Something of a mixed bag

The Monetary Policy Statement was released this morning, followed by the Governor’s press conference.  It was less entertaining than I’d feared, and he mostly stayed on mandate – albeit drifting off onto answering several questions about bank conduct (with no real attempt to tie his rhetoric to the Bank’s statutory responsibilities) rather than monetary policy.  Then again, the journalists seemed to give him a fairly easy time.  I’ll come back to some of the comments and questions a bit later.

I heartily commend the Bank on one thing.  This is from the first paragraph of the MPS

The direction of our next move is equally balanced, up or down. Only time and events will tell.

That puts them in a quite different place than the financial markets as a whole, or than respondents to the Bank’s survey of expectations, where almost everyone is convinced the next OCR change will be an increase.  After my post yesterday on the Survey of Expectations, the Bank sent out to respondents their slightly more detailed report.   That showed that none of the 41 respondents expected the OCR a year from now to be lower than it is today (I do, but although I printed off a copy of my answers, I seem to have omitted to submit them).    Sure, each individual respondent will have a probability distribution around their own responses, but it is a telling contrast to the Bank that not one has a central expectation of a lower rate.  Presumably the Governor’s willingness to be so upfront about this even distribution of risks over the next year or two (albeit not substantively that different from the line the Bank has taken previously) will have contributed to the fall in the exchange rate this morning.

That said, I’d issue the same caution as I’ve made previously. The Governor claimed, in his very first line that

The Official Cash Rate (OCR) will remain at 1.75 percent for some time to come.

“Will” is a very strong statement in a very uncertain situation (domestically and globally).  Wise central bankers don’t hold themselves out as knowing more than they do.  The Governor’s hunch at present might be that the OCR won’t change for a while, but he doesn’t (and can’t) know that much, and bald statements of this sort risk leaving the Bank more unwilling to move quickly (up or down) than might prove warranted.  The contrast with the modest tone of current RBA statements is striking.

We also had an outburst of transparency. The Governor told us that the decision to hold the OCR had had the unanimous support of his Governing Committee colleagues, and his internal Monetary Policy Committee staff advisers.    It is nice of him to tell us.  Graeme Wheeler did that once, apparently to buttress the case for the move he was then making, but then adamantly refused to release the same information about other (historical) decisions –  I discovered recently that the Ombudsman is still working his way towards a decision on my request that he review Wheeler’s decision.  Perhaps the new Governor could change courses and make this information routinely available, with a suitable (but modest lag).   Disclosure of information can’t threaten the national economic interest –  Wheeler’s assertion –  just when it happens not to suit the Governor for it to be released.

There was plenty of gush about the economy.  This line took me a bit by surprise

The recent growth in demand has been delivered by an unprecedented increase in employment.

But this is the chart of the HLFS employment (corrected for the series break in 2016).


Perhaps he just meant “unprecedented” since the last growth phase?

And amid all the talk about employment –  and the welcome (overdue) focus on labour market indicators –  the word “productivity”, and the near-complete lack of any growth it over recent years, appeared not once in the text of the entire document.  Nor in the Governor’s discussion of what he saw as puzzlingly low wage inflation.

In the course of the press conference, the Governor talked about his goal being to communicate better and more widely –  not just to “four bank economists” –   and about how the Bank would have to learn to communicate in plain English.  It is a laudable goal I guess, but it did sound a lot like the lines Graeme Wheeler was using only a few years ago.  Wheeler avoided one on ones with journalists of course (at least ones that might ask awkward questions), which Orr does not seem likely to do, at least in his early stages.  But Wheeler also made much of the number of speeches he and his staff were doing up and down the country in his early years.  Communication seems easy when you are starting out, and aren’t on the back foot.

I mentioned earlier that the Governor mostly stayed on mandate in the press conference.  There were a couple of small exceptions.  The first was when he was asked about what the obstacles were in the housing market, and his first clear simple response was “lack of affordable land”.   Graeme Wheeler was simply never that clear, and it was never clear if he actually appreciated the importance of the land issue and the associated regulatory failures.  Housing policy isn’t a matter for the Bank, but it is encouraging that the new Governor appears to recognise, at an analytical level, the core failure.   The other exception, which seemed to pass unnoticed (or not followed up anyway) was when the Governor suggested that with interest rates at current levels the government should be doing more investment spending.  Those aren’t calls for the central bank, on an issue where there will considerable partisan division of views.

Two aspects of the monetary policy responses puzzled and disconcerted me.

Bernard Hickey asked the Governor what he thought of the argument that central banks should be raising inflation now, so as to raise nominal interest rates, to provide more policy leeway in the next serious recession.   Orr’s rather glib response was that “I don’t think much of it at all”, suggesting that (a) central banks should just do what is right now, and (b) that there are other tools, methods and instruments.   Which is fine except that core inflation – even in New Zealand –  has been well below target for years so that, at least with hindsight, the central bank hasn’t been doing the right thing now.  Partly as a result market measures of inflation expectations are well below target.  And there is no other country where supplementary instruments (eg QE) have been so demonstrably successful that core inflation has quickly got back to target, even in a gradual recovery phase.   The Governor needs to get to grips with preparing more seriously for the next recession.  It will be along, perhaps before too long.

Perhaps even more startling, was his response when asked a question in which it was noted that Graeme Wheeler had failed to hit the inflation target midpoint, and Orr was asked whether he would be happy to be judged on his performance against that metric.  That seemed to set the Governor off in defence of his predecessors, claiming that the economy was in near-ideal cyclical sweet spot, and that he could not imagine a better place to start from as Governor.  A bit later he chipped in that he thought the Bank had been doing a ‘remarkable” job in forecasting core inflation –  a variable that hasn’t been anywhere near the explicit 2 per cent target since that target was put in place by Bill English almost six years ago.  I wouldn’t have expected him to criticise his predecessors explicitly –  although he more or less did so when discussing communications approaches –  but surely we should have hoped that the new Governor might have regretted that inflation had so persistently undershot, and committed to do everything in his power to avoid a repeat?   His failure to do so is a little disconcerting to say the least.    Even with a focus on employment/unemployment, the Governor’s own charts suggest that the labour market was allowed to run with quite unnecessary excess capacity for several years because the Bank misjudged the extent of inflation pressures.

Once again, we have a set of Bank projections that suggest things are just about to come right.  Productivity, for example, is just about to pick up, and so is inflation.  The Bank thinks that in two years time we will be almost back to 2 per cent inflation.  The problem, of course, is that the Bank has been running the same line for years now, and it just hasn’t happened.  Partly perhaps because he embraced the record of his predecessors, the new Governor gave us no reason to be confident that this time things really will be different.  That is quite a gap.

I see that ASB, continuing the plays on the Governor’s name, deems it an “Orrsome start”.  I wouldn’t call it an “Orrful start”, but if there are some encouraging aspects, there is plenty of room for improvement.  The Governor  –  being fluent –  seems to be prone to speaking a bit more quickly than he thinks.  Over time, that won’t necessarily serve him, or the Bank, that well.     But the absence of solid answers about why this time inflation really will get back to target –  in an economy that seems unlikely to grow even as fast as (the modest rates) managed over the last few years –  remains the most obvious gap.  Perhaps MPs could consider asking the Governor this afternoon about why we should believe him and his colleagues this time?

A sadly diminished central bank

Under the Reserve Bank Act as it stands at present, before a Governor is formally appointed the Minister of Finance is required to reach agreement on a Policy Targets Agreement (on monetary policy) with that person.  It is a strange system –  again one no other country has chosen to follow in law.  A Governor-designate may, for example, not know a great deal about monetary policy before taking up the job.  And it also appears to give a great deal of policy-setting power to an unelected official, treating the Governor-designate as almost an equal with the elected Minister of Finance.   Since the Governor-designate will generally be ambitious for the role –  and as even potential Governors give some deference to, for example, electoral mandates – in fact the Minister of Finance has the greater say.

The system is shortly to be replaced.  Here is what the Minister of Finance had to say in his announcement on the Reserve Bank reforms in late March.

Currently, the PTA is an agreement between the Minister of Finance and the Governor. Looking forward, as the MPC will be collectively responsible for making monetary policy decisions, it would be inappropriate for the Governor to be the sole member of the MPC to agree the operational objectives for monetary policy. As a result, we are changing to a model where the Minister of Finance sets the operational objectives for monetary policy. These objectives will be set after nonbinding advice from the Reserve Bank and the Treasury (as the Minister’s advisor) is released publicly.

The approach the Government has agreed to for the setting of operational objectives going forward was recommended by the Independent Expert Advisory Panel. This approach imposes discipline on the decisions of the Minister, given the fact that the Minister’s decision will need to take account of publicly disclosed advice from the Reserve Bank and the Treasury. Further accountability measures, such as requiring the Minister to justify decisions before the House, will be considered in the detailed design of this policy proposal.

It is also intended that the setting of monetary policy objectives going forward will involve greater transparency and public input. Decisions on monetary policy objectives are important, and therefore public debate and understanding should be required.

There are still a few unanswered questions, details to be fleshed out, but that looks a largely sensible approach.  I especially welcome the emphasis on

a) the routine pro-active disclosure of official (Treasury and Reserve Bank) advice on the setting of the operational objectives for monetary policy, and

(b) greater ex ante transparency, public input, and public debate.   Setting the operational objectives for monetary policy is the key bit of policy around macroeconomic stabilisation, and is far too important to be done secretly by the Minister and a few internal advisers.  In almost other area of multi-year policy, proposed frameworks would be open for much more public consultation, scrutiny and debate.  I’ve written previously about the much more open approach adopted to the five-yearly refresh of monetary policy targets in Canada.

So, well done Minister.

But despite the admirable promises about the future, in the most recent PTA (that signed with Adrian Orr in late March, a day before he took office), the process seems to have borne no resemblance to what the Minister promises for the future.

There was no public consultation (indeed, the Treasury papers that have been released talk of some consultation with some market economists in 2016 –  under a different government with a different view on monetary policy and the Reserve Bank).

The Treasury advice to the Minister has been pro-actively released (I wrote about it here), but it was disturbingly thin in key areas (issues around the effective lower bound for nominal interest rates, and the next recession).

And what of the Reserve Bank?  One might expect that the Reserve Bank itself would have the greatest concentration of official expertise on monetary policy and related issues –  not just drafting issues, but the key economic issues, including some of those monetary management issues that are just over the horizon).  One certainly wouldn’t want only Reserve Bank perspectives taken into account –  after all, one key part of the PTA involves the Minister, acting in the public interest, disciplining and holding to account the Reserve Bank –  but it would be astonishing if they didn’t have useful perspectives to add.   Perspectives that really should be seen by both the Minister of Finance and by the Governor-designate.  The Minister’s statement about future arrangements would suggest that, at least in principle, he’d agree.

When the Policy Targets Agreement was released I noted that I had lodged an Official Information Act request for the Reserve Bank’s analysis and advice on PTA issues, but that I didn’t really expect much, because I expected to be obstructed and delayed.

There was a bit of delay, in that the Bank took almost the full 20 working days to respond when –  as will shortly be clear –  they could have (and by law should have) responded almost immediately.

This was what I asked for

Copies of any papers relating to the new Policy Targets Agreement signed earlier this week.  I am interested in any advice to the Minister or his office, and any advice provided to the then Governor-designate, as well as any substantive internal advice or analysis papers prepared or obtained in the period since the current government was formed.

and this was the response

The Reserve Bank didn’t provide advice about the Policy Targets Agreement (PTA) to Adrian Orr prior to his start as Governor, and advice to the Minister of Finance was provided by the Treasury rather than the Reserve Bank.

That is a categorical statement: no advice (written or oral) to the Minister of Finance, and no advice (written or oral) to the Governor-designate.

In a follow-up email exchange, I also clarified with them that there were no “substantive internal advice or analysis papers prepared or obtained in the period since the current government was formed” either.

And there was also nothing of this sort in the Briefing for the Incoming Minister released late last year either.

It is almost literally incredible –  ie impossible to believe.  Public servants of my acquaintance have suggested that the Bank might just be lying, but I don’t believe that.  Or perhaps I crafted my request too narrowly?  Perhaps they had done substantive analytical pieces before the election rather than after it, but given the differences in emphasis between the two main parties it doesn’t seem likely that one would really be a substitute for the other.  And they probably will have provided comments to Treasury on drafts of its advice to the Minister, but nothing in that advice is a distinctively Reserve Bank contribution.

It seems rather a sad commentary on what the organisation seems to have become over recent years.  There has been much talk about collective monetary policy decisionmaking –  and ministerial commitments to legislate –  and yet the new Governor apparently neither sought nor received any advice from his (new) senior colleagues on the drafting of the Policy Targets Agreement, the key macroeconomic stabilisation policy document.  The Reserve Bank has substantial experience with the conduct of monetary policy here,  substantial exposure to what is done in other countries, and a significant research capability funded by taxpayers (presumably, at least in part, to shed light on such issues).   The Minister of Finance says he wants future PTAs (or their equivalent) to benefit from (published) advice from both the Reserve Bank and the Treasury, and yet he sought –  or at least received –  none this time from the Reserve Bank.  And yet the Bank itself, if its OIA response is to be believed, had done no substantive analysis or internal advice on PTA issues in the months between the government  – with, for example, its new emphasis on employment – taking office and the signing of a new PTA.

It seems like some sad mix of abdication of responsibility, and the sidelining of the institution that is supposed to be centre of official professional expertise in the area.

It is a far cry from, for example, the approach taken fifteen years earlier.  In April 2002 Don Brash resigned as Governor, and Rod Carr was appointed to act, holding the fort until a new permanent appointment could be made.  That process in turn spanned a general election.  At the time, Reserve Bank senior management took the view that it would prudent and useful for us to invest quite heavily in preparing background papers which could assist the Minister of Finance, The Treasury, the Board, and whoever was being considered for appointment as Governor to (a) get to grips with the issue, and (b) see where our reading of the evidence and arguments had led us to.  The resulting 100 page document is here.    And that wasn’t the limit of our involvement.  We provided advice to Alan Bollard (before he took office) for his discussions with the Minister of Finance, and participated directly in at least one (I say “at least” because I attended one  myself) of his meetings with the Minister on detailed issues around the negotiation of the Policy Targets Agreement.   It wasn’t a climate in which Reserve Bank staff and management perspectives were necessarily overly welcome –  the Bank was to some extent seen as almost an ideological “enemy” (see, as one cause, Don Brash’s 2001 speech I wrote about recently) and there was a great deal of opposition in the Beehive to the idea of anyone internal getting the job as Governor.     But it didn’t stop the Bank preparing and supplying what was (to my mind) reasonably good quality analysis and advice.

As I’ve said previously, the Reserve Bank certainly shouldn’t have a monopoly on advice/analysis in this area –  and much of its analysis on various issues in recent years has been less good than it should –  but the apparent complete lack of any serious analysis or advice to the Minister or the Governor-designate reflects pretty poorly on all involved –  Minister, “acting Governor”, Governor-designate.   It tells of a sadly diminished central bank.

Designing monetary policy committees, revisited

(This post is likely to interest only those with a relatively detailed interest in the reform of the Reserve Bank.)

A month or so ago the Minister of Finance announced the outline of his planned legislative reforms of the monetary policy provisions (objectives and decisionmaking) of the Reserve Bank of New Zealand Act.  According to the material released then

What are the next steps for progressing the outcomes of Phase 1 of the Review?
Officials will advise the Minister of Finance on detailed implementation issues associated with the high-level Phase 1 decisions by late May.

so presumably Treasury is beavering away at present, with the Reserve Bank chipping in to try to retain as much effective control with the Governor and his management team as possible.  Unless, that is, the new Governor is taking a quite different –  and more open and legitimacy-focused –  approach than the Deputy and Assistant Governor he inherited from Graeme Wheeler.   Legitimacy is a key focus in a major new book (Unelected Poweron the institutional design of central banks –  and other autonomous government policy/regulatory agencies – published a week or so ago, and written by Paul Tucker former Deputy Governor of the Bank of England.

I’ve written various posts on aspects of the detailed design issues.  And in a post last week, I dealt with a recent conference presentation on these and related issues by two former central bank officials, one of whom was David Archer, former Assistant Governor (and successively head of financial markets and head of economics) of the Reserve Bank, and now head of the department for central bank studies at the Bank for International Settlements (a “club” for central banks).

I’ve been learning from –  and often disagreeing with – David for almost 35 years now, since he was briefly my boss in my first year out of university, when I was tossed a paper he was writing on reforming the operational aspects of monetary policy and asked for my comments.  He was my boss in a couple of other stints, and then for most of his last few years at the Reserve Bank, he was head of economics and I was head of financial markets.  Frustrating as he could sometimes be –  and I’m sure the sentiment was reciprocated at times – I reckon that in many respects he’d have made a pretty good Governor, at least of a monetary policy focused central bank.  These days he has the advantage of moving among a bunch of very able experts, and perhaps the disadvantage that those people are mostly insiders (formally or not), and his employer is an organisation that doesn’t need to worry much about legitimacy.  Readers may think I’m given to idealism, but on a pragmatism-idealism scale, I’m further to the pragmatic/political end of the spectrum and David towards the idealistic/technocratic end.

As I hope was apparent in post last week, there is a great deal David and I agree on in the context of designing laws, and associated rules, for monetary policy.

  • moving away from a single decisionmaker model (an innovation in the 1989 Act that no one chose to follow, and which has become increasingly less appropriate),
  • that public confidence in the legitimacy of the institution is crucial if operational independence is to be sustained,

Thus far, most people would agree. But we go further:

  • groupthink is a serious risk in any institution, and in any Monetary Policy Committee, and groupthink can seriously undermine the advantages of establishing a committee,
  • free-riding is also a risk in any such committee, and thus
  • a Monetary Policy Committee should have a clear majority of outside members,
  • and those members should be individually accountable for their advice and their vote,
  • a diversity of views/perspectives should be sought, and encouraged (consistent with the high degree of uncertainty and the risks of groupthink in any institution),
  • a role for parliamentary scrutiny (in my case) or approval (in David’s) for people nominated to serve on an MPC,
  • proper and substantive minutes of MPC meetings should be published, with no more than a short lag.  Such minutes should capture and convey the differing perspectives that individual members bring to the discussion (whether about specific OCR decisions, or the approach the committee is taking to monetary policy).  A parallel exists in the form of the range of (majority and minority) opinions judges of higher courts often deliver in deciding cases.
  • individual MPC members should be free to give speeches or interviews articulating their perspective on monetary policy issues, and not be bound to present only a majority institutional view,
  • appointment terms should be staggered, and of a significant length.   David favours prohibiting reappointment, although I’m more hesitant about going that far (because very long term weakens the effective accountability we both seek).
  • periodic external reviews of monetary policy have an important role to play, and should be an established feature of the system (rather than, say, a response to specific episodes of discontent).

Since my post last week, David and I have been exchanging notes on a couple of the issues where our views diverge.  (There are probably others –  while I’d not be averse to a single non-New Zealand member of an MPC, David would  – on past form –  be more open to a larger foreign participation.  For me, one element of legitimacy is about –  in Paul Tucker’s phrase –  perceptions of “values compatibility”.  The New Zealand public need to be confident that an autonomous central bank is working for them, and that is more likely –  at the margin – when the decisionmakers are themselves drawn from that community).  David has given me permission to quote from our exchange.

In my earlier post, I quoted from the Archer/Levin slides

The MPC should formulate a systematic and transparent strategy that guides its specific policy decisions over the coming year or so.

and observed

Easy enough to write down, but hard to make it mean anything particularly specific.

In response he noted (emphasis and link added)

As in my comments on Rennie, and as in Andy’s presentation, I see 3 layers for policy. Call them framework, strategy and tactics. They correspond roughly with what goes into a PTA; the policy reaction function that goes into the forecasting model (alternatively, a Taylor rule or alternative rule that captures the systematic aspects of policy in pursuit of the target(s)); and the stuff around nowcasting and forecasting. Andy and John Taylor and others argue that the Fed should be articulating its strategy, and disclosing that, though Andy is more open on the form in which the strategy is articulated that John appears to be. You and I argue that the RBNZ should disclose its model, also so that the systematic parts of the Bank’s thinking are on display. We’re all talking about central banks being more open about the systematic elements that are under the their control, to improve discipline and legitimacy.

So I actually think we’re in a similar place. We might disagree on whether a Taylor Rule type of PRF [policy reaction function] “dumbs down” the policy process too much – in my view, the ability of the Taylor Rule (or variants thereof) to capture the essence of policy needs is remarkable and telling, as is the regularity with which departures from TRs have turned out to be mistakes. And we share the view that central banks should be required to explain why they think this time is different, which is helped by having a publicly disclosed benchmark.

We both agreed that forecasting is of little value.

Part of the context here is about proposals in the US to require, by law, the Federal Reserve to publish the reasons why its interest rate decisions deviate from the recommendations of, say, the Taylor rule (a fairly simple, but at times surprisingly useful, guide to how central banks (should/do) run monetary policy (using just a neutral interest rate, an output (or employment) gap, and the gap between the inflation rate and target).  David is more sympathetic to something along those lines than I am, and sees the primary role of an MPC as to formulate and articulate a strategy to guide monetary policy.

In response I wrote

I’m inclined to agree that the Taylor rule seemed to do a remarkably good job for a period, although am less sure of its value in the last 5-10 years, because one of the key questions that central banks have had to grapple with (implicitly or explicitly) is what is happening to the natural interest rate itself –  and Taylor can’t offer useful insights on that.  As you note, I would favour the RB publishing its forecasting model, including the reaction function (as part of much greater sense of input-transparency all round), altho I’m more sceptical about the ability of the reaction function to really represent all the contingencies a committee of policymakers (esp an individualistic one) is likely to have in mind.  I’d probably put more weight on the potential for good minutes –  of the sort you suggest –  combined with a requirement for MPC members to publish their individual estimates of key system parameters (neutral interest rate, NAIRU –  akin to the final observation in the Fed dot-plot) to provide a steer as to thinking, and something later to use for some sort of accountability.

In other words, I’m all in favour of an MPC publishing lots of its inputs (eg the background staff papers it receives) and a lot about individual members’ priors.  Like David, I favour the publication of good minutes.   But I’m sceptical that an MPC can usefully go very much beyond what is captured in a PTA –  the bit the Minister of Finance controls.   There is just too much uncertainty about how the economy works at any particular point in time –  more so in the last decade with a great deal of uncertainty about “the” neutral interest rate – for statements of MPC strategy to add very much value.

Our other area of disagreement seems to be over the type of people who should be appointed to serve on a statutory Monetary Policy Committee.

In his announcement of the proposed New Zealand reforms, the Minister of Finance indicated his view on that issue as follows:

External members will have knowledge and experience in relevant policy areas (such as economics, finance, banking, or public policy). However, members will not be limited to monetary policy experts. External members will need to be free from conflicts of interest and will not be on the MPC to represent a particular sector.

It is worth noting that there is no particular reason to expect that most of the internal members will be monetary policy experts either.  At present, for example, the Governor is chief executive for a broadranging organisation, and may not have had a strong background in monetary policy (neither Brash, Bollard nor Wheeler did), and the current deputy governor is a career public servant with an economics background mostly in labour and fiscal issues.

I wasn’t unhappy with Grant Robertson’s description of the sort of people he expected would be appointed.  But in the Archer/Levin slides, they argued

…..the MPC should comprise a diverse group of experts who are individually accountable for their policy decisions.

To which I responded briefly.

I’m not totally persuaded by the “experts” line myself –  one needs lots of expert input/advice to policy, but when it comes to decisionmaking, soundness is at least as important as cleverness.

To which David responded (we both agreed that the value of outsiders shouldn’t be in bringing a better class of business anecdote to the table –  the role the external advisers play at present)

….the big issues in policy-making, the ones that impact on welfare, concern choices of framework and choices of strategy. Right now, as you also argue, the greatest attention by far should be on whether policy design is right. Do we have the right tools? Can we get interest rates to move enough in response to demand perturbations, without banging into lower bounds? What do we think about the appropriate speed of response? If we had a price level “attractor”, would that help induce stronger responses to negative perturbations that risk acquiring a deflationary dynamic? When might asset prices or other indicators of collective manias sensibly affect policy making? Questions about the variability of the exchange rate come into play in open economies. These are the things that can make a real difference. Tactics don’t. So if we’re staffing a policy committee, we should staff it to be capable of handling such questions, and bring a diversity of approach to the thinking on them. From my observation, it’s in relation to these questions where Group Think has its greatest hold. People find it easy to disagree on timing and tactics, but find it very hard to challenge accepted frameworks.

Hence I come down in favour of a diversity of people with the expertise and inclination to handle evaluations of frameworks and strategy, rather than something aimed to reflect the composition of society or of economic activity. And I acknowledge a cost to that approach: political legitimacy is less readily supported, because the policy committee members are not obviously “like us”.

It is an ambitious vision.  I wasn’t persuaded though

…..where we disagree is whether one looks to the MPC members primarily as expert analysts and decisionmakers/communicators in one, or as customers/purchasers for expert analysis, and then decisionmakers/communicators.  I can’t think of many (any?) bodies in our society that function in the former way.  …..  I guess I”m inclined to think that I want MPC members (including the Governor) who will create a climate that encourages debate, and research, and engagement –  inside and outside the Bank –  on all the sorts of issues you raise, and more, rather than being those experts themselves.  It doesn’t mean I’m opposed to have some genuine experts on the committee, but it might be undesirable (even if enough were available) for them all to be experts. For a start, those people won’t necessarily have the (eg) communications skills a public agency needs, or the institutional political skills.  And realistically, not one of the Governors in my career (here and abroad, …..) has been what I would call a monetary policy expert.   Arguably, none of the deputy governors have been either.  Perhaps that should be changed, but there are pretty slim pickings, and frankly what worried me more about Graeme wasn’t his lack of expert background as his lack of openness to debate/challenge scrutiny.  Realistically also, even if we had resident academics who were strong in these areas, many might be better used –  and themselves prefer –  to be based in the academy, generating research and then interacting with policy people, than devoting large chunks of their time to “tactics” and related stuff.
You also note that “People find it easy to disagree on timing and tactics, but find it very hard to challenge accepted frameworks.”.   Maybe, altho your great chart from the Sept 08 FOMC [reproduced in last week’s post] argues against that (at a time when it counted).
On my telling, an MPC should be a balanced panel of people, dominated by outside non-executives, but drawing on high level technical expertise (staff and outside resources).  Since I favour separating monetary policy and regulatory functions into separate institutions, I would favour seeking a monetary policy expert as Governor (and chief executive).   To me, the parallel is with something like the Cabinet –  drawing on expert advice, sometimes ignoring it completely, without themselves being the experts.   That seems more like the way in which we typically run institutions in our society (a telecoms company board will typically benefit from having some people who really know tech/telecoms but will rarely be exclusively comprised of such people).
David responded, having emphasised his view that frameworks and strategies, rather than specific OCR decisions, are mainly what we want an MPC for.

How does one evaluate alternative frameworks and strategies? With extensive modelling exercises, and empirical evaluation of results of different frameworks and strategies at work in practice in comparable countries. Evaluating, making sense of, and extracting the lessons from such research is thus the main task. The expertise required should be sufficient to evaluate research effectively, but not necessarily to design and conduct that research. What the candidate MPC member needs is sufficient training in economics to understand the research they are being presented with. There’s a specialised vocabulary involved. Different research methods take quite some time to understand, especially in terms of the implicit assumptions involved in the choice of method. Perhaps most importantly, even very experienced lay people struggle to grasp the general equilibrium mind set, which is crucial to comprehending how the macroeconomy responds to various impulses over the time frames relevant to the design of frameworks and strategies.

…. Experts should not be equated with PhDs with great track records for research and publication (though they shouldn’t rule the person out).

I’m not persuaded.  There is certainly a need for plenty of background research, and the synthesising and application of that research to a New Zealand context. But I don’t think decisionmakers need to be literate in the issues in the sort of depth David suggests, and I think there is a real risk that – even if enough such people could be found in New Zealand –  such a panel of people might prove more interested in the esoterica of some of the debates (and the important issues that really matter, like the near-zero lower bound) than about actually making good OCR decisions that deliver inflation consistently at or near whatever target the Minister of Finance has set.  This is a point Paul Tucker makes in his book: reputation is a key element of public sector accountability, but for it to work, the appointed policymakers have to care about the stuff the public is looking for from th institution.   People with a stronger interest in the international conference circuit (I’m caricaturing, but it is a risk) than in short-medium term New Zealand macro outcomes, won’t end up with very much effective domestic accountability.

Tucker also makes a point I’ve made here repeatedly.   Requiring technical expertise to be brought to bear before decisions are made does not mean that the technical experts should be the decisionmakers.   We need to bring a lot of technical expertise to bear around monetary policy (tactical decisions and framework design) but in my view much of that expertise should reside on the staff of the Reserve Bank, and it should be one of the prime roles of the Governor to (a) foster such expertise, and (b) ensure it is exposed to external challenge and scrutiny (and alternative external perspectives) and (c) to ensure the results, and alternative interpretations, are translated into language decisionmakers –  on the MPC –  can make sense of, and can question and challenge (and where those decisionmakers have the incentive to do so).  I’m sure there is a place for some monetary policy experts on an MPC –  including among the externals – but the MPC should no more be dominated by such people than (say) major decisions on war and peace should be made by generals (no matter how valuable their technical advice might be).    Legitimacy is rarely achieved simply by technical expertise.

These are important issues to be thought through in the design of the new MPC for New Zealand, and in the process of making the first wave of appointments (which will establish much of how the MPC works).  In practice, in a New Zealand context (given limited pools of candidates) I’m not sure how far apart David Archer and I would end up being, but I hope Treasury and the Minister are giving some thought to the sorts of issues raised here.


Inflation still looks pretty subdued

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 18Nowhere 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.


“12 Angry Men” and the Reserve Bank

It wasn’t me that introduced that wonderful 1957 movie to discussions about Reserve Bank governance, but them.  I’ll get back to that.

Yesterday the Bank released its first on-the-record speech of the Orr era, although it must surely have been largely written before the new Governor came on board.  Chief economist John McDermott and one of his staff had prepared a paper for a Reserve Bank of Australia conference.  The title of the paper was Inflation targeting in New Zealand: an experience in evolution.   

I’ve not typically been a fan of McDermott’s speeches (eg here) but this one reads quite well.  It is mostly a background account of how inflation targeting developed and evolved in New Zealand, culminating in some brief, and fairly innocuous, comments on  the pending changes to the Reserve Bank Act that the government has recently announced.  For anyone looking for background or longer-term context on New Zealand monetary policy in recent decades, I’d happily suggest it as a reference (in fact, I just did for one reader).

I don’t have much problem with the description of the history –  and they draw on an old article of mine on the origins of inflation targeting – and although I’d describe a few things differently I think it is mostly a fair account.  As ever, I think the Bank tends to caricature the early days of inflation targeting to some extent, suggesting that things were done fairly rigidly or mechanically when the truth is –  whatever some of the rhetoric at the time – quite the opposite.    Then again, as I reflected on the speech I realised that there is –  as far as I can work out –  no one now at the Reserve Bank who was involved at all in monetary policy for the first seven or eight years of inflation targeting.  I guess it is a quarter of a century ago now, but even so that took me a little by surprise.  The Governor, for example, first joined the Bank in mid-1997 just in time to share responsibility for one of the more embarrassing episodes of the last 30 years, the Monetary Conditions Index.  (I’ve been meaning to write up that episode, which seems to me not well-documented, and now that Orr is back at the Bank perhaps it is time to do so.)

As it happens, the Monetary Conditions Index –  when for a year or more we set things up in a way that foreseeably introduced extreme short-term volatility to interest rates –  remains the only mistake the Bank seems willing to concede over almost 30 years (“the MCI was a branch that we lopped off fairly quickly”).  Certainly nothing about the persistent failure, over seven years now, to have core inflation near the 2 per cent focal point of the inflation target –  or the attempt to aggressively tighten policy in the midst of that –  all while, on their own numbers, unemployment was above estimates of a NAIRU.

But the prompt for this post was mostly some comments McDermott made about the planned introduction of a statutory Monetary Policy Committee, finally moving away from the single decisionmaker model that has few/no parallels among other central banks and financial regulators, and none among other New Zealand public sector agencies.

This was the paragraph that caught my eye

Of course, the creation of a formal (or indeed informal) committee does not guarantee superior outcomes. How the MPC will operate in practice is also extremely important. Committees are more successful when they have processes in place that aim to minimise various human biases, such as the pressure to conform, confirmation bias, and a tendency to rely on the most recent events to a greater extent than is sometimes warranted.[24] The Bank will continue to ensure our internal processes aim to maximise the benefits that committees can provide.

The footnote 24 reads as follows

24  The movie 12 Angry Men (1957, MGM) provides an excellent demonstration of how ‘committees’ (a jury in this case) should not behave, for example publicly revealing individual priors at the start of the meeting.

Of course, I agree that simply creating a legislated committee does not guarantee superior outcomes.  Much of the time it shouldn’t make much difference at all to the setting of the OCR –  whether for good or ill (thus the former Governor wanted his internal committee enshrined in law, and since it was gung-ho for tightening in 2013/14 as advisers, it is hard to believe they’d have taken a different collective view as decisionmakers).  Committees are, in large part, about institutionalising resilience, to protect us to some extent against idiosyncratic or bad actors (in this case, a bad Governor –  but it generalises in that Prime Ministers govern in Cabinets, higher courts operate as benches of judges, and so on).   Layers of review –  eg appeal courts –  can perform much the same sort of function.  Committees can help instill confidence, perhaps especially when –  as with the higher courts –  all judges are free to record, and have published, their considered opinions.   In many of these areas –  probably including the setting of the OCR – there is no objectively right or wrong answer, only a final one (for now).

McDermott rightly notes that there can be problems that undermine the effective contribution of legislated committees.  He notes “the pressure to conform, confirmation bias, and a tendency to rely on the most recent events to a greater extent than is sometimes warranted”, but there are others, including the possibility of individual committee members free-riding.  But he makes no attempt to relate the structure of committee that the government has chosen –  which seem to largely mirror the Bank’s preferences –  to the sort of biases and risks he is concerned with.  How does the chosen structure allay those risks?

Thus, the government has chosen to adopt a model in which:

  • outsiders will always be numerically dominated by insiders,
  • the Governor –  an insider in these terms – chairs the committee and controls all the resourcing of, and paper flow to, the committee, and where
  • the Governor will have a big influence on all the appointments to the committee (several will be his own staff, appointed on his recommendation, and the others will be appointed by the Minister on the recommendation of the Bank’s Board –  but with the Bank’s Board historically having served mostly to assist the Governor).
  • and outsiders (and insiders for that matter) will be unable to articulate their individual views in public, and won’t be held individually accountable for those views (or for their contribution to the committee).

In the hands of an exceptional Governor –  one genuinely open to debate and challenge, through the worst of times –  none of that might matter.  But we don’t legislate on the presumption that men are angels.   For a typical Governor –  moderately competent, moderately defensive, moderately arrogant –  it is a recipe for something as close as possible to the status quo.   And, frankly, for typical other members: insiders won’t see much payoff in resisting a Governor with a strong view, collegiality among management will encourage caucusing and a fairly common insider view, and anyone willing to take appointment as an outside member might be readily content to settle for the prestige, and the inside view of the process, rather than supposing that they have much chance of making much difference.   There will be no cost to just going along, and in the papers the Minister raised the threat of being dismissed if an outside member does make life awkward for the Governor.

I don’t want to overstate things. But the chances of getting the real benefits of a committee on this particular topic (monetary policy) have been undermined by the choices the government has made and the Bank appears to have supported.  Bureaucratic interest appears to have trumped the public interest.

And that footnote concerned me on a number of counts.  It obviously wasn’t just a throwaway line –  having been deliberately included as a footnote in a published text, which will have gone through numerous drafts.   It is an odd example to use in many ways. For example, a jury is a one-shot game (jurors typically don’t know each other previously, they decide one case, and then may never see each other –  let alone meet for another deliberation –  again).  Monetary policy decisions, by contrast, are a repeat game: the OCR is reviewed every six weeks or so, and the same individual or group of people make the decision for years at a time.  They bring their priors, their experiences, their past mistakes to the table, and are encouraged to do so.   It is also deliberating on issues where everyone –  inside the committee and outside –  has access to the same information, and no information is inadmissible. (And where the financial markets are trading that information continuously.)

McDermott seems to take as the lesson of 12 Angry Men that members of a committee should not outline their individual initial views at the beginning of the meeting.  Perhaps that is arguable (in principle), but in the case of the jury in question the “meeting” began only after all twelve jurors had been exposed to all the evidence in court –  defence and prosecution.  In that sense, the start of the jury deliberations in the movie reminded me quite a bit of OCR Advisory Group meetings I sat on for years:  we’d have spent several days listening to presentations, asking questions, listening to the questions of others, and then the small group would retire.  And often the Governor would go round the table and invite each member in turn to outline their view.  When we wrote our formal advice to the Governor, we were all supposed to do so independently –  and not read anyone else’s until we’d sent off our own.  And when the group reconvened there was never an opportunity to seriously debate the issues, or challenge the arguments that (say) an 11:1 majority of the Governor’s advisers were using.  In some ways, it felt a lot like 12 Angry Men, except without the heroic denouement in which truth was outed, and the majority converted.

The parallels are weaker than they might look.  For a start, no one’s life is on the line (as in the movie).  Perhaps more importantly, an OCR decision made today can be, and is, revisited 6-8 weeks hence.  And if all the members aren’t necessarily expert they at least have some ongoing familiarity with the subject matter, and exposure to the views of equally capable people outside the institution, in real-time.

But the challenge remains for the Bank (and the government).  How does it propose that the new committee will overcome the tendency for the Governor’s preference –  backed by resourcing, control of pay etc for internal members, an inbuilt majority, and an appointment procedure that will encourage the appointment only of house-trained outsiders –  to go on dominating, whether the Governor’s view (or the collective inside view) is right or not.  Sometimes it will be right, but those arguments should prevail on their merits, not on institutional biases that strengthen the hand of one dominant individual and his clique, and make unlikely the prospect that a single outsider will ever be able to make the sort of difference the (heroic) 12th juror in the movie made. Of course, it is only a movie…..then again, it was the Bank that introduced the reference, not me.

Far better to institutionalise a system more explicitly designed to air, test, and challenge the full range of views:

  • all members appointed directly by the Minister of Finance,
  • a majority of the members being non-executive outsiders,
  • those outsiders having access to (a limited amount of) resources to do/commission their own analysis research,
  • individual OCR votes being recorded, and published, by name,
  • full minutes –  with views attributed on a named basis –  be kept and published (paralleling the Swedish system, and –  in a slight different way –  the way the higher courts work),
  • individual members being free to engage externally (including making speeches) articulating openly their views and questions.

In the nature of the monetary policy issues –  repeat game, same information base open to everyone, huge uncertainty –  it seems like a model better designed to get the most from a committee system, and to be consistent with commitments –  from the government –  to more open government.  Of course, the Bank –  at least under the previous management –  never really wanted more than an fig-leaf committte. Any analysis of bureaucratic incentives means that shouldn’t be a surprise.  From McDermott’s comments yesterday, it isn’t clear that anything has yet changed.  But the bureaucrats –  with interests to protect –  shouldn’t be the ones driving the reforms.

Estimating NAIRU

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.


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.)

Preparing for the next serious recession

There have been three New Zealand recessions since inflation targeting was introduced.  That, in turn, wasn’t long after interest rates were liberalised and the exchange rate was floated in 1984/85.   Of those recessions, two were severe and one (the 1997/98 episode) was more moderate.    Here is how 90 day bank bill interest rates –  the benchmark indicator before the OCR was introduced –  fell (and were allowed to fall by monetary policy) in those episodes.

Mid-late 1990 to mid-late 1992                   780 basis points

Mid-1997 to end 1998                                   340 basis points

Late 2007 to mid 2009                                  590 basis points (OCR cut 575 basis points)

Over the first of those periods, medium-term inflation expectations fell by about 2 percentage points (from about 4.3 to 2.3 per cent) –  that was in the midst of the major drive to lower the inflation rate.  In the other two episodes there was no material change in surveyed inflation expectations.    So in the two severe recessions, short-term real interest rates fell (or were cut) by about 580 basis points, and in the less serious recession they fell by 340 basis ponts.

At present, the OCR is 1.75 per cent (and 90 day bank bill rates are about 1.9 per cent).    As things stand today (current laws, rules, and central bank practices), no one is confident that the OCR could be cut further than around -0.75 per cent.   Below that, it seems likely that it would become economic for large scale moves into physical cash (which earns zero less storage and insurance costs) to occur –  mostly not by households, but by market participants with large holdings of New Zealand dollars.  To the extent such shifts happen, market interest rates wouldn’t fall much even if the OCR was cut further.  That would dramatically undermine the effectiveness of conventional monetary policy (which works mostly either through direct interest rate effects, or through the influence of interest rates on the exchange rate).

There isn’t anything very controversial about that story.  At the Reserve Bank it was a conclusion we got to in a project I led back in about 2012 when the euro-crisis seemed to foreshadow risks of new externally-sourced crisis/recession.   It is consistent with the revealed practices of other central banks (no one has cut below -0.75 per cent), and is just pretty standard analysis.

So if the next recession hit today, the Reserve Bank could count on having around 250 basis points of policy adjustment capacity (the OCR could be cut that much).   But it has needed more than that in each of the (small sample of) recessions in recent decades.

And it isn’t that the New Zealand numbers are unusual.  In the US recessions going back to the 1960s, the median cut in the (nominal) Fed funds rate has been just over 500 basis points.

If the OCR can’t be cut as much as normal, monetary policy cannot do its job.  We have active discretionary monetary policy to minimise the output and employment losses in downturns (adverse economic shocks come along every so often, like it or not).    And if markets, and businesses, know that monetary policy is thus hamstrung, they will factor that into their expectations and the actual downturn will probably end up even worse (the monetary policy cavalry aren’t expected to ride to the rescue).

And so, every so often since I started writing this blog, I’ve been highlighting the potential problem the next time a serious recession comes along, and lamenting the apparent (certainly in public) indifference of our Reserve Bank, Treasury, and Ministers of Finance to the issue.  Other countries ran into the limits of conventional policy in the last recession.  They couldn’t do much about it then, and paid the price in a very sluggish recovery (slow closing of output and employment gaps). But no country needed to find itself in this position if it prepared the ground well before the next recession.

In raising these concerns, I’ve been in good company.    Since shortly after the last recession various prominent economists –  of pretty impeccable orthodoxy –  have been raising the possible need to think about an increase in inflation targets.  Two of the most prominent were former IMF chief economists, Ken Rogoff and Olivier Blanchard.  Their logic is simple.  Inflation targets were set on the assumption (implict or explicit –  in our case, we actually wrote it down at times) that the near-zero lower bound on nominal interest rates was only a theoretical curiosity, and of little or no practical relevance.  Experience in various countries proved that assumption wrong.   And in the medium to long term, the most reliable way to raise nominal interest rates –  and thus leave room for substantial cuts in future recessions – is to raise actual and expected trend inflation.  (One counter to this argument for some countries a few years ago was that since most central banks were having trouble meeting existing inflation targets, and had already exhausted conventional capacity, how could they hope to credibly target still higher inflation.)

Other economists –  Miles Kimball, Willem Buiter, and more recently Ken Rogoff –  have focused on the other side of the issue: can changes in currency laws or practices be put in place which would mean that nominal interest rates could be cut more deeply.  As various observers have noted, some estimates of a conventional Taylor rule suggest that ideally the Fed funds rate would have been cut –  for a short time perhaps –  as low as -3 or even -5 per cent at the height of the 2008/09 recession.

In practice, nothing much has changed yet.  No one has changed their inflation target –  or adopted, say, price level of nominal GDP level targeting which some (including the head of the San Francisco Fed) believe could provide more resilence –  or taken steps to deal directly with the practical lower bound.   We are drifting towards the next severe recession, with the toolkit severely depleted.

In New Zealand, it has been harder than in most places to get any serious debate going at all.   I suspect a variety of factors contributes to that, including:

  • the fact that we didn’t get particularly close to the near-zero lower bound ourselves in the last recession,
  • the persistent belief that before long interest rates will again be much higher,
  • the belief that New Zealand has lots of fiscal headroom such that even if monetary policy is constrained in some future recession it won’t matter,
  • given the perpetual discontent in some quarters in New Zealand around monetary policy (it has been an election issue for some or other party every election since 1990) a desire, among the orthodox, not to be seen as “giving aid and comfort to the enemy”.

There is also a bit of handwaving around the possibilities of QE (direct asset purchases), but this is mostly handwaving and attempting to play distraction as no one in other countries –  that have actually used QE –  believe it is an effective substitute, on feasible scales, for the conventional interest rate instruments.

I would not, myself, regard a higher inflation target as any sort of first-best option.  Indeed, in an ideal world, I’d be more comfortable with a regime that delivered average inflation near-zero over time (allowing for the modest measurement biases in the CPI).  Inflation has costs, although economists have struggled to find convincing estimates of large adverse effects at relatively low inflation rates.  And many of the costs that do exist arise from the fact that the tax system is designed for a zero inflation rate.  Inflation-indexing the tax system (mostly around the treatment of interest and depreciation) could tackle that issue quite directly (and there are official reports from decades ago, here and abroad) identifying how it could be done.   (It would treat savers, and borrowers, more fairly, even with a 2 per cent inflation target: perhaps I point I might make in my submission to the Tax Working Group.)

But if there are modest –  largely avoidable –  costs of a slightly higher inflation target, they quite quickly pale in comparison with the output and welfare losses if monetary policy isn’t able to operate as effectively in leaning against recessions.  Drifting towards imposing that cost on ordinary New Zealanders –  and it won’t be the Treasury or Reserve Bank officials who face those cyclical costs – should be pretty inexcusable.

And so I was encouraged when, the other day, Radio New Zealand’s Patrick O’Meara rang up.  He’d been reading my post which had noted, in passing, the IGM survey of US economists in which 86 per cent of those senior US academics agreed that

Raising the inflation target to 4% would make it possible for the Fed to lower rates by a greater amount in a future recession.

and was interested in how one might think about these issues, and do something about them (immediately and in the medium-term), in a New Zealand context.   We talked at some length, and then he talked to some other people, and the result was this story.

I was quoted this way

While uneasy about higher inflation, economic commentator and former Reserve Bank official Michael Reddell said increasing the Reserve Bank’s inflation target band of one to three percent was worth discussing.

“It’s really important to start planning, having the discussions about how we’re going to cope with the next downturn.”

“The next recession could be relatively minor,” he said.

“We could just get away with needing to cut the OCR by 50 or 100 basis points [0.5 to one percent].”

“But the typical severe recession, whether it’s in the US or New Zealand needs, typically, [400-600] basis points of interest rate cuts, and we’re just not positioned for that,” Mr Reddell said.

What surprised me was the comments from others that O’Meara talked to –  not so much the conclusion, but the argumentation.    In fairness to the individuals, I don’t know exactly what they were asked, or how much of their response was used, so what follows is a response to the Radio New Zealand reporting.

There was Kirk Hope, head of Business New Zealand, who (frankly) seemed an odd person to ask about details of macroeconomic policy and contigency planning for future recessions.

Business would also suffer, Business New Zealand chief executive Kirk Hope said.

“If the target is too high and there’s too much inflation and interest rates are too high, then it reduces investment in the economy … and that in the end costs jobs.”

As quoted, those proposition are simply wrong.  They don’t, for example, distinguish  –  quite importantly – between real and nominal interest rates.  All else equal, higher real interest rates might reduce investment.  Unchanged real interest rates –  actually perhaps a bit lower in a transition period – are unlikely to affect investment or jobs adversely.

And there is no sign that Hope had even engaged with the “how do we handle the next severe recession” –  when investment and jobs really will be adversely affected if monetary policy is hamstrung –  question.  Perhaps it wasn’t put to him?

The other person asked specifically was Arthur Grimes, these days a researcher on all manner of interesting things, but formerly a senior manager at the Reserve Bank (and, for a time, chair of the Reserve Bank Board).  Arthur has long been a vocal, and articulate, defender of the status quo.

Here was what RNZ reported of his views

Victoria University School of Government professor Arthur Grimes was adamant New Zealand’s existing inflation target band was more than adequate.

Professor Grimes said raising inflation to four percent, for example, would do nothing but hit households in the wallet.

“Why would we want the cost of living to be rising any faster than that? Don’t forget the cost of living makes it harder for people to live. It’s wonderful that inflation expectations are low and that inflation is pretty low.”

His response was more surprising, given his background.  Not that he didn’t favour raising the target (I don’t either) but the quoted thrust of his argumentation.  Higher (expected) inflation  –  and inflation expectations are at the heart of the story about nominal interest rates –  don’t “hit households in the wallet”; they see both wages and prices (and welfare benefits) rising a bit faster than otherwise.  If there are real adverse costs of higher inflation they come from things like the tax system effects (see above).  The confusion of reals and nominals in these quoted remarks seems pretty extraordinary.  If wages and price are both rising at 2 per cent per annum, and then subsequently – well foreshadowed –  they are both rising at 4 per cent, there simply isn’t a “cost of living” problem which “makes it harder for people to live”.

And again –  and perhaps he wasn’t asked –  there is simply no engagement with the case that people like Blanchard and Rogoff used in raising the option of a higher inflation target: how do we cope with the next severe recession when the OCR can’t be cut as much as we are used to?

My own position remains much as I outlined it the other day.  The first priority needs to be some serious engagement on the issue, and recognition, of the likely threat –  the constraint on the ability of monetary policy to do the job we’ve asked of it since the end of the Great Depression.   In my view, the second priority should be serious work on removing or greatly attenuating the near-zero lower bound, by taking steps (and being open about them) to limit the scope for large scale conversions to cash.  Far better to deal with the issues, and risks, now, than to attempt to grapple with them in the middle of the next serious recession (especially given recognition lags).

And for the immediate future, in the context of the PTA that has to be agreed in the next few days, and any associated letter of expectation to the new Governor, as I suggested the other day

  • In conducting monetary policy, and without derogating from its obligation to act to keep inflation within the target, the Reserve Bank should be required to have regard to the desirability of there being as much effective policy capacity (or at least rather more than at present) as possible to respond to the next serious recession, and

  • consistent with that, the Minister could indicate that he would be more comfortable if core inflation over the next few years fluctuated in, say, the 2.0 to 2.5 per cent part of the target range, than if core inflation continued to fluctuate around 1.4 per cent as it has now for a number of years.

Raising the inflation target itself should only be a fallback option.  I deliberately don’t use the words “last resort” –  that way nothing will happen until well into the next severe recession when it will be too late  – but if, after careful and open considerations, officials come to the conclusion that whatever can feasibly be done around easing or removing the near-zero lower bound won’t produce (with certainty) the desirable degree of policy flexibility, than we should be seriously considering a higher target. It might not be ideal, but we don’t live in a first-best world.  If one of the key assumptions that underpinned the current targets has been invalidated, and can’t be dealt with directly, the target would need to be revisited.

And finally, as much to anticipate commenters as anything, a couple of quick thoughts on the exchange rate and fiscal policy:

  • as I’ve pointed out here more than once, in such an adverse scenario –  with our OCR at the floor –  the exchange rate is likely to be very much lower.  Which is consoling, but unlikely of itself to be adequate.  After all, in typical New Zealand recessions we have both large OCR cuts and large falls in the exchange rate,
  • our net public debt is quite low, and clearly there is more room for fiscal expansion than in many countries.   Nonetheless, experience suggests that that room will prove smaller than it might appear (not so much technically but politically).  And since few other advanced countries will regard themselves as having much fiscal room, the advanced world as a whole will be short of offsetting stimulus.  Moreover, typically monetary policy can be deployed much more quickly than fiscal policy, suggesting that at best fiscal headroom is a poor substitute for fixing the monetary policy constraints.

And for anyone interested in another analysis of the option of raising the inflation target, this recent piece from the Bruegel thinktank in Europe, emphasising the importance of robustness, covers some of the ground quite nicely.