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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Monetary policy will remain accommodative for a considerable period.

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

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

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

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

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

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

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

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

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

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

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

Here are the unemployment rates for the largest OECD economies

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

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

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

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

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

Sometimes ill health does strange things. I’ve been quite unwell for the last couple of months (slowly getting back to normal now) and in that time my interest in current monetary policy and the monetary policy words/actions of the Reserve Bank dropped right away (displaced, according to my book list,  by copious Trollope novels and books of early 20th century history). I didn’t write a post about the last OCR review, and it is more than eight weeks since I last wrote a post about current monetary policy issues at all.

In the grand scheme of things, monetary policy just isn’t that important.  Bad monetary policy won’t impoverish us, and the best monetary policy possible won’t make any material difference in reversing our decades of economic underperformance.  But the same is true of lots of things, and monetary policy is one of the things I know.  And over shorter-term horizons it makes more difference to the fortunes of individuals (and firms) than many other things government agencies do.

The Reserve Bank is charged with keeping annual CPI inflation “near” 2 per cent on average.  Monetary policy takes time to work, and there are all sorts of “one-offs” that muddy the water, so no one would ever expect out-turns averaging bang on 2 per cent, except by chance.  The Policy Targets Agreement talks about “near”, and outlines various reasons why actual inflation might appropriate deviate from the target.  One of the salient ones is the direct impact of government taxes and charges: when the government raises tobacco taxes or cuts ACC levies, those aren’t things you hold monetary policy to account for, or expect monetary policy to try to offset.  Any other approach would deliver daft results.

So how do things stand on inflation now, four years into the Governor’s term?

Here is headline CPI inflation, the focus of the Policy Targets Agreement.

The 2 per cent focal point has only featured in the Policy Targets Agreement since the end of September 2012  (although prior to that 2 per cent was also the (unstated and unfocused on) midpoint of the target range).

The Governor has often rightly called our attention to the role falling global oil prices have played in dampening headline inflation.  The CPI ex petrol series somewhat overstates the contribution of falling oil prices, because exchange rate pass-through into domestic prices is pretty full and immediate for oil/petrol, and the Governor’s monetary policy choices are one of the things that has held up the exchange rate.  But setting that caveat to one side for the moment, here is the CPI ex petrol series.

Inflation on that measure is not only well away from the 2 per cent focus, but it is below the bottom of the 1 to 3 per cent target range.  And doesn’t really look to be picking up much, unless perhaps you put a great deal of weight on the one particularly low annual number at the end of last year.

What of the various other core measures?  At times, the Governor has put a very heavy weight on the Bank’s sectoral core factor model measure of inflation.  It has shown some signs of having turned a corner, and started picking up.  Unfortunately, the way that measure is calculated leaves it prone to quite significant revisions as new data are added (if I recall rightly, back in 2011, the real-time estimates suggested core inflation was above 2 per cent).

In this chart, I’ve just shown the estimates for the sectoral core measure a year ago, and those now.  In that time, new data have led to past estimates of the sectoral core inflation rate being revised further down (ie the trough was worse than the Bank realized).  And the current estimate of 1.5 per cent is slightly lower than the 1.6 per cent being reported only a few months ago.

There is no perfect measure of core inflation –  empirically, or perhaps even conceptually.   And the measures the Bank and SNZ report show quite a range of numbers.

The median of those estimates is 1.2 per cent.

We are approaching the next Reserve Bank Monetary Policy Statement.  As everyone is aware the Reserve Bank has cut the OCR quite a long way over the last 16 months, and has indicated that its projections suggest further cuts will be needed to ensure that inflation settles back near 2 per cent.

Only two years ago, in its December 2014 Monetary Policy Statement, the Governor indicated that he expected further increases in the OCR, from the then level of 3.5 per cent.  They soon realized that was a mistake.  But here are those core measures for the year to September 2014 (the latest CPI data in December 2014) and for the most recent year.

On only one of those six measures is core inflation any higher now than it was then, although in all cases there were lower numbers at some point between then and now.   The cuts in the OCR –  reversing the unwarranted 2014 increases – may have helped stem the decline in core inflation, but haven’t yet done much to get it back to near 2 per cent.

Perhaps there are still further increases in core inflation in the pipeline?  But recall that the largest cuts in the OCR were concentrated in 2015 –  100 basis points of cuts between the June and December 2015 MPSs.  Not all the effects of those cuts will yet have been felt, but the effects are likely to start waning fairly soon.   This year so far we’ve had 50 basis points of OCR cuts, some of which simply offset the impact of falling inflation expectations.  And the exchange rate has been rising this year.

As I noted earlier, when governments raise indirect taxes (eg on tobacco) or cut government levies (eg the ACC component of vehicle registration fees) one really wants to look through such effects.  Unfortunately, SNZ does not publish a series for the CPI excluding taxes and government charges –  and I would urge them to consider doing so – but they do publish a series of non-tradable inflation excluding government charges and the cigarette and tobacco subgroup.  At present, those two exclusions capture the tobacco tax and ACC effects.  Non-tradables inflation typically averages well above tradables inflation (for various reasons) and so can’t meaningfully be compared with the CPI inflation target midpoint, although some people –  including some who should know better –  do so.  Here is the chart of that inflation series.

To be consistent with overall CPI inflation of around 2 per cent, this series would have to be inflating at somewhere nearer 3 per cent per annum.  But this inflation rate has picked up quite a bit, and quite steadily over the last year or so.  That should be a slight cautionary note when considering what should be done with the OCR from here, but it is worth noting that this series also picked up quite a bit in 2013 and that proved to be a false signal.

Like the Reserve Bank, I do think the OCR should be cut further, and I expect it will be cut.  But I might be a little more cautious now than perhaps I would have been at the start of the year about just how large future cuts might desirably be.

Of course, in part that depends on one’s sense of the strength of the economy.   The global picture looks no rosier, and although dairy prices have picked up somewhat, other impulses must be waning.  Growth in tourist arrivals seems to be slowing, as does the sharp growth in foreign student numbers (and the residence approvals programme numbers have been cut a bit).  The Christchurch rebuild impulse is well past its peak, and I don’t see much reason for optimism about a renewed surge in other private domestic construction.  Then again, interest rates work with a lag, and although real interest rates are still higher than they were say three years ago, they are lower than they were 12 to 18 months ago.  And between new prisons (another non-tradables shock tending to boost the real exchange rate) and other government capital expenditure to catch up with the unexpectedly rapid growth in the population, there probably isn’t much reason to expect the modest per capita growth over the last couple of years to slow that much in the next year.

As I’ve said before, however, forecasting is a bit of a mug’s game.  For me, two considerations still tilt me to favouring at least another 50 basis points of cuts:

1. The unemployment rate is still lingering well above official estimates of the NAIRU, and that is something monetary policy can do something about, and
2. Because we will go into the next recession (whenever it is, although history would suggest some time in the next five years) with much less ability to cut the OCR than we have had in past recessions, in the current climate if monetary policy errs at all it should be erring towards delivering inflation outcomes perhaps a little above target (even if still “near 2 per cent”) rather than quite a way below target as in recent years.  Inflation expectations for the next few years quite a bit higher than we have now would be a positively desirable outcome.    The Bank doesn’t really have a mandate to target expectations much above 2 per cent, but if it is going to err –  as it has, quite materially, in recent years – better now to err on the high side.

And for all the rhetoric from the government and their cheerleaders, it is not as if the economy has been doing that well.  Non-existent productivity growth and no better than middling per capita GDP growth aren’t signs suggesting we should just ignore low inflation and bask in our “economic success”.

A couple of weeks ago, the Herald ran their annual Mood of the Boardroom survey, capturing the views of 101 (mostly) chief executives on a wide range of business, political and policy issues.  It is a slightly frustrating survey because, despite the heavy coverage the Herald gives it, they don’t report the exact questions, and as everyone surely recognizes, how one frames a question influences –  intentionally or otherwise –  the answers one gets.

Often enough the answers are pretty predictable.  Sometimes predictably depressing.  Daft and detached from reality as I’ve argued that the Prime Minister’s line about New Zealand as a haven for the rich, the “Switzerland of the South Pacific” is, the CEOs (79 per cent of them) seem to like it.

But the question that caught my eye was one about monetary policy.  Asked whether the government should “rewrite its agreement with the Reserve Bank”, so as to “consider wider economic factors beyond inflation” the answers reported were:

Yes                                    48 per cent

No                                      38 per cent

Unsure                              14 per cent

It is now less than 12 months until a new Policy Targets Agreement is required, and the Minister of Finance has poured cold water on the idea of major changes in the PTA.  But on this occasion, business leaders –  often important defenders of the status quo around monetary policy – seem to be calling for change.  As the Herald notes, it is “a marked change from previous surveys”.

It would be interesting to know quite what these CEOs had in mind, as there isn’t much hint in the supporting article.  One CEO is quoted as suggesting that the Reserve Bank needs to think about economic growth too, and that is about all.  There is no reference in the article to the exchange rate, unemployment, asset prices, credit or any of the considerations that people sometimes argue that the Bank should pay more attention to.  But since these respondents aren’t monetary policy experts, we can assume they don’t just have in mind minor technical rephrasing on some clause or other in the PTA.  There must be some genuine angst in CEO-land about how monetary policy is being run.

Without more follow-up questions, it is hard to know what the balance of thinking among respondents was.  Some will probably will favouring lowering the inflation target, to bring the target into closer alignment with actual inflation outcomes in recent years.  Perhaps some favour linking monetary policy and the Bank’s regulatory powers more closely.  Some might be channeling stuff they read from abroad suggesting a new approach to monetary policy is needed, with little real sense of what a different approach might look like (no other country having changed its framework).  But others might be reflecting more of a Labour/New Zealand First unease about the framework, emphasizing perhaps international competitiveness, or more of a focus on full employment.  Perhaps some are just reacting to the failings of the current Governor in conducting policy?

We don’t know what the balance is, but the survey result does feel rather like a straw in the wind, something for the powers that be to focus on as the negotiation of the new PTA next year approaches.  The latent unease among business leaders –  whatever motivates it –  reinforces the argument I’ve made here several times in the past that the process leading to negotiating a Policy Targets  Agreement really should be a much more open one.  The PTA is the principal guide to short-term macroeconomic management in New Zealand, for five years at a time, and yet it is a process shrouded in secrecy from beginning to (well after the) end.   There was no public consultation on the changes to the PTA in 2012 (or those in 2002), and even after the event the Reserve Bank has refused to release background papers relating to the PTA negotiation.

Perhaps none of this matters very much if there is a strong consensus in favour of the status quo –  although even then it is as well to have to articulate the case from time to time, and deal with the challenges, even if they come from only a small minority of voices.  But this time, according to this survey, a plurality of business leaders favours changing the PTA.  Regulatory agencies have to publish consultative documents on proposed changes. New legislation has to be worked through a select committee. The government publishes a Budget Policy Statement setting out in advance the key considerations that will shape its subsequent Budget.  But there is nothing remotely similar around the key policy guide to short-term macroeconomic management, the PTA.  Democratic deficits abound in matters relating to the Reserve Bank, but this is one that could be quite easily fixed.    As part of the lead-up to next year’s PTA, the Minister of Finance should announce that the Treasury will be hosting a workshop/conference, perhaps around six months from now, to consider papers on the appropriate content and structure of the Policy Targets Agreement.  Several background papers could be commissioned, the Reserve Bank and Treasury themselves might submit papers (with some caution about those from the Reserve Bank, given that it is the institution whose conduct the PTA is supposed to shape, and hold to account), and outside experts (academic and otherwise) and interested parties could be invited to contribute.

No doubt some would worry about “upsetting the markets” but (a) this is a democracy, and one that often espouses the importance of open government and (b), as importantly, markets can read too.  The Mood of the Boardroom results are no secret, and nor is the unease that most Opposition parties feel about the New Zealand monetary policy framework.  Nor, for that matter, is the ongoing international debate about how best ot run monetary policy in future a secret.

To be clear, I am not myself advocating material change.  If I were starting from scratch, I would rewrite the PTA at about half its current length, but would not change any of the central features of the current document.  That isn’t because the current system is perfect, or likely to be the end of monetary history (the system we still have 100 years hence), but because the case for any real-world alternative has not yet been made compellingly.  And because I think getting the forecasts more accurate, and reforming the governance of the Reserve Bank –  including getting the right people running the place – are more important than tweaking the target.

I was, however, interested in one of the Herald survey’s advocates of changing the PTA.  Don Brash, former Governor of the Reserve Bank, was included in the survey as chair of ICBC, one of the Chinese banks operating in New Zealand.  Don is quite clear in his view that

over the longer term monetary policy can’t significantly effect an improvement in real economic growth or employment.

But, he argues,

And the Government should probably either reduce or widen the inflation target band. It’s not obvious to me that an average movement in the price of goods and services (as measured by the CPI) of say 0.5 per cent a year should be regarded as a serious problem to be solved.

“There’s not much evidence of people holding off spending because the CPI is at current levels,” said Brash

I think Don Brash is just wrong on this one.

First, he ignores the extent to which the unemployment rate (just over 5 per cent) is still above the natural or sustainable rate in New Zealand –  estimated by Treasury at around 4 per cent.  Very low inflation is not necessarily a problem in itself, but it can point to an extent of unused capacity in the economy.  That is most obvious in the unemployment numbers, but is also reflected in just how weak per capita GDP growth has been in the current upswing.  We simply could have done better.

But my bigger concern is about what lowering the inflation target would do to our capacity to cope with future severe economic downturns.  I’d be happy, in an ideal world, to lower the inflation target, back to perhaps 0 to 2 per cent per annum (there are some modest upwards biases in the CPI measure of inflation).  Apart from anything else, the closer to price stability the economy averages the less distortionary the tax system is.

But…the rest of the advanced world has spent the last decade discovering the limitations of conventional monetary policy.  With current technologies, laws, and central bank practices, no one thinks that nominal policy interest rates can be cut much below zero (something around -0.75 per cent seems to be accepted as near a practical floor).  Fortunately, New Zealand hasn’t faced those constraints yet.  We had to cut the OCR as much as almost anyone in the advanced world, but since our interest rates have averaged so much higher than those in other countries, the OCR hasn’t yet fallen below 2 per cent (and even the doves don’t think it needs to go below 1 per cent).

As the Reserve Bank has noted, weak inflation over recent years has been accompanied by falling inflation expectations.  But those inflation expectations have typically fallen quite sluggishly, partly because people still seem to think that eventually inflation will get back to something around 2 per cent.  If the target was changed, to say 0 to 2 per cent, they would have no reason to expect inflation to average anywhere near 2 per cent, and their expectations (explicit and subconscious) would be revised down towards 1 per cent.  All else equal, that would amount to an increase in real interest rates –  and to prevent inflation falling further, nominal interest rates would have to be cut even more.

In typical downturns in New Zealand, the OCR (or the 90 day bill rate pre 1999) have been cut by hundreds of basis points (500 basis point falls haven’t been unusual).  Even with an inflation target centred on 2 per cent, we don’t have anything like that sort of leeway when next a recession hits New Zealand.  We would simply be foolish to give away any of the capacity we do have by cutting the inflation target now.  Of course, if the government, the Treasury and the Reserve Bank were finally going to get serious about taking the sort of steps that would largely remove the near-zero bound on nominal interest rates it would be a quite different matter.  But this issue need to be taken seriously in any discussion of future PTA options.

Six months or so ago I was getting a little frustrated by talk suggesting that low inflation was just one of those things. No one else, it was implied, was succeeding in meeting their inflation targets, and so we shouldn’t really be expecting the Reserve Bank of New Zealand to meet the target the Minister of Finance had set for them.

And so I wrote a short post about Norway.  It was a small advanced economy, which has had substantial issues around rising house prices and high household debt, and which had been hit by an even nastier terms of trade shock (falling oil prices) than New Zealand had faced.  Oh, and Norway has typically had lower policy interest rates than New Zealand (so perhaps less room for manoeuvre), and has a higher inflation target (2.5 per cent rather than 2 per cent).     Like New Zealand, they started raising policy rates again quite soon after the 2008/09 recession (and crisis conditions) ended, but they realized that wasn’t necessary and reversed themselves.  Unlike our Reserve Bank, they didn’t make same mistake twice.

Norway also saw its inflation rate fall away quite sharply in the aftermath of the recession.  Here is the suite of core inflation measures that the Norges Bank itself highlights –  recall that the target is 2.5 per cent inflation.

Inflation –  even core inflation – seems to be more variable in Norway than in New Zealand.  It was very low in 2011 and 2012, but has been trending back upwards for several years now.  When I wrote about Norway last in February, these core measures averaged 2.5 per cent.  Core inflation has increased further since then, now averaging 3.5 per cent (although the Norges Bank observes that they expect it to settle back nearer 2.5 per cent).

It isn’t as if Norway’s economy has been booming.  Indeed, Norway’s unemployment rate –  while still below New Zealand’s –  has risen quite markedly in the last few years.

No doubt there are lots of other detailed differences between the two countries’ experiences, but it seems to me that the biggest of them has been the New Zealand policy mistake –  promising to raise the OCR aggressively, then doing so, and only reluctantly reversing that mistake.   Here are two countries’ policy interest rates.

Here are the BIS index measures of the two countries’ exchange rates.

In Norway, the central bank doesn’t anguish about tradables inflation being negative for years and outside their control.  Here is the chart from a recent Norges Bank MPS that I reproduced in February.
And here are two-year ahead inflation expectations in the two countries –  the Reserve Bank survey for New Zealand, and a survey measure for Norway that I’ve taken from their MPS.

It looks a lot like a story in which

(a) the Reserve Bank of New Zealand badly misread (actual and prospective) inflation pressures,

(b) leading them to raise the OCR when they should have been holding or cutting it,

(c) which drove the exchange rate up (the juicy prospects of high and rising NZ yields)

(d) and drove tradables inflation more persistently negative than it should have been

(e) all while the Reserve Bank only very slowly realized its error, never explicitly acknowledged it, and only very reluctant reversed the rate hike cycle,

(f) all of which understandably dampened expectations of future inflation  quite a long way, while still suggesting to people looking at NZD assets that if there was ever yield to be found anywhere in the OECD the RB woiuld do its utmost to make sure that place was New Zealand.

As a result, the exchange rate (while quite variable) stays high, inflation stays low, and inflation expectations are at constant risk of falling further.  All because the Governor (and his advisers) got things wrong, and refuse to convincingly change tack.  As I noted yesterday –  and as several others have now pointed out –  the Governor was given an easy opportunity to affirm that he’d do whatever it takes to get inflation back to target.  For whatever reason, he simply passed up the opportunity. People, probably quite rationally, think he will in fact be very reluctant to do what is needed.

Frankly, if Norway can get inflation back to (and even beyond) target, so can we. It is mostly a matter of (a) reading inflation pressures roughly correctly, and (b) really wanting to.  The Governor –  and his advisers –  have failed on both counts.

It isn’t always true, but sadly over the last few years it wouldn’t be wildly wrong to suggest that New Zealand outcomes would have been better over the Wheeler years if the Governor and his senior team had simply taken a holiday, and done nothing at all to the OCR for four years.  We’d have avoided the badly misjudged tightening cycle, and although the OCR would still be a bit higher now –  it was 2.5 per cent when Wheeler took office –  inflation expectations would almost certainly be higher, and so real interest rates would, most likely, be no higher at all.  That would have had the incidental benefit of leaving New Zealand more headroom against the risk of hitting the near-zero lower bound at some point.

Perhaps spurred on by criticism in various quarters that the Governor doesn’t make himself available for searching interviews, he seems to have established a pattern of talking to the Herald after the release of the MPS.  The latest sets of questions and answers is here.  It is all pretty soft-soap stuff, with no follow-ups or challenges, allowing the Governor to get away without even answering the question (as here, where he –  in customary style – injects a variety of interesting but not very relevant detail, while not dealing with central issue.)

Rate cuts are supposed to bring the currency down, this didn’t. What’s happened?

Since the June statement we’ve seen the Bank of Japan ease, Bank of England ease, we’ve seen the Reserve Bank of Australia ease. If you combine that with quantitative easing that is larger than at any other time – and it was pretty large in 2009 – and with negative interest rates in countries that account for a quarter of world output, you’re just in a phenomenal situation.

There is no doubt the world is in a puzzling situation, but the Bank –  and the Governor –  are paid to do a competent job, not to end up sounding as if it is all too hard and is someone else’s fault.  I’m sure his markets staff had advised him that the probability of the exchange rate rising yesterday was quite high –  if they didn’t, they certainly weren’t doing their job.  The Governor simply made a choice –  he is a reluctant cutter, and that became clear once again yesterday.

It is a shame that the Herald, given the privileged access, didn’t ask a few more questions such as:

• Why didn’t you cut by 50 basis points, given that your own forecasts suggests further OCR cuts will be needed, and that on those forecasts it is still another two years until inflation gets back to target?
• Why are you so apparently indifferent to an unemployment rate that has now been above any NAIRU estimate for seven years?
• What plans and preparations are you putting in place to cope with the possibility that New Zealand finds itself exhausting the limits of conventional monetary policy?
• Inflation was below 2 per cent when you took office, has not been near 2 per cent since then, and on your own forecasts won’t be back to 2 per cent until a year after your term ends.  You and the Minister put the 2 per cent midpoint explicitly in the PTA.  How would you assess your performance in respect of the Bank’s primary responsibility, monetary policy?