Towards the Monetary Policy Statement

Tomorrow brings the first of the Reserve Bank Monetary Policy Statements under the new Governor, Adrian Orr.  I’ve noticed several preview commentaries headed up with plays on the Governor’s surname: BNZ’s was “Either Or”, and ASB’s was “Rowing with a new Orr” .  I was tempted to head up this post with “Rowing with just one Orr”, a reminder that –  for all the promised new legislation (at least in respect of the monetary policy powers) –  for the time being, the Governor governs alone.  One unelected official alone has the legal authority to make OCR decisions –  and to decide on all the other bits of policy and operations the Reserve Bank has statutory responsibility for.   It isn’t a good formula –  failing tests of both legitimacy and robustness.  It isn’t helped by the threadbare nature of the parliamentary scrutiny of the Bank and the Governor.    In the terms Paul Tucker uses in his new book, the Governor is an ‘overmighty citizen’.

That isn’t Orr’s fault.  The law is what it (unfortunately) is, and perhaps will soon be changed.   But the conduct of the Bank, and the Governor personally, is something that Orr has totally under his control.    One of the things former Bank of England Deputy Governor Tucker advocates in his new book is that if central banks want to sustain operational independence, and if that independence is to work for the good of society, an ethos of self-restraint is really important.   It is reiterated in the very last line of his entire book

“Beyond the parameters of the formal regime, an ethic of sefl-restraint should be encouraged and fostered.”

Society delegates a great deal of power to our independent central bank.  It can do us good (we hope, typically) or harm, but unelected officials who exercise such great power need to act, and speak, as if they know their limits.  They aren’t politicians, they have no general mandate, and if they have a platform it is for the purposes Parliament has set down, not to champion personal causes, or even to “help out” governments in other roles.   It is a distinctly limited role.

In his first six weeks in office, there have already been reasons to doubt that the Governor understands, or shares, that view –  itself all the more important when (formally) the Reserve Bank is a one-man show.   We’ve seen him stray well beyond the Reserve Bank’s areas of responsibility in various interviews, and in ways that could often be read as quite politically-aligned.  We’ve seen him all over the place on financial conduct issues, and the politics of possible inquiries –  none of which has anything to do with his mandate –  including rushing to sign on with the FMA’s populist demands of banks, which again have nothing to do with the Reserve Bank’s statutory mandate or powers.   You can win cheap popularity for a time by going with the mob –  or even with popular elite opinions –  but you safeguard the institution and its important role, over the longer-term, by doing what Parliament asks you to do, in a moderate and responsible manner, and leaving other stuff to other people.

The real test for the Governor tomorrow is unlikely to be the Monetary Policy Statement document itself –  much as the analysts will be looking for evidence of a distinctive Orrian perspective.  The test is much more likely to be the press conference an hour later, and perhaps even the Finance and Expenditure Committee hearing later in the day.    Given the Governor’s garrulous style to date, journalists must be almost salivating at the opportunity to tempt the Governor into some rash remark, as he answers questions, live and unscripted, for a prolonged period.   Much of the rest of the Reserve Bank must be ever so slightly uneasy.

The BNZ commentary put it this way

…it goes without saying that Adrian Orr’s presentation style in the post MPS news conference will be more dynamic than his predecessor.

“Dynamic” perhaps being a euphemism for things like freewheeling, unpredictable, entertaining –  not words that (for good reason) one typically associates with a central bank Governor.   Leaders of political parties, yes; central bank Governors, no.  Central bank press conferences shouldn’t an occasion to which to bring the popcorn.

In many ways, I’m sure an Orr press conference will be a welcome relief after many of the Wheeler ones.  The previous Governor often came across as morose and defensive –  and even he wandered off reservation at times (I recall an answer about the possible implications of some North Korean action).  But I hope we don’t see an over-correction from an exuberant new Governor.  We should certainly welcome a more open and frank exchange on monetary policy issues, perhaps even a Governor willing occasionally to acknowledge the odd mistake, but unpredictable free-for-alls aren’t going to be good for the institution, for the individual, or for the country –  gruesomely entertaining as they might well be in the short-term.

One of the last bits of data before the MPS came out yesterday: the Reserve Bank’s quarterly survey of expectations (the Bank itself will have had the data several days earlier).  There wasn’t much of great interest in the the quarter to quarter changes.  But it is worth nothing that respondents seem to think we’ve reached the peak of the economic cycle: after eight years of expecting the unemployment rate to fall further over the medium-term, for the last few quarters they’ve been expecting things to turn around (albeit only a bit).

Looking through the longer runs of data, a couple of things caught my eye.  Analysts  (me included) often don’t pay much attention to year-ahead measures of inflation expectations, which get tossed around by all sort of short-term effects (oil price changes, changes in taxes and government charges, and even climatic effects on fruit and vegetable prices).  On the other hand, it is also a horizon analysts know a little more about –  there are specifics and not just models –  and a horizon where, by the time the expectation is being recorded, the Reserve Bank can’t do much more about the outcome.   So I thought this chart, showing year-ahead inflation expectations since mid-2012 was a sober reminder that monetary policy hasn’t been quite right.

infl expecs 1 year

Recall that the target was 2 per cent inflation.  These expectations – with all their short-term noise –  haven’t been centred on 2 per cent, but something a bit lower.  Not surprisingly, outcomes have also been centred somewhere lower: headline CPI inflation averaged about 1 per cent over this period, and even the Bank’s preferred core inflation rate measure averaged 1.4 per cent.   So even at these sorts of short horizons, the analysts have had an upside bias to their inflation forecasts, and even those forecasts haven’t centred at 2 per cent.  Perhaps a question might be in order for the Governor tomorrow?

I was also interested in another longer-run chart.  The survey asks respondents where they think the 10 year bond rate will be at the end of the current quarter, and in a year’s time.  The difference between those two responses is an indication of how respondents think the underlying trends in interest rate markets will start to play out.  Here is a chart of the actual New Zealand 10 year bond yield going back to 1995 when these survey questions start,

10 yr bond may 18

There are cycles, of course, but the trend has been pretty clearly downwards, especially so since around 2011.

And yet here is what respondents to the Reserve Bank survey expected.

bond expecs

The expected changes are never that large, but what is interesting is the sign of the expected movement.  With the exception of pretty brief periods when domestic interest rates here were particularly high (mid 90s and the couple of years prior to the 2008/09 recession) the Bank’s respondents have persistently expected bond yields to start rising again.   Even the short-term variability in the series has been lower in the  post-recession period, such is the apparent strength of the view.     Respondents  –  no doubt like the Reserve Bank, which has repeatedly told us that in their view neutral interest rates are much higher than current rates –  have mostly just had the wrong model.  (I’m not sure what my views would have been in the early post-recession period, although they were probably similar to the consensus. I’ve been in the survey itself for the last three years and my records suggest that in none of those surveys have I predicted an increase in bond yields –  in all but one I picked a reduction.)

Quite possibly, similar surveys in other countries would have produced similar results, but it is a cautionary reminder of just how wrong the mainstream view has mostly been in the post-recession years.

Last year the Reserve Bank revised the survey to add questions about expectations of inflation five and ten years hence (previously we’d had only two-year ahead expectations).   It is still early days, but the results look much as you might expect: both five and ten year ahead expectations seem centred on 2.1 per cent, just a touch above the midpoint of the inflation target (my own expectations for these horizons, which stretch beyond the current Governor/government, are lower).  Two-year ahead expectations are about the same.   With current 10 year bond rates at around 2.8 per cent, and inflation expectations (in the survey) at around 2.1 per cent over the whole 10 years, respondents seem to think New Zealand real interest rates are very low (only around 0.7 percentage points).

But again we have the contrast between the recorded (and anonymous) views of local survey respondents, and the implied view of people putting money on the outlook for inflation.  The current 10 year nominal government bond yield features in both comparisons.

But what about our inflation-indexed government bond yields?  The 7.5 year bond was at 1.34 per cent yesterday, and the 12.5 year bond was at 1.7 per cent, suggesting a 10 year real government interest rate of around 1.5 percentage points.

And here is the gap between the yield on a 10 year nominal bond, and the two relevant inflation-indexed bonds.

IIBs may 18

There isn’t any sign that markets are trading as if they believe inflation over the next 10 years will average where the respondents to the Reserve Bank survey say it will.  Ten years from now is roughly halfway between those two indexed bond maturity dates: the latest observation of the average of those two series would be around 1.25 per cent.  People with a choice of holding indexed or nominal bonds to maturity (eg long-term superannuation funds) will be worse off holding conventional bonds if inflation is anything like what the survey respondents think than if they held indexed bonds.  It is a real money choice.  Bondholders are positioned consistent with the survey respondents being wrong.

I labour this point for two reasons.  First, one reason for having inflation indexed government bonds is to provide a market check on what people actually transacting are acting as if inflation will be (rightly or wrongly).  And second, because when it regularly tells us that medium to long-term inflation expectations are stable at around 2 per cent, the Reserve Bank relies on survey measures, and appears to put no weight on market measures at all, even though they are telling a quite different story (and in fairly settled times).  The Reserve Bank never attempts to justify this one-eyed approach, and never seems to reference market-based expectations measures at all.

Given that the Bank itself, and survey respondents, have been so persistently wrong about inflation (and about interest rates) it might be worth someone –  journalist or MP –  asking the new Governor tomorrow about whether he is more confident average inflation is finally about to rise than people staking money on the issue appear to be, and if so what is the basis for his confidence.  Open engagement on that sort of issue is just the sort of thing that might have people reasonably thinking more highly of the new Governor.

(In a similar vein, the Minister of Finance has promised that the minutes of meetings of the future statutory Monetary Policy Committee will be published in a timely way.  There would be nothing to stop the Governor taking the lead now and publishing –  tomorrow or with a lag of no more than a couple of weeks – the minutes of any meetings of his Governirng Committee relating to tomorrow’s MPS and the associated OCR decision.  Doing so would be a small, but telling, promissory note, a token foreshadowing a new era of greater transparency.)

Surveyed expectations

The Reserve Bank’s quarterly survey of semi-expert opinion on the outlook for various macroeconomic variables was out the other day –  a bit earlier than usual, presumably because of the changes in the schedule of MPS releases.  This is a really rich survey, covering a wide range of variables, and has been running now for nearly 30 years.  But I noticed that the number of respondents is now down to only 52 (and on some questions there were fewer than 40 answers).  Once upon a time, if my memory isn’t failing me, there were nearer 200 respondents.

My impression is that the Bank’s aims have shifted over time: when the survey began in 1987 it was designed to capture the expectations of people making key transactional decisions in the economy.  There were always some economists, but quite a lot of effort went into getting business people and –  reflecting the much greater role of collective employment contracts then  – union officials to participate.   We even had large enough samples that we used to report responses separately for the different classes of respondents.  For some years, we ran a staff survey in parallel, which occasionally highlighted interesting differences between staff and external expectations for the same variables.    I’m not sure who is captured in the 52 respondents the survey now has, but I suspect economists must now make up quite a large proportion.  There isn’t necessarily anything wrong with that –  I suspect few people other than economists have explicit expectations for most macroeconomic variables (inflation might be an exception) and if they ever need such forecasts, they will typically draw on the numbers prepared by economists.  But it probably means the survey is drifting progressively ever closer to something like a consensus forecasts exercise of economists, rather than capturing how people are necessarily thinking in the wider economy.  It is broader than, say, the NZIER Consensus exercise, or than the pool of forecasters the Reserve Bank benchmarks its forecasts against (after all, it includes views of people like me who don’t prepare formal forecasts), but it is a similar class of exercise.

But what to make of the latest survey?  Only one thing really took me by surprise and that was that inflation expectations didn’t fall further.  I revised mine down, after having been stable for several quarters, and had expected the overall survey to show something similar.  After all, the June quarter CPI had surprised on the low side, the exchange rate had increased quite markedly and –  for what its worth –  the breakeven inflation rates derived from indexed and conventional government bonds had fallen further.  In fact, there was barely any change  –  if anything, a barely perceptible increase.

But it is worth remembering just how very weak these inflation expectations are.  The target midpoint –  which the Bank is required to focus on –  is 2 per cent, and last survey in 2014 was the last time two year ahead expectations were as high as 2 per cent.  And that was before the easing phase even got underway.  There have only been two quarters in the last four years when one year ahead expectations have been as high as 2 per cent.  Many of the deviations aren’t that large, but respondents really don’t believe the Bank will be delivering inflation fluctuating around 2 per cent.  That should trouble the Reserve Bank, and must trouble those paid to hold the Bank to account.  After all, actual inflation has been below 2 per cent for a long time now.

There is some short-term noise in the inflation expectations series, and there is some seasonality in the CPI.  But here is another way of looking at the data.   I’ve just averaged the last four observations for each of the four inflation expectations questions (this quarter, next quarter, year ahead, two years ahead) and annualized the two quarterly numbers. In the chart, I’ve shown them against the target midpoint, going all the way back to the end of 1991 –  which was when inflation dropped into the target range for the first time.

inflation expectations ann avg

That prompts several thoughts:

  • we’ve never previously seen all the measures below the midpoint. The last eighteen months or so really is different
  • we’ve never previously seen the two year expectations measures detach from all the other measures for so long,
  • when the shorter-term expectations often ran above the two year measure during the pre-2008 boom, it was the shorter-term measures that better aligned with (I’m hesitant to say “predicted”) what happened to the core inflation measures (the Bank’s own preferred, quite stable, measure peaked above 3 per cent).

The Reserve Bank might defend itself arguing that the fact that the two year expectations are still not too far below 2 per cent is reassuring –  “people trust us, despite the short-term variability”.   I don’t think that is a particularly safe interpretation –  especially when for the shorter-term horizons, about which respondents have much more information, expectations just keep on tracking very low.  Another common response from the Bank is to highlight exchange rate and oil price movements –  but most of the collapse in oil prices was 18 months ago now, and the current exchange rate is around the average for the Governor’s term to date.

A couple of other aspects of the survey caught my eye.  The first was the question about monetary conditions.  Here is what respondents said when asked about the conditions they expected a year from now.

mon conditions yr ahead.png

For seven surveys in a row, respondents have revised down their future expectations. This question has only been running since 1999, but that sort of run of downward revisions has no precedent –  not even during the 2008/09 recession.  Typically, the Bank raises or lowers the OCR and people seem to eventually expect policy to work and conditions to get back to normal. You can see that during 2008/09  –  by the June 2009 survey, respondents were already beginning to revise back up their future expectations.   But not –  yet –  this time.  I’d argue that isn’t surprising –  after all, the 2014 tightening cycle was a mistake, and even now with the OCR at 2.25 per cent, real policy interest rates are still higher than they were as that cycle was getting underway.  But perhaps there is another interpretation that is more favorable to the Bank?

I was also interested in the responses on expected 90 day interest rates –  a close proxy for the OCR.  Quarter ahead and year ahead expectations both fell by 10 basis points, but by next June the median respondent still thinks the 90 day rate will be 2.1 per cent.  That is probably consistent with the OCR at 1.85 per cent.  Respondents expect one more OCR cut –  most probably next week, according to the survey responses, but aren’t sure there will be anything much beyond that.  Perhaps more surprising, the lower quartile response for the year ahead was 2 per cent.  No one can tell the future with any great confidence, but I’d have thought there was rather more of a chance than that that the OCR might need to be cut to 1.5 per cent, or even below, to get inflation back nearer target.

It isn’t obvious how it is going to happen otherwise.  Respondents expect GDP growth to remain around 2.5 per cent.  And they don’t expect any material further reduction in the unemployment rate –  even though I see that Treasury has now revised its NAIRU estimate to 4 per cent –  and they expect only as very modest increase in nominal wage inflation (and of course those responses were completed before yesterday’s wages data).  It typically takes increased capacity pressure to get an acceleration in core inflation, and there is little or no sign of those sorts of pressures emerging in this survey.

So perhaps what we have is respondents reading the Governor much the way I do –  really reluctant to cut the OCR, but he will do so if events overwhelm him (his recent statement suggests next week’s MPS might be that time, if there hasn’t been another miscommunication or policy reversal).  But such a stance offers little chance of inflation getting sustainably back to around 2 per cent in the foreseeable future –  unless there is some really big unforeseen demand shock.

So those two year ahead survey expectations of inflation still look too high to me.   For many years, the ANZ’s survey of (non-expert) small and medium businesses had inflation expectations results above the Bank’s two year ahead survey.  Even those non-expert respondents now have (year ahead) expectations of only 1.49 per cent –  and that much larger survey has had an upside bias, over-predicting actual inflation, over the years.  I still feel pretty confident that the OCR will get to 1.5 per cent before too long –  but the sooner it is done, the less the risk of having to cut even further to restore practical confidence that future inflation will be averaging near the target the Bank has been set.  Sadly, with only 13 months of his term to go, it seems unlikely that Graeme Wheeler will ever preside over a 2 per cent inflation rate, let alone one that averages 2 per cent. But he can still set a better platform now for his successor.