over 2007 and 2008). But it was when I read the second sentence that I started to get concerned. What possible analytical or empirical basis is there for that claim?

For decades the Reserve Bank has told us (and rightly so) that there are no material long-run trade-offs between inflation and activity/unemployment/”prosperity”. That is so on the upside – you can’t buy sustained prosperity or lower unemployment by pursuing or settling for a higher inflation rate – but it is also largely true on the other side. Not only does lower inflation not create permanent adverse economic outcomes, but it is not a magic path towards materially better economic outcomes either. At best, and this is a line the Bank has also run for years, sustained and predictable low inflation, or price stability, may be conducive to the wider economy functioning a little better than otherwise, but any such effect is typically viewed as very small, and difficult to isolate statistically.

Unfortunately, Conway’s line has the feel of political spin, the sort of thing we might here these days from Luxon or Hipkins amid talk of a “cost of living crisis”. But, as the Reserve Bank MPC members should know only too well, real hits to economywide material living standards are not a consequence of general inflation but of supply shocks that (a) central bank can do nothing about, and (b) which would have been a thing, with adverse consequences for average living standards, even if the central bank’s MPC had done its job better over the last few years (Conway himself was not there when the mistakes were being made). As it happens, the process of actually getting inflation back down again will – on the Bank’s own forecasts – actually, and necessarily, involve some temporary losses of output and “prosperity”.

It was pretty poor from the chief economist of the central bank who (unlike his boss, the deputy chief executive responsible for macro matters and monetary policy) is a qualified and experienced economist.

Then we get the curious claim that monetary policy “is only part of the solution to reducing inflation”. Except that it isn’t. The way things are set, the Reserve Bank Monetary Policy Committee is responsible for keeping (core) inflation at or near the target midpoint, after taking into account all the other stuff that is going on, all the other policy initiatives here or abroad. Monetary policy isn’t the only influence on inflation, but it is given the job of delivering low inflation having factored in all those other influences. Thus, when the Canterbury earthquakes happened and there was a huge stimulus to demand over the next few years, it was still monetary policy (and monetary policy alone) that was responsible for delivering inflation near to target. We wouldn’t have wanted the repair and rebuild process slowed down just to have made the Reserve Bank’s job a bit easier. Same will go, on a smaller scale, for the repairs etc after the recent storms. Perhaps Conway or his colleagues think the government should be running a different fiscal policy, but as monetary policymakers it is really none of their business: fiscal policy and the central bank should normally each do their own jobs. As it is, Conway’s line gives aid and comfort to people talking up things like temporary petrol excise tax cuts as a way of helping ease inflation.

But bad as some of that stuff was it was the last three sentences that really struck me, including because Conway likes to talk about productivity (he was head of research at the Productivity Commission in that agency’s better day, and produced a range of interesting papers). We should all be able to agree that, in general, higher economywide productivity growth would be a good thing. People would be better off and individuals and governments would have more real choices.

But it isn’t a path to lower inflation, let alone lower interest rates, whether in the short or long run. And it isn’t clear why Conway appears to think otherwise.

In the short run, perhaps he has in his mind a model in which the Reserve Bank determines nominal GDP growth. If it did then, all else equal, the higher real economic activity was in any particular period then, mechanically, the lower inflation would be in that period. If higher productivity was an element in that higher real economic activity, and nothing else changed as a result, then higher productivity might be part of such a story. But the Reserve Bank does not control nominal GDP growth in that sort of mechanical sense, and if firms suddenly stumble on paths to higher productivity it is very likely nothing else will change as a result. Over the longer-term, higher rates of real GDP growth – and productivity growth – tend to be associated with higher, not lower, interest rates (a “good thing” in that context, as not only is there typically strong investment demand to take advantage of the productivity shocks and the opportunities they create, but also expected future incomes will be stronger and people will rationally want to lift consumption now in anticipation of those future gains). And if, as it appears may be the case, Conway is more focused on the short-term (“without the need for ongoing interest rate increases”) then it is really just magic fairy stuff, distracting from the (hard) choices the Reserve Bank has been having to make. Productivity growth isn’t just conjured out of the air at short notice to suit the cyclical preferences of central bankers.

It might have been better if Conway had declined to participate in this elite vox pop (after all, monetary policy really hasn’t much to offer, and we shouldn’t want to hear a central banker’s personal views on other policies) but if he was going to participate he really should have produced something better than what actually appeared. Yes, he didn’t have many words to play with, but the basic points aren’t hard to make quite simply. Whatever shocks, positive or negative, the economy experiences the Reserve Bank should be looking to provide a stable macroeconomic backdrop, and nothing monetary policy does can do more than take some of the rough edges off the worst of booms and busts while delivering a stable and predictable general level of prices. After the failures of recent years, that wouldn’t be nothing.

8 thoughts on “Really?

  1. What Conway should have said is: our only tool is interest rates; if other agencies’ actions hinder the country’s ability to produce goods and services by e.g., turning producers into bureaucrats and increasing red-tape, interest rates will need to be higher.

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  2. Reading through it sounds like the brief described in the column isn’t the brief the contributors were given. They all just go on about whatever they were to be talking about at the conference. Wonder if somebody just stuck a rebuild bit at the top of the column for relevance.

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    • Probably right (in fact I summed up the two pages to my son yesterday as “people sounding off on their individual hobbyhorses).

      None of that of course changes the problems with Conway’s actual text.

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      • And it was very interesting to read those brief summaries given by the participants on their various hobbyhorses. Fascinating micro-study on how diverse our worldviews are and really instructive (I thought) in terms of how our perception and experience influences the particular ‘lens’ through which we interact socially and determine our priorities. Thanks for linking to the article as I had not read it earlier.

        And not good that the RBNZ commentator misinterprets monetary policy cause and effect in the way you describe.

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  3. His task wasn’t hard… I rustled this up in 10 minutes….

    The Reserve Bank has only a tangential role to play in assisting cyclone recovery as our function is to ensure price and financial stability. Inflation has recently lifted to multi-decade highs due to a confluence of events both here and abroad, which have boosted both domestic and imported cost pressures. The Reserve Bank remains committed to bringing inflation back down to the mid-point of its one-to-three per cent inflation target at the earliest opportunity. The Bank’s Monetary Policy Committee is encouraged in this action by the fact that longer-term measures of inflation expectations remain well anchored, suggesting the broader public anticipates price stability will be restored. Meanwhile, natural disasters present a very different challenge, causing stresses and strains on the financial system that may have been masked by previous calm. Indications observed to date suggest the financial system remains well capitalised and flexible, but there remains no cause for complacency.

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