OCR cuts as plausible as increases

The CPI data for the September quarter were released yesterday.  They were the last for the period Graeme Wheeler was Governor of the Reserve Bank –  charged with targeting inflation – although of course the lags mean that policy choices Wheeler made will still be influencing inflation through next year.    The target Wheeler willingly signed up for five years ago was 2 per cent CPI inflation.  In his time in office, he saw annual inflation that high only once (of 20 observations).  On his preferred core measure –  which is probably the best indicator of the underlying trend in inflation –  September 2009 was the last time core inflation was as high as 2 per cent.

In fact, here is that (sectoral factor) measure of core inflation back a decade or so.

core inflation

There are various readings one could put on that chart.  On the one hand, core inflation (on this measure) has been astonishingly stable in the last six years or so.   That would normally be to the credit of the Governor concerned.   Then again, the same Governor explicitly signed up for a focus on 2 per cent inflation, and there has been no sign that the trend in inflation is any closer to fluctuating around 2 per cent than it was in 2012.

On the other hand, at the start of chart, back in 2006/2007 at the peak of the last boom, inflation was clearly too high (relative to the target the government had given us).   Partly for that reason, I continued to recommend OCR increases throughout most of 2007.  With hindsight –  but probably only in hindsight – those increases weren’t needed.  But my point here is to recognise that the gap between actual core inflation and the target midpoint (2 per cent) was materially larger then that it is now.  As it happens, we didn’t have this particular core measure in 2007, but when we sat around the table debating what Alan Bollard should do with interest rates then, we knew a best estimate of core inflation was around 3 per cent (we were also pretty confident that the unemployment was well below a sustainable level).  In fact, at the time the Bank’s Board was asking uncomfortable questions as to quite how 3 per cent annual core inflation squared with the statutory mandate of “a stable general level of prices” (I wrote a, from memory, slightly casuistical paper in response.)

So, if there are legitimate questions about the conduct of monetary policy right now –  the Bank having already undone its 2014/15 mistake –  they pale in comparison with those that should have been being asked in 2007.  (As I recall it, Stephen Toplis was raising such questions then, and attracting the ire of the then Governor).

What do yesterday’s inflation data show?

I’ve previously shown a table of six core inflation measures

Core inflation, year to Sept
CPI ex petrol 1.8
Trimmed mean 2
Weighted median 2
Factor model 1.8
Sectoral factor model 1.4
CPI ex food and energy 1.5

A couple of those measures are actually bang on 2 per cent.  On the other hand, the Reserve Bank has been consistently clear in recent years that its favoured measure is the sectoral factor model (a statistical exercise that searches of underlying common trends in the disaggregated components of the CPI), and international comparisons often use a CPI ex food and energy measure (it is the one core measure the OECD reports for its member countries).

Hawks might be inclined to dismiss the Bank’s preference for the sectoral factor model as just “cover for a reluctance to raise the OCR to where it ‘should’ be”.  I think they would be wrong to do so.  It isn’t that long since the median core inflation measure was running materially below the sectoral factor model number, and the Bank was then asserting that the core inflation measure was a better guide.   I wasn’t fully convinced at the time, but it seems that they were probably right.

We only have consistent data for all six core measures back three years or so, but even that is enough to illustrate the point.  In this chart I’ve shown the sectoral core measure and the median of the other five measures.

core inflation measures oct 17

The gap between the two lines was larger a couple of years ago than it is now.  I don’t think many observers will find it that credible that in the sort of economy we’ve experienced in the last couple of years “true” core inflation has picked up as strongly as the blue line suggests.  The general understanding of how inflation works, in settled and stable economies, is that there is lots of short-term noise, but that the underlying trend –  the bit monetary policy should usually focus on –  is pretty sticky and slow-moving.   Personally, I find it more convincing to believe that core inflation has been pretty consistently low for several years than to suppose it has gone through the quite large cycles some of the other measures suggest.  In support of this proposition, over the almost 25 years for which we have estimates from the sectoral factor model, it is easy –  with hindsight –  to tell a persuasive story about what was going on in that series.  Less so with some of the other measures.

One other way to illustrate the point is to compare the sectoral factor model numbers to a couple of the other core inflation indicators for which there is a long run of data.    This compares the sectoral factor model and the factor model (an earlier iteration, using a similar class of filtering techniques).

core measures

Or in this one a comparison of the sectoral factor model with the CPI ex food and energy (in the latter I haven’t manually excluded the 2010 GST spike).

core measures 2

You will struggle to find an economist who thinks that, in an economy like New Zealand’s, the underlying trend in inflation is anything like as noisy as those other measures suggest.

We don’t have a formal Policy Targets Agreement at present, but for some years now PTAs have included this phrase

For a variety of reasons, the actual annual rate of CPI inflation will vary around the medium-term trend of inflation, which is the focus of the policy target.

There isn’t much sign either that the medium-trend of inflation is fluctuating around 2 per cent –  where it supposed to have been –  or that it has been increasing and getting any closer to target.

Here is another way of looking at the issue.   Headline inflation is thrown around by changes in taxes and government charges, and although SNZ don’t (unfortunately) publish a series of CPI inflation excluding taxes and charges (as many other countries’ statistical agencies do), they do publish a series of non-tradables inflation excluding government charges and the cigarettes and tobacco component (the latter having been the subject of repeated large tax increases in recent years, which have nothing to do with the underlying inflation process).  The data only go back 10 years or so, but here is what that chart looks like.

NT ex govt charges and tobacco oct 17

This measure of core non-tradables inflation is off its lows (in 2010, 2012, and 2015) but shows no sign of racing away.    Construction cost pressures play a big role in this series, but even with the pressures in that sector, this measure of non-tradables inflation is currently running at only around 2.25 per cent.   The 2014 peak was (a bit) higher. (Consistent with this story, wage inflation –  although quite high relative to productivity growth –  has also been showing no signs of acceleration).

I saw one commentary yesterday suggesting that if non-tradables inflation was above 2 per cent that was grounds for thinking about tightening –  after all, 2 per cent is the inflation target midpoint.  Actually, for decades non-tradables inflation has averaged well above tradables inflation.  Our benchmark in discussions at the Bank was often along the lines of “a 2 per cent inflation target means tradables inflation averaging about 1 per cent and non-tradables inflation averaging about 3 per cent”.  As it happens, for the 17 years the Bank has data on its website, tradables inflation has averaged 1.0 per cent, and non-tradables inflation has averaged 3.2 per cent (CPI inflation averaged 2.2 per cent).

If the Reserve Bank is serious about ensuring that core inflation fluctuates around  per cent, they will need to be seeing quite a lift in non-tradables inflation from here.  There is nothing in the data suggesting that lift is already getting underway.  And, of course, that is largely why their own projections haven’t shown any OCR increases for some considerable time.

Against this backdrop, the troubling question remains why every commentator (I’ve seen) has been focused on the timing of a potential OCR increase (even if all agree it is probably still some time away).    Core inflation is persistently below target, the best measure of core inflation shows little or no sign of picking up, and –  not irrelevantly – the unemployment rate is still above any credible estimates of the long-run sustainable rate.  It is not as if rapid productivity growth is driving prices downward either –  some sort of “good low inflation”.  Instead, there is no aggregate productivity growth.  And few commentators seem to envisage GDP growth (headline or per capita) accelerating from here.  Even if there are some encouraging signs in the world economy at present, it isn’t at all clear to me why one would think the next OCR change was any more likely to be an increase than a cut.

I wouldn’t be pushing for an OCR cut at present, but it isn’t hard to envisage how we might be better off if the OCR was a bit lower than it is now.   I’ve resisted the argument that house price inflation should be an additional factor in OCR decisions, and I’m not about to reverse that stance just because house price inflation is (temporarily?) subdued, but for those who did want to give house price inflation some extra weight even that argument against further OCR cuts probably has to be put to one side for now.

In conclusion, I noticed this paragraph in the BNZ commentary on yesterday’s numbers

What is peculiar to New Zealand, however, is the very confused governance picture we have at the moment. Not only do we have a caretaker governor but we also don’t know who the incoming government is or what its expectations are for future fiscal stimulus, the Policy Targets Agreement and the Reserve Bank Act itself. Until these questions are answered it is very difficult to make any meaningful comment on future RBNZ action with any degree of certainty.

I’d largely agree with all that. It remains possible that the Bank could be operating under a different PTA as soon as next week (it happened to varying degrees in each of 1990, 1996, 1999 and 2008), and even then the (unlawful) caretaker Governor has little or no effective mandate to do anything much, minding the store until a permanent appointee is in place.  Of course, even when all those uncertainties are resolved –  Governor, and any (or no) changes to the PTA or Act – it will still be hard “to make any meaningful comment on future RBNZ action with any degree of certainty”.   Doing so would require a degree of knowledge about future inflation pressures not gifted to central banks, or to private forecasters.  We (more or less) know what we see now, and not much beyond that (ever).

 

 

 

LVRs, interest rates and so on

I was recording an interview earlier this afternoon, in which the focus of the questioning was the Real Estate Institute’s call for some easing in the Reserve Bank’s LVR restrictions.

Of course, I never favoured putting the successive waves of LVR restrictions on in the first place.  They are discrimatory –  across classes of borrowers, classes of borrowing, and classes of lending institutions –  they aren’t based on any robust analysis, as a tool to protect the financial system they are inferior to higher capital requirements, they penalise the marginal in favour of the established (or lucky), and generally undermine an efficient and well-functioning housing finance market, for little evident end.  Oh, and among types of housing lending, they deliberately carve-out an unrestricted space for the most risky class of housing lending –  that on new builds.

That doesn’t mean I think it is remotely likely that the Reserve Bank will be easing the restrictions any time soon –  apart from anything else, it would leave their consultation paper on debt to income ratio restrictions looking a little silly.   Of course, it would be good if the Reserve Bank did lay out some specific criteria for lifting these ostensibly temporary restrictions, but with the toxic brew of rapid population growth and continuing land use restrictions in place, if I saw the world as they seem to, I wouldn’t be in a hurry to lift the restrictions either.

In any case, it isn’t that clear quite how large a role the LVR restrictions are playing in the reduction in sales volumes.   They must be playing a part, but so too will higher interest rates, and the apparent increase in banks’ own lending standards, and pressure through the parents from APRA (on the lending standards across the whole of Australian banking groups).  Which, of course, is also why it isn’t clear quite how much difference any easing back in the New Zealand LVR controls might make.  Some presumably, but even the Reserve Bank has never claimed that LVR controls would have a very large impact on house prices, or housing market activity, for very long.   And while I noticed an article this morning about negative equity, it is worth bearing in mind that, on the REINZ index (not using median prices), house prices have risen 65 per cent in the last five years, and are currently 0.6 per cent off their peak.

But what of interest rates?  A year ago, the OCR was 2.25 per cent, and today it is 1.75 per cent.  Thus, the Reserve Bank talks of having eased monetary policy.   Here are mortgage rates though.

mortgage ratesI don’t suppose anyone is taking out four or five year fixed rate mortgages, but across the entire curve, interest rates are higher not lower.   Or we could go back another year or so, to just prior to when the Reserve Bank began cutting the OCR.   The OCR has been cut by 175 basis points since then.   Even at the shortish end of the mortgage curve, rates are down only 50-70 basis points.

Having been reflecting this morning on Graeme Wheeler’s performance over his term, I had a look back at where interest rates were when Wheeler took office in September 2012.

mortgage rates sept 12Barely lower, even though core inflation –  on their own favoured measure – is as low today as it was then (and has been consistently low throughout his term).

I wondered if there were offsetting factors but:

  • Two year ahead inflation expectations are about 25 basis points lower than they were then (largely offsetting any reductions in nominal mortgage rates, to leave real rates little changed)
  • the TWI measure of the exchange rate is a bit higher than it was then,
  • the ANZ commodity price index, in inflation-adjusted world price terms, is hardly changed from what it was then.

Of course, the unemployment rate has fallen since September 2012, but there hasn’t been any sign of a pick-up in the best indicator of labour scarcity –  real wage inflation.

So, overall, it is a bit of a puzzle how the Governor expected to get core inflation back to fluctuating around the target midpoint without actually easing monetary conditions.  I don’t happen to agree with him on this one, but he keeps talking about how the huge migration inflows have reduced net inflation pressures (supply effects outweighing the demand effects).  If he really believes that it is even more puzzling that monetary conditions haven’t been eased.

I’m not sure how he’d respond.  But perhaps he could explain that too in the forthcoming speech.

 

Tightening conditions impede inflation getting back to target

Five years ago, the then incoming Governor, Graeme Wheeler, signed a Policy Targets Agreement with the then Minister of Finance.  In that document, he committed to run monetary policy with a

focus on keeping future average inflation near the 2 per cent target midpoint.

Earlier this week the CPI  was published.  It was the last such release that will appear while the Governor is still in office.

On a chart showing the 2 per cent focal point the Governor willingly committed himself and the Bank to, here are (a) the actual CPI inflation rates and (b) the Governor’s preferred measure of core inflation (the sectoral factor model measure) for the last five years.

Wheeler inflation 17

Not once in five years has core inflation (on this measure) even come close to 2 per cent.  In only a single quarter –  one of 20 – did headline CPI inflation get to 2 per cent.

Of course, the Governor can’t really be held to account for inflation outcomes in the first year or so of his term –  those outcomes were determined by choices made by Alan Bollard.  And for the next year or so, it will be Graeme Wheeler’s policy choices that have the biggest policy influence.  Nonetheless, to be so consistently far away from the newly-adopted target isn’t a great legacy.  Perhaps (but probably not) the Bank’s Board will reflect on those outcomes in their forthcoming Annual Report?

The sectoral factor model is only one measure of core inflation, albeit the most stable of them (and so the dip down in the latest release should be a bit disconcerting).  Here is the table I’ve run previously, of six measures of core inflation.

Core inflation: year to June 2017
CPI ex petrol 1.7
Trimmed mean 1.8
Weighted median 2.0
Factor model 1.7
Sectoral factor model 1.4
CPI ex food and energy 1.6
Median 1.70

The poor track record on inflation might have been more tolerable if:

  • productivity growth was really strong, driving down costs and prices.  But it hasn’t been.  In fact, there has been no labour productivity growth at all in the Wheeler years (not the Bank’s fault), or
  • if the unemployment rate was exceptionally low.   But it hasn’t been.   The current unemployment rate (4.9 per cent) is still materially above most estimates of the NAIRU, and well above pre-recessionary levels.  For what it is worth, it is also now above the unemployment rates in a couple of Anglo countries with pretty flexible labour markets (the US and the UK), which had to grapple with having reached the limits of conventional monetary policy during the post-recessionary years.
  • core inflation was still rising now (mistakes happen, but fixing them promptly makes up for quite a lot).  But, for example, the sectoral core measure is back to the same level it was in September 2015, when the Bank was just beginning to unwind its ill-judged 2014 tightenings.

Mostly, monetary policy in the Wheeler years hasn’t been well run.    When Graeme Wheeler took office core inflation had fallen quite a bit over the previous year.  A sensible response would have been to have cut the OCR.   The OCR increases in 2014 were never necessary (I choose the word advisedly –  there was plenty of time to wait and see if core inflation was in fact just about to pick up strongly).  Those increases were then unwound only rather grudgingly.

Of course, in fairness to the Bank, it did rather less badly for most of the period than most of the market economists whose views are covered in the local media.    For most of the time, most (almost all) of them were forecasting higher inflation, and a higher OCR, than the Reserve Bank was delivering.   But it isn’t much consolation, since (a) the Reserve Bank has far more analytical resources at its disposal than the private banks, and (b) the Reserve Bank is paid to conduct monetary policy, and market economists aren’t.

We’ll see next month what the Reserve Bank makes of the latest inflation outcomes.   But the data must be quite disconcerting.     There are some specific pockets of inflationary pressure –  building costs notably (and not that surprisingly, given the population pressures).   But here is non-tradables inflation (quarterly) for the June quarters of the last nine years.  Non-tradables inflation is what the Reserve Bank has most influence over in the medium-term.

NT june quarters

Only in 2015 was June quarter non-tradables inflation lower than it has been this year. Annual non-tradables inflation has dipped slightly to 2.4 per cent.  That might not seem too bad –  after all the target midpoint is 2 per cent – but as even the typically-hawkish BNZ noted in their commentary the other day one would really expect non-tradables inflation to be quite a lot higher to be consistent with delivering overall CPI inflation near the target midpoint.    A simple approach to a core non-tradables inflation rate is the SNZ series that excludes government charges and the cigarettes and tobacco subgroup (where taxes are being raised substantially each year).

NT ex jun 17

An annual inflation rate in this series nearer 3 per cent would be more consistent with core CPI inflation settling around 2 per cent.  At present, it is nowhere near 3 per cent, and moving in the wrong direction.

So why is inflation still (a) quite a way from target, and (b) looking to be falling again?  Broadly speaking, I reckon the answer is about (a) an economy that continues to run below capacity, and (b) tightening monetary and financial conditions.   The Reserve Bank’s latest published estimate was that the output gap is around zero (roughly, a fully-employed economy).   I noticed one local bank published an estimate the other day suggesting they thought the output gap was more like +1 per cent of GDP.     With the unemployment hovering around 5 per cent –  and best estimates of the NAIRU somewhere around 4 per cent, and demographic reasons to think the NAIRU might be falling, that simply seems unlikely.  It is much more likely there is still some excess capacity in the system, and demand growth simply hasn’t been strong enough.     The job of monetary policy is to manage interest rates in ways that deliver enough demand to keep inflation near target.

The current state of excess capacity is a long-running difference of opinion.  But what isn’t really in much doubt is that monetary and financial conditions have been tightening quite substantially in the last few quarters.

The OCR was cut to the current level of 1.75 per cent last November.   We might have expected inflation to pick up a little further since.    But retail interest rates have been rising:

  • the Bank’s measure of SME overdraft rates troughed in January 2017, and had risen by 19 basis points by June,
  • the Bank’s measure of floating mortgage rates for new borrowers troughed in October 2016, and has risen 25 basis points since then,
  • the Bank’s six month term deposit rate measure troughed in July last year and has risen 15 basis points since then,
  • one and two year fixed mortgage interest rates are also up by around 20 basis points

These aren’t large moves, but with inflation having been consistently below target (and the Bank having been repeatedly surprised) there was no good reason for the Reserve Bank to have accommodated such tightenings.

It isn’t just retail interest rates.   Here is the trade-weighted exchange rate measure

TWI july 17

The exchange rate fell quite a long way in 2015, as dairy prices fell, and the Reserve Bank began cutting the OCR.  At the time, the Governor spun tales about how this would help get inflation back to 2 per cent.  Exchange rates are somewhat variable, but broadly speaking the trend has been upwards since then.    Yes, dairy prices and the terms of trade have improved, but it all adds up to another tightening of monetary conditions when inflation has been persistently below target.

And, of course, credit conditions have also tightened.  Some of that is the Reserve Bank’s own doing –  last year’s latest iteration of the LVR controls –  but much of it isn’t: it is lenders reassessing their own willingness to lend.  We don’t have good statistical indicators of credit conditions, but there is little doubt they’ve been tightening.

It all adds up to a picture in which shouldn’t really be very surprising at all: inflation isn’t rising and may well have begun falling again.  Of course, some surprises reinforce the more systematic elements.  Weaker oil prices (for example) probably will spill over to some extent into core measures of inflation.  And unlike the situation in 2010 and 2014, this isn’t a case where the Reserve Bank has gone out actively seeking to tighten monetary conditions –  indeed, the Governor has been commendably moderate, especially relative to most local market commentators.  But it does look a lot like another case where the Bank (and the Governor personally, as single legal decisionmaker) has been too invested in a story that the economy was strong, inflation was picking up, and would continue to pick up, that it missed the way in which monetary conditions were tightening, and continued to largely (and deliberately) ignore the signals coming from the labour market.  Instead of repeatedly talking –  as the Governor does –  about how accommodative (or even “highly accommodative”) monetary policy is, the Bank would be much better advised to treat the low level of interest rates as normal, for the time being (it has after all been more than 8 years now since they were sustainably higher), and put much more weight on seeing hard evidence that (a) inflation is settling back at around 2 per cent, and (b) unemployment is nearer credible estimates of the NAIRU, before acquiescing in any material tightening in monetary conditions.   After getting it so wrong for so long, they should be willing to run the risk of core inflation heading a bit above 2 per cent for a time –  after so many years of undershoots, no one is suddenly going to think the Bank is soft on inflation if core inflation is 2.2 or 2.3 per cent for a couple of years.

Looser monetary conditions now would, most likely, be more consistent with the Bank’s mandate.  I’m not sure it is good form for the Governor to take the market by surprise with a cut from the blue as he heads out the door. But the case for establishing an easing bias in next month’s Monetary Policy Statement is beginning to strengthen.    Hawks will, of course, cite the various business and consumer confidence measures.  None is any stronger now than they’ve been over the last couple of years, and over that period inflation simply failed to pick up anything like enough to get back to target.   Expecting something different now, when the background conditions haven’t changed, is either just wishful thinking, or something worse –  including an inexcusable indifference to the lingering high number of people unemployed.

 

Some Reserve Bank forecast surprises

The Reserve Bank of Australia had an interesting Bulletin article out recently, offering some insights on this chart

rba wage inflation surprises

The RBA’s wage inflation forecasts have been persistently too strong.  Mostly, they’ve forecast an acceleration of wage inflation, and yet actual wage inflation has continued to fall.

I was curious what a comparable New Zealand picture might look like.  The way wage inflation series are calculated differs from country to country.  In our Labour Cost Index, we have two measures of private sector wage inflation –  the headline one, and what is labelled the Analytical Unadjusted series.  The latter seems to be more comparable to the Australian measure in the RBA chart, while the headline LCI series attempts to adjust for changes in productivity (ie capturing only wage increases in excess of  what firms identify as productivity growth).    Here is what the two series look like.

LCI series

The fall in New Zealand wage inflation (between 2 and 2.5 percentage points since 2008) is pretty similar to the fall in Australian wage inflation in the first chart.

The Reserve Bank of New Zealand publishes forecasts of annual wage inflation for the LCI private sector wages and salaries series (the orange line).  I dug out their forecasts published in the June quarter of each year and this is the chart I came up with.

Reserve Bank wage forecasts

It isn’t quite the same picture as in Australia –  they had a genuine business investment boom which had taken wage inflation almost back up to pre-downturn levels –  but the broad picture is much the same.  Each year since 2010, the Reserve Bank has forecast an increase in this measure of wages (notionally at least productivity-corrected) and each year it hasn’t happened.   Perhaps this year’s forecast will prove more accurate?

What I found interesting is that the errors seem not to have been related to productivity surprises (I’ll come back to those), but simply to misreading overall inflation pressures.

Why do I say that?  Well, here is a chart showing the Bank’s furthest ahead forecasts for wage and price inflation.   They forecast three years ahead, so the forecasts associated with June 2017 (and published in that quarter) relate to inflation in the year to March 2020.   Inflation forecasts that far ahead aren’t thrown around by things like unexpected petrol prices changes or weather shocks to fruit and vegetable prices.  They are closely akin to forecasts of core inflation.

rb wages 2

The wage inflation and price inflation forecasts are so close together that it is quite clear that for some years the Bank has simply been forecasting this measure of wage inflation on the basis of an assumption of unchanged real unit labour costs.    Whatever happens to productivity growth, the Bank assumes that over the medium-term, this measure of wages (notionally productivity-adjusted) will rise at around the same rate as CPI inflation.     (That in itself is interesting as throughout this period the unemployment rate has been above Bank estimates of the NAIRU.  I can’t really show you a meaningful chart of their unemployment forecast surprises, because of the historical revisions to the HLFS).

The grey line shows actual inflation outcomes for the period that lines up with those medium-term forecasts.  I’ve used the Bank’s preferred sectoral core inflation measure, not because it is ideal but because (a) it is available, and (b) it is their own preference.   The last observation is sectoral core inflation for the year to March 2017, which is compared to forecasts for that period published in the June quarter of 2014.

What about the Bank’s productivity forecasts?  In many ways, their view on future medium-term productivity growth doesn’t greatly affect their view of inflation pressures (higher assumed productivity growth will tend to raise both potential and actual output).  So the productivity surprises chart is mostly about simply charting the declining performance of the New Zealand economy.

The Reserve Bank publishes forecasts for growth in a trend measure of productivity, and the trend estimates are revised as new data are added.   But here are the forecasts, lined up against their most recent estimates of trend productivity growth (again using the forecasts published in each June quarter).

rb productivity forecasts

The Bank has, again, consistently forecast a pick-up in productivity growth (the first observation on each line is the Bank’s then-current estimate of the most recent actual).  And for some of the earlier years (2009 to 2011) their latest estimates of actual trend productivity growth are higher than they thought at the time (it happens, as new revisions to GDP data come out).    But as their estimates of actual trend productivity growth rates have continued to fall  –  near zero for the last couple of years –  they’ve continued to forecast a rebound.  Indeed, the rebound in the latest set of forecasts –  out just a couple of weeks ago –  is as steep as any of those in recent years.   Perhaps in their shoes I’d also forecast a rebound –  it seems excessively pessimistic to assume zero productivity growth for ever –  but you do have to wonder what they think is about to change that means we’ll see the rebound beginning strongly in 2017/18 –  ie, right now.

This post is probably already excessively geeky for many readers.   But, as I do, the further I got into the data the more fascinated I got.  I could show you a similar chart for output gap estimates and forecasts, but it is hard to read and fairly predictable –  the Bank has fairly consistently over-estimated how much resource pressure would build up over successive forecast periods.  That shouldn’t be a surprise, given the weak inflation outcomes.

But they did get some things pretty much right over this period.    This chart shows two lines.  One –  the orange line –  is their latest (June 2017) estimate for the average output gap for the year ending March of each year.  And the others shows the contemporaneous forecasst done in each June quarter for the year ending March of that year.  Thus, the 2017 observation is the June 2017 MPS estimate of the average output gap for the year to March 2017.  When those estimates are done, the GDP numbers for March 2017 still aren’t known (but the first three quarters of the year are).  Potential output is always an estimate.

contemporaneous output gap forecasts

With one (important) exception, the contemporaneous estimates and the current ones are astonishingly close.   That isn’t so surprising for the last couple of years, and additional data could yet lead to material revisions in the estimates for the output gaps for 2015 and 2016.      But for the earlier years, despite all the revisions to the data, and all the new information, the Bank’s contemporaneous estimates for the then-current output gap hold up very well against today’s estimates.  These are annual averages, not estimates for the output gap in the March quarter itself, but….still…..I was pleasantly surprised.     The forecasts might be pretty hopeless (as I noted last week, and as is typically true of other forecasters too) but the contemporaneous estimates aren’t bad at all.   Simple monetary rules, such as the Taylor rule, encourage central banks to not put much emphasis on medium-term forecasts, but to adjust policy based on how they assess the current situation (output or unemployment gaps, and inflation gaps).

Of course, one observation in that chart does stand out.  In 2014, the Bank thought there was a reasonably materially positive output gap.  They now recognise that there wasn’t.  And that was the time when they made the policy mistake, of raising the OCR by 100 basis points (and talking up even further increases beyond that), only to have to reverse those increases quite quickly.    In any serious post-mortems of that episode (such as they suggest will be coming out shortly), they should be looking hard at how they got that output gap assessment so wrong –  much more wrong than in any of the other post-recession years illustrated on the chart.

Getting the read on the current situation right is hard enough, and medium-term forecasting is typically adding no value, whether in understanding the actual future, or in understanding how the Bank itself might react to its own mistakes.  The Bank would be better advised to focus its energies –  analysis, communications, and policy deliberations –  on what it knows at least something about, rather than on what it (and the rest of us) know little or nothing about.

Reflecting on the macro data

The Reserve Bank’s Monetary Policy Statement (Graeme Wheeler’s second to last) will be out on Thursday.  I’m not in the market economists’ game of trying to tell you what the Bank will do and say (although no one expects they will do anything concrete with the OCR this time).  I’m more interested in questions around what they should do.  In time, what they should do, they usually will do.  But sometimes not until they’ve tried the alternatives.

I wrote about last month’s CPI data a few weeks ago, concluding that there had been a welcome, and expected, increase in core inflation (it is what typically happens if inflation is below target and the OCR is cut fairly substantially) but that

With the unemployment rate still above estimates of the NAIRU, and most indicators of inflation suggesting that core is probably (a) still below target, and (b) not picking up very rapidly, it certainly isn’t time for hawkish talk about near-term OCR increases.

Not everyone agrees of course.  I noticed the BNZ’s economic commentary yesterday which opened with this confident assertion

There is no excuse for the cash rate to be just 1.75% in New Zealand.

I don’t think I’m unduly caricaturing their record to say that, for at least the last decade, the BNZ economics team has never seen an OCR increase they didn’t like, even –  or perhaps especially –  those which had to be quickly reversed.  But mindful that in the story of the boy who cried wolf, the wolf eventually did come, I thought it was worth having a look at the latest wave of data.  Last week, we got the full quarterly set of labour market data (HLFS, QES, and LCI), and the Reserve Bank’s quarterly expectations survey.  To cut a long story short, it doesn’t alter my view.

Take the expectations survey first.   The headline story was one in which the two year ahead expectations of the inflation rate (of a sample of moderately informed observers –  including me) rose quite materially, and now stand at 2.17 per cent (up from around 1.65 per cent in each quarter last year).

infl and expecs

This measure of expectations isn’t typically very volatile, but it is typically somewhat responsive to changes in headline CPI inflation.  We’ve just had quite a large change in headline inflation, so some increase in the expectations measure shouldn’t be surprising. It certainly shouldn’t be concerning.  After all, ideally, the Reserve Bank wants people to believe, and act as if they believe, that on average over time CPI inflation will average around 2 per cent –  the mid-point of the target range, and the explicit focus of the current (but about to expire) PTA.

In fact, no one really knows whether this survey measure captures how people actually think and behave in real transactions in the goods, labour and financial markets.   It might be as good a proxy as we have, but (a) we don’t know, and (b) it still might not be good at all.  Glancing at the time series, there is a tendency for falls and rise to be at least partly reversed quite quickly.

But if inflation expectations are really in some sort of 2 to 2.2 per cent range, I’d welcome that.  With repeated increase in tobacco excises –  not some underlying economic process –  there is a reasonable case, in terms of the PTA, that headline inflation should average a little higher than the mid-point, and than “true” core inflation.  Only if inflation expectations were to rise further from here might I start to get a little disquieted.

In trying to make sense of the inflation expectations numbers, one thing I haven’t seen mentioned is the Labour Party’s monetary policy release.   There was a quite a bit of focus last month on their pledge to add some sort of employment objective to the Reserve Bank Act, and concerned expressed in some quarters that that could lead to higher inflation over time.   If it was a factor, you’d presumably have to take the probability of Labour leading a new government (call it a coin toss at present?) and multiply that by the probability that the change in regime (and perhaps the sort of people a new government might appoint) would make a material difference over time.  I have no evidence one way or the other, but it wouldn’t surprise me if there was a small effect of this sort.   (My own two year ahead expectation in the survey was 1.5 per cent –  around the current rate of inflation in the Bank’s preferred sectoral factor model).

Not many commentators seem to pay much attention to the rest of the expectations survey, even though its strength is partly the range of macro questions that are asked (although I’ve suggested some modifications to the Bank in their review of the survey).

Take GDP for example. There is no sign of respondents expecting real growth to accelerate.  Two years out they expect annual real GDP growth of 2.6 per cent – down on the previous quarter, but not far from the average response over the last couple of years.    But the survey also asks for quarterly GDP predictions for the next couple of quarters, and year-ahead predictions.   That enables one to derive an implied six monthly growth rate for the second half of the coming year.  Here is the gap between the expected growth rates for the first six months and the second six months, going back to just prior to the 2008/09 recession.

expec GDP growthAs we headed into the recession there was a lot of expectation of a strong rebound.  Even up to around 2012, respondents expected growth to accelerate.   For the last few years they haven’t expected any acceleration, and now the expect it to slow.  To be specific, respondents expect 1.6 per cent total growth in the first half of this year, slowing to 1.2 per cent in the second half of this year.     We don’t know quite why –  perhaps they expect immigration numbers to slow –  but it doesn’t speak of a sense that things are getting away on the Reserve Bank.   Similarly, two years out respondents expected that the unemployment rate would still be 4.9 per cent.

Perhaps these respondents will be proved wrong –  they often are, forecasting is like that –  but at the moment it doesn’t look like an imminent risk of core inflation rising much further, or to levels that might prove problematic for a flexible inflation targeter focused on medium-term inflation outcomes around 2 per cent.

What of the actual labour market data?   We have some problems at present because of the breaks in various HLFS series that occurred when the revised survey questions were put in place last year.  I’m still staggered they could have made these changes without running the two sets of questions in parallel for perhaps a year, to allow robust adjustments to be made for the discontinuities.   HLFS hours worked measures, employment measures, and probably participation rate measures all seem to have been affected to some extent.   We are pretty safe in saying that the number of people employed in New Zealand did not grow by 5.7 per cent last year (as the HLFS suggests).

What of the simplest headline number, the unemployment rate?   There isn’t much doubt that the unemployment rate has been falling over the last few years.  It is what one should expect after a serious recession, and with the stimulus to demand provided by low interest rates and large migration inflows (given that immigration typically adds more to demand in the short-term than it does to supply, thus tending to lower unemployment and use up spare resources in the whole economy).

But what should be somewhat disconcerting is that the unemployment rate has (a) gone largely nowhere in the last year, and (b) is still well above pre-recession levels (unlike the situation in many other advanced countries with their own monetary policies).   In the prevous boom, the unemployment rate got down to around 4.9 per cent as early as the start of 2003.     The picture isn’t much different if one looks at the broader (not seasonally adjusted) SNZ underutilisation measure.

U and under U

There still appears to be some progress in using up spare capacity in the labour market, but not very much at all.

What about the rate of job growth.  Fortunately, we have two measures: the (currently hard-to-read) HLFS household survey measure of numbers of people employed, and the QES (partial) survey of employers asking how many jobs are filled.   Unsurprisingly, the trend in the two series are usually pretty similar, even if there is a fair bit of quarter to quarter volatility.

employment

Since we know there are problems in the HLFS, and the QES doesn’t look to be doing something odd, perhaps we are safest in assuming that the number of jobs has been growing at an annual rate of around 2.5 to 3 per cent.   That isn’t bad at all. But SNZ also estimates that the working age population has been growing at around 2.7 per cent per annum.  No wonder the unemployment rate is only inching down.

One can do a similar picture for the annual growth rates in the two (HLFS and QES) hours worked series.

hours qes and hlfs

It was pretty clear that there was around a 2 per cent lift in HLFS hours worked from last June, just on account of the new survey questions.  It seems safer to assume that total hours worked across the economy might have grown by around 3 per cent in the last year.   That is faster than the growth in the working age population, pointing to some increase in effective utilisation, but not a dramatic one.  For what it is worth, in the latest releases, the two hours measures were both quite weak in the March quarter.

(And remember that nothing in the expectations survey data suggested pressures were likely to intensify from here.)

And what of wages?    There is a variety of measures.  The QES measure is quite volatile –  there are issues of changing composition –  and I don’t put much weight on it.  But for what it is worth, average hourly earnings rose 1.6 per cent in the last year on this measure, around the lowest rate of increase seen for decades.    The Labour Cost Index measures should get more focus (but have some challenges of their own).

lci inflation 2Perhaps there is some sign of a possible pick-up in the analytical unadjusted series (which doesn’t try to correct – inadequately –  for productivity changes) but it is a moderately volatile series, and the most recent rate of increase is still below the peak in the last little apparent pick-up a year or two back.

A common response is “ah, but what about the lags?”.  But as we’ve shown, there is little sign of any material tightening occurring in the overall labour market, no sign of expectations that that is about to change, and so little reason to expect much different wage inflation outcomes over the next couple of years from what we’ve seen in the last couple.  At best, there might be some slight pick-up in wage inflation (especially if the increase in inflation expectations is real), but any pick-up is going to be from rates of increase that have, over the last couple of years, been consistent with disconcertingly low rates of core inflation.

So where does it all leave me?  Mostly content that an OCR around 1.75 per cent now is broadly consistent with core inflation not falling further, and perhaps continuing to settle back where it should be –  around 2 per cent.   Of course, there is a huge range of imponderables, domestic and foreign, so no one should be very confident of anything much beyond that.   But it is worth bearing in mind that the unexpectedly strong net migration over the last few years has been a significant source of stimulus to overall domestic demand (including demand for labour).  In the face of typically too-tight monetary policy, it is part of why the unemployment rate finally started gradually coming down again after 2012.

Whatever happens to the cyclical state of the Australian economy, the National government is already putting in place immigration policy changes that should be expected to lead to some reduction in the net inflow of non-citizens, and two of the main opposition parties are campaigning on promises of much sharper reductions than that.   If such policy changes come to pass then, all else equal, the OCR will need to be set lower than otherwise.  It isn’t something that Graeme Wheeler can or should actively factor into this week’s OCR decision, but it may well be something the acting Governor needs to think hard about (if any decisions he makes are in fact lawful) after the election.

What to make of the CPI?

The media headlines make a lot of the fact that yesterday’s CPI puts annual headline inflation above the 2 per cent target midpoint (and contractural focal point) for the first time since 2011.  The Governor has almost completed his five year term, so it is a first sight for him.

Of course, current headline inflation isn’t the focus of monetary policy.  The almost-expired Policy Targets Agreement (PTA) explicitly tells the Governor to focus on “future” inflation, and the “medium-term”.  In longstanding words:

For a variety of reasons, the actual annual rate of CPI inflation will vary around the medium-term trend of inflation, which is the focus of the policy target. Amongst these reasons, there is a range of events whose impact would normally be temporary.

There are almost always plenty of those.  There are genuine market prices that are quite volatile – oil/petrol prices and fresh fruit and vegetables are the two most obvious examples.  There are discretionary government charges –  eg ACC levies –  developments in which have very little to do with underlying pressures in the economy.  And there are straight out consumption taxes that appear directly in the CPI, but again have little or nothing to do with real resource pressures (or even rates of money and credit creation).   GST changes – we’ve had them about once a decade –  are the best example, but the repeated large increases in tobacco excises this decade are another.  Exchange rate changes can also muddy the waters.

As I noted in a post a few months ago, monetary policy works –  which shouldn’t surprise anyone, but apparently does –  and we’ve seen this as part of the explanation for an increase in inflation over the last year or so.   Some increase should be very welcome, since the various core measures had been dropping further below the target midpoint, and people appeared to becoming more used to treating as normal inflation outcomes well below 2 per cent.  Reversing the ill-judged OCR increases of 2014 seems to have dealt with that problem/risk for now –  although we (like most other advanced countries) remain quite exposed when the next recession hits.

Quite how much core inflation has really increased is a bit of an open question.   In various previous posts I’ve highlighted a selection of six possible measures.  Here they are again for the year to March 2017.

Annual inflation rate
Yr to March 2017
CPI ex petrol 1.7
Weighted median 2.2
Trimmed mean 2.2
Factor model 1.8
Sectoral factor model 1.5
CPI ex food and energy 1.6
Median 1.75

The sectoral factor model measure was the Governor’s avowed favourite measure.  A year or so ago, it was the highest of the six measures of core inflation.  Right now, it is the lowest.     Historically, it tends to be the most stable of all the measures, and although prone to revisions as new data are added, it probably does deserve more weight than the other measures.  That measure of core inflation picked up about 18 months ago, but has been steady at 1.5 per cent for the last year or so.

I am sensitive to the suggestion of cherry-picking data.  From memory, I was inclined to de-emphasise the core inflation number a year ago, so I don’t want to suggest now that it is the only variable that matters.  But in many countries, quite a bit of attention is paid to CPI ex food and energy measures as a proxy for core inflation, and the picture isn’t much different there.    It would be interesting to understand quite why the trimmed mean measure – one given quite a lot of attention in Australia – has moved around so much.  It was as low as 0.4 per cent (annual inflation) as recently as the end of 2015.

But if core inflation has picked up a bit, there is little in the data that suggests it is, or is about to, race away.    When I opened up the SNZ CPI tables, a few things caught my eye:

  • on the first page, I noticed that quarterly non-tradables inflation (and non-tradables tends to be more persistent, and hence attract more policy focus) had been 1.0 per cent.  That was exactly the same rate as in the March quarter of 2016, and a little lower than in the three previous March quarters.  (Non-tradables inflation is high in the March quarter because of the succession of tobacco tax increases.)
  • one of my favourite series is non-tradables inflation excluding central and local government charges and tobacco taxes.  March quarter inflation there was 0.6 per cent, lower than in the March 2016 quarter (and also lower than in the September and December quarters).
  • construction costs look like a potential pinch-point in the economy, and yet the seasonally adjusted data on construction cost inflation (and, in fact, property maintenance costs) both showed quarterly inflation rates for March quite a lot lower than we were seeing for much of last year.

Wage inflation measures are probably also relevant here, not so much through some sort of “cost plus” model of inflation, but because developments in the labour market will also be a good reflection of overall resource pressure (and the wage aggregates aren’t so affected by tax changes, government charges and similar one-offs –  although they will be affected, in future, by arbitrary policy interventions like “pay equity” settlements).   In some ways, wage measures might be a better (if politically infeasible) policy target for monetary policy.

Here is a chart of the Labour Cost Index (LCI) inflation, using the raw “analytical unadjusted” series.

LCI analytical

There isn’t evidence of much, if any, pick-up there, and perhaps especially not for the private sector.   The headline LCI numbers aren’t much different and the (volatile) QES data are even weaker.

We’ll get another round of labour market data in early May.  Perhaps there will be more signs of an acceleration in wage inflation, or even a material drop in the unemployment rate (suggesting that excess capacity is dissipating and, hence, future inflation risks may be rising) but for now probably the best one can say is that macro outcomes are suggesting that the OCR set at current levels might have been about right.   With the unemployment rate still above estimates of the NAIRU, and most indicators of inflation suggesting that core is probably (a) still below target, and (b) not picking up very rapidly, it certainly isn’t time for hawkish talk about near-term OCR increases.

I’ve noticed some market economists talking of altering the timing for their first expected OCR increases.  I guess it is an occupational hazard for them having to make such calls, still mostly about the far future.  But such are the uncertainties –  about the global environment, the domestic economy, the inflation process, let alone about who will be Governor (or MPC) and what the PTA will look like –  that it seems something of a fool’s errand.  It would, in many ways, be good if the next warranted OCR move were to be an increase, but such are the limitations of our knowledge that probably the best we can say at present is that the current OCR is probably the best prediction of the OCR for the next year or two, with reasonably wide confidence intervals around even that prediction.

Finally, Paul Walker at the University of Canterbury had an interesting and useful post yesterday on his blog highlighting the way that relative price changes muddy reported headline measures of “inflation”.   As he notes, and I have already noted here, getting at the “pure” inflation rate is both important but not necessarily that easy.

Walker links to an old paper by a couple of US academics highlighting the possibilities of factor analysis to distill the underlying trends, the “pure inflation”.  That is much the same approach used in the Reserve Bank’s preferred sectoral core factor model.  Here is Walker.

Using US data Reis and Watson found that

… most of the movements in conventional measures of inflation like the Consumer Price Index (CPI), its core version, or the GDP deflator are due to relative-price changes. Only around 15-20% of the movements in these measures of inflation correspond to pure inflation.

Given that they had measures of relative price changes and pure inflation Reis and Watson could look for evidence of money illusion in their data. They found that once they controlled for relative price changes, the correlation between (pure) inflation and real activity is essentially zero. So,

… when we see that high inflation typically comes with low unemployment or high output, this is indeed driven by the change in relative prices hidden within the inflation measure. When there is pure inflation, that is when all prices increase in the same proportion independently from any relative price changes, nothing happens to quantities.

Which would be fine (and it is a while since I looked at that paper), but here is a chart for New Zealand showing the Reserve Bank’s sectoral factor model measure of core inflation, and the unemployment rate.

U and P

Of course, there are other things going on in both series (including changes in inflation targets and inflation expectations).   And the sectoral core measure probably isn’t a perfect representation of core inflation.  But it is pretty clear that, in New Zealand, there is a (expected) short to medium term relationship between real activity measures (indicators of excess capacity) and developments in inflation even when many (if not all) of the “pure” relative price changes are stripped out.

Agreeing with the Governor

If I go on finding myself agreeing with Graeme Wheeler, there won’t be much point writing about OCR announcements.  But, as it happens, he has only three more to deliver.

I could quibble about a few details in this morning’s announcement, but the only one I wanted to highlight briefly was this proposition

Monetary policy will remain accommodative for a considerable period.

In six months and a few days, the Governor will have moved on.  We’ll then have an acting Governor, with no Policy Targets Agreement, for six months.  And not until this time next year will we have in place a monetary policy decisionmaker, with an agreed target, who can make moderately credible statements about possible monetary policy decisions over the medium-term.    So to be strictly accurate,  that sentence should probably have read something like

“If the forecasts underpinning today’s decision are roughly right, and if my successors have (a) the same target I do, and (b) the same interpretation of that target, and the same reaction function, then monetary policy will remain accommodative for a considerable period.”

But in this post, I’m backing the Governor, and one line I was particularly pleased to see was this one (emphasis added)

Global headline inflation has increased, partly due to a rise in commodity prices, although oil prices have fallen more recently. Core inflation has been low and stable.

I made that point here a while ago, so I was pleased to see the Reserve Bank also highlight the  point.    Here is what I mean, using the OECD’s data on CPI inflation ex food and energy –  the one readily available and consistently compiled core inflation measure.

OECD inflation ex food and energy

I’m using monthly data, to be as up-to-date as possible, and New Zealand and Australia don’t have monthly CPI data.  But the comparable quarterly chart doesn’t look materially different.

I’ve shown two lines.  The first is the median core inflation rate for all individual OECD countries (with monthly data).  But that includes 19 euro countries (plus Denmark) that have only one monetary policy.  So the second line is the median core inflation rate for the distinct monetary policy countries/areas –  ie delete the individual euro area countries, and replace them with an inflation rate for the euro area as a whole.  I’d probably tend to emphasise that measure.

But on neither measure is there any sign that core inflation has been picking up at all.  And although the US has been raising its policy interest rate to some extent, there have been more cuts in policy interest rates in the last 18 months or so (the sort of time it takes policy to work) than increases.

Of course, that is only actual inflation outcomes.  Perhaps there is more inflation just ahead of us –  a story markets seem to have taken a fancy to.

For what it is worth, international agencies still thought there was a negative output gap across the advanced world last time they looked (the OECD thought it was -1.4 per cent last time they updated their published forecasts).

The unemployment picture –  another read on excess capacity and resource pressures -is a bit different.    For the G7 countries as a whole, the unemployment rate is now a touch below the troughs reached at the peak of the last boom.    For the OECD group as whole – even including places like Greece –  it is only around 0.7 percentage points higher than at the peak of the last boom.  For the median OECD country, the unemployment rate now only about half a percentage points above the average for the last boom year (2007).

Here are the unemployment rates for the largest OECD economies

U rates big countries

The unemployment rates have been falling for some considerable time, and there has been no pick up in inflation yet.  For each fall, of course, the respective NAIRUs must be getting closer, but it is probably safer to wait and see that core inflation has actually begun to rise –  especially in view of the low starting level –  than to simply assume that it must happen soon.

Of course, when one looks at unemployment rates what does tend to stand out is how little the unemployment rates in New Zealand and Australia have come down.

U rates NZ and AusIn both countries the current unemployment rate is around 1.5 to 1.7 percentage points higher than it was in the year or so prior to the global downturn.  And neither country was troubled by a domestic financial crisis, nor did they run out of room to use conventional monetary policy.  The monetary policy authorities should have been able to do better.   If I look across the monetary areas in the OECD (again replacing individual euro area countries with the region as a whole), the only places with a worse record on this score –  unemployment rates now compared to the pre-recession levels – are:

  • the euro area as a whole (visible in the first chart above) where they did run out of conventional monetary policy options,
  • Norway, and
  • Turkey, not a paragon of economic management or political stability.

Core inflation measures have been picking up a little here, as they should have after the sharp cuts in the OCR the Reserve Bank had to implement.    But our unemployment record –  at a time when much of the rest of the advanced world has been able to run unemployment rates back near pre-recessionary levels without (yet) seeing signs of core inflation rising –  is one reason why I think the Governor is quite right not to express any bias about the direction of the next change in interest rates, however far away (and delivered by a person yet unknown) that might be.