inflation

Forecasting and policy mistakes

Michael Reddell inflation, Monetary policy, Reserve Bank

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

Today, a few more numbers to support the story.

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

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

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

expenses $bn

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

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

expenses % of GDP

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

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

obegal

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

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

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

macro forecasts tsy

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

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

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

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

RB U forecasts

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

rb inflation forcs

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

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

core infl and target

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

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

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

Inflation

Michael Reddell inflation, Monetary policy, Reserve Bank, Uncategorized

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Inflation

Michael Reddell inflation, Monetary policy

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

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

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

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

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

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

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

core inflation apr 21

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

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

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

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

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

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

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

But where to from here?

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

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

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

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

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

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

5x5

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

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

OECD core inflation apr 21

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

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

Not expecting enough inflation

Michael Reddell inflation, pandemic

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

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

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

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

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

2 yr expecs july 2020

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

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

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

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

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

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

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

In this chart I’ve calculated breakevens as follows:

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

long-term breakevens

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

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

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

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

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

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

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

2025 real yield

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

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

US 5 yr

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

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

 

Why economic policymakers need to respond aggressively

Michael Reddell Economic history, inflation, pandemic, Uncategorized

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

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

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

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

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

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

short-term 2020

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

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

long-term 2020

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

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

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

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

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

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

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

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

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

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

 

Where in the world is inflation?

Michael Reddell inflation, unemployment

According to the IMF these are the countries that will have an inflation rate in excess of 20 per cent this year.

Turkey 20.3
Liberia 27.2
Yemen 30.0
South Sudan 40.1
Zimbabwe 42.1
Argentina 47.6
Islamic Republic of Iran 51.1
Sudan 72.9
Venezuela 1555146.0

I’m guessing there is some margin of error around that curiously specific estimate for Venezuela.

In most of these countries, inflation is forecast to be higher this year than it was last year.  Here is one stark example.

arg infl

It can be done –  although one might well wish to avoid the Argentine experience.

On the other hand, the IMF also forecasts that there will be 13 countries with 2019 inflation rates of 0.5 per cent or less.    (The median inflation rate across all countries this year is expected to be 2.4 per cent.)

In the advanced economies there isn’t much sign of any rebound in (core) inflation

core inflation 19

What about expectations?    Bond yields are falling again, and not all of it seems to be falling real rates.  Here is a chart I saw yesterday showing implied five year forward expectations for average inflation in the euro-area.

euro infl swaps

That is a long way below 2 per cent.

Things aren’t as bad in the US.  Here is the latest chart for 10 year inflation breakevens.

US breakevens may 19

And in both Australia and New Zealand the gap between indexed and conventional government bond yields is not much more than 1 per cent.  That is a long way from the 2.5 per cent and 2.0 per cent targets respectively.

This was a bit of context for the last IGM survey of economics academics that I saw the other day.

IGM Fed

I guess the question was asked in the specific context of the aborted nominations of Stephen Moore and Herman Cain, but it is posed more generally.

I’d probably have answered the same way, especially bearing in mind the way the question is phrased (note that “primarily”).  Apart from anything else, choosing anyone for anything primarily based on their political views is a recipe for trouble (even in Cabinet or the organisational side of a political party one usually wants competence as well).

And yet, and yet.  It is hardly as if the actual monetary policymakers in much of the advanced world have done such a great job in the last decade that things couldn’t have been improved on.  Arguably, the US Federal Reserve has done better than most central banks, but even then it was hardly a record to write home about (slow to recognise the recession in the midst of it, constantly champing at the bit to tighten afterwards, nothing done to prepare for the next serious recession etc).

When I was young the predominant narrative around central banks was that one needed to keep politics and politicians clear, because otherwise high inflation would be a recurring –  perhaps permanent –  problem.  I’ve long been fairly sceptical of that view, even as an explanation for history during the Great Inflation, but look at where we’ve been for the last decade, with inflation sitting below target in most advanced countries even as unemployment was (for a long time) slow to fall.    It isn’t impossible that in those specific circumstances (even if not generally) monetary policy decisionmakers with a stronger political focus might have done less badly than the actual decisionmakers did.   That, at least, should have been the out-of-sample forecast of the more vocal champions of technocratic rule if this argument had been run a decade ago.   (Of course, political bias can cut both ways: there have been both technocrats and politically-attuned people on the right in the last decade championing the case for higher interest rates, arguing that if anything raising interest rates pre-emptively might assist in rebalancing the economy.)

I’m not arguing to junk professional expertise when it comes to monetary policy, any more than one should in any other area of policy, but in and around monetary policy the limits of technical expertise are pretty real and substantial (or we’d have easy compelling and generally accepted answers to the issues of the last decade) and it isn’t obvious that professional experts are necessarily the best final decisionmakers.  In the face of great uncertainty, I’m increasingly inclined to think that the decisions should rest more squarely with those who are electorally accountable –  drawing on professional expertise to the extent it can help, but recognising the need for contest, scrutiny, and considerable scepticism about the best insights of institutional “experts”.  In that world, central bankers provide analytical inputs, and operational implementation of policy choices, but have less weight in the policymaking itself.

In a New Zealand context, it was sobering to read the other day that the UK statistics office had just announced that the British unemployment rate had fallen to the lowest rate since 1975 (and the US unemployment rate is the lowest since 1969), without inflation having become an obvious problem.    In New Zealand, the unemployment rate in 1975 was about 2 per cent.  Just to get back to the lowest unemployment rate this century in New Zealand we’d need to see a drop of another 0.9 percentage points.   In view of our central bank’s statutory mandate around “maximum sustainable employment” it would be interesting to see their analysis of why we can’t manage something like that.  Perhaps there are regulatory or welfare obstacles (eg high minimum wages relative to median wages) –  and if so, central banks can’t do much about those – but with inflation still persistently a bit below target, it sure looks as though New Zealand’s unemployment rate could be a bit below 4.3 per cent without creating inflationary trouble.

 

What to make of the inflation data?

Michael Reddell inflation, Monetary policy

There seemed to be a little in this week’s CPI numbers for everyone.   The Reserve Bank’s favoured core inflation measure was unchanged at 1.7 per cent (and the model slightly revised downwards the estimate for a couple of quarters back), bringing up now a full nine years in which this core measure has been below 2 per cent.   The CPI ex food and energy series –  a standard international core inflation indicator –  doesn’t get much attention in New Zealand, but annual inflation in that measure was (up a bit) 1.6 per cent.  The last time that inflation measure was above 2 per cent –  excluding the GST change –  was late 2007.  That was so long ago, there will be voters in next year’s election who don’t even remember 2007.

New Zealand inflation measures –  even the sectoral core measure –  are biased upwards these days by the repeated large increases in tobacco taxes.  The price indexes rise as a result, but these tax increases aren’t what economists typically think of when they use the term “inflation”.     Neither Statistics New Zealand nor the Reserve Bank publish a decent core measure that also excludes government charges and tobacco taxes, so I’ve come to quite like the series SNZ does publish for non-tradables inflation excluding government charges and cigarettes and tobacco.  Here is the annual inflation rate in that series.

nt ex jan 19

The annual inflation rate in this measure did pick up a little, but (a) is no higher than the last couple of local peaks, and (b) even 2.5 per cent core non-tradables inflation just isn’t consistent with core overall inflation being back to 2 per cent.   The Reserve Bank was still cutting the OCR in late 2016 when this particular inflation rate series was around current levels.

What about the wider world environment?  Here is CPI ex food and energy inflation for the G7 group of countries.

g7 cpi ex

The picture for China also doesn’t suggest global inflation is rising.

And all this is against a backdrop in which both the world economy and New Zealand’s economy seem to be losing steam.      The pick-up in the sectoral core factor model measure of inflation to 1.7 per cent in the last couple of quarters might be “encouraging” in some sense, if one could readily point to factors that were likely to intensify resource pressures from here, or drive up perceptions of a “normal” or natural inflation rate.  But….the Christchurch rebuild is winding down, immigration seems to edging down, and the terms of trade show no sign of moving to a new higher plateau. There is no fresh wave of productivity growth, inducing firms to invest heavily, and encouraging consumers to spend in anticipation of future higher living standards.  If you believe in housing wealth effects (I don’t see any evidence in aggregate for them), even house price inflation has faded.   There is some fiscal stimulus in the pipeline, but it is nothing like some of the positive demand shocks we’ve gone through in the last 10 or 15 years.  This has the feel of being about as “good as it gets” (thoroughly lousy when contemplating productivity, but here I’m just thinking of capacity pressures, and things which might boost core inflation).

And it isn’t too different abroad.   Global growth projections are getting revised down a little: in the US fiscal stimulus is fading and monetary tightening is beginning to bite, in the euro-area activity indicators are weakening (and add in some Brexit uncertainty on both sides of the Channel), and in China things don’t seem to be developing well.  Commodity prices were a big worry at the end of the last boom, in 2007 into 2008 –  concern about spillover into inflation expectations and wage demands – but not so much now.  And it isn’t as if global monetary policy has suddenly got a lot looser either.  There just isn’t much reason to think core inflation –  here or abroad –  is likely to rise further, and neither here nor in most countries abroad is inflation at target.   When the next recession comes, core inflation is likely to fall from here.

The market doesn’t seem convinced that there is higher inflation in prospect either.  Breakevens from the indexed and conventional government bond market have been falling in other countries.  And here is the New Zealand picture, updated so that the last observation in this monthly chart is yesterday’s data.

breakevens jan 19

In the US, at peak, markets were pricing future inflation averaging a touch above 2 per cent.  Here we never quite got even to 1.5 per cent, and in the last couple of months the breakeven inflation rate (implied expectation) has dropped away again.  People putting real money on these things are implicitly pricing the average inflation rate over the next 10 years in New Zealand at 1.1 per cent.   That seems too low to me, even allowing for an excessively cautious central bank over the last decade (and hardly a vote of confidence in the amended Reserve Bank legislation passed last month), but even if you are sceptical of the level, the direction should be troubling the Governor (and his associates just about to be appointed to the new Monetary Policy Committee).   There doesn’t seem to be any sense any longer that a normal inflation rate in New Zealand is 2 per cent. (My thoughts on making sense of the indexed bond numbers are here.)

It is clear that, with the benefit of hindsight, the OCR should have been a bit lower over the last couple of years.    That is simply the same as observing that core inflation has again undershot the target (and implied expectations suggest that outcome isn’t simply an anomaly).    That isn’t the same as recommending now that the Governor should cut the OCR at next month’s review – and I’m quite he won’t anyway.   There is a reasonable case to be made for a cut now – low inflation, growth pretty insipid etc, tempered by the fact that the unemployment rate (a lagging indicator) is probably around the NAIRU –  but the cautious bureaucrat still lurking in me probably wouldn’t yet go that far.  But the case for a more explicit easing bias does seem increasingly clear.

(It is always good to have diversity of views. My post the other day on the Prime Minister’s FT article seems to have excited another local economics blogger.  Apparently I am a member of the “New Zealand establishment” –  surely a thought that would appal them as much as it appals me –  and some sort of lackey of the National Party (and, worse, the US Republican Party).  I almost fell off my chair a few months ago when someone told me that Simon Bridges had made some positive remarks about this blog, but I doubt any regular readers would ever have taken me as sympathetic to a party that failed to do anything about productivity, failed to do anything about housing, and which seems more interested in pandering to the PRC –  and keeping the funding going –  than in the wellbeing of New Zealanders and the integrity of our society.)

 

 

Inflation-indexed bonds: are they telling us anything?

Michael Reddell indexed bonds, inflation

Data from New Zealand’s inflation-indexed bond market has been a bit of a mystery for some time.

If one looks at US data, the gap between conventional and indexed government bond yields –  the “breakeven” or implied inflation expectation – makes sense.  Here is the data for the last five years or so.

US IIBs

The US inflation target is around 2 per cent and for the last couple of years the breakevens have been pretty close to that.  There was a period of real weakness in 2015/16 but it didn’t last that long, and even then the breakevens were only averaging around 1.5 per cent.   If you were inclined to focus on the severe limitations US monetary policy will face in the next serious recession, you might even think 2 per cent breakevens for the average of the next 10 years is a bit high –  after all, the Fed has struggled to get inflation to average 2 per cent in the last decade –  but that would be a non-consensus perspective, and I’ll leave it to one side for now.

The New Zealand indexed bond market was, for a long time, rather patchy to say the least.  Indexed bonds were tried for a while in the 1980s, and then one more-modern-style long-term indexed bond was issued in the mid-late 1990s (about the time I and a colleague wrote this article).  But The Treasury was never very keen, and there was a diminishing volume of public debt anyway.     If there is any upside to the higher volume of public debt this decade (in general I’m not convinced) it is the advent of a range of government inflation-indexed bonds.  There are four on issue now, with maturity dates out to 2040.

Unlike the situation in the US, no one makes readily available here constant-maturity data for either indexed or conventional bond yields.  When the “10 year bond yield” is quoted here, it is rarely actually 10 years.  But the Reserve Bank does publish a yield series for each of the indexed bonds.  If one time-weights the (September) 2025 and 2030 indexed bond yields, one gets this approximation to a 10 year indexed yield since September 2015. (I’ve also show the yield for the 2025 bond from the end of 2013 to September 2016, when it was at least moderately close to 10 years).

indexed bond yield NZ

The fall in long-term real interest rates is certainly striking –  consistent with the fact that five years ago the Reserve Bank and most of the market thought short-term interest rates would be more like 4 or 5 per cent looking ahead. In fact, of course, the OCR has been 1.75 per cent for the last couple of years, and is currently expected to remain low pretty indefinitely.

And what if we then take the Reserve Bank’s “10 year bond yield” series for conventional bonds, and subtract the indicative indexed bond series in the previous chart?

NZ IIBs

This is the chart that parallels the US one at the start of the post.  As you can see, the two charts (one daily, one monthly) look quite similar at the start.  Breakevens here were also around 2 per cent, the target set for the Reserve Bank.  But then they diverge –  the short term cycles are similar, but the levels are very different.  On this measure, it has been three years since the New Zealand breakeven rate got even to 1.5 per cent.  As of yesterday’s data, the gap was 1.34 per cent.

Meanwhile, of course, at every opportunity the Reserve Bank assures us that inflation expectations –  survey measures, which involve respondents staking no money, and rarely any reputation (since responses are published mostly in aggregated form) –  are “securely anchored” at 2 per cent.   And, rather than address the indicators from the indexed bond market, the Bank simply passes by in silence.

Over the years, there have been various stories put forward for why information from the indexed bond market should be discounted.  For a long time, there was only one maturity, and there really wasn’t all that much of that bond on issue (just over $1 billion).   Then there were stories about illiquidity –  not much trading in indexed bonds and few or no price-makers.   Glancing through the historical data for turnover in the Feb 2016 bond, there were lots of weeks when the outright trades totalled less than $5 million, and quite a few when there were no trades at all.

But these days there are four bonds on issue, totalling about $16 billion.  Talking to a funds manager recently, I learned that another bank has just become a pricemaker in indexed bonds, such that there are now three local and three offshore institutions offering two-way prices in these instruments.  And the Reserve Bank turnover data suggests that if these markets aren’t exactly awash with trade, there is now a respectable volume of secondary market turnover in at least the 2025 and 2030 maturities (and there isn’t much turnover in conventional bonds beyond 2030 either).

I queried the fund manager as to his view on why the New Zealand breakevens are so low.  He argued that it wasn’t now a market liquidity issue (although you have to think that if you wanted to dump a $200 million position it would still be a great deal easier in the conventional market than the indexed market).   His argument was the market was still new and that there limited interest still from the buy side, including the offshore market in particular.    I was a bit surprised by that, as I recalled (long ago) when the indexed bonds were being issued in the 1990s that a lot of demand initially came from offshore (it surprised us at the time, and New Zealand inflation indexation seemed like something more naturally appealing to local pension funds than to offshore funds).   But I looked up the data, and this is what I found.

Per cent of bonds in market held by non-residents, Oct 2018
Conventional
Apr-23 67.7
Apr-25 52.2
Apr-27 67.1
Apr-29 75
Apr-33 46
Indexed
Sep-25 50.7
Sep-30 37.6
Sep-35 21.3

And, sure enough, a materially smaller proportion of the indexed bonds is owned offshore than of the conventional bonds.   The offshore proportion isn’t trivial by any means, but it is smaller (and, if anything, looks to have been shrinking a bit over the last few years).

I don’t have a good story for why that might be.  After all, New Zealand indexed bonds offer some of the highest yields in the advanced world (our longest maturity yields 50 basis points more than the US 20 year indexed bond, and the US is now a high yielding advanced economy), and much of the story of the last few years has been of a search for yield.  Search for yields often involves sacrificing liquidity.  And (critical as I am of New Zealand economic performance) the creditworthiness of our bonds, indexed and nominal, looks better than ever in relative terms, as being among the handful of advanced countries with budget surpluses and low debt.

I did hear a story a while ago suggesting that the government has simply glutted the market by issuing too many inflation indexed bonds too quickly.  At one level it is an argument that looks a bit hard to refute (the resulting yields are high relative to equivalent maturity and credit risk conventional bonds), but standing back a bit I’m not sure how persuasive a story it is.  The world markets are big, New Zealand is small (and fairly sound), and the appetite for yield has been strong.

Which is partly why I don’t think it is safe for the Reserve Bank to simply ignore that New Zealand inflation breakevens.  They may well be telling us something about medium-term expectations of inflation (implicit expectations as much as explicit ones).  After all, core inflation this decade has averaged around 1.5 per cent, the Bank has (twice) proved too quick to tighten, and if inflation has picked up a little recently, it would be reasonable to think that there will be a downturn along again before too long.

sec factor model nov 2018

Perhaps there is a more compelling story that “exonerates” the Reserve Bank.  But it would be good to see them make it, and to be able to test the quality of their analysis and research.  Simply ignoring a pattern that has now persisted for three years –  breakevens averaging less than 1.5 per cent when the inflation target as 2 per cent –  seems not particularly responsible, not particularly transparent, not particularly accountable.

 

What to make of the inflation data

Michael Reddell inflation, Monetary policy

The CPI data were released a couple of days ago.   There was, inevitably, a lot of commentary around higher petrol prices, although most commentators noted that the Reserve Bank was likely to “look through” what we are seeing, and not adjust monetary policy just because of higher petrol prices.  That would, indeed, be consistent with the Bank’s mandate –  and practice –  over almost thirty years of inflation targeting.

One can have all sorts of debates about what sorts of effects should be “looked through”.  We used to have lengthy discussions attempting to distinguish between petrol price effects themselves, indirect effects (eg higher airfares or courier costs directly resulting from higher fuel prices) and second-round effects –  the real worry, if changes in oil/petrol prices came to affect the entire inflation process, including medium-term expectations of inflation.   Those risks were real, and realised, back in the 1970s oil shocks, and that set the scene for much of the subsequent discussion and precautionary debate.

SNZ only has a CPI ex-petrol series back to 1999.  In this chart, I’ve shown the headline CPI inflation rate, the CPI inflation rate ex-petrol, and the Reserve Bank’s preferred core inflation measure, the sectoral factor model.

petrol price inflation

I’ve highlighted four episodes in which petrol price inflation was much higher than overall CPI inflation, and one (quite recent) when it was much lower.

In the first of those episodes –  around 2000 –  the surge in petrol prices coincided with quite a lift in core inflation.  Bear in mind that the economy was recovering from the brief 1998 recession, and the exchange rate had fallen sharply.

In the second episode –  2004 and 05 – the surge in petrol price inflation coincided with no change in core inflation.

In the next episodes –  2008 and 2010 –  the surge in petrol price inflation coincided with a fall in core inflation.  In the 2008, the Reserve Bank explicitly recognised some of this at the time, and talked of scope to cut the OCR soon, despite the high headline inflation.

And in the recent episode when petrol price inflation was very low, there was no fall in core inflation –  if you look hard enough, it may actually have increased very slightly.

There is talk that, if oil prices persist, headline inflation could get as high as 2.5 per cent before too long.  The experience of the last couple of decades suggests that will tell us nothing useful about underlying/core inflation trends, or about the appropriate stance of monetary policy.  And the preferred core inflation measure remains below the target midpoint, as it has been for almost a decade now.

Here are a couple of other series worth looking at.

other infl measures

The blue line is a fairly traditional sort of exclusions-based core inflation measure: excluding volatile items (food and fuel) and (administered) government charges (altho not tobacco taxes), and the orange line is non-tradables inflation excluding government charges and cigarette and tobacco taxes (which, you will recall, have been raised relentlessly each year, in a political non-market process).  There is no sign in either of these series of underlying inflation moving higher in the last year or two.  Core non-tradables inflation of under 2.5 per cent is not consistent, typically, with core (overall) inflation being at 2 per cent.

Having said all that the financial markets appear to have taken a slightly different view of this week’s inflation data.  Here is a chart of the breakeven inflation rate from the government bond market –  the difference, in this case, between the 10 year conventional bond rate and the 2030 indexed bond (real) rate.  I’ve highlighted the change since the inflation data were released.

IIBs oct 18 2018

At 1.4 per cent, the gap is still miles off the 2 per cent target midpoint (or than the comparable numbers in the US), but the latest change does look as if it is worth paying at least a bit of heed to.  Perhaps it will dissipate over the next few weeks, but if not it wouldn’t be a cause for concern, but some mild consolation that –  after all these years –  there was some sign of market implied inflation expectations edging a little closer to target.

What about a longer run of data?   We only have a scattering of inflation indexed bonds, in this case one maturing in September 2025 and one maturing in September 2030.  The 2030 bond was first introduced five years ago this month.    Creating a rough constant maturity 12 year indexed bond series –  the 2025 bond had 12 years to run in 2013, and the 2030 one has 12 years to run now –  and subtracting the result from the Reserve Bank’s 10 year conventional bond series produces this (rough and ready) chart.

iib constant maturity breakeve

A clear rebound from the lows of 2016, but implied breakeven inflation rates still much lower than they were five years ago.

There still seems to be quite a long way to go for the Reserve Bank to really convince investors that, over the decade ahead, they will do a better job of keeping inflation averaging near target than they have done this year to date.

Continuing to talk down the risks of the next serious recession, and the limitations of policy here and abroad to act decisively to counter such a recession and the likely deflationary risks, is cavalier and irresponsible.  It might (seem to) help confidence in the short-run, but if those risks crystallise –  and central banks should focus on tail risks in crisis preparedness –  the Bank will bear a lot of the responsibility if the economy performs poorly, and inflation ends up so low as to vindicate (and more) the evident lack of confidence among people putting real money on a view about the average future inflation rate.

 

Inflation and the tax system

Michael Reddell inflation, Taxation, zero lower bound

When I went looking for the interim report of the Tax Working Group, I found that various other papers had been released.   These include background papers prepared by the Treasury and IRD secretariat looking at various possible options for reducing other taxes if, for example, new capital taxes were to provide more government revenue.

Among them was a short and rather unconvincing paper on productivity.   It was notable for highlighting how difficult it was to give any concrete meaning to the aspiration repeatedly expressed by the Minister of Finance, and included in the terms of reference, of “promoting the right balance between the productive and speculative economies”.  And it was also notable for the aversion of officials to lowering the company tax rate (or the effective tax rate shareholders pay on company income), even though they accept that our business income tax rates are now high by international standards, and that business investment (including FDI) is low by international standards. This chart is from the paper.  In general, what is taxed heavily you get less of.

corp income tax

But this time I was more interested in another of the background papers, this one on the possibility of inflation indexing the tax system.   Even with 2 per cent inflation, failing to take explicit account of inflation in the tax system introduces some material distortions and inefficiencies.  Many of the costs of inflation arise from the interaction with the tax system, and these distortions may be greater in New Zealand than in many other countries because of the way we tax retirement income savings (the TTE system introduced, as a great revenue grab at the time, in the late 1980s).

In the days of high inflation there was some momentum towards doing something about indexation. It had, for example, been a cause championed by former Reserve Bank Governor Ray White.  And in the late 1980s, the then government got as far as publishing a detailed consultative document.  But then inflation fell sharply (and maximum marginal tax rates were cut) and the issue died.  We don’t even have the income tax thresholds indexed for inflation, allowing Ministers of Finance ever few years to present as a tax cut an increase in revenue that should never have occurred in the first place.

In the early days of inflation targeting there might even have been a case for letting the issue die.  The inflation target was centred on 1 per cent annual CPI increases, and that target was premised on a view that the CPI had an annual upward bias of perhaps as much as 0.75 per cent per annum).  But since then, the extent of any biases in the CPI have been reduced, and the inflation target has twice been increased.   The inflation target now involves aiming for “true” inflation” of at least 1.5 per cent per annum.

The distortions are most obvious as regard interest receipts and payments.  Take a short-term term deposit rate of around 3 per cent at present.  Someone on the maximum marginal tax rate (33%) will be taxed so that the after-tax return is only 2 per cent. But if, as the Reserve Bank tells us, inflation expectations are 2 per cent, that means no real after-tax return.  Compensation for inflation isn’t income and it shouldn’t be taxed as such.  Only the real component of the interest rate (1 per cent) should be taxed.   The same distortion arises on the other side, for those able to deduct interest expenses in calculating taxable income: in the presence of inflation, this tax treatment subsidises business borrowing.  The amounts involved are not small.   As economist Andrew Coleman notes in his (as ever) stimulating TWG submission

Even at low inflation rates, these distortions are substantial. In 2017, for instance, residential landlords borrowed $70 billion. Even if the inflation rate is as low as 1 percent, this means residential landlords can deduct $700 million of real principal repayments from their taxable income, a subsidy worth over $200 million per year. New Zealand households lend in excess of $150 billion. When the inflation rate is 1 percent, lenders are expected to pay tax on $1.5 billion more than they ought. Many people who invest in interest-earning securities are elderly, risk averse, or unsophisticated investors. For some reason the New Zealand Government believes these investors should pay more tax than any other class of investors in New Zealand. It is a strange country that taxes the simplest, most easily understood, and the most easily purchased financial security at the highest rates. It suggests the Government has little interest in equity, its protestations notwithstanding.

There are other distortions too, notably around trading stock valuations and asset valuations on which true economic depreciation would be calculated.

As reflected in the paper released this week, officials are very wary about doing anything about fixing these distortions (and they fairly note that “no OECD country currently comprehensively inflation indexes their tax system”), and they devote many pages to outlining the practical challenges they believe would be involved, and the new distortions they believe would arise from partial approaches to indexation.

I have some sympathy with the stance taken by officials on the specific challenges to doing comprehensive indexation, especially in a way that does not bias transactions through favoured institutional vehicles.  But it is a particularly bloodless document that seems to reflect no sense of the injustice involved in taxing so heavily relatively unsophisticated savers (while subsidising business borrowers, especially those financing very long-lived assets).

This seems like a case where some joined-up whole-of-government policy advice would be desirable.  There would be no systematic distortions arising from the interaction between inflation and the tax system if there was no systematic or expected inflation.   Systematic inflation isn’t a natural or inevitable feature of an economic system –  in some ways it is about as odd as changing the length of a metre by 2 per cent a year, or the weight of a gram by 2 per cent a year.  In the UK, for example, (and with lots of annual variation) the price level in 1914 was about the same as it had been in 1860).  And the most compelling reason these days for targeting a positive inflation rate is the effective lower bound on nominal interest rates, itself created by policymakers and legislators.   Take some serious steps to remove that lower bound and (a) we’d be much better positioned whenever the next serious economic downturn happens, and (b) we could, almost at a stroke, eliminate the distortions –  and rank injustices –  that arise from the interaction between continuing, actively targeted, positive inflation, and a tax system that takes no account of this systematic targeted depreciation in the value of money.

It wouldn’t be hard, but our ministers, officials (Treasury and IRD), and central bankers currently seem utterly indifferent to the issue.