A canary in the coalmine?

A couple of days ago, I put this chart and brief comment on Twitter

I added “I do not think nom GDP targeting is generally superior to inflation targeting for NZ, but recent outcomes (latest annual 5.9%) are at least one reason for a little caution about further aggressive OCR increases”.

There is a long history of people writing about nominal GDP targeting (it was being championed in some of the literature before inflation targeting was even a thing). I’ve written about it a few times (including here and here) and just this morning I noticed a new commentary from Don Kohn, former vice-chair of the Federal Reserve looking (sceptically) at some of the issues. No central bank has shifted to nominal GDP targeting (whether in levels or growth rates) but a fair number of people (including Kohn) will suggest that there may still be useful information in developments in nominal GDP – something to keep at least one eye on.

Almost every piece of economic data has been made harder to interpret over the last couple of years by Covid. In my chart, the eye immediately tends to go to the unprecedented fall (in 2020) and unprecedented rebound following that. But my eye next went to what wasn’t there: the most recent rate of increase (nominal GDP in the June 2022 quarter is estimated to have been 5.9 per cent higher than that in the June 2021 quarter) wasn’t at all out of line with typical experience in the last few decades. It is quite a different picture than we see with headline and core inflation measures. And although Covid has continued to affect economic numbers, last June quarter seemed relatively little affected by Covid here (the Delta outbreak was mid-August), and by the June quarter we were through the worst of the restrictions. Perhaps as importantly for what follows, the June quarter was pretty normal for most other countries too (and the June 2020 quarter was pre-Omicron disruptions).

One upside of New Zealand’s slow publication of macroeconomic data is that when our GDP numbers are finally published, pretty much everyone else’s are available for comparison. And although people often note (fairly) that nominal GDP numbers are published with a longer lag than inflation numbers, we are also now in the long New Zealand hiatus where it is two months since we last saw an inflation number, and another month until we get another one. The MPC makes its next OCR decision before that.

So how did New Zealand’s estimated nominal GDP growth for the year from the June quarter last year to the June quarter compare with the experience of other OECD economies? Here I’m focused on places having their own monetary policies, and so show the euro-area rather than the individual countries in that area. I’m also going to leave Turkey off my charts – mostly to keep them more readable, in a context where they are running a crazy monetary experiment and have recorded nominal GDP growth of 115 per cent in the last year.

Nominal GDP growth in (fairly low inflation) Norway went sky-high because the invasion of Ukraine etc has sent oil and (especially) gas prices very high.

But look at New Zealand: we had the fourth lowest rate of nominal GDP growth in that year among all the OECD countries (monetary areas). And two of those below us – Switzerland and Japan – had not only not eased monetary policy in 2020, but had spent years grappling with such low inflation they’d needed persistently negative policy interest rates.

Absolute comparisons like this can mislead a bit. Some countries have higher inflation targets than others – Chile, Costa Rica, Mexico, and Colombia for example target 3 per cent inflation, and have historically had somewhat higher nominal GDP growth rates consistent with those higher targets. But I could take the Latin American countries (poor enough that they are really OECD diversity hires) off the chart and it wouldn’t much change the picture as it affects New Zealand and the countries we often compare ourselves to. In Australia, for example, nominal GDP increased by almost 12 per cent in the year to June.

The last quarter before Covid was December 2019. Across the OECD as a whole (and in New Zealand) core inflation at the time was generally a bit under the respective (core) inflation targets, and many central banks had been cutting policy rates that year.

Here is nominal GDP growth (as now recorded – GDP revisions are a thing) for the same group of countries for the last pre-Covid year.

New Zealand’s rate of nominal GDP growth then was a bit higher than the median OECD country, perhaps consistent with the fact that our population growth rate was faster than those for most advanced countries. But our nominal GDP growth rate that year was also a bit higher than the average rate New Zealand had experienced in the previous decade or more. (Note Norway again; not even the staunchest advocates of nominal GDP targeting recommend it for countries with terms of trade shocks on that scale.)

The next chart shows annual growth in nominal GDP for the latest period less annual growth to the end of 2019. The idea is to see how much acceleration there has been (with the sort of lift in core inflation we’ve seen across most of the world all else equal one might expect to have seen quite a lift in nominal GDP growth).

Fair to say that New Zealand stands out somewhat. In the year to June 2022 New Zealand was the only OECD country to have had nominal GDP growth lower than in the immediate pre-Covid period. And if our terms of trade have fallen a bit in the last year, that was still in a context where (NZD) export prices were up 17 per cent in the most recent year, with import prices up even more.

I am genuinely not sure what to make of these pictures and the New Zealand comparisons specifically. If you look across that last chart you would have little hesitation in suggesting that a lot of monetary policy tightening (interest rate rises) has been warranted in the advanced economy world. For the median country, nominal GDP growth has accelerated by 6 percentage points. But in New Zealand, nominal GDP growth has slowed.

And if one were a champion of nominal GDP levels targeting, here is New Zealand’s nominal GDP over the last decade

Things have (inevitably) been bumpier in the Covid period, but there is nothing there suggesting things have gone off track in recent times (although the mix has changed, with less population growth and more inflation).

The usual fallback position when anyone invokes nominal GDP numbers is to note (entirely fairly) that revisions to GDP are very much to be expected. Perhaps we will find, five years hence, that nominal GDP growth in the year to June 2022 was really a couple of percentage points higher than SNZ currently estimate. That would be a pretty large change for a single year (as distinct from historical levels revisions as data collections and methodologies change). But – if every other country’s estimates didn’t change – one could revise up New Zealand’s rate of nominal GDP growth by 2 percentage points and we would still be equal lowest (with Japan – where they are still running avowedly expansionary monetary policy) on that chart showing the acceleration in the rate of nominal GDP growth.

Two other considerations are worth noting. It isn’t true that our Reserve Bank was particularly early in raising the OCR again – about six of these countries were ahead of them – but market interest rates had already risen quite a bit last year in anticipation and we had had one of the frothiest housing market during the Covid period, and are now somewhat ahead of the pack in seeing house prices and house turnover falling away. Even if – as I am – one is sceptical of house price wealth effects, housing turnover itself is one (modest) component of GDP. Either way, our subdued nominal GDP growth may be foreshadowing what could be about to happen elsewhere.

Monetary policy is avowedly run on forecasts – that would be true (or the rhetoric) even if one were targeting nominal GDP growth rather than inflation – and I guess it is always possible that we might see an acceleration of nominal GDP growth from here, that might support further Reserve Bank tightening from here. Perhaps, but it is difficult to see quite where this acceleration might come from.

I have been a little more sceptical than some in recent months of quite how much further the OCR is really likely to need to be raised, but I am not drawing strong policy conclusions from these data just yet. But they do seem like a straw in the wind that (a) warrants further investigation and (b) might make one somewhat cautious about championing further tightenings, especially in the absence of timely fresh inflation data. Subdued growth in nominal GDP is more or less exactly what one might expect to see if, with a lag, core inflation was already on track to slow, perhaps quite a bit.

A voice from the past

Various media this morning have given quite a lot of coverage to the new paper released by the NZ Initiative, headed How Central Bank Mistakes After 2019 Led to Inflation. The authors are Bryce Wilkinson of the Initiative and former Reserve Bank Governor (2012-17) Graeme Wheeler – the coverage probably mostly because of the trenchant words from the former Governor, I think the first we have heard from him since he moved back to corporate board land in late 2017.

I’m not one of those who has any particular problem with former Governors and Deputy Governors commenting on what is going on with monetary policy. If it isn’t always common, well we have a fairly thin pool of commentators in New Zealand, and these are hardly ordinary times. The quality of the debate is only likely to be improved by hearing, and challenging/scrutinising, alternative perspectives. We can only hope that one day the Reserve Bank’s own Monetary Policy Committee will learn from that sort of example, instead of continuing to act as some impenetrable monolith, even faced with the inevitable huge uncertainties of macroeconomics and monetary policy. And if Graeme Wheeler was not, to put it mildly, known during his term as Governor for welcoming debate and dissent – internally or externally – I guess we can only say better late than never.

In some ways the Wilkinson/Wheeler collaboration is a curious one. They go back 45 years to when Wilkinson was Wheeler’s boss in the macro area of The Treasury, and have apparently been friends since. But whereas Bryce Wilkinson has long been sceptical of any sort of active monetary policy (I have various emails on file challenging me as to what evidence there is that central bank policy activism has accomplished anything much useful over the years), Wheeler chose to take on the job of central bank Governor under an entirely-standard policy target, put into sharper relief than previously with the addition that the Governor was to be required to focus explicitly on keeping future inflation close to the 2 per cent midpoint of the target range. And there was nothing very unusual or distinctive about the way monetary policy was run on his watch – conventional models, conventional judgements, and in many ways conventional errors. If there were distinctives, they were mostly that Wheeler proved more thin-skinned than your typical central bank Governor or Monetary Policy Committee members (the young or those with short memories may have forgotten Wheeler deploying his entire senior management group to attempt to silence criticisms from BNZ’s Stephen Toplis – several relevant posts here).

The (quite short) paper isn’t specifically focused on New Zealand and our central bank, and consistent with that the authors have secured a Foreword from Bill White, former deputy governor of the Bank of Canada, and then long-serving Chief Economist of the Bank for International Settlements, from which perch he irritated many with his warnings about system fragility in the years leading up to 2008. He is a really smart guy and what he writes is usually worth thinking about, and I’ve enjoyed various stimulating discussions/debates with him over the years. His views today, reflected in the Foreword, still stand out of the mainstream (rightly or wrongly). If he is keen on fiscal consolidation etc across the advanced world, he champions “significant tax increases, particularly on the wealthy”, and while suggesting this would be desirable but politically impossible then suggests that a heavy reliance on monetary policy may pose a threat to democracy itself. White appears to believe that we are on the cusp of a very substantial adjustment, as the public and private debt built-up over the last few decades is sorted out (“we must review carefully our judicial and administrative procedures to ensure the necessary debt restructuring, and there will be a lot of it, will be orderly rather than disorderly”. Perhaps, but it is a long way from debates about how monetary policy has been run in the last 2.5 years or so. (And, for what it is worth, New Zealand has low public debt, and (for ill) its housing debt remains underpinned by governments and councils that refuse to free up land use on the margins of our cities.)

But enough introductory discussion. What should we make of the substance of the note? There is 13 pages of it, but about half is itself scene-setting or largely descriptive stuff. There are bits I might quibble with, bits I strongly agree with (unexpectedly high core inflation is the responsibility of central banks and the results of mistake choices by them – given inflation targets that is close to being a tautology), five big charts. Oh, and this was good to see.

Wheeler and Wilkinson seem to think QE-type operations (including our LSAP) are more effective macroeconomically (for good and ill) than I reckon, but the sheer scale of the losses is a reminder that even if there are some potential benefits, those would need to be weighed against the potential downside risks.

But the heart of the note is in the six points under this introduction

The first is “Central banks became over-confident in their inflation targeting frameworks”.

Much of the discussion of this point could have been written 15 years ago, although even then if there was much to the story it wasn’t so in New Zealand. We grappled with needing interest rates higher than the rest of the world to keep inflation near target, as well as repeated political assaults on whether we had the right target or the right tools.

But the story of the decade prior to Covid, in New Zealand and most other advanced countries, was of central banks struggling to keep inflation UP to the respective targets. New Zealand went for a decade with core inflation never once getting up to the 2 per cent midpoint that Wheeler himself had signed up to target. Now, I think it is probably true that in 2020 and early 2021, many central banks and central bank observers were more focused on the previous decade and its (very real) downside surprises, and not perhaps alert enough to the possibility of (core) inflation rising sharply. But that seems to me to be an importantly different thing to what Wheeler and Wilkinson are arguing.

They end this discussion with this point

But for now I think the evidence is against them. With headline inflation as high as it is, what is striking is how low market-based measures of inflation expectations still are (around 2 per cent here and in the US). The Bank’s own survey of 2 year ahead expectations, at 3.3 per cent in May, is higher than it should be, but probably not disastrously so at this point (and I reckon there is a good chance that the next survey, just being finished now, will show slightly lower numbers). Central banks were slow to act last year, but for now evidence suggests some confidence that they have, and will, acted decisively to keep medium-term inflation in check.

I also reckon that Wheeler and Wilkinson don’t adequately grapple with complexities and uncertainties of the Covid shock. It doesn’t really excuse the slow unwind last year – as, for example, the unemployment rate was falling rapidly – but it certainly makes much more sense of the initial monetary policy easing in 2020. Wheeler faced nothing of the sort during this term.

I had to splutter when I read the second item in their list: “Central banks were over-confident in the models they use to base monetary policy decisions”. Several paragraphs follow making the widely-accepted point that it is hard to work out the size of the output gap at any particular time, or to know with confidence the neutral interest rate. All very true, but who is going to disagree with them on that?

Well, one person who might was Governor Graeme Wheeler over the period from about 2013. He was convinced – quite convinced – that the OCR was a long way below its neutral level, and that large increases would be appropriate to get things back in check. So much so that in late 2013 he was openly asserting (in public) that 200 basis points of OCR increases were coming (any conditionality was very muted). These were the 90 day/OCR forecasts the Bank published while Wheeler was Governor

He was convinced that inflation pressure were building and rate rises would be required. Overconfidently, he started out on his tightening cycle in 2014, got 100 basis points in, and then finally was confronted with the data. The rate increases had to be reversed in pretty short order (and later in his term, the Bank was much more modest in its assertions). Note that although there were a number of central bankers globally who were keen on eventually getting policy rates higher, Wheeler was one of the few to back his model with ill-fated policy rate increases.

And to be fair to today’s central bankers, I haven’t detected an enormous amount of confidence in comments over the last couple of years, but rather (a) a huge amount of uncertainty, and then (b) some really big (but widely-shared) forecasting mistakes.

In the podcast interview that accompanies the research note, Wheeler does show some signs of (belatedly) accepting that he made a mistake. But even then he continues to claim it wasn’t really his fault, that the domestic economy really had been overheating, and that it was all the fault of the inscrutable foreigner (ok, he calls it “tradable inflation”, from the rest of the world.

Very little of this stacks up:

  • core inflation (whether something like the sectoral core model that the Bank claimed to favour during the Wheeler years or the simple CPI ex food and fuel) was well below the midpoint of the target range throughout the Wheeler term.
  • Wheeler claims that non-tradables inflation was high but (a) non-tradables inflation always runs higher than tradables, and (b) if one looks at core non-tradables inflation it was at a cyclical low when Wheeler took office, was not much higher when he left office, and was never high enough to be consistent with 2 per cent economywide core inflation, and
  • Whatever the vagaries of output gap estimates, the unemployment rate lingered high (even at the end above most NAIRU estimates) throughout his term.

But read his press statement from early 2014 and you’ll see someone in the thrall of their model (at the time many people supported the broad direction of policy, but not all – whether outside or inside the Bank).

The third item on the Wheeler/Wilkinson list is “Central banks were excessively optimistic that they could successfully “fine tune” economic activity”. This is a longstanding Wilkinson theme, but is a curious one for Wheeler to have signed up to, given that he signed up to a tighter inflation target (focus on the midpoint) and after 2015 was more focused on getting inflation back up towards target. And, in fairness to our RB, their “least regrets” framework exploicitly recognises the huge amount of uncertainty that was abroad in the Covid era/

The fourth item is “Central banks took their eye of their core responsibilities and focused on issues that were much less central to their roles”. Of course, I agree with them that the Orr Reserve Bank has chased after all sorts of non-core hares (to the list WW provide one might add the “indigenous economies” central bank network), and I’ve been quite critical of that. But I just don’t think the case has compellingly been made that these fripperies really made that much difference to the conduct of policy. Take it all out and in the NZ context, Orr was still as he was, the MPC was weak and muzzled, and the Bank’s forecasts often weren’t that different from those in the private sector. Perhaps the (chosen) distractions made a substantive difference, but there needs to be a stronger case made than WW yet have (and central banks with much more talented Governors and MPC often seem to have made similar monetary policy mistakes to those of the RBNZ).

The fifth item in the list is “Dual mandates for monetary policy create conflicts”. In principle they can, in practice the case simply is not made as regards the last 12-18 months, when both inflation and employment limbs pointed the same way (here and abroad). Arguably they did so in 2020 too, at least on the forecasts/scenarios central banks, including our own, were working with. Forecasting was the biggest failure…….faced with a shock for which there was simply no modern precedent.

The final item on the list is “Did some central banks try too hard to support government political objectives in making judgements about monetary policy?”

The short answer is that WW offer no evidence whatever of anything of the sort, either in New Zealand or other advanced economies. They make this claim

which is probably true in some less developed countries, but do they have any examples in mind in advanced economies or New Zealand? I think not. In New Zealand, MPC members have been reappointed with no scrutiny, and politicians – government or Opposition – seem reluctant to focus on the central bank’s part on the inflation outcomes. There is no sign of any serious pressure on the Bank – not even much sign Grant Robertson cares much. Look at the underwhelming crew he just appointed to the Reserve Bank board – not evidently partisan, just deeply inadequate to the task (including holding the Bank and MPC to account).

And that is it.

In the end there simply isn’t a great deal there. It is good to have more voices sheeting home responsibility for high core inflation to the central banks. If you accept the assignment of responsibility for achieving an objective, you are responsible when things fall short (even if, as Wheeler argues was true of his own stewardship) you’ve done the best job possible with the information to hand at the time. How much that sort of explanation is sufficient to the current situation can and should be debated, but it probably needs much more engagement with data, and forecasts etc, than WW have room for in their piece.

Wheeler and Wilkinson end this way

I largely agree (although would put much more weight on top notch macro and monetary policy expertise, relative to financial markets). But what is noticeable throughout the paper is how little weight they appear to put on transparency or accountability. There is no call for diverse views and perspectives on the MPC, openly testing alternative perspectives, and individually accountable. But I guess – given his onw track record re dissent – such a suggestion would be too much for Graeme Wheeler even now five years safely out of office. It might after all have required more openness to stringent criticisms from people with a view different than the Governor’s

Incidentally I am pleased to see that his attitude to external scrutiny and challenge from former central bankers has moved on a little from his approach just a few years back when he claimed to believe that former staff – surely even more former Governors – owed some vow of omerta to the Bank and its mistakes, whether operational or policy.

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.

Forecasting and policy mistakes

Yesterday’s post was a bit discursive. Sometimes writing things down helps me sort out what I think, and sometimes that takes space.

Today, a few more numbers to support the story.

I’m going to focus on what the experts in the macroeconomic agencies (Treasury and Reserve Bank) were thinking in late 2020, and contrast that with the most recent published forecasts. The implicit model of inflation that underpins this is that even if the full effects of monetary policy probably take 6-8 quarters to appear in (core) inflation, a year’s lead time is plenty enough to have begun to make inroads.

Forecasts – and fiscal numbers – in mid 2020 were, inevitably all over the place. But by November 2020 (the Bank published its MPS in November, and the Treasury will have finalised the HYEFU numbers in November) things had settled down again, and the projections and forecasts were able to be made – amid considerable uncertainty – with a little more confidence. And the government was able to take a clearer view on fiscal policy. The Treasury economic forecasts in the 2020 HYEFU incorporated the future government fiscal policy intentions conveyed to them by the Minister of Finance. The Reserve Bank’s forecasts did not directly incorporate those updated fiscal numbers, but…..the Reserve Bank and The Treasury were working closely together, the Secretary to the Treasury was a non-voting member of the Monetary Policy Committee, and so on. And, as we shall see, the Bank’s key macroeconomic forecasts weren’t dramatically different from Treasury’s.

The National Party has focused a lot of its critique on government spending. Here are the core Crown expenses numbers from three successive HYEFUs.

expenses $bn

From the last pre-Covid projections there was a big increase in planned spending. But by HYEFU 2020 – 15 months ago – Treasury already knew about the bulk of that and included it in their macro forecasts. By HYEFU 2021 the average annual spending for the last three years had increased further. But so had the price level – and quite a bit of government spending is formally (and some informally) indexed.

Here are the same numbers expressed as a share of GDP.

expenses % of GDP

By HYEFU 2021 the government’s spending plans for those last three years averaged a smaller share of GDP than Treasury had thought they would be a year earlier. (The numbers bounce around from year to year with, mainly, the uncertain timing of lockdowns etc).

There are two sides to any fiscal outcomes – spending and revenue. The government has been raising tax rates consciously and by allowing fiscal drag to work, such that tax revenue as a share of GDP, even later in the forecasts, is higher than The Treasury thought in November 2020. And here are the fiscal balance comparisons.

obegal

Average fiscal deficits – a mix of structural and automatic stabiliser factors – are now expected to be smaller (all else equal, less pressure on demand) than was expected in late 2020.

Fiscal policy just hasn’t changed very much since late 2020, and the fiscal intentions of the government then were already in the macro forecasts. Had those macro forecasts suggested something nastily inflationary, perhaps the government could have chosen to rethink.

But they didn’t. Here are the inflation and unemployment forecasts from successive HYEFUs.

macro forecasts tsy

In late 2020, The Treasury told us (and ministers) that they expected to hang around the bottom end of the target range for the following three years, with unemployment lingering at what should have been uncomfortably high levels. If anything, on those numbers, more macroeconomic stimulus might reasonably have been thought warranted.

There were huge forecasting mistakes, even given a fiscal policy stance that didn’t change much and was well-flagged.

That was The Treasury. But the Reserve Bank and its MPC are charged with keeping inflation near 2 per cent, and doing what they can to keep unemployment as low as possible. For them, fiscal policy is largely something taken as given, but incorporated into the forecasts.

Their (November 2020_ unemployment rate forecasts were a bit less pessimistic than The Treasury’s, but still proved to be miles off. This is what they were picking.

RB U forecasts

And here were the Bank’s November 2020 inflation forecasts, alongside their most recent forecasts.

rb inflation forcs

Not only were their forecasts for the first couple of years even lower than The Treasury’s, but even two years ahead their core inflation view was barely above 1 per cent. (The Bank forecasts headline inflation rather than a core measure, but over a horizon as long as two years ahead neither the Bank nor anyone else has any useful information on the things that may eventually put a temporary wedge between core and headline.) All these forecasts included something very much akin to government fiscal policy as it now stands. Seeing those numbers, the government might also reasonably have thought that more macroeconomic stimulus was warranted.

As a reminder the best measure of core inflation – the bit that domestic macro policy should shape/drive – is currently at 3.2 per cent.

core infl and target

There were really huge macroeconomic forecasting mistakes made by both the Reserve Bank and The Treasury, and – so it is now clear – policy mistakes made by the Bank/MPC. You might think some of those mistakes are pardonable – highly unsettled and uncertain times, not dissimilar surprises in other countries etc – and I’m not here going to take a particular view.

But of all the things Treasury and the Bank had to allow for in their forecasts, fiscal policy – wise or not, partly wasteful or not – just wasn’t one of the big unknowns, and hasn’t changed markedly in the period after those (quite erroneous) late 2020 macro forecasts were being done.

I guess one can always argue that if fiscal policy had subsequently been tightened, inflation would have been a bit lower. But Parliament decided that inflation – keeping it to target – is the Reserve Bank’s job. The government bears ultimate responsibility for how the Bank operates in carrying out that mandate – the Minister has veto rights on all the key appointees (and directly appoints some), dismissal powers, and the moral suasion weight of his office – but that is about monetary policy, not fiscal policy or government spending,

Inflation

The National Party, in particular, has been seeking to make the rate of inflation a key line of attack on the government. Headline annual CPI inflation was 5.9 per cent in the most recent release, and National has been running a line that government spending is to blame. It is never clear how much they think it is to blame – or even in what sense – but it must be to a considerable extent, assuming (as I do) that they are addressing the issue honestly.

I’ve seen quite a bit of talk that government spending (core Crown expenses) is estimated to have risen by 68 per cent from the June 2017 year (last full year of the previous government) to the June 2022 year – numbers from the HYEFU published last December. That is quite a lot: in the previous five years, this measure of spending rose by only 11 per cent. Of course, what you won’t see mentioned is that government spending is forecast to drop by 6 per cent in the year to June 2023, consistent with the fact that there were large one-off outlays on account of lockdowns (2020 and 2021), not (forecast) to be repeated.

But there is no question but that government spending now accounts for a larger share of the economy than it did. Since inflation was just struggling to get up towards target pre-Covid, and I’m not really into partisan points-scoring, lets focus on the changes from the June 2019 year (last full pre-Covid period). Core Crown expenses were 28 per cent of GDP that year, and are projected to be 35.3 per cent this year, and 30.5 per cent in the year to June 2023 (nominal GDP is growing quite a bit). That isn’t a tiny change, but…..it is quite a lot smaller than the drop in government spending as a share of GDP from 2012 to 2017. I haven’t heard National MPs suggesting their government’s (lack of) spending was responsible for inflation undershooting over much of that decade – and nor should they because (a) fiscal plans are pretty transparent in New Zealand and (b) it is the responsibility of the Reserve Bank to respond to forecast spending (public and private) in a way that keeps inflation near target. The government is responsible for the Bank, of course, but the Bank is responsible for (the persistent bits of) inflation.

The genesis of this post was yesterday morning when my wife came upstairs and told me I was being quoted on Morning Report. The interviewer was pushing back on Luxon’s claim that government spending was to blame for high inflation, suggesting that I – who (words to the effect of) “wasn’t exactly a big fan of the government” – disagreed and believed that monetary policy was responsible. I presume the interviewer had in mind my post from a couple of weeks back, and I then tweeted out this extract

I haven’t taken a strong view on which factors contributed to the demand stimulus, but have been keen to stress the responsibility that falls on monetary policy to manage (core, systematic) inflation pressures, wherever they initially arise from. If there was a (macroeconomic policy) mistake, it rests – almost by definition, by statute – with the forecasting and policy setting of the Reserve Bank’s Monetary Policy Committee.

I haven’t seen any compelling piece of analysis from anyone (but most notably the Bank, whose job it is) unpicking the relative contributions of monetary and fiscal policy in getting us to the point where core inflation was so high and there was a consensus monetary policy adjustment was required. Nor, I think, has there been any really good analysis of why things that were widely expected in 2020 just never came to pass (eg personally I’m still surprised that amid the huge uncertainty around Covid, the border etc, business investment has held up as much as it has). Were the forecasts the government had available to it in 2020 from The Treasury and the Reserve Bank simply incompetently done or the best that could realistically have been done at the time?

Standard analytical indicators often don’t help much. This, for example, is the fiscal impulse measure from the HYEFU, which shows huge year to year fluctuations over the Covid and (assumed) aftermath period. Did fiscal policy go crazy in the year to June 2020? Well, not really, but we had huge wage subsidy outlays in the last few months of that year – despite which (and desirably as a matter of Covid policy at the time) GDP fell sharply. What was happening was income replacement for people unable to work because of the effects of the lockdowns. And no one much – certainly not the National Party – thinks that was a mistake. In the year to June 2021, a big negative fiscal impulse shows, simply because in contrast to the previous year there were no big lockdowns and associated huge outlays. And then we had late 2021’s lockdowns. And for 2022/23 no such events are forecast.

One can’t really say – in much of a meaningful way – that fiscal policy swung from being highly inflationary to highly disinflationary, wash and repeat. Instead, some mix of the virus, public reactions to it, and the policy restrictions periodically materially impeded the economy’s capacity to supply (to some unknowable extent even in the lightest restrictions period potential real GDP per capita is probably lower than otherwise too). The government provided partial income replacement, such that incomes fell by less than potential output. As the restrictions came off, the supply restrictions abated – and the government was no longer pumping out income support – but effective demand (itself constrained in the restrictions period) bounced back even more strongly.

Now, not all of the additional government spending has been of that fairly-uncontroversial type. Or even the things – running MIQ, vaccine rollouts – that were integral to the Covid response itself And we can all cite examples of wasteful spending, or things done under a Covid logo that really had nothing whatever to do with Covid responses. But most, in the scheme of things, were relatively small.

This chart shows The Treasury’s latest attempt at a structural balance estimate (the dotted line).

In the scheme of things (a) the deficits are pretty small, and (b) they don’t move around that much. If big and persistent structural deficits were your concern then – if this estimation is even roughly right – the first half of last decade was a much bigger issues. And recall that the persistent increase in government spending wasn’t that large by historical standards, wasn’t badly-telegraphed (to the Bank), and should have been something the Bank was readily able to have handled (keeping core inflation inside the target range).

The bottom line is that there was a forecasting mistake: not by ministers or the Labour Party, but by (a) The Treasury, and (b) the Reserve Bank and its monetary policy committee. Go back and check the macro forecasts in late 2020. The forecasters at the official agencies basically knew what fiscal policy was, even recognised the possibility of future lockdowns (and future income support), and they got the inflation and unemployment outlook quite wrong. They had lots of resources and so should have done better, but their forecasts weren’t extreme outliers (and they didn’t then seem wildly implausible to me). They knew about the supply constraints, they knew about the income support, they even knew that the world economy was going to be grappling with Covid for some time. Consistent with that, for much of 2020 inflation expectations – market prices or surveys – had been falling, even though people knew a fair amount about what monetary and fiscal policy were doing. In real terms, through much of that year, the OCR had barely fallen at all. It was all known, but the experts got things wrong.

Quite why they did still isn’t sufficiently clear. But, and it is only fair to recognise this, the (large) mistake made here seems to have been one repeated in a bunch of other countries, where resource pressures (and core inflation) have become evident much more strongly and quickly than most serious analysts had thought likely (or, looking at market prices, than markets themselves had expected). Some of that mistake was welcome – getting unemployment back down again was a great success, and inflation in too many countries had been below target for too long – so central banks had some buffer. But it has become most unwelcome, and central banks have been too slow to pivot and to reverse themselves.

Not only have the Opposition parties here been trying to blame government spending, but they have been trying to tie it to the 5.9 per cent headline inflation outcome. I suppose I understand the short-term politics of that, and if you are polling as badly as National was, perhaps you need some quick wins, any wins. But it doesn’t make much analytical sense, and actually enables the government to push back more than they really should be able to. Because no serious analyst thinks that either the government or the Reserve Bank is “to blame” for the full 5.9 per cent – the supply chain disruption effects etc are real, and to the extent they raise prices it is pretty basic economics for monetary policy to “look through” such exogenous factors. It seems unlikely those particular factors will be in play when we turn out to vote next year.

Core inflation not so much – indeed, the Bank’s sectoral core factor model measure is designed to look for the persistent components across the whole range of price increases, filtering out the high profile but idiosyncratic changes. Those measures have also risen strongly and now are above the top of the target range. That inflation is what NZ macro policy can, and should, do something about. But based on those measures – and their forecasts – the Reserve Bank has been too slow to act: the OCR today is still below where it was before Covid struck, even as core inflation and inflation expectations are way higher. Conventional measures of monetary policy stimulus suggest more fuel thrown on the fire now than was the case two years ago.

When I thought about writing this post, I thought about unpicking a series of parliamentary questions and answers from yesterday on inflation. I won’t, but suffice to say neither the Minister of Finance, the Prime Minister, the Leader of the Opposition, or Simon Bridges or David Seymour emerged with much credit – at least for the evident command of the analytical and policy issues. There was simply no mention of monetary policy, of the Reserve Bank, of the Monetary Policy Committee, or (notably) the government’s legal responsibility to ensure that the Bank has been doing its job. It clearly hasn’t (or core inflation would not have gotten away on them to the extent it has). I suppose it is awkward for the politicians – who wants to be seen championing higher interest rates? – and yet that is the route to getting inflation back down, and the sooner action is taken the less the total action required is likely to be. With (core) inflation bursting out the top of the range, perhaps with further to go, the Bank haemorrhaging senior staff, the recent recruitment of a deputy chief executive for macro and monetary policy with no experience, expertise, or credibility in that area, it would seem a pretty open line of attack. Geeky? For sure? But it is where the real responsibility rests – with the Bank, and with the man to whom they are accountable, who appoints the Board and MPC members? There is some real government responsibility here, but it isn’t mainly about fiscal policy (wasteful as some spending items are, inefficient as some tax grabs are), but about institutional decline, and (core) inflation outcomes that have become quite troubling.

Since I started writing this post, an interview by Bloomberg with Luxon has appeared. In that interview Luxon declares that a National government would amend the Act to reinstate a single focus on price stability. I don’t particularly support that proposal – it was a concern of National in 2018 – but it is of no substantive relevance. Even the Governor has gone on record saying that in the environment of the last couple of years – when they forecast both inflation and employment to be very weak – he didn’t think monetary policy was run any differently than it would have been under the old mandate. That too is pretty basic macroeconomics. It is good that the Leader of the Opposition has begun to talk a bit about monetary policy, but he needs to train his fire where it belongs – on the Governor – not, as he did before Christmas, forcing Simon Bridges to walk back a comment casting doubt on whether National would support Orr being reappointed next year. In normal times, you would hope politicians wouldn’t need to comment much on central bankers at all. But the macro outcomes (notably inflation), and Orr’s approach on a whole manner of issues (including the ever-mounting LSAP losses) suggest these are far from normal times. Core inflation could and should be in the target range. It is a failure of the Reserve Bank that it is not, and that – to date – nothing energetic has been done in response.

Inflation

The possibility of a sustained rise in the inflation rate (internationally and here) has been getting a lot of attention in the last few months. Note that I call it a “possibility” rather than a “risk”, because “risk” often has connotations of a bad thing and, within limits, a rise in the (core) inflation rate is something that should be welcomed in most advanced economies where, for perhaps a decade now, too many central banks have failed to deliver inflation rates up to the targets either set for them (as in New Zealand and many other countries) or which they have articulated for themselves (notably the ECB and the Federal Reserve). I’m not here engaging with the debate on whether targets should be higher or lower, but just take the targets as given – mandates or commitments the public has been led to believe should be, and will be, pursued.

Putting my cards on the table, I have been quite sceptical of the story about a sustained resurgence of inflation. In part that reflected some history: we’d heard many of the same stories back in 2010/11 (including in the countries where large scale asset purchases were then part of the monetary policy response), and it never came to pass – indeed, the fear of inflation misled many central banks (including our own) into keeping policy too tight for too long for much of the decade (again relative to the respective inflation targets). Central banks weren’t uniquely culpable there; in many places and at times (including New Zealand) markets and local market economists were more worried about inflation risks than central banks.

I have also been sceptical because, unlike many, I don’t think large-scale asset purchases – of the sort our Reserve Bank is doing – have any very much useful macroeconomic effect at all (just a big asset swap, and to the extent that there is any material sustained influence on longer-term rates, not many borrowers (again, in New Zealand) have effective financing costs tied to those rates). And if, perchance, the LSAP programme has kept the exchange rate a bit lower than otherwise, it is hardly lower than it was at the start of the whole Covid period – very different from the typical New Zealand cyclical experience. In short, (sustained) inflation is mostly a monetary phenomenon and monetary policy just hadn’t done that much this time round.

Perhaps as importantly, inflation has undershot the respective targets for a decade or so now, in the context of a very long downward trend in real interest rates. There is less than universal agreement on why those undershoots have happened, in so many countries, but without such agreement it is probably wise to be cautious about suggesting that this time is different, and things will suddenly and starkly turn around from here. At very least, one would need a compelling alternative narrative.

Having said that, there have been a couple of pleasant surprises in recent times. First, the Covid-related slump in economic activity has proved less severe (mostly in duration) than had generally been expected by, say, this time last year when some (including me) were highlighting potential deflationary risks. That rebound is particularly evident in places like New Zealand and Australia that have had little Covid, but is true in most other advanced countries as well where (for example) either the unemployment rate has peaked less than expected or has already fallen back to rates well below those seen, for example, in the last recession. Spare capacity is much less than many had expected.

And, in New Zealand at least, inflation has held up more than most had expected (more, in particular, than the Reserve Bank had expected in successive waves of published forecasts. The Bank does not publish forecasts of core inflation, but as recently as last August they forecast that inflation for the year to March 2021 would be 0.4 per cent (and that it would be the end of next year before inflation got back above 1 per cent). That was the sort of outlook – their outlook – that convinced me that more OCR cuts would have been warranted last year.

As it is, headline CPI inflation for the year to March was 1.5 per cent. But core measures are (much) more important, and one in particular: the Bank’s sectoral core factor model, which attempts to sift out the underlying trends in tradables and non-tradables inflation and combines them into a single measure: a measure not subject to much revision, and one which has been remarkably smooth over the nearly 30 years for which we now have the series – smooth, and (over history) tells a story which makes sense against our understanding of what else was going on in the economy at the time. This is the chart of sectoral core inflation and the midpoint of successive inflation targets.

core inflation apr 21

It is more than 10 years now since this (generally preferred) measure of core inflation has touched the target midpoint (a target itself made explicit from 2012 onwards). With a bit of lag, core inflation started increasing again after the Bank reversed the ill-judged 2014 succession of OCR increases, but by 2019 it was beginning to look as if the (core) inflation rate was levelling-off still a bit below the target midpoint. It was partly against that backdrop that the Reserve Bank (and various other central banks) were cutting official rates in 2019.

The Bank’s forecasts – and my expectations – were that core inflation would fall over the course of the Covid slump and – see above – take some considerable time to get anywhere near 2 per cent. So what was striking (to me anyway) in yesterday’s release was that the sectoral measure stepped up again, reaching 1.9 per cent. That rate was last since (but falling) in the year to March 2010.

As you can, there is a little bit of noise in this series, but when the sectoral factor model measure of core inflation steps up by 0.2 percentage points over two quarters – as had happened this time – the wettest dove has to pay attention.

To be clear, even if this outcome is a surprise, it should be a welcome one. (Core inflation) should really be fluctuating around the 2 per cent midpoint, not paying a brief visit once every decade or so. We should be hoping to see (core) inflation move a bit higher from here – even if the Bank still eschews the Fed’s average inflation targeting approach.

Nonetheless, even if the sectoral factor model is the best indicator, it isn’t the only one. And not all the signs are pointing in the same direction right now. For example, the annual trimmed mean and weighted median measures that SNZ publishes – and the RBA, for example, emphasises a trimmed mean measure – fell back in the latest quarter. The Bank’s (older and noisier) factor model measure is still sitting around 1.7 per cent where it first got back to four years ago. International comparisons of core inflation tend to rely on CPI ex food and energy measures. For New Zealand, that measure dropped back slightly in March, but sits at 2 per cent (annual).

Within the sectoral factor model there is a non-tradables component – itself often seen as the smoothest indicator of core inflation, particularly that relating to domestic pressures (resource pressures and inflation expectations). And that measure has picked up a bit more. On the other, one of the exclusion measures SNZ publishes – excluding government charges and cigarettes and tobacco – now has an inflation rate no higher than it was at the end of 2019 and – at 2.4 per cent – probably too low to really be consistent with core inflation settling at or above 2 per cent (non-tradables inflation should generally be expected to be quite a bit higher than tradables inflation).

I think it is is probably safe to say that core inflation in New Zealand is now back at about 2 per cent. That is very welcome, even if somewhat accidental (given the forecasts that drove RB policy). As it happens, survey measures of inflation expectations are now roughly consistent with that. Expectations tend not to be great forecasts, but when expectations are in line with actuals it probably makes it more likely that – absent some really severe shock – that inflation will hold up at least at the levels.

But where to from here?

Interestingly, the tradables component of the Bank’s sectoral factor model has not increased at all, still at an annual rate of 0.8 per cent. All indications seem to be that supply chain disruptions and associated shortages, increased shipping costs etc will push tradables inflation – here and abroad – higher this year. But it isn’t obvious there is any reason to expect those sorts of increases to be repeated in future – the default assumption surely has to be that shipping, production etc gradually gets back to normal, perhaps with some price falls then.

And if one looks at the government bond market, participants there are still not acting as if they are convinced core inflation is going higher. If anything, rather the opposite. There are four government inflation-indexed bonds on issue, and if we compare the yields on those bonds with the conventional bonds with similar maturities, we find implied expectations over the next 4 and 9 years averaging about 1.6 per cent, and those for the periods out to 2035 and 2040 more like 1.5 per cent. Again, these breakevens – or implied expectations – are not forecasts, but they certainly don’t speak to a market really convinced much higher inflation is coming. One reason – pure speculation – is that with the Covid recession having been less severe than most expected, it isn’t unreasonable to think about the possibility of a more serious conventional recession in the coming years with (a) little having been done to remove the effective lower bound, and (b) public enthusiasm for more government deficits likely to reach limits at some point.

So I guess I remain a bit sceptical that core inflation is likely to move much higher here, even if the Reserve Bank doesn’t change policy settings. Fiscal policy clearly played a big role in supporting consumption last year but we are likely to be moving back into a gradual fiscal consolidation phase over the next few years. And if the unemployment rate is now a lot lower than most expected, it is still not really a levels suggesting aggregate excess demand (for labour, or resources more generally). For the moment too, immigration isn’t going to be providing the impetus to demand, and inflation pressures, that we often expect to see when the economy is doing well (cyclically). And if you believe stories about the demand effects of higher house prices – and I don’t- house price inflation seems set to level off through some mix of regulatory and tax interventions and the exhaustion of the boom (as in numerous previous occasions).

What should it all mean for monetary policy? Since I don’t think the LSAP programme is making much difference to anything that matters – other than lots of handwaving and feeding the narratives of the inflationistas who don’t seem to realise that asset swaps don’t create additional effective demand – I’d be delighted to see the programme canned. But I don’t think doing so would make much sustained difference to anything that matter either. So in a variant of one of the Governor’s cheesy lines, it is probably time for “watch, hope, wait”. The best possible outcome would be a stronger economic rebound, a rise in core inflation, and the opportunity then to start lifting the OCR. But there is no hurry – rather than contrary after a decade of erring on the wrong side, tending to hold unemployment unnecessarily high. And there is little or no risk of expectations – or firm and household behaviour – going crazy if, for example, over the next year or two core inflation were to creep up to 2.3 or 2.4 per cent.

But what of the rest of the world? I’ve tended to tell a story recently that if there really were risks of a marked and worrying acceleration in inflation it would be in the United States, where the political system seems determined to fling borrowed money around in lots of expensive government spending programmes.

But for now, core inflation measures still seem comfortably below 2 per cent (trimmed mean PCE about 1.6 per cent). The Cleveland Fed produces a term structure estimate for inflation expectations, and those numbers are under 2 per cent for the next 28 years or so (below 1.7 per cent for the next 15 years). And if market implied expectations have moved up a lot from the lows last year, the current numbers shouldn’t be even remotely troubling – except perhaps to the Fed which wants the market to believe it will let core inflation run above 2 per cent for quite a while before tightening, partly to balance past undershoots. Here are the implied expectations from the indexed and conventional government bond markets for the second 5 years of a 10 year horizon (ie average inflation 6-10 years hence).

5x5

These medium-term implied inflation expectations are barely back to where they were in 2018, let alone where they averaged over the decade from about 2004 to 2014 – for much of which period the Fed Funds rate sat very near zero.

What of the advanced world beyond the US. It is harder to get consistent expectations measures, so this chart is just backward-looking. Across the OECD, core inflation (proxied by CPI inflation ex food and energy) has been falling not rising (these data are to February 2021, all but New Zealand and Australia having monthly data).

OECD core inflation apr 21

Are there other indicators? Sure, and many commodity prices are rising. And markets and economists have been wrong before and will – without knowing when – be wrong again. Perhaps this will be one of those times. Perhaps we’ve all spent too much time learning from the last decade, and forgetting (for example) the unexpected sustained surge in inflation in the 60s and 70s.

But, for now, I struggle to see where the pressures will come from. Productivity growth is weak and business investment demand subdued. Global population growth is slowing (reducing demand for housing and other investment). We aren’t fighting wars, we don’t have fixed exchange rate. And if interest rates – very long-term ones – are low, it isn’t because of central banks, but because of structural features – ill-understood ones – driving the savings/investment (ex ante) balance. For now, the New Zealand story is unexpectedly encouraging – inflation finally looks to be near target – but we should step pretty cautiously before convincing ourselves that the trends of the last 15 or even 30 years are now behind us, or that high headline rates – here and abroad – later this year foreshadow permanently higher inflation (or, much the same thing, higher required interest rates).

Not expecting enough inflation

I’ve been banging on about the decline in inflation expectations, and the apparent indifference of the Reserve Bank to that, for most of this year.

It was different late last year.  Then, the Bank was making the case –  at least after the event –  for easing monetary policy fairly aggressively with one of the considerations being avoiding the risk of inflation expectations settling lower than was really consistent with the target.  Then –  last year –  the Governor went so far as to suggest that he would prefer to be in a situation where hindsight proved that they had overdone things a little, with expectations rising, and needing to think about raising the OCR again.   They were totally conventional sorts of line for central bankers to enunciate, especially if they were getting uneasy about approaching the conventional limits of the OCR.  I commended the Bank at the time.

This year the Bank –  Governor and MPC –  seem to have given up again, just when it matters; amid the most severe economic downturn in ages, amid significant actual falls in inflation expectations.  As a reminder, unless steps have been taken to remove the effective lower bound on nominal interest rates (and that has not been done anywhere yet) then the lower inflation expectations are, all else equal, the less monetary policy capacity there is to do the core macro-stabilisation job of monetary policy.   And that risks being a self-reinforcing dynamic.

There is no single or ideal measure of inflation expectations.  There are different classes of people/firms for whom such expectations matter, and different time horizons that matter.   Very short-term expectations get thrown around by the short-term noise (notably fluctuations in oil prices).  Very long-term expectations (a) may not matter much (since there are few very long-term nominal contracts) and (b) probably won’t tell one much about the current conduct of macro policy (whatever inflation is going to be between, say, 2045 and 2050 isn’t likely to much influenced by whatever is going on now, or those –  ministers or MPCs –  making monetary policy decisions now.

For a long time, the Reserve Bank’s preferred measure of inflation expectations was the two-year ahead measure from the Bank’s survey of the expectations of several dozen moderately-informed or expert observers.  Two years got beyond the high-frequency noise, and the survey only added questions about five and ten years expectations in 2017.

2 yr expecs july 2020

In the latest published survey expectations fall very sharply.    There will be an update on this series published next week.  I wouldn’t be surprised if there was a bit of a bounce, but I wouldn’t expect it to be large.  The Reserve Bank’s own Monetary Policy Statement will be released the following week.  Perhaps they may have become a bit more optimistic, but recall that in May their inflation outlook –  even backed by their beliefs about the efficacy of their LSAP bond purchases –  was very weak.   Two years ahead their preferred scenario had inflation just getting back up to about 1 per cent.

Now, of course, things are somewhat freer in New Zealand than they were back when those earlier surveys and forecasts were done –  perhaps even more so, sooner, than most expected back then.  On the other hand, the border restrictions remain firmly in place and the wider world economy –  which seems to get all too little comment here –  is only getting worse.   I noticed in the Dom-Post this morning that that is now the official advice of The Treasury to the Minister of Finance.

All of this is, however, known by people participating in the government bond market.  And since the New Zealand government now issues a fairly wide range of bonds, and a mix of conventional bonds and inflation-indexed bonds, we can get a timely read on the inflation rates that, if realised, would leave investors equally well off having held a conventional bond or an inflation-indexed bond (the “breakevens”).   They aren’t a formal measure of inflation expectations, and at times can be affected by extreme illiquidity events, but it is also unlikely there is no relevant information (although Reserve Bank commentary tends to act as if this data can/should be completely ignored).

For a long time, there was only a single indexed bond on issue in New Zealand.  The Bank had persuaded the government to issue them back in the mid 1990s, but then emerging budget surpluses meant issuance was discontinued.  The single indexed bond matured in February 2016.  For a long time the longest conventional bond was a 10 year maturity.  But even with all those limitations, the gap between the indexed bond yield and the Bank’s 10 year conventional bond rate looked plausibly consistent with “true” inflation expectations.  Through much of the 00s, for example, the breakeven was edging up to average about 2.5 per cent.   Recall that there was never much of the indexed bond on issue, and never much liquidity either.

Since 2012 there has been a new programme of inflation-indexed bond issuance, and there are now four maturities on issue (September 2025. 2030. 2035, and 2040).   Go back five or six years to the time when the Reserve Bank (and most the market) thought higher interest rates were in order and you find that the breakevens were close to 2 per cent.  Given that in 2012 the government had slightly reframed the Reserve Bank’s monetary policy goal to require them to focus on the target midpoint of 2 per cent, breakevens around that level were what one would have hoped to see.  And did.

After that, things started to go wrong, with the breakevens beginning to fall persistently below target.  As it happens, of course, by this time it was increasingly realised that actual core inflation was also falling below target.

But what of the more recent period?   One problem in doing this sort of analysis, if you don’t have access to a Bloomberg terminal, is that the data on the Reserve Bank website used to provide yields for the four individual inflation-indexed bonds, but only benchmark five and ten year yields for conventional bonds (ie not yields on specifically identified individual bonds).  That didn’t much over very short-term horizon –  there just aren’t that many bonds on issue –  but potentially did for slightly longer-term comparisons.  However, in the last week the Bank has started releasing daily data on yields on all the individual government bonds on issue, indexed and conventional, back to the start of 2018.  That is most welcome.  As it happens, the government has also now started issuing a conventional bond maturing in May 2041, reasonably close to the maturity of the longest inflation-indexed bond.

In this chart I’ve calculated breakevens as follows:

  • take each of the indexed bond maturity (September 2025, 2030, 2035 and 2040)
  • use conventional bonds maturing in April 2025 and May 2041, and interpolated between bonds maturity in April 2027 and April 2033, and between bonds maturing in April 2033 and April 2037 (to give implied conventional bond yield for April 2030 and April 2035)
  • calculate the difference between each indexed bond and the yield on the conventional bond with the closest maturity date.

long-term breakevens

These breakevens, or implied inflation expectations, were uncomfortably low (relative to the target) even back in 2018. Things have only got worse since then.

Not that these are not breakeven inflation rates (or expectations) for a single year –  say 2025-  in the way that survey expectations (including the RB survey) are.  They are indications about average CPI inflation over the whole period to, say, 2025.

I thought there were several things that were interesting about the chart:

  • breakevens seemed to be trending downwards (if only modestly) well before the current recession began.  That seemed pretty rational –  the growth phase (here or abroad) wasn’t likely to last forever, and it was becoming increasingly clear that central banks were likely to feel quite constrained in the next downturn,
  • the divergence between the blue line and the other two this time last year.  That was when the Reserve Bank felt obliged to cut the OCR quite bit, and to start running those lines I referred to at the start of this post about downside risks around inflation expectations.  One could interpret the subsequent closure of the gap as a mark of some credibility for the Reserve Bank.  Expectations of inflation over the next five years rose a bit, and the gap between the 2025 and later expectations closed up again.
  • the sharp decline in the breakevens, for all three maturities, beginning in March.  Some of that will have been about the extreme illiquidity event in global (and local) bond markets in mid-March (something similar happened in 2008/09), prompting various central banks, including our own, to intervene in bond markets,
  • perhaps most importantly, the substantial divergence that has now opened up between the breakevens for the period to 2025 and those for the longer maturities.  All three lines picked up to some extent after the Reserve Bank added inflation-indexed bonds to the list of assets they would buy under LSAP, but since then the breakeven for the period to 2025 has gone basically nowhere, sitting at just above 0.4 per cent per annum (compared to an inflation target over the period of 2 per cent per annum).  By contrast, the grey line is back close to 1 per cent, not that much below where it was last year.   Even these lines understate the extent of divergence, because the breakeven to 2035 includes the five years to 2025.    If we could back out an implied breakeven just for the five years from 2030 to 2035 it might be around 1.3 per cent –  still not great, still not consistent with the target, but no worse than last year.
  • to the extent one can yet read anything into the 20 year numbers, and implied breakeven inflation rate for 2035 to 2040 would be higher still, although still below 2 per cent.

There are pluses and minus to be taken from all this.

The positive feature is that if one looks 15 years ahead, markets don’t expect New Zealand to deliver on a 2 per cent inflation target, but their (implied) view on that is no worse now than it was last year.  That isn’t great but it is better than the alternative.   On the other hand, it tells you almost nothing about the current conduct of monetary policy, since (a) current monetary policy won’t be affecting inflation outcomes 15 years hence, and (b) almost certainly, neither will the current key players (Orr or Robertson).

The negative feature is just how weak those five-year average expectations are, averaging around 0.4 per cent, well below the bottom of the target range, let alone the 2 per cent midpoint the MPC is supposed to focus on.   And this is the horizon that current monetary policy is affecting, and which the current key players (Orr, Robertson, and the MPC) will be affecting.    And these breakevens are down so far this year that real interest rates have not fallen much at all.   Here, for example, is the real yield on the 2025 inflation-indexed bond.

2025 real yield

No change over a year.  Or even if there was something odd going on at the end of July last year, no material change since (say) February this year, even as a severe recession and deflationary shock hit New Zealand and the world.  Even with the Reserve Bank intervening to support this market.   That is a pretty damning commentary on monetary policy simply not doing its job –  real yields over a five year horizon will always be heavily influenced by expected changes in short-term real policy rates.

As a final cautionary note, the deflationary shock was pretty much global in its effect, but here is the five year breakeven chart for the United States since the start of 2018.

US 5 yr

Not only can you see how much closer the breakeven has been to the Fed’s target for the inflation rate but, more importantly in the current context, how strongly the five-year breakeven has rebounded since March.   It is a very different picture to what we’ve seen in New Zealand.   There are some differences: the respective inflation-indexed bonds are slightly differently specified, and the Fed is not buying indexed bonds (unlike the RBNZ). But all else equal, the fact that the RB is buying indexed bonds and the Fed is not should be pushing New Zealand breakevens up relative to those in the US.  [UPDATE: A reader  draws my attention to the fact that the Fed is buying TIPS.]

The Governor and the MPC seem to have been all too keen to abdicate responsibility in this crisis, deferring almost everything to fiscal policy and simply refusing to cut the OCR further.  How much fiscal stimulus to do is a political matter outside the Bank’s control, but however much the government has done –  and it will soon be doing less, as the wage subsidy ends –  it is increasingly clear that the Reserve Bank is simply not doing enough.  Low and falling inflation expectations are inappropriate, inconsistent with the mandate, at the best of times, but far more troubling when central banks are unwilling to take official short-term rates deeply negative.  The Governor and his colleagues seemed to know that last year when it wasn’t much of an issue, but to have forgotten –  or simply chosen to ignore it –  this year.  It is as if they are simply indifferent to the (un)employment consequences.  That shouldn’t be acceptable, including to the Bank’s Board and the Minister of Finance who are responsible to us for the MPC’s stewardship.

 

Why economic policymakers need to respond aggressively

Yesterday I dug out some discussion notes I’d written while I was working at The Treasury during and just after the last New Zealand recession.  One of them –  written in June 2010, already a year on from the trough of the global downturn (although as the euro-crisis was really just beginning to emerge) – had the title “How, in some respects, the world looks as vulnerable as it was in 1929/30”.     The point of the “1929/30” was that the worst of the Great Depression was not in the initial downturn from1929 –  which, to many, seemed a more-or-less vanilla event – but from 1931 onwards.    It was only a four or five page note, and went to only a small number of people outside Treasury/Reserve Bank, but in many respects it frames the way I’ve seen the last decade, capturing at least some of issues that still bother me now, and lead me to think that  –  faced with the coronavirus shock –  macro policymakers should err on the side of responding aggressively (monetary and, probably, fiscal policy).

The more serious event –  akin to the 1930s –  didn’t happen in the last decade, at least outside Greece.    At the time, much of the focus of macroeconomic policy discussion  –  including in New Zealand –  was around ideas of rebalancing and deleveraging.    My note pointed out that, starting from 2010, it was very difficult to envisage how those processes could occur successfully over the following few years consistent with something like full employment.     To a first approximation it didn’t happen.  There was fiscal consolidation in many advanced countries, but not material private sector deleveraging. In most OECD countries it took ages –  literally years –  to get the unemployment back to something like the NAIRU.  And, of course, there was a huge leveraging up in China.  In much of the advanced world investment remained very subdued.

There were twin obstacles to getting back to full employment.  On the one hand, short-term policy interest rates in many countries had got about as low as they could go.  And on the other hand there was a view –  justified or not –  that fiscal policy had done its dash, and whether for political or market (or rating agency) reasons, further fiscal stimulus could not be counted on (even in a New Zealand context: I found another note I’d written a year earlier just before the 2009 Budget, which noted of “scope for conventional market-financed fiscal easing” that “our judgement –  more or less endorsed by the IMF and OECD – is that we are more or less at that point [scope exhausted]”.

The advanced world did, eventually, get back to more-or-less full employment.   But the world – advanced world anyway –  never seemed more than one severe shock away from risking dropping into a hole that it would be very hard to get back out of.  The advanced world couldn’t cut short-term interest rates by another 500 basis points.   For a time that argument didn’t have quite as much force as it does now –  when excess capacity was still substantial one could tell a story about not being likely to need so much policy leeway next time –  but that was then.  These days we are back starting from something like full employment.   There was also the idea of unconventional monetary policy instruments: but while some of them did quite some good in the heat of the financial crisis, and in the euro context were used as an expression of the political determination to hold the euro-area together come what may, looking back no one really regards those instruments as particularly adequate substitutes for conventional monetary policy (limited bang for buck, diminishing marginal returns etc).  And then there is fiscal policy.   Few advanced countries are in better fiscal health than they were prior to the last recession –  and New Zealand, reasonably positioned as we are –  is not one of the few, and the political/public will to use huge amounts of fiscal stimulus for a prolonged period remains pretty questionable.

Oh, and there is no new China on the horizon willing and able to have its own massive new credit/investment boom – resources wisely allocated or not – on a global scale to support demand elsewhere.

How about that monetary policy room?  Here are median nominal short-term interest rates for various groupings of OECD countries.

short-term 2020

You can see where we are 10 years ago.   Across all the OECD monetary areas (countries with their own monetary policy plus the euro-area) the median policy rate is about where it was then (of the two biggest areas, the US is a bit higher and the euro-area a bit lower).  Same goes for the G7 grouping.  And as for “small inflation targeters” (like New Zealand) those countries typically have much less conventional monetary policy capacity than they had in 2010 (New Zealand, for example, had an OCR of 2.75 per cent when I wrote that earlier note, and is 1 per cent now).

Back then, of course, the conventional view –  not just among markets but also to considerable extent among central banks –  was that before too long things would be back to normal.  Longer-term bond yields hadn’t actually fallen that far.  Here are the same groupings shown for bond yields.

long-term 2020

One could, at a pinch, then envisage central banks acting to pull bond yields down a long way (and with them the private rates that price relative to governments).  These days, not so much.  Much of the advanced world now has near-zero or even negative bond rates.  A traditionally high interest rate country like New Zealand now has a 10 year bond rate around 1 per cent.   Sure those yields can be driven low, but really not that much if/when there is a severe adverse shock.

And 10 years ago if anyone did much worry about these sorts of things –  and there were a few prominent people –  there was always the option of raising global inflation targets.  In the transition that might have supported demand and getting back to full employment. In the medium-term it would have meant a higher base level of nominal interest rates, creating more of a buffer to cope with the next severe adverse shock.   It would have been hard to have delivered, but no country even tried, and now it looks to be far too late (how do you get inflation up, credibly so, when most of your monetary capacity has gone, and it would hard to convince people –  markets –  of your sustained seriousness).

My other point 10 years ago in drawing the Great Depression parallels was that the Great Depression was neither inevitable nor inescapable.  But it happened –  in reality it might have taken inconceivable cross-country coordination to have avoided by the late 1920s –  and it proved very difficult (not technically, but conceptually/politically) to get out of.  The countries that escaped earliest –  the UK as a prime example –  did so through a crisis event, crashing out of the Gold Standard in 1931 that they would have regarded as inconceivable/unacceptable only a matter of months earlier.  For others it was worse –  in New Zealand the decisive break didn’t come until 1933, and even then saw the Minister of Finance resigning in protest.    If we get into a deep hole in the next few years –  international relations generally not being at their warmest and most fraternal, domestic trust in politicians not being at its highest –  it could be exceedingly difficult to get out again.  Look at how long and difficult (including the resistance of central banks to even doing all they could) it proved to be to get back to full employment last time.

In the Great Depression one of the characteristic features was a substantial fall in the price level in most countries.   The servicing burdens of the public and private debt –  substantial in many countries, including New Zealand/Australia –  escalated enormously, and part of the way through/out often involved some debt defaults and debt writedowns.

Substantial drops in the price level seem unlikely in our age.  Japan, for example, struggled with the limits of monetary policy and yet never experiencing spiralling increases in the rates of deflation (of the sort some once worried about).  But equally, inflation expectations ratcheted down consistent with the very low or moderately negative inflation, meaning real interest rates were never able to get materially negative.  Japan at least had the advantage that in the rest of the advanced world, nominal interest rates and the inflation rate were still moderately positive.

That could change in any new severe downturn.  A period of unexpectedly weak demand, with firms, households and markets all realising that authorities don’t really have much useable firepower, could see assumptions/expectations about normal rates of inflation dropping away quite sharply (in New Zealand they fell a lot, from a too-high starting point, last time round, even with unquestioned firepower at our disposal).  In that scenario, authorities would struggle to lower real interest rates at all for long –  falling nominal rates could quite quickly be matched with falling inflation expectations.  As people realise that, it becomes increasingly hard to generate a sustained recovery in demand, and very low or negative inflation risks becoming entrenched.  It isn’t impossible then to envisage unemployment rates staying very high –  unnecessarily and (one hopes) unacceptably high –  for really prolonged periods (check the US experience in the 1930s on that count).  An under-employment “equilibrium” brought by official negligence is adequately dealing with the effective lower bound on nominal interest rates.

I cannot, of course, tell if the current coronavirus is that next severe adverse shock.  But it looks a great deal as though it could be, and the risks are sufficiently asymmetric –  not much chance of inflation blowing out dangerously –  that we shouldn’t be betting that it won’t be.  Some people argue that since the virus will eventually pass for some reason it isn’t as economically serious as other shocks.   That seems wrong.  All shocks and recessions eventually pass –  many last not much more than a year or two  –  and the scale of disruption, and reduction in activity, we are now seeing (whether in the New Zealand tourism and export education industries, or much more severely in northern Italy, Korea and the like) has the potential to markedly reduce economic activity, put renewed downward pressure on inflation and inflation expectations (we see the latter in the bond market already), all accompanied by a grim realisation of just how little firepower authorities really have, or are really politically able to use.  (Ponder that G7 conference call tomorrow, and ask yourself how much effective leeway the ECB has now, compared to 2007, or even 2010. )

Against that backdrop, it would seem foolhardy now not to throw everything at trying to prevent a significant fall in inflation expectations, by providing as much support to demand and economic activity as can be done.   That means monetary policy, to the extent it can be used –  in New Zealand for example, a central bank that was willing to move 50 points last August, on news that was weak but not very dramatically so, should be champing at the bit to cut at least that much this month.  The downside to doing so, in the face of a very real threat to norms around inflation –  and a likely material rise in unemployment – is hard to spot.  And since everyone knows monetary policy has limited capacity –  and those who haven’t realised it yet very soon will –  we need to see fiscal policy deployed in support, in smart, timely, and effective ways.   In some countries it is really hard to envisage that being done well –  the dysfunctional US in the midst of an election campaign, starting with huge deficits –  but there really is no such excuse in countries such as New Zealand and Australia.  (Oh, and of course –  and after all these years –  something needs to be done decisively re easing the effective lower bound.)

(There is, of course, widespread expectations of a huge Chinese stimulus programme.  That is as maybe, although it will bring both its own risks –  domestic ones just kicked a little further down the road –  and the risk of new immediate dislocations, including the possibility of a significant exchange rate depreciation, exporting (as it were) deflationary pressures to the rest of the world.)

We are only one serious adverse shock away from a very threatening economic outlook, where the limits of macro policy would mean it would be difficult to quickly recover from. By the day, the chances that we are already in the early stages of that shock are growing.  Perhaps it will all blow over very quickly, and normality resume, but (a) even if that very fortunate scenario were to eventuate, the risks are asymmetric, and (b) we’d still be left sitting with very low interest rates and typically high debt, one serious adverse shock away from that hole.