Profits

A couple of weeks ago I wrote a post here, prompted by a paper by the former Bank of England Deputy Governor Sir Paul Tucker. Tucker’s paper was written in the context of the huge losses central banks in many countries, including his own UK, have run up through their large scale asset purchase programmes, especially those undertaken in 2020 and 2021 when bond yields (actual and implied forwards) were already incredibly low. While central banks continue to hold the bonds, the losses are seen every year now as the funding costs on those bond positions (the interest paid on the resulting settlement cash balances) swamp the low earnings yields on the bonds themselves. Bond positions purchased at yields perhaps around 1 per cent are financed with floating rate debt now paying (in New Zealand) 3.5 per cent (a rate generally expected to rise quite a bit further).

Tucker explored the idea that central banks might in future choose not to fully remunerate all settlement cash balances (while still applying the policy rate at the margin), and that if they did not then politicians might in future be reluctant to authorise future LSAPs and associated taxpayer indemnities (this seemed like a bonus to me, but Tucker is a bit more open to the potential of QE generally than I am (for New Zealand). With $60 billion or so of settlement cash injections still in the system (although with other offsets, total settlement cash balances are less than that), there is a lot of money potentially at stake.

My post was pretty sceptical of the idea – it seemed like arbitrary “taxation” by an entity with no mandate and little accountability – and in a Herald article at about the same time I was pleased to see several former colleagues also expressing considerable scepticism. In the wake of my post I had a bit of an email exchange with Tucker and while that didn’t change my mind it did help clarify the importance of reaching a view on whether the LSAP additions to settlement cash balances had resulted in something akin to a windfall boost to bank profits or not. Here is Tucker

Now, reaching a definitive view on a matter like this isn’t easy. Formalised models might even help, although I’m a bit sceptical even they could ever offer anything very definitive, and – in arbitrary taxation at least as much as criminal justice – we might reasonably expect something close to a “beyond reasonable doubt” test to be applied (especially when no one compelled the state to ever do LSAPs at all). You could think of a hypothetical world in which such a windfall might appear to rise – central banks buy the bonds from pension or hedge funds who simply deposit the proceeds with banks and happily (or resignedly) just accept zero interest on the resulting deposits – but it doesn’t seem very plausible. Perhaps there are other hypotheticals, but it still seems a stretch (and we aren’t in the world decades ago where, for example, banks were forbidden from paying interest on transactions balances).

I don’t have the resources or data for the sort of in-depth analysis that might be required if governments and central banks were to be seriously considering the Tucker option. But what do the high-level indicators we do have show? This, inevitably, bleeds into the recent (and annual or semi-annual) ritual in which the political left and the popular media bemoan the profitability of the banking system more generally.

The first increase in the OCR was in October 2021. Until then, settlement balances had been earning 0.25 per cent per annum, so that even if banks had somehow been paying nothing on the counterpart deposits, the amounts involved would have been too small to have shown up in the aggregate data (0.25 per cent per annum on $60 billion is about $150m per annum). But we have aggregate data now up to and including this year’s June quarter.

I’m including some long-term charts here (from the Reserve Bank website data, going as far back as their data go), as background to some comments on bank profitability too.

There is return on assets

return on equity

and the net interest margin (shown on the same chart as the average interest rate earned on interest-earning assets)

It is early days – the much higher OCRs for the September and December quarters may shed more light in some months’ time – but at present there isn’t anything much pointing to windfall earnings, whether directly from the Tucker effect or from the LSAP or other Covid interventions. Returns dipped during the 2020 deep (if brief) downturn, and then seem to have returned to about pre-Covid average levels. If the net interest margin has risen a bit, in the June quarter it was at about the average level for the previous 15 years.

On the other hand, supporters of the Tucker story could point to this chart. It is interesting that interest-bearing liabilities have dropped to a record (over this 30 year period anyway) low but (a) perhaps it is less surprising given that, at least to June, the absolute level of interest rates remained very low (and well below the prolonged period 20 years earlier when the interest-bearing share of total liabilities was also unusually low) and (b) as yet, there is no sign of this reflected in unusually high bank returns (see earlier charts).

Time will tell, but to this point there is no smoking gun, in New Zealand anyway. Tucker does note that (at least in the UK context) windfall returns could be paid away in management bonuses, so that they wouldn’t show up in after-tax profit figures, but (a) that seems more like a UK issues (big bonuses in the City etc) and (b) you would expect to see it showing up in bank disclosures (eg CEO salaries etc) and I’m not aware of any sign it (yet) has.

More generally, what to make of the bank profits story? On a cyclical basis there were reasons one might have expected the last year to have been the best for some time: the economy was extremely overheated, unemployment was extremely low, and although house prices have been falling more recently they only peaked in November last year, having risen to an extraordinary extent over the previous 15 months or so. Banks tend to make lots of money in circumstances like that (and, on the other hand, to do poorly in deep recessions). Perhaps reflecting the abnormal and uncertain state of the Covid world over 2021/22, in fact none of those charts above suggest anything exceptional about bank profitability (at times, really high reported bank profits can themselves be a worrying financial stability indicator – lots of poor quality loans with high upfront fees and/or dodgy accounting can produce very flattering short-term numbers, all while storing up big future losses. Cyclically, the year ahead looks a lot less favourable for banks (as the ANZ CEO noted they are now writing a tiny fraction of the number of new mortgages they were doing at peak) and a recession (with all the attendant reduction in demand for products, reduction in servicing capacity, and outright losses) is generally agreed to be looming.

What about overall average rates of return? When they left aren’t making cyclical complaints, this tends to be where they focus. And of course the return on equity is better than you are going to get on a bank deposit, but it is also a great deal riskier.

One obstacle to analysing the issue in a specifically New Zealand context is that hardly any New Zealand banks are listed on the stock exchange as such, so we don’t have a good read on the value the market puts on them. But the big-4 banks are the dominant players in Australia too, housing lending makes up almost two-thirds of credit in Australia, and Australia has similarly absurd house price to income ratios in its largest cities. Historically, rates of return have also looked quite high

(One might also add that in recent decades the New Zealand and Australian banking systems have been amongst the most stable anywhere).

Then again, the market seems less impressed with the Australian banks than the New Zealand political left are. Price to book value ratios don’t look particularly impressive – for long-established “licence to print money” entities – and of the four big Australian banking groups, in three cases the first time the current share price was reached was well over a decade ago.

We (and Australia) have big banks. When regulation renders house prices absurdly expensive, you need entities that will facilitate very large amounts of debt. Big banks require lots of capital, and on lots of capital lots of money can and should be made. But if the left is so convinced there is money for jam on offer there is a readily accessible market response: buy more shares with their own savings.

Instead, from the party that wants to make us all poorer, force people to live in expensive townhouses, and do all they can to discourage cars and planes (oh, and free speech too), yesterday we got a proposal that there should be an “excess profits tax”. The Green Party’s discussion document is here. I guess it is mostly just political spin to try to keep up the radical left vote, but it really was an astonishingly threadbare document.

For precedent, we are reminded on a couple of occasions that there were excess profits taxes in World Wars One and Two. And since we actually conscripting people – and ordering them into the military or directed service – and restricting all manner of other economic activity probably few people had much problem with that (the idea of “conscripting capital” was (understandably) big on the left in New Zealand. But while the left may like to claim we are now in some “moral equivalent of war”, in fact we are running a market economy in which firms and individuals are free to come and go, invest or not, as they choose. We are also told about windfall taxes on energy companies in Europe at present, but again these are rather more equivalent to an actual wartime situation (very high returns to lower cost renewables producers for example are arising out of the foreign policy choices of governments around the Russian/Ukraine situation).

But nothing in the Greens’ document establishes a serious case for New Zealand now (eg for better or worse we aren’t tied into the global LNG supply chain)

And then there are the basics. This appears early on.

I followed the footnote to be sure I was using the same sources. From the Annual Enterprise Survey

So you can see the $103.3 billion. But you might also note the sharp fall in this measure of profits the previous year (Covid disruption and all that), and the smaller fall the year prior to that. Actual profits before tax on this measure were about 5 per cent high in the 2021 years than in the 2018 years.

And nominal GDP? Well, it was up 17 per cent over roughly the same period (calendar 2021 over calendar 2018).

Then we get charts like this.

I have no idea where any of the lines comes from but note (a) the orange line, which claims to be taken from the AES, has a latest observation LOWER than the one a couple of years earlier, and (b) while the Greens claim that “the graph below demonstrates that profits are already exceeding prepandemic levels; and are several times higher in real terms than in the 1990s” they fail to point out that real GDP is a lot higher than it was in the 1990s too.

How do those ratios look? From the national accounts we have a breakdown between compensation of employees on the one hand and returns to business (including labour income for self-employed operations). Wage and profit shares have ebbed and flowed but nothing about the last few years looks very unusual.

The same data are now available on a quarterly basis, but only since 2016 (and inevitably the more recent observations are subject ot revisions). This time I’ve just shown the two series as cumulative growth rates since 2016

Labour costs and non-labour components of the income measure of GDP have risen over the full period by almost exactly the same percentage (seasonally adjusting through the Covid lockdowns is a real challenge so I wouldn’t pay much attention to those particular quarters).

We are left wondering where all these excess returns the Greens are on about really are. If they mean house prices rising in 2020 and 2021, well of course I can quite understand (and we know they like the idea of a capital gains tax) but……house prices are now falling quite a lot, and excess profits taxes aren’t usually aimed at Mum and Dad (indeed the rest of the document is all about th rapacious capitalists).

One could go on, but I won’t. The Greens seem keener on planning to spend the proceeds of their tax than provide firm analytical underpinnings to it, and of course while feeding the narrative that somehow there is money for jam being left on the table, there seemed to be no mention of countervailing reductions in business taxation if/when there is a deep recession or windfall losses (and in the nature of windfalls, losses are as likely as gains). But why would anyone really be surprised?

The document has this line: “The Green Party considers that record profits during a time of economic hardship for many New Zealanders are immoral and unsustainable”. Except that whether one uses their AES measure, or national accounts measures there isn’t anything very remarkable about profits in recent years – except of course that there is lots of inflation, but even then as that final chart shows returns to labour in total have been growing at about the same rate of returns to providers of other resources.

A bad idea

There is increasing attention being paid (among a certain class of nerdy central bank watcher) to the scale of the losses to the taxpayer central banks have run up as a result of their large-scale bond purchases (particularly those) over the time since Covid broke upon us in early 2020. In New Zealand, the best estimate of those losses was about $9.5 billion as at the end of September (to its credit, the Reserve Bank of New Zealand marks to market its bond holdings – and thus its claim on the Crown indemnity – something many other central banks don’t do).

A particularly interesting paper in that vein turned up a couple of days ago, published by the UK Institute for Fiscal Studies and written by (Sir) Paul Tucker, formerly Deputy Governor of the Bank of England and now a research fellow at Harvard. The 50+ page paper has the title Quantitative easing, monetary policy implementation and the public finances. (Public finances are quite the topic of the month in the UK, but although many of the numbers in the paper are very up to date, I suspect the paper itself was conceived before the fiscal/markets chaos of recent weeks.)

Tucker is particularly clear on what QE actually was: it was a large-scale asset swap in which the Crown (specifically its Bank of England branch) bought back from the private sector lots of long-term fixed rate government bonds, and in exchange issued in payment lots of (in our parlance) settlement cash balances held by banks and on which the (frequently reviewed) policy interest rate (here the OCR) is paid in full. When such an operation is undertaken, the entities undertaking the swap (and the taxpayer more generally) will lose money if policy rates rise by materially more than was expected/implicit when the swap was done. It is not a new insight – and I’ve been running the asset swap framing here since 2020 -but Tucker puts its very clearly, and in a context (UK) where the focus is less on the mark to market value of the bond position, and more on the annual cash flow implications (over time they are two ways – with different emphases – of putting much the same thing).

Tucker seems, at best, a bit ambivalent about the 2020 QE, illustrating nicely that whereas the early UK QE was done when actual and implied forward bond yields were still quite high, that was by no means the case by the start of 2020. But as he notes, that is water under the bridge now. Big bond purchases did happen, partly because few central banks have really got rid of the effective lower bound (although here he is too generous to many central banks, including the BoE, since few sought to reach the practical limits of negative rates (on current technologies) when they could have in 2020). But whether or not QE could have been avoided, given the macro outlook as it stood in March 2020, (whether by more reliance on fiscal policy or deeper policy rate cuts) it wasn’t. Central banks now have large bond positions, purchased at exceedingly low yields, being financed at increasingly high short-term rates.

In New Zealand, for example, total settlement cash balances have just been hitting new highs, in excess of $50 billion

Not all of this is on account of the LSAP (New Zealand’s QE). Weirdly, the Reserve Bank is still making concessional funding available to banks under the crisis Funding for Lending programme, but at least they are paying on the resulting settlement cash balances what they are earning from the loans. And fluctuations in government spending, revenue, and borrowing also affect the level of settlement cash balances.

But you can think of the approximately $50 billion of LSAP bond purchases (over 2020 and the first half of 2021) as having a counterpart in the level of settlement cash balances. On $50 billion of settlement cash, the Reserve Bank pays out interest at a current annual rate (OCR of 3.5 per cent) of $1750 million per annum. All the conventional bonds were bought at much much lower yields than that (unlike the Bank of England, our Reserve Bank did buy some inflation indexed bond, but they were less than 5 per cent of the total purchases.) This is a large net cost to the taxpayer.

The policy thrust of Tucker’s paper is to explore the idea of cutting those costs by changing policy and not paying interest on the bulk of settlement balances (or paying a materially below-market rate). Central banks did not always pay market rates on settlement cash balances, but it has become the practice over the last 20-25 years (in the Fed’s case being rushed in in late 2008 to hold up short-term market rates, consistent with the Fed funds target, when large scale bond purchases began). New Zealand followed a similar path.

Paying different rates on different components of settlement cash balances is quite viable. For some years until early 2020, for example, the Reserve Bank paid full market rates on balances it estimated each bank needed to hold (to facilitate interbank payments etc), while paying a below market rate on any excess balances (which were typically small or nil). The ECB and the Bank of Japan introduced negative policy interest rates some years ago, but protected the banks by paying an above-market rate on most of their settlement cash holdings, only applying the negative rate at the margin.

As a technical matter there would be no obstacle to the Bank of England (or the Reserve Bank of New Zealand) announcing that henceforth they would pay zero interest on 80 per cent of balances – some fixed dollar amount per bank – while only paying the policy rate (the OCR) on the remaining balances. Since the OCR would still apply at the margin, that part of the wholesale monetary policy transmission mechanism should continue to function (compete for additional deposits and you would still receive the OCR on any inflows to your settlement account). The amounts involved are not small: in the UK context (they did QE a lot earlier) Tucker talks of “the implied savings would be between 30 billion and 40 billion pounds over each of the next two financial years” – perhaps 1.5 per cent of GDP. In New Zealand, if we assume the OCR will be 4 per cent for the next couple of years, applying a zero interest rate to $40 billion of settlement cash would result in a saving of $1.6 billion a year (almost half a per cent of GDP). You could pay for quite a few election bribes with that sort of money.

It is an interesting idea but it seems to me one that should be dismissed pretty quickly, even in the more fiscally-challenged UK (where they already impose extra taxes on banks). It would be an arbitrary tax on banks, imposed on them because it could be (no vote in Parliament needed), by a central bank that would be doing so for essentially fiscal reasons (for which it has no mandate). Tucker rightly makes the point that central bankers should not seek to do their operations in ways that are costly to the taxpayer when there are cheaper (less financially risky) options available, but the time to have had those conversations was in March 2020 (preferably earlier, in crisis preparedness) not after you’ve taken a punt on a particular instrument and the punt has turned out badly (and costly).

It might be one thing to decide not to remunerate settlement cash balances, and thus “tax” banks, when those balances are tiny (for a long time we ran the New Zealand system on a total of $20 million – yes, million – of settlement balances) and quite another when those balances are at sky-high levels not because of any choices or fundamental demands by banks, but solely as a side-effect of a monetary policy operation chosen by the central bank (and in both countries indemnified by the Crown). Even central banks have no particular interest in there being high levels of settlement balances (it isn’t how they believe QE works); it is just a side effect of wanting to intervene at scale in the bond markets. But central banks have a choice, while the banking system as a whole does not (banks themselves can’t change the aggregate level of settlement cash, which is totally under the control of the central bank). The Tucker scheme – which to be fair, it isn’t entirely clear he would implement were he in charge – forces banks to hold huge amount of settlement cash, and then refuses to remunerate them on those balances.

To implement it would be a fairly significant breach of trust. Here, the Reserve Bank has kept on (daftly) offering Funding for Lending loans arguing that it needs to keep faith with some moral commitment it claims to have made, despite the crisis being long past. I don’t buy the “anything else would be a betrayal” line there – where in any case the amounts involved are small (this funding might be 25 basis points cheaper than they could get elsewhere) – but it would much more likely to be an issue if the Bank (or overseas peers) suddenly recanted on the practice of paying market interest on all or almost all settlement balances. $1.6 billion a year, even divided across half a dozen banks, would attract attention.

I’ve heard a couple of suggestions as to why an additional impost on banks might be fair. One was that QE may have helped set fire to the housing market, boost bank lending and bank profits, and thus an additional tax now might be equivalent to a windfall profits tax. I don’t buy either strand of that argument – I don’t think the LSAP made that much difference, but if it did it was supposed to do so (transmission mechanism working) – but even if I did in 2020, we are now seeing the reverse side of that process: house prices are falling, housing turnover is falling, new loan demand is falling, and there will be loan losses to come. Most probably any effects will end up washing out.

The second was the bond market trading profits the banks may have made in and around the LSAP. Perhaps there were some additional gains, but it is hard to believe they were either large or systematic (and won’t have come close to $1.6 billion per annum).

And the third was the Funding for Lending programme. No one can pretend that was not concessional finance for banks (were it otherwise banks would not have used the facility at scale), but the amounts involved don’t compare: $15 billion of FfL loans might have a concessional element over three years of $100m or so, not really defensible, but not $1.6 billion per annum either.

The taxpayer is poorer as a result of the LSAP and how market rates turned out (as Tucker rightly notes, it needn’t have turned out that way, although by 2020 the odds were against them – and as I’ve pointed out often there is no sign in NZ at least that a proper ex ante risk analysis was done). Those costs have to be paid for and will mean, all else equal, that taxes are higher over time. But conventional fiscal practice is not to pick on one sector and put the entire additional tax burden on them (“broad base, low rate” tends to be the New Zealand mantra). And that is so even if some in the New Zealand political space – sometimes including the Governor – seem to have a thing about (evil and rapacious) “Australian banks”.

Tucker devotes some space to the question of how banks would react (other than heavy lobbying on both sides of the Tasman and fresh pressure for the Governor to be ousted). Even if short-term wholesale rates – the policy lever – aren’t likely to be changed, banks are unlikely to just sit back and take the hit: they may not be able to recoup all or even most of it, but it isn’t hard to envisage higher fees, higher lending margins, tighter credit conditions across the board, including as boards become more wary about New Zealand exposures. Non-bank lenders – who hold no settlement balances – would be at a fresh competitive advantage (akin to what we saw with financial repression of banks decades ago)

But unfortunate as it would be if a change of this sort of made now – essentially an ex post tax grab so focused it would come close to being a bill of attainder – I might almost be more worried about the future. One might have hoped that the episode of the last couple of years would have made central banks more cautious about using large-scale bond buying instruments (and finance ministries more cautious about underwriting them), with a fresh focus on removing the effective lower bound on nominal interest rates (or if they won’t do that then looking again at the level of the inflation target). But knowing that big bond purchases could be done freely, with the taxpayer capturing all of any financial upside, and banks (and customers) wearing all/most of any downside, skews the playing field dramatically (and also further reduces the financial incentive on governments to keep inflation down – since the real fiscal savings on offer rise the higher nominal interest rates are. And what of banks? If there really is a place for future QE – I’m sceptical but I’m probably a minority – up to now banks have had no really significant financial stake one way or the other, but adopt the Tucker scheme once and banks will know it could be used on them again, and they will become staunch opponents (in public and in private) of any future large scale bond buying operations for purely their own financial reasons. And that is no way to make sensible policy.

Tucker has produced a 50 page paper which will repay reading (for a select class of geeky reader – although it is pretty clearly expressed). Since it is 50 pages there is plenty there I couldn’t engage with in depth in this post, but in the end my bottom line was initially “count me unpersuaded”, and then the more I thought about it the more I hoped that no one here would seriously consider the option (ideally not in the UK other). Far better to accept that losses have been made, that those costs will have to be paid for by taxpayers’ generally, and to redouble the efforts to ensure that in future crises there is less felt need for central banks to engage in such risky operations. Central banking, well done, really should involve neither large risk nor large cost to the taxpayer, and there are credible alternatives, even if neutral real interest rates stay very low (as Sir Paul assumes, and as still seems most likely to me).

UPDATE: Thanks to the reader whose query made me realise that in my haste to produce some stylised numbers, I forgot that the LSAP bonds had been purchased at price well above face value. The actual settlement cash influence from all LSAP purchases (central and local government bonds) was $63.9 billion. The rest of the analysis is unchanged, but the numbers (floating rate financing cost) are larger.

Orr defending the LSAP

The Governor of the Reserve Bank must have been feeling under a bit of pressure recently about the LSAP programme. Losses have mounted and some more questions have started to be asked – by more than just annoying former staff – about value for money.

And thus on Thursday morning “Monetary Policy Tools and the RBNZ Balance Sheet” dropped into inboxes. It was an 10 page note setting out to defend the Bank and the MPC over the bond-buying LSAP programme and the inaptly-named Funding for Lending programme, the crisis facility under which the Bank is still – amid an overheated economy and very high core inflation – lending new money to banks.

Of course, the Monetary Policy Statement had been out the previous day. Had the Governor been serious about scrutiny and engagement, he’d have released his note a day or two before the MPS (or even simultaneous to the MPS). Then journalists could have read the paper and asked questions about it in the openly-viewed press conference. The Bank’s choice not to do so revealed their preferences. Oh, and then the note was released less than an hour before the Finance and Expenditure Committee’s hearing on the MPS, and since FEC no doubt had other things to consider it is unlikely any of the members had read the note before the hearing. That too must have been a conscious choice by the Bank (one that didn’t go down well with the Opposition members).

I noted earlier that the paper was 10 pages long, but there wasn’t a lot of substance. We still have nothing but the Bank’s assertions for their claims that the LSAP programme was worthwhile, and while we are told that they hope to provide some more analysis in a review document at the end of the year, attempting to kick for touch for another four months frankly really isn’t good enough. And, of course, we’ve heard nothing at all from the three non-executive MPC members who share responsibility for the programme. As it is, the 10 page note does not even provide a serious attempt at a rigorous framework for evaluating costs, benefits, and risks – there is more handwaving, and attempts to blur any analysis, than serious reasoning.

There are two separable strands. I am going to focus on the LSAP rather than the Funding for Lending programme (FLP), but it is worth making a few points on the latter:

  • the Bank claims that the FLP was necessary because banks were not yet operationally capable of managing a negative OCR, but the FLP was only finally launched in December 2020, and the Bank has separately told us that by that time banks’ system were in fact capable of coping with a negative OCR.   Sure, the FLP had been foreshadowed over the previous few months and probably had some impact on retail rates then, but then the possibility of a negative OCR had also been foreshadowed,
  • the FLP was misnamed from the start (creating of lot of unnecessary controversy at the time about housing finance), with the name feeding an entirely fallacious mentality that shortages of settlement cash were somehow a constraint on bank lending.  I am pleased to see that in this document the Bank (now that it suits) explicitly states “there is little evidence that higher settlement cash balances resulting from these programmes have directly impacted bank lending”.  Paying the full OCR on all settlement cash balances – a Covid novelty that continues – will also have that effect.
  • it remains extraordinary that the Bank is still undertaking new lending under the FLP until the end of this year.  It was a crisis programme, launched belatedly when crisis conditions had all but passed anyway, and there has been no clear justification for continuing new loans for at least the last year (recall the Bank wanted to raise the OCR last August).   Arguments about predictable funding streams just fall flat, when the entire economic and financial climate was so uncertain, and when banks like everyone else recognise that circumstances have moved on from where they were two years ago.  The Bank’s claim –  that somehow banks would not future bank commitments seriously if they terminated early – deserve little more than to be scoffed at.  And although the Bank will tend to play this down, we can tell that the FLP is relatively cheap funding –  if it were not, banks would not still be tapping the facility.  Similarly, arguing (as they do) that the OCR can offset the FLP is to concede the point: increases in the OCR should be leaning against real inflation pressures, not counteracting other lingering stimulatory crisis interventions.

But enough of the FLP, daft as it is still to be running it, the costs and risks are fairly small.

Not so the LSAP, where costs and risks are demonstrably high (now conceded by the Bank) while the alleged benefits are hard to pin down (not helped by the Bank making no serious public effort so far), and the water is being deliberately muddied by the Governor’s bluster and absence of careful delineation of the issues and arguments.

On financial costs, this from the Bank’s document is clear and straightforward (and I would hope might finally silence those who keep trying to claim they aren’t “real” costs, are all “within the Crown” or whatever).  The Bank is clear that the financial losses themselves are real.

The best estimate of the net cost of LSAP is measured by the value of the Crown’s indemnity – unrealised losses based on current market valuation, reflecting a higher OCR – and losses realised by RBNZ upon the sale of the Bonds.  

As to quantum, the claim under the indemnity fluctuates each day, and some of the Bank’s claim has now been paid by Treasury, but the Bank’s Assistant Governor was happy at FEC to use a ballpark $8bn figure. $8bn is roughly $1600 per man, woman, and child in New Zealand.

In the rest of this post, I am drawing on three sources of Bank comment: the 10 page document itself, the Bank’s appearance at FEC on Thursday (comments from Orr, Silk, and Conway, the chief economist), and the Governor’s full interview with the Herald (linked to in this article). Orr has made stronger claims orally than what is in the formal document, asserting twice that the wider economic gains of the LSAP programme were “some multiple” of the financial losses, following up to add that in his view it wasn’t even close. “Some multiple” must mean at least two, so at minimum the Governor is asserting (and recall there is no evidence advanced and not much argument) that the LSAP resulted in real economic gains of at least $16bn. At minimum, he is claiming a benefit of about 5 per cent of GDP at the time the LSAP was first launched. These are really huge claims, and you’d think he’d have at least some disciplined framework to demonstrate their plausibility (even just as ballpark estimates).

Instead, we are offering not much more than handwaving, and lines that at best veer close to outright dishonesty.

There seem to be three broad strands to whatever case Orr is trying to make:

  • there is the “least regrets” rhetoric,
  • there is talk (especially in the Herald interview) of the gains from bond market stabilisation back in March 2020, and
  • there is lots of talk (even the chief economist went down this line at FEC) about how much stronger than forecast the economy has been than was being forecast in 2020.

As Orr now tells it, “least regrets” meant the Bank would run monetary policy in such a way that it would prefer to see a grossly overheated high inflation situation (actual outcome) than a deep depression and entrenched deflation. Perhaps many people might share that preference if it was the only choice. But it wasn’t, and we’d be better off sacking and replacing all involved if they really want us to believe it was. Go back to 2020 and then when they were first talking about “least regrets” it was the much more reasonable framing (eg here) that, at the margin, and given that inflation had undershot the target for 10 years, they might be content with (core) inflation being a little above the target midpoint for a while rather than jump on things too early and risk keeping the unemployment rate higher than necessary for longer than necessary. Not everyone would necessarily have agreed with them on that, but it would have commanded pretty widespread assent (I wasn’t unhappy myself)….and in any case was entirely hypothetical at the time since, as I’ve documented in recent posts, actual inflation forecasts (Bank and private) were well below the target midpoint even as the Bank added no more stimulus beyond that (from OCR, LSAP, FLP or whatever) already embedded in the economic and inflation forecasts. So don’t be fooled by Orr rhetoric suggesting we should smile benignly on their handling of things because “the alternative was some Armageddon”. We pay him and his offsiders a lot of money to help ensure that those aren’t the choices.

Back when the LSAP programme was first announced – 23 March 2020 – there was a twin (related) motivation: generally to ease monetary conditions, and specifically to underpin the functioning of the government bond market. Global government bond markets were then in a mess, reflecting primarily US-sourced extreme illiquidity and flight to cash (at the time stock markets had been falling very sharply too). For those interested, here are a couple of links to what was going on at the time (here and here). Government bond rates were rising (even as policy rates had been cut): the disruption was real enough and it was getting very difficult to place paper. I’ve even gone on record here in the past stating that, even allowing for the moral hazard risks, I had no particular objection to some stabilising interventions, especially in the Covid context.

But here is a chart of US and NZ 10 year government bond rates for the month of March 2020 (with the US rates lagged a day to line with the NZ ones – changes in NZ bond rates in the morning are usually mostly a reflection of what has happened in the US overnight (the previous day for them).

You can see yields rising in that third week of the month even though both central banks had cut policy rates sharply that week (and the Fed had announced restarting of bond purchases). The NZ market is less liquid at the best of times than the US one. But yields in both countries peaked on 19 March (NZ).

As did the gap between New Zealand and US rates. Days before the Reserve Bank did anything or even announced their own LSAP (although they had foreshadowed that one might be coming).

And if the Reserve Bank announced its LSAP on 23 March, on the same day (but remember the time difference) the Fed greatly expanded its own bond-buying programme. Almost immediately New Zealand long-term bond yields were back down to around 1 per cent.

Simple charts of yields – of the most liquid part of each market – don’t directly get to the illiquidity in other markets, but all indications are that the worst (globally) was already over by the time the Reserve Bank made its announcement, and given the US-sourced nature of the shock, it seems far more likely that the US actions were the more decisive policy contribution to stabilising markets. I don’t want to begrudge the Bank its small part in domestic market stabilisation (and they had some other interventions, including thru the fxs swaps market – but remember it is the LSAP they are defending), but even if we run through to 10 April, total bond purchases by the RBNZ to that point was only $3.6bn. Sure, a willingness to go on intervening offered a bit of cheap insurance to market participants, but if Orr wants to make much of what those earlier operations contributed (and it really can’t be much, given lockdowns, extreme economic and policy uncertainty etc) it relates to less than a 10th of the risk the Bank eventually exposed the taxpayer to through the LSAP.

(And if you want to note that over the month New Zealand bond yields did not fall as much as those in the US, recall that at the start of much US policy rates had much more room to fall than NZ ones did – and expectations of future short rates are the main medium-term influence on bond yields).

The third broad strand of Orr’s defence now appears to rest on how unexpectedly strong the economy (and inflation) proved to be.

From the 10 page report

His new chief economist tried the same line at FEC, with less nuance, and Orr himself when asked by Nicola Willis what evidence there was of the net benefits of the LSAP responded succinctly “the economy we live in today”.

It really is borderline dishonest. After all, all those dismal 2020 sets of forecasts – the Bank’s, the Treasury’s, and the myriad private sector ones – all included the effects of the policy stimulus (including the LSAP), and views on the path of the virus itself, so the resulting massive forecast error (for which I am not particularly blaming anyone) logically cannot be proof – or even evidence – of the effectiveness of a single strand of monetary policy (LSAP), or even of macro policy taken together. Since Orr and Conway are smart people, and know this point very well, it must be a deliberate choice to continue to muddy the waters as they do. They never even address the probability – high likelihood in my view – that most economists simply got wrong the extent of the adverse demand shock. At very least any serious analysis would have to unpick the various elements.

Instead, in none of their written material, or the comments of Orr and his offsiders, has there been any attempt (even conceptually) to think about the marginal effects of the LSAP programme itself. It was a discretionary (and last minute) addition to the toolkit. And even if we granted them a free pass for the first $3.6 billion or so of purchases (see above) all the rest was their choice. We know the financial costs (that $8bn or so of losses) but the alleged huge gains (Orr’s “multiples”) are unidentified – no effort has even been made. As just one small example, when the Herald’s journalist asked Orr whether, for example, they could have done less LSAP and instead cut the OCR to zero (which as even the Bank notes has no material market risk), Orr simply avoided answering the question.

I’ve run through previously the various reasons to be sceptical that the LSAP had much useful macro effect (those vaunted $16bn of gains Orr would need to show). In particular, even if the impact on longer-term bond rates was as large as Orr has claimed (again numbers that have never been documented), it isn’t at all obvious how that would have translated to large useful macro gains. It is commonly understood that the most important element in the interest rate bit of the New Zealand transmission mechanism is the short-end. Short rates (1-2 year bond rates) shape most retail lending rates, and are themselves largely influenced by expectations of the future OCR. Had the Bank been interested, say, in managing down a 3 year bond rate – as the RBA was – it could have done that directly, at very little financial risk. But instead they focused their bond buying at the longer end of the yield curve. Government borrowing costs may have been a bit less than otherwise as a result, but monetary policy isn’t supposed to be about getting cheap finance for the government but about macro stabilisation. Few private borrowers take borrowing at long-term fixed rates.

The Bank also claims that the exchange rate may have been lower than otherwise as a result of the LSAP. Perhaps, but (a) it depends on the counterfactual (they could have lowered that OCR further instead but chose not to) and (b) in most models the real economic effects of exchange rate moves take quite a long time to be felt, and even the Reserve Bank argues (contrary to quite a lot of literature) that the impact of the LSAP was decaying over time.

And it is worth pointing out that, as their document notes, they used the LSAP because of issues around operational readiness of banks for negative OCRs, but whose responsibility over the previous decade had it been to have ensured that banks were operationally ready? The taxpayer was exposed to the massive financial risk from the LSAP – without, it appears, any robust prior risk analysis – because of the Bank’s own failures. Just maybe there were some macro gains, but in a better world we’d have got those without the huge financial risk (and $8bn of losses). (A former colleague noted to me the other day that if we’d wanted to throw around an extra $8bn we’d almost certainly have gotten more macro bang for the buck by just giving $1600 to every man, woman and child and setting them free to spend – probably would have seemed a bit more equitable too.)

Oh, and did I add that if the last big macro policy tool deployed – the LSAP – was really as potent as the Governor seems to claim, then given how overheated the economy has been and the fresh ravages of high core inflation, it might have been much better (and lower risk) if the keys to the ill-prepared drawer marked LSAP had never been found and the instrument left untouched. We pay central bankers to do (materially) less badly than this, even (especially?) in difficult and uncertain times.

Bottom line: there has so far been no serious attempt by the Reserve Bank to frame an analysis that looks at the marginal impact of the LSAP programme, whether numerically or conceptually. Until there is, everything else they utter on the subject is really just defensive bluster. The public deserves better from senior officials of such a powerful institution. But as so often with the Bank, the question again arises as to why those paid to hold the Governor and MPC to account seem utterly uninterested in doing so.