A mixed bag

Quite a bit later than almost all other advanced countries we finally got an update on December quarter inflation yesterday. Even then, our quarterly CPI is mostly a measure of the change from mid-August to mid-November, while almost all other OECD countries have data for the month of December.

From the government we heard more of the same old spin, about how low New Zealand’s inflation is relative to that in other countries. At a headline CPI level there is, of course, some truth to that, but (a) we have an independent (of other countries) monetary policy to ensure that we can control our own inflation rate, and (b) New Zealand, mercifully, has not faced the gas price shock most of the European countries have. I presume not even the government is claiming credit for that – it is almost entirely just good luck, a rare advantage of our extreme remoteness.

For international comparisons across a wide range of countries that focus on the inflation central banks and governments can sensibly be held accountable for, really the only available data are for the respective CPIs ex food and energy. It isn’t a perfect measure by any means – and differences in the ways countries put together their CPIs, notably the treatment of housing, also matter – but it is what we have. Here are the latest annual CPI ex food and energy inflation rates for the OECD countries (euro-area shown as a single number, reflecting the single monetary policy). (The OECD has not yet updated their table for yesterday’s Australian CPI, so I use here the very similar RBA series CPI ex volatile items (ie fruit and vegetables and motor fuel).

New Zealand and Australia are both at 6.7 per cent, just a touch above the median country. But note that if there are countries that have done worse than us, all the main advanced countries or country groupings (Japan, euro-area, Canada, UK, US – something close to the G7) are now less bad. Most haven’t done very well – 5 per cent core inflation is nothing to be complacent about or comfortable with – but less bad than us, or more specifically our central bank.

On a quarterly basis, the New Zealand exclusion measures of core inflation also don’t look particularly good – the latest annualised rates are around 8 per cent.

Once one gets away from international comparisons, it is often better to focus on the so-called analytical measures of core inflation. In New Zealand’s case these still aren’t ideal as (unlike the ABS) SNZ does not report these on a seasonally adjusted basis, but eyeballing the series seasonality does not appear to be particularly strong.

These measures either exclude or de-emphasise particularly large price changes and try to get to something more like a central tendency (the Reserve Bank’s sectoral core inflation series also aims to do something like this, but it uses annual data only and is prone to big revisions when the inflation rate is moving around a lot).

This chart seems to me the most favourable story one can currently tell about New Zealand inflation. There is an unusually large gap between the rates of increase in the two series – which should be a little troubling – but both series suggest that the peak has passed, that quarterly inflation was at its worst in perhaps the March quarter of last year (by when the OCR was still below pre-Covid levels). Given that the unemployment rate stayed at/near record lows all last year – and on all forecasts is expected to increase from here – one could take a reasonable amount of comfort from this chart. (Core) inflation should never have been allowed to get away – that it was is a generational failure by the new MPC – and is still, in annualised terms, a long way from 2 per cent, but things seem to be heading in the right direction.

One of the wild cards in the entire story is the price of air travel, and particularly international air travel (the latter currently 83 per cent more expensive than just prior to Covid)

You would have to suppose that in time (real) prices will fall back, and it is in some sense a Covid phenomenon. On the other hand, it is also a classic case at present where excess demand (relative to available capacity) is an issue, and excess demand often shows up more in some places than others (a few quarters back it was domestic construction costs that were increasing at annualised rates of around 20 per cent). High air travel prices aren’t now a direct consequence of current government interventions – and the New Zealand government is actually still in the last few months of subsidising international air freight capacity, having kept air travel capacity higher than otherwise. But you wouldn’t want central bankers aggressively targeting a measure that currently gives a significant weight to air transport prices.

For now, things look to be moving in the right direction in New Zealand. They would need to be, after such a signal policy failure. The forward indicators are for much weaker economic growth quite soon which, all else equal, will continue to pull the inflation rate back towards target – although the question forecasters will need to grapple with is “how rapidly?”. The coming suite of labour market data will be the next piece in the New Zealand puzzle.

Whether or not things are yet on track in New Zealand, this is one of those times when one would much rather be sitting in the New Zealand central bank than at the RBA. Here are the analytical measures of quarterly core inflation for Australia

Not only are they now higher than those for New Zealand, but there is no sign they have necessarily yet peaked. It is perhaps not too surprising when the RBA was so late to start raising the policy rate – against a very similar Covid and economic backdrop to New Zealand (and a stronger terms of trade).

At it again

At last year’s Annual Review hearing at the Finance and Expenditure Committee the Reserve Bank Governor was shown to have misled (presumably deliberately) Parliament twice. Last month he was at it again with the preposterous claim to FEC that the Bank would have to have been able to forecast back in 2020 the Ukraine invasion for inflation now to have been in the target range. It was just made up – quite probably on the spur of the moment – and of course they’ve never produced any later analysis to support the claim (despite an MPS and the five-yearly review of monetary policy in the following weeks).

On Wednesday afternoon the Bank was back for this year’s Annual Review hearing. It was the last day of term for Parliament, and there was quite a feel to it in the rather desultory scatter-gun approach to the questioning from the Opposition. You wouldn’t know that the two Opposition parties had just openly objected to the Governor’s reappointment to a new five year term.

But MPs – and the viewing public – were still subject to more of Orr being anything other than straightforward, open, and accountable. More spin, usually irrelevant and sometimes simply dishonest.

The meeting opened with Orr apologising that the Board chairman was absent. Apparently he had some function to attend in his fulltime executive job, but you might have thought that when you were the chair of the Board through a year when inflation went so badly off the rails, and still chair now when the Bank is averring that a recession will be needed to get things back under control, you might have made it a priority to turn up for Parliament’s annual scrutiny of the Bank’s performance. And if your day job commitment was really that pressing you might have sent along a deputy. Whether prior to 1 July (the year actually under review) or since the Board was explicitly charged with holding the Governor and MPC to account. and the Board controls all the nominations for (re)appointments. The Board was, after all, complicit in barring people with actual relevant expertise from serving as external MPC members.

No doubt the failure of anyone from the Board to show up just speaks to how – whatever it says on paper – the Bank is still a totally management (Orr) dominated place.

Then there was Orr’s transparent attempt to talk out the clock, reducing available question time with a long opening statement (with not even a hint of contrition over the Bank’s monetary policy failures). Mercifully, the committee chair eventually told him to cut it short.

If the Opposition’s questioning was never very focused or sustained, to his credit National’s Andrew Bayly did attempt a question about the appointment of Rodger Finlay – then chair of NZ Post, majority owner of Kiwibank, subject to Reserve Bank prudential regulation – to the “transition board” as part of the move to the new governance model from 1 July this year. As regular readers will know, the Reserve Bank has been doing everything possible to avoid giving straight answers on the Finlay matter, and Orr was at it again on Wednesday. First, he attempted to deflect responsibility to the Minister of Finance as the person who finally makes Board appointments (even though documents the Minister and The Treasury have already released make it clear that management and the previous Board were actively involved in the selection of people to recommend for the new Board) and then he fell back on the twin claim that there was no conflict of interest as regards the “transition board” (which had no formal powers) and that if there were any conflicts they had been removed by the time Finlay was on the Board itself.

There was no follow-up from Bayly, who could and should have made the point that when Finlay was appointed to the “transition board”, in October 2021, he was also appointed to the full Reserve Bank Board from 1 July 2022, and at that time – indeed right up to mid-June this year when Cabinet was considering his reappointment to the NZ Post role – there had been no suggestion that Finlay would not remain in his NZ Post role while serving on the Reserve Bank Board which would be directly responsible for prudential regulation. Indeed, documents already released reveal that the Bank had told The Treasury and the Minister that they had no concerns about this. It was an egregious appointment, inconceivable in any well-governed country, and yet the Opposition did not pursue the matter and the Governor – the one who likes to boast of his “open and transparent” institution – makes no effort to honestly account for his part in this highly dubious appointment.

If Orr was put under no pressure on the Finlay matter, on monetary policy and related issues he had a clear field. There were no questions at all – nothing for example about the Annual Report (the basis for the hearing) in which climate change featured dozens of times and the inflation outcomes – well outside the target range, on core metrics – got hardly any attention. No suggestion that a simple apology from the Governor and MPC might be in order – not one of those faux ones regretting the shocks the New Zealand economy was now exposed to. It was after all these people who voluntarily took on the role (and pay and prestige) of macro stabilisation and, on this occasion and perhaps with the best will in the world, failed. Just nothing.

And so the field was left to Orr. In his opening remarks we had this

Which is just spin. He seems to want to claim credit for New Zealand’s low unemployment rate even though (a) as he often and rightly points out the Reserve Bank has no influence on the average rate of unemployment or the NAIRU (which are functions of structural policy), and (b) the extremely overheated labour market and unsustainably low unemployment rate are a big part of our current excessively high core inflation problem. In the end, aggregate excess demand is the fault of the Reserve Bank. not something they should be claiming as a “good thing”, let alone seeking credit for. (In their better moments – eg the MPS – they know this, talking about the labour market being unsustainably overheated, but then Orr’s spin inclinations take hold). At the peaks of booms, unemployment is always cyclically low (or very low). But often what matters is what needs to be done to get inflation back in check.

And what about that claim on inflation? Well, if he wants to simply say the New Zealand is fortunate not to be integrated to the global gas and LNG market that is fine, but it is a complete distraction from a central bank that is responsible primarily for core inflation in New Zealand. On core inflation – in this case, because it is available and comparable, CPI inflation ex food and energy – for the year to September (latest NZ data) we are no better than the middle of the pack.

An honest central bank Governor, committed to serious scrutiny, might better say that we are in a quite unfortunate situation, for which the Reserve Bank itself has to take much of the responsibility. Instead we get more spin

“Even with the expected slowdown in the period ahead, it is anticipated that the level of employment will remain high.”

which is no doubt true, but the Bank’s own forecast is for a sharp rise in the rate of unemployment.

But Orr is more in the realm of minimising (his) responsibility. In recent months we’ve had the absurd and unsupported claim that without the war inflation would have been in the target range. We’ve also had the suggestion – heard a couple of times from his chief economist – that perhaps half the inflation is overseas-sourced. This claim also appears to be undocumented, and simply doesn’t stack up: core inflation is the Bank’s responsibility, the New Zealand domestic economy is badly overheated, and the whole point of floating the exchange rate decades ago was so that even if other countries had increases in their core inflation rates, New Zealand did not need to suffer that inflation. We had our own independent monetary policy, and a central bank responsible for New Zealand core inflation outcomes.

To FEC, Orr ran this claim

It is certainly true that if the Bank had begun to raise the OCR a little earlier in 2021, it would not have made that much difference to inflation (core or headline) now. 25 basis points in each of May and July 2021 might together have lowered headline inflation by September 2022 by half a percent at most. But in this framing – also in their recent Review – there are two elements that are little better than dishonest. Purely with the benefit of hindsight (their own criterion) it is now clear that monetary policy should not have been eased at all in 2020, and that monetary policy should have been run much tighter over the period since then. Had that been done, core inflation would have stayed inside the target range. Now that might be an impossible standard, but that is simply to point out what I noted in my post on the Review was the major weakness: there was just no sign the Bank or MPC had devoted any serious thought or research to trying to understand what they (and everyone else) missed in 2020 and 2021. But they were responsible.

And then there is the continual effort to blame food and energy price shocks, in a way that simply flies in the face of the data. Headline inflation is the year to September was 7.2 per cent. Excluding food and energy, it was 6.2 per cent. 6.2 per cent is a long long way above the top of the Bank’s target rage – more than 4 percentage points above the target midpoint the Minister of Finace requires them to focus on.

And as I pointed out in a post debunking the “war is to blame” claim, core inflation was very high, the labour market well overheated, before the war.

Oh, and Orr was at it again with his claim – apparently intended as a defence – that

I’ve shown before that 7 OECD central banks (out of 20 or so) had started raising their policy interest rates before the Reserve Bank of New Zealand (Orr seems to want to claim credit for stopping the LSAP but (a) he has claimed that by 2021 it wasn’t having much effect anyway and b) the Funding for Lending programme carried on all the way to this month). And since each central bank is responsible for its own country’s (core) inflation, a simple ranking of who moved when reveals precisely nothing. As early as the end of 2020, only 8 OECD central banks were experiencing annual core inflation (ex food and energy) higher than New Zealand (quite a few with higher inflation targets than New Zealand, including chaotic Turkey). By mid 2021, there were only 7 central banks with higher core inflation than New Zealand (mostly the countries that began raising policy interest rates earlier than New Zealand). New Zealand’s core inflation then was already materially higher than that in Australia, Canada, the UK, and the euro area (but behind the US, and I find the Fed’s approach to monetary policy last year quite impossible to defend).

Overall it is hard to find any OECD central banks that have done a good job over the last couple of years (the central bank of Korea looks like one candidate for a fairly good rating). It is quite possible – current core inflation might suggest it – that the Reserve Bank of New Zealand has done no worse than average. But that isn’t ever the spin we get from the Governor, for whom responsibility let alone contrition seem like words from a foreign language for which no dictionary was available. No one is suggesting the last 3 years have been other than hard and challenging for central banks, but that is nothing to what they are proving for the people who have suffered – and will suffer over the next year or two – from their misjudgments, well-intentioned as they may well have been.

Orr’s behaviour has been given licence by the Minister of Finance – reappointing him despite his poor record on multiple counts. But it would have been nice if Parliament’s Finance and Expenditure Committee had ever shown a bit more vigour and focus in holding the feet of the Governor and his colleagues to the fire, instead of all wishing each other Merry Christmas and heading off for the holidays.

Making stuff up and misleading Parliament

Legislatures typically take a dim view of efforts to mislead them or their committees. This is from our own Parliament’s online “How Parliament works”

The Governor of the Reserve Bank seems just not to care, treating Parliament’s Finance and Expenditure Committee with as much contempt, and disregard for basic standards of honesty and care as some juvenile delinquent.

Yesterday the Governor and a couple of offsiders fronted up to the FEC, as they always do, following the release of the six-monthly Financial Stability Report. Were one of a particularly generous cast of mind one might almost have felt a little sorry for the Governor at times: the report was about financial stability not monetary policy, and yet most of the serious questioning was more about monetary policy, and then there was the old game of MPs attempting to get officials to say something (whether on tax, spending, immigration policy or whatever) that helps their party in its partisan jostling, even if such matters were nothing to do with the Bank’s own responsibilities. But Orr is paid a lot of money and given a lot of power, and doesn’t even make an attempt to treat elected MPs – from whose legislation flows his power and his office – with even a modicum of respect. As it was, no one forced him to answer monetary policy questions – he responded to most of them by referring MPs to their internal review of the last five years of monetary policy, to be released next week. But when he chose to answer, he had some fundamental obligation to give straight answers, not trail red herrings and other outright spin (or worse) across the path.

Orr has form. Last December, he fronted up for the Bank’s Annual Review and he and a senior offsider actively misled the committee about senior staff turnover (something that became very clear very quickly). It took a little longer, and an OIA request, to show that he had also actively misled the committee with claims that the Bank had done modelling of its own about the (supposed) climate change threat to financial stability, when in fact they’d done none.

You can watch the full hearing here, or you read an account of the relevant bits here. Orr was on the backfoot over the stewardship of monetary policy – and there is at least an arguable connection to financial stability (more so to individual financial stress) given the cycle in both interest rates and house prices, and the likely cycle in unemployment). There are some things Orr (and the MPC) can and should be held accountable for – floating exchange rates mean that what happens with inflation in New Zealand is largely a New Zealand monetary policy (passive or active) choice – and others that the central bank has never been expected to counter (the most obvious example is the price effect of GST increases, but you could think too of exogenous shocks like sudden oil price changes).

Orr’s first claim in his defence was that New Zealand has one of the “lower inflation rates in the OECD”. That is probably defensible. The ways CPIs are calculated differs across countries but on the headline numbers reported by the OECD for the year to September 2022 there were eight OECD countries with lower inflation rates than New Zealand’s 7.2 per cent (and Australia’s was almost the same at 7.3 per cent). Even if one were to treat the euro-area countries as a single unit (they all have the same monetary policy), the picture doesn’t change much. Not, of course, that we should care too much what inflation rates other countries have when we are so far from target – the exchange rate was floated 37 years ago to give us effective monetary policy independence – but when a bunch of countries have made similar mistakes (not that Orr yet concedes to regretting anything), it is better to be on the less-bad side of the pack.

But not all countries experience the same shocks the same way. Wars, rumours of war, and associated sanctions/boycotts etc have affected energy prices in particular this year. No one has ever expected inflation targeting central banks to prevent the direct price effects of immediate energy price shocks – indeed, mandates (including in NZ) have often explicitly urged central banks to “look through” such effects and focus or core measures and/or any spillover into generalised future inflation).

The CPI ex food and energy is the most commonly used measure for international comparisons of core inflation (not because it is ideal, but because it exists), and is well-suited this year when fuel and (to a lesser extent) food have been in the spotlight in the context of the Russian invasion etc. Some countries are very very heavily exposed to changes in gas prices in particular, and others (notably including New Zealand which for better or worse is not linked into a global LNG supply chain) are not. But here is how CPI ex food and energy inflation for the year to September looked (chart scale truncated – Turkey is worse than that).

New Zealand? Middle of the pack, and almost identical to the numbers for Australia and the United States (a bit higher than the UK, and a lot higher than the euro-area). This is closer to the stuff central banks individually are responsible for.

But this is really just scene-setting. Orr’s most egregious claim – and it was particularly egregious for being repeated twice perhaps 40 minutes apart – was that for New Zealand’s inflation to have been inside the target range now, the Bank would have had to have forecast the Russian invasion back in 2020.

It was just a mind-boggling claim – not that any MP on the FEC seemed to be alert enough to notice. It seemed to be implying that if we abstracted from the direct price effects of the war, inflation would otherwise be in the 1 to 3 per cent per annum target range. But here is what those data show, using the SNZ exclusions covering both fuel individually and fuel and food.

For the year to September, all those exclusion measure of inflation were still in excess of 6 per cent, more than double the rate of inflation envisaged by the very top of the target range.

Oh, and when did the war start? The invasion began on 24 February. The March quarter CPI is centred on mid-February, and all those exclusion measures were already between 5.7 and 6 per cent by then. Before the war began. Now, it is certainly true that oil prices had risen in the preceding months as rumours of war mounted but (a) that wasn’t until late last year, and b) these are exclusion measures (ie excluding the direct effects of higher fuel prices). And the best indicator of domestic cyclical stress – the unemployment rate was already at 3.2 per cent in the December quarter last year (and again in March), also before the war began.

And what about more analytical measures of core inflation here in New Zealand?

For what it is worth, the highest rate of quarterly inflation on these core measures had already been recorded in the March quarter CPI, which (need I remind you) is centred on 15 February (most prices are surveyed mid-quarter), before the war began. Perhaps unsurprisingly, the worst of the (core) inflation was around the time the unemployment rate was falling to its lowest level (at a time when monetary policy was being particularly slow to act – recall that it was not until February that the OCR got back to pre-Covid levels). High core inflation – in annual terms on these measures now between 5 and 7 per cent – is a domestic phenomenon, for which monetary policy is (by default, being the last mover) responsible.

Of course, Orr knows all this (and, linking back to that parliamentary document, ought reasonably to have known it – having chosen to take the job, and accepted the $830000 salary for it). And his staff knew all this. The Governor was appearing at FEC remotely from his office, and it would have been easy for his economics staff to have slipped him a note saying “Governor, you really can’t make those claims about inflation and the war”, but (a) Orr is known to be intolerant of dissent and correction, and (b) if perhaps some brave staffer did slip him such a note, he went ahead and repeated the big and preposterous claim again later in the same appearance.

There are many many reasons why Orr should not be reappointed but simply making out stuff, that he knows – and certainly should know if he holds that job – to be simply false is not one of the least of his offences. Misleading Parliament really should matter, if we care at all about good governance any longer. On the further evidence of yesterday’s performance Orr seems not to. Just imagine if one of the institutions he regulated tried that sort of performance on him.

Inflation and monetary policy

In a post a couple of weeks ago I outlined some reasons for scepticism about the case for increasing the OCR by 50 basis points specifically at the then-forthcoming OCR review. My point was mostly about the data hiatus – the OCR decision would be taking place almost 3 months after the most recent CPI data and more than 2 months since the last main labour market data. It seemed (and seems) foolish for the MPC to stick to its schedule of review dates, including the long summer holiday it will give itself after next month’s MPS. It remains highly problematic that New Zealand governments have penny-pinched on core statistics and as a result we have such slow and infrequent macro data (we got the September quarter CPI inflation data yesterday, Switzerland by contrast released September month data on 3 October).

But there were also some considerations in the macroeconomics

  • the reasonably long lags in monetary policy (the OCR really only having been aggressively tightened fairly recently)
  • weakening commodity prices,
  • relatively subdued nominal GDP growth, among the very lowest in the OECD,
  • and some indications in core inflation measures that at least things had not been getting worse (continuing to spiral upwards)

All the inflation rates were, of course, unacceptably high.

Of course, as was universally expected the MPC did raise the OCR by 50 basis points in their October review. And yesterday we got the September quarter CPI data, which took by surprise all those who’d published forecasts (and, I guess, almost any of us who’d heard their headline forecasts). The outcome was higher than the Reserve Bank’s last published forecast, but since that forecast was more than two months old and anyway isn’t broken down into headline and core components – and they’d given us no sense of an update in the October review – not too much weight should now be put on that particular aspect of the surprise.

I don’t do short-term components forecasting, so what follows isn’t about the extent of the surprise (immediate prior expectations vs outcomes) but about what to make of the actual outcomes and current inflation. First, I’ll step through and update the charts from the earlier post.

These two – commonly used abroad – core inflation measures might suggest a little room for encouragement. Both quarterly changes are still high (far too high), and the gap between them is unprecedented, but they both look as though they could be past their respective peaks.

Monetary policy always takes time to work, and as this Reserve Bank chart reminds us it was only late last year that new mortgage rates really started rising.

But then there are these two exclusion measures

neither of which offers any reassurance.

And the picture here is similar

and from these monthly food price components, a bit of a mixed bag, but at least nowhere near as bad now as a few months ago.

The building market has been one of “hottest” areas of the economy and the labour market, with staggering rates of increases

Those numbers are still high but seem to be beginning to move in the right direction.

And then there are rents. Rents now make up just over 10 per cent of the CPI. On a quarterly basis the rents item in the CPI increased by 1.2 per cent in the September quarter, as high (equally high) as it has been this cycle. On an annual basis, this is the picture

In the CPI rents are included using a stock measure – the rate of increase in the average rents being paid by all tenants. And there is a certain logic to that, but we also know that new rents are falling (not just the growth rate slowing, but the level of rents dropping)

The flow measure – new rents – is (naturally) noisier but it (also naturally) leads the stock measure. There is a lag from monetary policy to the CPI for numerous reasons, but one is the choice to include average prices rather than marginal prices for rents. New rents – the ones policy and market developments affect most immediately – have now been falling for several months.

For completeness, I’m including this chart of the Reserve Bank’s sectoral factor model measure of core inflation.

It used to be the Reserve Bank’s preferred measure (and mine too – I championed it when I was still at the Bank), and it is probably still the single best guide to historical core inflation, but (in the nature of the technique) it is prone to big and lagging revisions when inflation is moving a lot. When the September 2021 CPI came out last October the model estimated core inflation then to have been 2.7 per cent (high, but still inside the target range), but the model – learning from what has happened since – now reckons core inflation last September was already up to 3.8 per cent. At this point, there really isn’t any information (good or ill) in the latest quarterly observations (which in any case use annual rather than quarterly data).

Moving beyond the specific inflation data series, there are a few other considerations that seem relevant to me. The first is to remember the lags (something notably absent from any of the media coverage I heard or read). There are at least two that are relevant. First, the September quarter CPI is really a mid-August measure: there are some noisy components – notably petrol – sampled weekly, and food is captured monthly but the whole thing is centred on 15 August, which is now a bit more than two months ago. So we (and the RB) aren’t exactly using real-time data. And second, the OCR takes time to work – this isn’t in dispute and shows up in all the modelling work – and on 15 August the OCR was 2.5 per cent (it was raised at the MPS a couple of days later). In fact – and it is easy to forget this now – until 12 April, the OCR was no higher than 1 per cent, the level (designed to be somewhat stimulatory) it had been at immediately prior to Covid. Now, of course markets and market pricing anticipated OCR increases to come to some extent, but the market (let alone firms and households) have been repeatedly surprised, constantly revising up their view of what OCR would be required.

I’m also not about to take a view on what the Reserve Bank could or should do in November. Market economists have to, I don’t. There is another round of really important labour market data due out in a couple of weeks (of which the most important bits should be the employment and unemployment numbers rather than wages). Of course, it lags too – centred on mid-August (and I really don’t understand why a household survey collected by phone within a quarter can’t be processed much more quickly than SNZ manages) – but it will still represent an addition to our knowledge. If, for example, the unemployment rate were to have dropped further, the argument for a big OCR increase would inevitably strengthen, all else equal – people will cut central banks less slack now than they might have if we were dealing with core inflation at, say, 3.5 per cent.

But is always going to tempting to just ignore the lags, even after increases in the OCR of unprecedented pace this year. And the lags are real, the lags matter. Robert MacCulloch, macroeconomics professor at Auckland, yesterday reminded us of Milton Friedman’s take on that issue almost 55 years ago.

There was a time for 75 or even perhaps 100 basis point OCR increases – last November or February perhaps – but for now it is much less clear that now is one of those times (and few if any of those now calling for such large increases now were calling for them then).

Of course, it doesn’t help that the MPC chooses to take a long summer holiday. That really should be revisited now.

And just one last graph, since air travel prices were a non-trivial influence in yesterday’s headline (and exclusion) measures. More than a little noise in those series.

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,