Inflation-indexed bonds: are they telling us anything?

November 30, 2018 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

October 18, 2018October 18, 2018 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

September 22, 2018September 24, 2018 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.

Exchange rate moves: trivial in historical context

August 17, 2018August 18, 2018 Michael Reddell Exchange rate, inflation

I saw a curious story the other day which reported the Minister of Finance and the National Party spokesperson on finance arguing over who was to blame (or who could take the credit) for the fall in the exchange rate that followed the Reserve Bank’s Monetary Policy Statement. From one side there seemed to be talk of the fall being part of the much-vaunted (but little seen) economic transition – the Prime Minister herself has claimed this – and from the other talk of loss of confidence in the economy, combined with some inflation risks.

Mostly it seems to be a difference about almost nothing. Here is one of the OECD measures of New Zealand’s real exchange rate, for which data are available back to 1970. Obviously, we don’t have Q3 data yet, but I’ve taken the fall in the nominal TWI measure of the exchange rate for this quarter to date (latest observation for the RB website today) and applied it to the Q2 data to proxy a current observation.

RER ULC aug 18

Over almost 50 years, there have been lots of ups and downs in the series, even in the period (up to early 1985) before the exchange rate was floating. Some have been the start of something pretty sustained – see the falls in the mid 70s, or after 1987. Others have been very shortlived (see for example the fall in 1986 or 2006 – times when, for example, markets got a bit ahead of themselves in thinking our economy was slowing and interest rates would be falling). Over the full period (and this is quarterly average data, which takes out some of the noise anyway) there have been at least eight episodes when this real exchange rate index has fallen by at least 10 index points (roughly 10 per cent). The last occasion was in 2015, as markets somewhat belatedly realised – not quite as belatedly as the then Governor – that the Reserve Bank’s OCR increases weren’t going to be sustained.

This episiode isn’t one of them. The latest (estimated) observation is a mere six per cent below the most recent peak (18 months ago). And the latest observation is nowhere near the low reached in the second half of 2015.

In fact, the current level of the TWI is 2.4 per cent below the average level for the June quarter. Over the entire life of the series (fixed and floating periods) the average quarterly change (up or down) has been 2.7 per cent. Taking just the floating period (since March 1985), the average quarterly change has been 3.1 per cent per quarter, and if we take just this decade (which, eyeballing things, has been a bit more stable, at least as regards big sustained moves) the average quarterly change has been 2.4 per cent.

Perhaps the fall we’ve seen so far this quarter (or even since the MPS last week) will be the start of something more. If there is a serious global risk-off event, or a serious New Zealand downturn, that probably would happen. But all we’ve seen so far is a change that is about the size of the change one sees, on average, each and every quarter – some up, some down, and most not implying anything very much for the economy.

The idea that the fall foreshadows some promised rebalancing in the economy is pretty laughable. There have been no policy changes to bring about any such rebalancing (any more than there were with the other – larger – falls in the previous 20+ years). Then again, so is the notion that a lower exchange rate – a modest fall at that – is a material inflation risk. The Reserve Bank itself published research a few years back suggesting noting that, in fact, a lower exchange rate has tended to be associated with lower non-tradables inflation, and often – notably when commodity prices are also fallling – with lower overall inflation.

Unpicking the inflation numbers

July 20, 2018July 20, 2018 Michael Reddell inflation, Monetary policy, Uncategorized

On the face of it, the CPI numbers released earlier in the week seemed quite noteworthy. The Reserve Bank’s preferred sectoral core measure of CPI inflation is still clearly below the 2 per cent the Bank has been told to focus on, and was last at 2 per cent in the year to December 2009, almost a decade ago. But the sectoral core measure has increased again, now up to 1.7 per cent, having averaged about 1.4 per cent (without a lot of short-term noise) for the previous five years. If the trends suggested by this series continue, sectoral core inflation could be back to 2 per cent some time next year.

sec core infl to june 18

That would, all else equal, represent good news not bad (after all, three successive governments now have taken the view that a target midpoint of 2 per cent inflation is best for New Zealand).

But even on this series alone there is still some reason for caution. The sectoral factor model filters the data, and the nature of the filter means the endpoint estimates (in particular) are prone to revision, and as the paper I just linked to illustrates there are margins of error around any of these estimates. I’m reluctant to back away from the sectoral factor model numbers – it has generally been quite a good guide in the years since it was introduced, and tells plausible stories about history. But, equally, it doesn’t make sense to focus only on this one series.

For example, the CPI ex-petrol is a very simple core measure. Petrol prices are quite volatile.

CPI ex petrol to June 18

And yet the latest observation in this series is still a touch below the average inflation rate for the previous five years (and at 1.2 per cent well below the target midpoint). And that is so even though the exchange rate has been unusually high in the last 12-18 months (headline CPI is sensitive to changes in the exchange rate).

There isn’t much sign of rising core inflation being an issue abroad either. Here is the OECD data on CPI inflation ex food and energy, for the G7 grouping as a whole, and the median of the countries/areas with their own currencies (thus the euro area, like the US, is just one observation).

OECD core inflation jul 18

Both series bounce around a bit, but there isn’t much sign of any sort of breakout to a consistently higher rate of inflation. Even among the G7, the latest observations suggest that if US core inflation is edging up a bit, that in the UK and the euro-area is falling back a bit (Japan’s June numbers aren’t available yet).

New Zealand might be different of course. It isn’t obvious why we would be – eg our unemployment rate hasn’t fallen away further or faster than those in most other OECD countries – but we might. Here is the NZ version of the same series: CPI inflation ex food, vehicle fuels, and household energy.

cpi ex nz jul 18 2

Indirect taxes and government charges also complicate the interpretation of the inflation numbers. Weirdly, SNZ still does not publish a straightforward series excluding these effects, to give us a clean read on market prices. It is not as if these are trivial issues either – there was the GST increase a few years ago, there are large increases in tobacco taxes every year (which have had the effect of materially increasing the tobacco weight in the CPI), and there are changes in things like ACC levies and (this year) in government subsidies for tertiary fees.

Here are some individual exclusion measures.

cpi ex jul 18

And here is a series SNZ does publish: non-tradables inflation excluding both central and local government charges and tobacco.

NT ex govt and tobacco jul 18

That might suggest a moderately encouraging story, of core non-tradables picking up. But even if so, it would be the third pick-up in the past five or six years, and neither of the previous ones amounted to much. Perhaps this time will be different?

One reason to think it might be a little different is developments in housing inflation: construction costs and rents make up quite a substantial proportion of non-tradables.

housing components

Rents are a much larger component of the CPI (9.2 per cent) than construction costs of new houses (5.5 per cent) but most of the cyclical fluctuations are in the construction cost component. Construction cost inflation has been dropping away quite markedly since the start of last year (and for all the talk of renewed waves of housebuilding – which I rather doubt will happen) there isn’t any obvious reason to think that phase of the cycle will reverse soon. Some of the earlier increases in core non-tradables inflation will have reflected increasingly high inflation in construction costs, but since construction costs have been slowing for the last 18 months, the latest pick-up can’t be simply written off as a construction story. But, whatever the story, core non-tradables inflation of only around 2.4 per cent is simply not going to be high enough to be consistent with core CPI inflation getting back to 2 per cent. We’d need to see further increases in core non-tradables inflation from here, and with the rate of growth of demand having weakened it isn’t yet obvious that that is the most likely outcome.

And what do the bond markets make of the situation? Recall that there are two indexed bond maturities either side of the 10 year nominal bond.

IIB breakevens jul 18

There has been some drift high in the inflation breakevens, or implied inflation expectations, over the last 12 months or so. But however one looks at things, it is hard to see the market pricing average inflation for the next decade much higher than about 1.6 per cent. That is still a long way from the target midpoint of 2 per cent.

So where does all that leave me? At very least, there is no sign that core inflation is falling and perhaps some reason to be encouraged, and to think it is picking up. But however one looks at the numbers, current core inflation isn’t even close to 2 per cent, and by this stage of a long-running cycle (especially one characterised by weak productivity growth) one might have hoped – even expected – that core inflation might be running a bit above any target midpoint. Notwithstanding the sectoral core measure, it seems too early for too much encouragement – perhaps things are finally on course for a return to 2 per cent, but there are conflicting signs, and not too many compelling reasons to yet think that this time will be different.

What of the outlook? With ebbing population pressures, weak business confidence, no fixes for the over-regulated and dysfunctional urban land markets, and various policy proposals that not only engender uncertainty but could act as considerable drag on actual and potential growth (eg net zero emissions targets), it isn’t obvious why core inflation is likely to rise from here. Headline measures will, as always, be tossed around by oil prices developments (and petrol taxes), and a weakening exchange rate will push prices up a little. Some might argue that public sector wage pressures, and higher minimum wage rates, will themselves contribute to higher domestic inflation. Perhaps so, although I remain a bit sceptical that they will amount to much (even if there are some material relative price changes). And, although no one knows when, the next recession is coming – here and abroad. From an inflation perspective, including positioning ourselves for the next downturn, we’d have been better off if the OCR had been a bit lower over the last couple of years

Inflation bonds and breakevens

June 25, 2018 Michael Reddell inflation, Interest rates

I spent a large chunk of Friday interviewing funds managers. In the course of our conversations, talk turned to the yields on government inflation-indexed bonds (a sensible asset for funds offering indexed pensions) relative to the yields on conventional government bonds. There are a lot more inflation-indexed government bonds on issue now than there used to be, and I was encouraged to learn that, as a result, bid-ask spreads are also tighter.

The gap between nominal and indexed bond yields is what is known as the “breakeven” inflation rate – the actual inflation rate that, over the life of the respective bonds, would generate the same return whether one was holding indexed or nominal bonds. It can be seen as a proxy for market inflation expectations.

As regular readers know, one of my favourite charts is this one, showing the gap between those yields in New Zealand for the last few years.

IIB breakevens June 18

10 years from now is June 2028, so something nearer the average of the two series is at present a reasonable fix on a 10 year inflation breakeven for New Zealand. But whichever series you use, the numbers have been consistently well below 2 per cent for several years now. By contrast, at the start of the chart, it looks as though 10 year inflation breakevens were around 2 per cent (10 years ahead then was 2024, so the blue line was the more relevant comparator).

You might expect that a chart like this one would bother the Reserve Bank (paid to keep inflation around 2 per cent). Instead, they simply ignore it. Their statements repeatedly claim that inflation expectations are securely anchored at 2 per cent, relying on surveys of a handful of economists. They simply ignore the indications from market prices.

It isn’t as if what we see in New Zealand is normal. Here is the chart of US 10 year breakevens for the same period.

US breakevens jun 18

At something a little above 2 per cent, US breakevens are around the US inflation target (expressed in terms of the private consumption deflator, rather than the CPI- which the bonds are indexed to).

What about other countries? Courtesy of Fisher Funds, here are a couple of charts. First the 10 year breakevens for the last year or so.

global breakevens

“DE” here is Germany. As Fisher noted to us, it seemed a little anomalous that New Zealand 10 year breakevens are lower than those in Germany (although the German economy is one of the stronger in Europe, and they have no domestic monetary policy).

And here are the 20 year breakevens

20 year breakevens

BEI 2035 and BEI 2040 are New Zealand. I’ve always tended to discount the UK numbers, because of the different tax treatment of indexed bonds there, but both the US and Australian breakevens look a lot closer to the respective inflation targets (2.5 per cent in the case of Australia) than is the case here.

One of the fund managers we talked to on Friday made a throwaway comment about people simply looking at the last headline CPI number. Maybe, but annual headline CPI inflation in New Zealand for the last six years has averaged 1.0 per cent. The Reserve Bank’s favoured core measure has averaged 1.4 per cent over the same period. And the Reserve Bank has never reached the limits of conventional monetary policy (the OCR hasn’t gone lower than 1.75 per cent) – inflation could have been higher had they chosen differently. It might not be irrational for investors to treat the track record of the last several years as a reasonable pointer to the period ahead. After all, the last six years has been a period with a strong terms of trade, and sustained (albeit moderate) growth. Even if, as all the fund managers we talked to suggested, we are now in a “late cycle” phase when inflation might be expected to pick up, “late cycle” phases tend to come just before the end of the cycle. There will be downturns in the next 10 or 20 years.

What of other possible explanations for these now persistently narrow New Zealand inflation breakevens? In years gone by there was almost no liquidity in the indexed-bond market (for a long time there was but a single indexed bond). All else equal, that might mean investors demanding a higher yield to hold the indexed bond (relative to a conventional bond), narrowing the observed breakevens relative to “true” market expectations of future inflation.

But if it was true once, it must be a less important story now. There are four indexed bonds on issue, each with principal of several billion dollars. As I noted earlier, if bid-ask spreads are still wider than those (a) on nominal bonds, and (b) on indexed bonds in say the US, they are tighter than they used to be. It isn’t an attractive instrument for high frequency trading, but these are multi-month, even multi-year, trends we are looking at.

The other possible story I heard a while ago was the suggestion that the government had glutted the market by issuing too many indexed bonds. It had an air of plausibility about it. It isn’t as if there are many natural holders of these instruments – there are no indexed bond mutual funds in New Zealand, they don’t count as a separate asset class in many mandates, and so on. Then again, in a low yield (and yield hungry) global environment, these instruments offer a pretty juicy yield (the government has a AAA or AA+ credit rating, and its 2040 indexed bonds are offering just over 2 per cent real – there isn’t much around to match that combination). Here is the 10 year indexed bond yield chart (again from Fishers – ignore the UK again).

real 10 year yields

Over the last few years, this is the proportion of New Zealand government bond sales that have been in the form of indexed bonds.

About 24 per cent of New Zealand government bonds on issue are currently inflation-indexed.

I’m not sure how that compares generally with other countries, but in the UK – long a keen issuer of inflation indexed government bonds – the share is also about a quarter. The British also appear to be winding back their issuance – to 21 per cent of new sales this year. According to a FT story from earlier this year

Robert Stheeman, chief executive of the UK’s Debt Management Office, said that “no other country regularly issues a quarter of its debt in inflation-linked bonds”, which “gives us pause for thought”. In contrast Italy — the continent’s largest issuer of inflation-linked bonds — raises just 13 per cent of its debt in this way, according to figures from the DMO.

It may well have been prudent then for our own government to have wound back its issuance plans for index-linked bonds. But that news has now been out since the Budget last month, and there is still no sign that 10 year breakevens are more than about 1.5 per cent – still well short of the 2 per cent inflation target, that was recently reaffirmed by the new government.

There is an OCR review announcement later this week. We don’t get much analysis in a one page press release, but as the Governor mulls his decision, and his communications, and looks towards the next full Monetary Policy Statement, it might be worth him inviting his staff to (a) produce, and (b) publish any analysis they have, as to why we should not take these indications from market prices as a sign that inflation expectations are not really anywhere close to the 2 per cent the Bank regularly claims. Perhaps there is a good compelling alternative story. If so, it would be nice of them to tell us. But given the actual track record of inflation, it would be a bit surprising if breakevens persistently below 2 per cent were not telling us something about market expectations (right or wrong) of inflation.

Towards the Monetary Policy Statement

May 9, 2018May 9, 2018 Michael Reddell expectations, inflation, Reserve Bank Act reforms, Uncategorized

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

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

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

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

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

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

The BNZ commentary put it this way

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

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

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

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

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

infl expecs 1 year

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

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

10 yr bond may 18

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

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

bond expecs

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

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

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

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

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

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

IIBs may 18

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

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

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

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

Inflation still looks pretty subdued

April 21, 2018April 21, 2018 Michael Reddell inflation, Monetary policy

The latest CPI data were released a couple of days ago. Perhaps the only real news was that nothing much seemed to have changed, here or abroad, in the last few months’ data.

Here is a chart of OECD core inflation rates

oecd core inflation apr 18

I’ve shown a few different indicators. Whichever you prefer there isn’t much sign of inflation picking up in the rest of the advanced economies.

Here is the Reserve Bank’s preferred core inflation measure.

sec fac model april 18

If there has been some hint of inflation picking up a little, it remains as excruciatingly slow as ever. In a series with lots of persistence, the 2 per cent target midpoint seems a long way away. And although the Reserve Bank and some outside analysts like to suggest this is all about tradables inflation (a) the gap between the core tradables and non-tradables inflation at present is just around the historical average, and (b) tradables inflation, in New Zealand dollar terms, is at least in part an outcome of monetary policy (the exchange rate directly influences it).

Here are a couple of non-tradables series I’ve shown before.

NT inflation bits

This measure of core non-tradables remains persisently below the rate (somewhere near 3 per cent) that would be consistent with overall core inflation remaining around the 2 per cent target. The extent to which construction cost inflation has been falling away again is now quite marked: it doesn’t just look like noise.

And what of market implied expectations of future inflation from the government bond market?

IIB breakevens Apr 18 Nowhere near 2 per cent, and if anything a bit lower than they were three months ago when the last inflation numbers were released.

Pictures like these should be a challenge for the new Governor as he ponders his first OCR decision and associated communications. After all these years, there still isn’t much sign of (core) inflation getting back to 2 per cent, and there doesn’t seem much impetus from either domestic demand (for which construction cost inflation is often an important straw in the wind) or foreign inflation.

Some who have previously been “dovish” now point to higher oil prices as a reason – either directly, or just as a straw in the wind – why perhaps core inflation will finally pick up. Perhaps, but it is hardly been an infallible indicator historically. Others note that our exchange rate has fallen. That’s true too, but at present the TWI is about 2-3 per cent lower than the five-yearly average level (not much more than noise), and historically falling exchange rate have often been associated with falling non-tradables inflation (depending what drives the particular exchange rate move).

Time will tell, but in his RNZ interview the other day I heard the Governor praising the “courage” of central banks internationally for having held interest rates so low for so long, despite very strong growth, to help get the inflation rates back up to target. I wasn’t sure I recognised any element of the description – in the advanced world, central banks have mostly been reluctant to have interest rates low, and growth has rarely been particularly strong (both caveats seem to describe New Zealand). But perhaps the Governor needs to consider displaying some of courage he says he has admired and take steps to get New Zealand inflation securely back to target.

Estimating NAIRU

March 15, 2018March 15, 2018 Michael Reddell inflation, Monetary policy, unemployment

The Reserve Bank of New Zealand has long been averse to references to a “natural rate of unemployment” or its cognate a “non-accelerating inflation rate of unemployment” (NAIRU). It started decades ago, when the unemployment rate was still very high, emerging from the structural reforms and disinflation efforts of the late 80s. We didn’t want to lay ourselves open to charges, eg from Jim Anderton, that we regarded unemployment as natural or inevitable, or were indifferent to it, let alone that we were in some sense targeting a high rate of unemployment. Such a criticism would have had little or no analytical foundation – we and most mainstream economists held that a NAIRU or “natural” rate of unemployment was influenced largely by labour market regulation, welfare provisions, demographics, and other structural aspects (eg rate of turnover in the labour market) that were quite independent of monetary policy. But the risk was about politics not economics, and every election there were parties looking to change the Reserve Bank Act. And so we never referrred to NAIRUs if we could avoid it – which we almost always could – preferring to focus discussions of excess capacity etc on (equally unobservable) concepts such as the output gap. In our formal models of the economy, a NAIRU or a long-run natural rate could be found lurking, but it made little difference to anything (inflation forecasts ran off output gap estimates and forecasts, not unemployment gaps).

Other central banks do things a bit differently, perhaps partly because in some cases (notably Australia and the US) there is explicit reference to employment/unemployment in monetary policy mandates those central banks are working to. In a recent article, the Reserve Bank of Australia observed that

“When updating the economic forecasts each quarter, Bank staff use the latest estimate of the NAIRU as an input into the forecasts for inflation and wage growth”

It may not make their monetary policy decisions consistently any better than those here, but it is a difference in forecasting approach, and in how the RBA is prepared to talk about the contribution of unemployment gaps (as one indicator of excess capacity) to changes in the inflation rate.

I’ve been arguing for some years – first inside the Bank, and more recently outside – that our Reserve Bank put too little emphasis (basically none) on unemployment gaps (between the actual unemployment rates and the best estimate of a NAIRU). It has been the only central bank in the advanced world to start two tightening cycles since 2009, only to have to reverse both, and I had noted that this outcome (the reversals) wasn’t that surprising when for years the unemployment rate had been above any plausible estimate of the NAIRU. The Bank sought to fob off criticisms like this with a new higher-tech indicator of labour market capacity (LUCI) – touted by the Deputy Governor in a speech, used in MPSs etc – only for that indicator to end badly and quietly disappear.

But since the change of government – a government promising to add an explicit employment dimension to the Bank’s monetary policy objective (now only 12 days to go til the new Governor and we still haven’t seen the new PTA version) – there has been some pressure for the Bank to be a bit more explicit about how it sees, and thinks about, excess capacity in the labour market, including through a NAIRU lens. In last month’s Monetary Policy Statement, they told us their point estimate of the NAIRU (4.7 per cent) and in the subsequent press conference, the Governors told us about the confidence bands around those estimates. All this was referenced to an as-yet-unpublished staff research paper (which still seems an odd inversion – senior management touting the results before the research has had any external scrutiny).

Last week, the research paper was published. Like all RB research paper it carries a disclaimer that the views are not necessarily those of the Reserve Bank, but given the sensitivity of the issue, and the reliance on the paper at the MPS press conference, it seems safe to assume that the paper contains nothing that current management is unhappy with. What the new Governor will make of it only time will tell.

There was interesting material on the very first page, where the authors talk about the role of monetary policy.

The focus of monetary policy is to minimise fluctuations in cyclical unemployment, as indicated by the gap between the unemployment rate and the NAIRU, while also maintaining its objective of price stability.

I would very much agree. In fact, that way of stating the goal of monetary policy isn’t far from the sort of wording I suggested be used in the amended Reserve Bank Act. Active discretionary monetary policy exists for economic stabilisation purposes, subject to a price stability constraint. But the words are very different from what one has typically seen from the Reserve Bank over the years (including, for example, in their Briefing to the Incoming Minister late last year).

But the focus of the research paper isn’t on policy, but on estimation. The authors use a couple of different techniques to estimate time-varying NAIRUs. Since the NAIRU isn’t directly observable, it needs to be backed-out of the other observable data (on, eg, inflation, wages, unemployment, inflation expectations) and there are various ways to do that. The authors draw a distinction between a “natural rate of unemployment” and the NAIRU: the former, conceptually is slower moving (in response to changes in structural fundamentals – regulation, demographics etc), while the NAIRU can be more cyclical but tends back over time to the longer-term natural rate. I’m not myself convinced the distinction is that important – and may actually be harmful rhetorically – but here I’m mostly just reporting what the Bank has done.

The first set of estimates of the NAIRU are done using a Phillips curve, in which wage or price inflation is a function of inflation expectations, the gap between the NAIRU and the unemployment rate, and some near-term supply shocks (eg oil price shocks). Here is their chart showing the three variants the estimate, and the average of those variants.

nairu estimates.png

Perhaps it might trouble you (as it does me) but the authors never mention that their current estimates of the New Zealand NAIRU, using this (pretty common) approach, are that it has been increasing for the last few years. Frankly, it doesn’t seem very likely that the “true” NAIRU has been increasing – there hadn’t been an increase in labour market regulation, the welfare system hadn’t been becoming more generous, and demographic factors (a rising share of older workers) have been tending to lower the NAIRU.

As it happens, the authors have some other estimates, this time derived from a small structural model of the economy.

NAIRU NK

Even on this, rather more variable, measure, the current central estimate of the NAIRU is a bit higher than the authors estimate it was in 2014. But the rather bigger concern is probably the extent to which over 2008 to 2015, the estimated NAIRU on this model seems to jump around so much with the actual unemployment rate. Again, the authors offer no thoughts on why this is, or why the pattern looks different than what we observed in the first half of their sample. Is there a suggestion that the model has trouble explaining inflation with the variables it uses, and thus all the work is being done by implicitly assuming that what can’t otherwise be explained must be down to the (unobserved) NAIRU changing? Without more supporting analysis I just don’t find it persuasive that the NAIRU suddenly shot up so much in 2008/09. For what it is worth, however, do note that the actual unemployment rate was well above the NAIRU (beyond those grey confidence bands) for years.

Here is what the picture looks like when both sets of estimates are shown on the same chart.

nairu x2

On one measure, the NAIRU fell during the 08/09 recession, and on the other it rose sharply. On one measure the NAIRU has been steadily rising for several years, while on the other it has been jerkily falling. No doubt the Bank would like you to focus on the end-point, when the two sets of estimates are very close, but the chart does have a bit of a “a stopped clock is right twice a day” look to it. When the historical estimates coincide it seems to be more by chance than anything else, with no sign of any consistent convergence.

I noted the end-point, where the two estimates are roughly the same. But end-points are a significant problem for estimating these sorts of time-varying variables. The authors note that in passing but, somewhat surprisingly, they give us no sense of how material those revisions can be, and have been in the past. I went back to the authors and asked

I presume you’ve done real-time estimates for earlier periods, and then checked how – if at all – the addition of the more recent data alters the estimates of the NAIRU for those earlier periods, but if so do you have any comments on how significant an issue it is?

To which their response was

An assessment of the real-time properties of the NAIRU and the implied unemployment gap was beyond the scope of our paper.

Which seems like quite a glaring omission, if these sorts of model-based estimates of a time-varying NAIRU are expected to play any role in forecasting, or in articulating the policy story (as the Governors did in February).

As it happens, the Reserve Bank of Australia published a piece on estimating NAIRUs etc last year. As a Bulletin article it is a very accessible treatment of the issue. The author used the (reduced form) Phillips curve models (of the sort our Reserve Bank used in the first chart above).

nairu rba

The solid black line is the current estimate of Australia’s NAIRU over the whole of history. But the coloured lines show the “real-time” estimates at various points in the past. In 1997 for example (pink line) they thought the NAIRU was increasing much more – and thus there was less excess labour market capacity – than they now think (or, their model now estimates) was the case. In 2009 there was a stark difference in the other direction. Using this model, the RBA would have materially underestimated how tight the labour market actually was.

It would be surprising if a comparable New Zealand picture looked much different, but it would be nice if the Reserve Bank authors would show us the results. These end-point problems don’t mean that the model estimates are useless, but rather that they are much more useful for identifying historical NAIRUs (valuable for all sorts of research) than for getting a good fix on what is going on right now (the immediate policy problem). That is true of many estimates of output gaps, core inflation (eg the RB sectoral core measure) and so on.

Having said that, at least the Australian estimates suggest that Australia’s NAIRU has been pretty steadily falling for the last 20 years or so, with only small cyclical dislocations. Quite why the Reserve Bank of New Zealand’s Phillips curve models suggest our NAIRU has been rising – when demographics and welfare changes typically point the other way – would be worth some further examination, reflection, and commentary (especially if Governors are going to cite these estimates as more or less official).

Comparing the two articles, I noticed that the RBA had used a measure of core inflation – their favoured measure, the trimmed mean – for their Phillips curve estimates, while the RBNZ authors had used headline CPI inflation (ex GST). Given all the noise in the latter series – eg changes in taxes and government charges – I wondered why the authors didn’t use, say, the sectoral factor model estimate of core inflation (the Reserve Bank’s favoured measure). It would be interesting to know whether the NAIRU results for the last half decade (when core inflation has been very stable) would be materially different. It might also be worth thinking about using a different wages variable. The authors use the headline LCI measure, as a proxy for unit labour costs. But we have actual measures of unit labour costs (at least for the measured sector), and the authors could also think about using, say, the LCI analytical adjusted series and then adjusting that for growth in real GDP per hour worked (a series that has itself been revised quite a bit in the last year). No model estimate is going to be perfect, but there does seem to be some way to go in refining/reporting analysis research in this area.

I have argued previously that the Reserve Bank should be required to report its estimates of the NAIRU, and offer commentary in the MPS on the contribution monetary policy is making to closing any unemployment gaps. I’d have no problem with the Bank publishing these sorts of model estimates, but I’d have in mind primarily something a bit more like the Federal Reserve projections, in which the members of the (new, forthcoming) statutory Monetary Policy Committee would be required to publish their own estimates of the long-run sustainable rate of unemployment that they expect the actual unemployment rate would converge to (absent new shocks or structural changes). The individual estimates are combined and reported as a range. No doubt those individual estimates will have been informed by various different models, but in the end they represent best policymaker judgement, not the unadorned result of a single model (end-point) problems and all.

And finally, the Reserve Bank (aided and abetted by the Board) has always refused to concede it made a mistake with its (eventually reversed) tightening cycle of 2014 – sold, when they started out, as the beginning of 200 basis points of increases. The absence of any emphasis on the unemployment rate, or unemployment gaps, was part of what got them into trouble. In the latest research paper there is a chart comparing the Bank’s current estimates of the NAIRU (see above) with their current estimates of the output gap.

nairu and output gap

The tightening cycle was being foreshadowed in 2013, it was implemented in 2014, it was maintained well into 2015. And through that entire period, their unemployment gap estimates were outside the range of the output gap estimates.

We don’t have their real-time estimates of the unemployment gap, but we do have their real-time output gap estimates. They might now reckon that the output gap in mid 2014 (blue line) was still about -1 per cent but in the June 2014 MPS they thought it was more like +1.5 per cent.

output gap from june 2014 mps

The failure to give anything like adequate weight to the direct indicators of excess capacity from the labour market (ie the unemployment rate and estimates of the NAIRU) looks – as it felt internally at the time – to have contributed materially to the 2014 policy mistake.

(In this post, I’m not weighing into the specific question of what exactly the level of the NAIRU is right now, and the Bank does emphasise that there are confidence bands around its specific estimates, but I’m aware that is also possible to produce estimates in which the current NAIRU would be 4 per cent or even below.)

The Reserve Bank’s McDermott again

February 16, 2018February 16, 2018 Michael Reddell inflation, Reserve Bank

Earlier in the week I wrote about Reserve Bank chief economist John McDermott’s rather strange attempt to distract attention from the Bank’s own GDP forecasts – which some had suggested were a bit optimistic – by suggesting that private bank economists didn’t understand the process the Reserve Bank used, and even using the word “nonsense” in an attempt to bat away what seemed like quite legitimate questions. Somewhat to my (pleasant) surprise, Westpac – one of the banks that had questioned the Reserve Bank’s forecasts – actually went public in response , although being an institution regulated by the Reserve Bank they still seemed to feel the need to express due deference to the powerful, ending their note this way, (emphasis added)

We are comfortable respectfully maintaining that difference of opinion.

After each Monetary Policy Statement the Reserve Bank’s senior staff fan out across the country to do a series of post-MPS presentations (I used to do some of them myself). These events are all hosted, and paid for, by the commercial banks, and commercial clients of those banks are the invited guests. It is an arrangement that is convenient for the Reserve Bank – the banks rustle up an audience – but which has always seemed a bit questionable to me: preferential access to senior public officials, on sensitive policy issues, for the invited clients of particular banks. The tone and thrust of questioning might be a little different if some such occasions were hosted by the Salvation Army or unemployed worker advocacy groups.

These occasions are supposed to be off-the-record, whatever that means. The Bank defends it on the basis that it is supposed to let them speak more freely. But the reason people turn up is to garner information and perspectives from – and ask questions of – senior public officials. And no one supposes that financial markets people in the room don’t (a) use, and (b) pass on to clients anything interesting, any different angles, that are raised when the Governor (in particular) and his leading offsiders are talking. As I’ve noted previously, the contrast with the Reserve Bank of Australia is striking: senior officials will give speeches to private audiences, but the standard practice is, wherever possible, to post the text of the address and a webcast or audio of the address and any question and answer sessions, to minimise the extent to which some have access to Reserve Bank information/views others don’t have.

After my post the other day, a reader who had been at the post-MPS presentation John McDermott had given last Friday got in touch to pass on some of what McDermott had said there. My reader felt – and based on his report I agree – that they didn’t put this senior official, or the Reserve Bank, in a particularly good light. The reports are secondhand (ie I wasn’t there), so I’m relying on my reader to have captured the thrust of what McDermott said reasonably accurately. But having worked closely with McDermott in the past, what I read had a ring of authenticity to it. My reader has given me explicit permission to quote from the email I was sent.

He spent the first five minutes of his short presentation defending their record by displaying a chart showing CPI, broken down into tradables and non-tradables components, over the last 50 years or so. Essentially he was highlighting how insignificant the recent deviations from target look when you compare it to the extreme volatility in prior, pre-OCR, decades. He also claimed the RBNZ can only influence the non-tradables component and was rather self-congratulatory in how well they had done there.

Something didn’t sound quite right about that (the tradables vs non-tradables breakdown doesn’t go back that far), so I asked the Bank for a copy of McDermott’s slides (which, legally required to respond as soon as reasonably practicable, they supplied within 24 hours). In fact, this paragraph was summarising two slides. The first is, from memory, one of McDermott’s favourites.

mcdermott 1

In the 70s and 80s inflation was very high and volatile, and for the last 25+ years it hasn’t been. It is a worthwhile point to make from time to time, but doesn’t have much bearing on anything to do with how monetary policy should be run right now (a bit looser, a bit tighter or whatever). Apart from anything else, almost every advanced country could show a similar, more or less dramatic, chart. And in the earlier decades, inflation wasn’t being targeted – until 1985 the ‘nominal anchor” was the (more or less) fixed exchange rate.

The second chart was this one

mcdermott 2

This is presumably what McDermott was talking about when, as my reader reported,

He also claimed the RBNZ can only influence the non-tradables component and was rather self-congratulatory in how well they had done there.

There is no doubt that, in the short-term, the Reserve Bank is a pretty minor influence on tradables inflation, which is thrown round quite a bit, and most obviously, by fluctuations in petrol prices (changes in which closely track international oil prices) and the influence of weather events of fresh food prices. The Reserve Bank can’t do much about those, and is specifically instructed (in every PTA) not to focus on them. Of course, in the very short-term the Reserve Bank can’t do much about non-tradables inflation either – it is quite persistent (ie not very volatile), and inflation right now is a response to monetary policy choices from perhaps 18 months ago, and economic forces (often hard to forecast) from the last year or so.

But it would be nonsense to suggest (if in fact McDermott did) either that tradables inflation is outside the Bank’s influence, or that the track record on non-tradables inflation is just fine. New Zealand can’t do anything much about the world price of tradables, but monetary policy is a direct influence on the exchange rate, and thus on the New Zealand dollar price of tradables. That can’t sensibly produce a stable tradables inflation rate quarter to quarter, but it can (and does) have a material influence on the trend – “core tradables inflation” if you like. And McDermott’s chart seems deliberately designed to avoid focus on the fact that, over time, tradables tend to inflate less rapidly than non-tradables. As I’ve noted previously, the rule of thumb around the Bank used to be that if one was targeting 2 per cent inflation, that might typically involve something nearer 1 per cent tradables inflation and something nearer 3 per cent non-tradables inflation.

As it happens, the Reserve Bank produces estimates (from its sectoral factor model) of core tradables and core non-tradables inflation. I ran this chart of those data a few weeks ago

sec fac model jan 18

Not only is this estimate of core tradables inflation not terribly volatile, but the gap between the two series isn’t unusually large or small. Overall (core) inflation has simply been too low to be consistent with the target set for the Reserve Bank. There isn’t anything for current Reserve Bank management to be proud of.

One of the reforms the new government is promising is the addition of some sort of employment objective (non-numerical) to the Bank’s statutory monetary policy responsibilities. We don’t know the details, and probably neither does the Bank – The Treasury was accepting submissions on that point right up to today – but I presume we will get a hint when the Policy Targets Agreement with the new Governor (under existing legislation) is signed and released next month. But it is an obvious area of interest and apparently McDermott was asked some questions about the new environment. You may recall that in the MPS the Bank released, for the first time, an estimate of the NAIRU (the estimated rate of unemployment at which there is neither upward nor downward pressure on inflation from the labour market) – “released”, but in a footnote (repeated in the press conference), citing analysis in an as-yet-unpublished research paper.

My reader reports that McDermott was asked about this, including

whether their estimate of NAIRU came about as a result of the likely addition of an employment mandate to the PTA, and … how they went about coming up with that number. His initial reply was “I’ve got a lot of very smart people working for me” and then he went on to basically say that the analysis and maths involved are too complicated for us to understand. He also highlighted, to the point of seeming rather proud of, the fact his team had decided to come up with the estimate on their own accord without any suggestion from him. It didn’t seem to me that even he knew how they came up with 4.7%, nor that he particularly cared much.

The final sentence is clearly editorial in nature, and may or may not represent McDermott’s actual view, although it was clearly how he came across to this particular member of his audience. As for the rest, when you put out a number in a footnote, don’t simultaneously make available the workings and background research, fall back on “very smart” staff, and won’t even attempt to explain the intuition of the work that has been done, it isn’t a particularly good look from a senior public servant. (I’ve also heard that in fact the “acting Governor” had been all over staff, as a matter of urgency, to produce publishable estimates of the NAIRU.)

I’m still looking forward to seeing the research paper when they finally get round to publishing it. Perhaps the 4.7 per cent estimate of the NAIRU (with confidence bands) will prove to be robust, although it seems implausibly high to me. But it is worth remembering that the Bank has form when it comes to rushing out new labour market indicators in high profile documents endorsed by senior managers, that play down any notion of ongoing excess capacity, without having first adequately road-tested and socialised the background research. Persevering readers may recall the saga of LUCI , touted a couple of years ago by a Deputy Governor as the latest great thing, allegedly demonstrating that the labour market was already at or beyond capacity (and at least in that case the associated Analytical Note had already been published), before the interpretation of the whole indicator was quietly changed, and then it disappeared from view.

The questioner of McDermott apparently continued and

….suggested NAIRU will presumably become a more important consideration for the Bank going forward if they are handed a ‘full-employment’ mandate but he didn’t really address that question and instead spent 5 minutes explaining why it would need to be the Bank, and not politicians, who define what full-employment means at any given time, a suggestion I wasn’t aware anyone had made otherwise. He pressed the point that he didn’t believe the change to the mandate would make any difference whatsoever and sarcastically pointed out that they already consider employment when making decisions.

Since neither we, nor McDermott, has seen the new mandate, and since the new Governor (not yet in office) will be the single legal decisionmaker for a time, and then the new statutory Monetary Policy Committee will take responsibility, it isn’t clear how or why McDermott thinks he can say with any confidence that a new mandate won’t make any difference to policy. Perhaps he wishes it to be so, but then he has been one of key figures in the regime of the last six-plus years that has delivered core inflation consistently below target even while (even on their own estimates) the unemployment rate has been above the NAIRU for almost the whole of that time. As reported, it didn’t seem a very politically shrewd answer either – it is one thing to emphasise that (as everyone agrees) in the long-run monetary policy can only influence nominal things (price levels, inflation rates etc), and quite another to suggest that there aren’t legitimately different short-run reaction functions.

We deserve better from our operationally independent central bank. Lifting the quality, and authority, of the Bank’s work around monetary policy will be one of the challenges for the new Governor, and needs to be borne in mind too by those devising the details of the new Reserve Bank legislation.

croaking cassandra

Economics, public policy, monetary policy, financial regulation, with a New Zealand perspective

inflation