Self-imposed constraints (the latest from the RB)

The Governor of the Reserve Bank had an op-ed in the Sunday Star Times yesterday, and I’d intended to use it as the basis for post today.   The column is quite as complacent, relative to the fast-unfolding reality, as anything we’ve had from Orr since first we heard from him on the coronavirus topic at the mid-February Monetary Policy Statement.  Even last week he was telling Mike Hosking that his level of concern wasn’t really that high (“six out of ten” was his line, and none of it sounded like simply an attempt not to spark a panic, and he told RNZ’s Kathryn Ryan that it was ridiculous to compare what was unfolding with the Great Depression (of course the specific causes are differerent, but when people make those comparisons they are typically highlighting the scale and severity of the drop in output and/or the  –  largely self-imposed –  limitations of monetary policy).  Everything Orr has said on the subject has sounded as if it might have been reasonable 10 days earlier, but not when he actually said or wrote things.   Complacency has been the best description, in a climate in which it is the last thing we can afford from our powerful, but barely accountable, head central banker.

But I’m not going to waste time unpicking the latest column, which it isn’t even clear why he wrote.

Before moving on, this is the standard real GDP estimates for New Zealand for the Great Depression (there are no official numbers that far back, although there were a lot of partial indicators).

nz depression

Real GDP in New Zealand is estimated to have fallen by about 15 per cent, peak to trough, over three years ( as a reminder it had fully regained those losses, though not got back to the previous trend, before Labour’s icon Michael Savage took office in December 1935).

Any bets on how deep the fall will be in New Zealand’s GDP over even just the first half of this year?   It depends a bit on how intense any lockdown is, but if someone forced me to put a number on the likely fall (June quarter GDP relative to last December quarter’s) it would probably be 25-30 per cent (similarly numbers are bruited about by serious people in the US, with the risks skewed to something worse.

And, reverting to the Great Depression, what got things going again then?  Well, the UK –  our major market, and less hard-hit than many countries – went off the Gold Standard in September 1931 allowing a substantial easing in monetary conditions.  And we, without yet having a proper currency of our own, further devalued against sterling in January 1933  (the US threw in some monetary policy easing later in 1933 as well).  In other words, letting off the previous self-imposed shackles of monetary policy made a great deal of difference for the better.

This is a quite different, but for now much more severe, sort of shock.    It seems unlikely that we can envisage even beginning much of any economic recovery until the virus situation is more or less sustainably under control, not just here and abroad.  Neither monetary nor fiscal policy will stop the deep drop in GDP going on right now, and probably shouldn’t even think to try right now (we are deliberately closing things down as part of fighting the virus).

But that doesn’t mean significant monetary policy easing would not still be helpful.  There are those worrying falls in inflation expectations, and more immediately there are the still-high servicing costs of a rising stock of private debt.  Public and private debt overhangs were a big issues, including in New Zealand, in the Great Depression, exacerbated then by the sharp fall in the price level.    It is pretty unconscionable that in this climate, where time has no value, floating rate business borrrowers are still paying 5 , 6 or more per cent interest rates.  That is almost solely because the Governor and the Bank refuse to do anything about significant negative interest rates possible –  it is this generation’s Gold Standard (there was a real aversion to moving away from it, and yet doing so finally made a huge difference for the better).

The Governor likes to claim that the Bank still has lots of monetary policy leeway within his own refusal to take the OCR negative (even though his chief economist told the public two weeks ago that it really wasn’t so)

yuong ha

Really just “a little”.

And I think it is safe to say that we have had fairly confirmation of Ha’s (generally not very controversial point) this morning.  The Bank and MPC issued a statement in which they committed to buying $30 billion of government bonds over the coming year.

It was a pretty feeble programme, even if the headline number was big.  A year is a very long time at present.  And whereas the RBA the other day announced an asset purchase programme centred around targeting government bond yields of three years to maturity at 0.25 per cent, it isn’t really clear what the goal of our MPC actually.  Settlement cash balances –  which is what banks get when market participants sell bonds to the Reserve Bank –  aren’t the binding constraint on anything.

And what did this large asset purchase programme announcement do?   The yield on a 10 year government bond fell by 50 basis points.  That is a big move for a single day, but……that still leaves the 10 year bond rate materially above the lows reached after the MPC’s cut in the OCR last Monday.  Quite possibly, without this action bond yields and corporate credit spreads would have spiked still higher.  So I’m not opposed to the action, but all it has done is to stop monetary and financial conditions tightening further, when what the circumstances demand is a really substantial easing of monetary conditions.    It isn’t as if there was a great deal (much at all, it seems) of an easing in the exchange rate either.   And this was the MPC’s preferred unconventional tool……as I said last week, if they are going to refuse to go negative it really is game over for monetary policy, at just the time when adjustment is most needed.  Recall the 400+ basis point cuts in retail rates we typically see in a New Zealand downturn, all of which will have been less dramatic than what we are now experiencing.  Central banks huff and puff and wave their hands to suggest lots of action, and they have done useful stuff on liquidity (again to stop conditions tightening) but the Reserve Bank of New Zealand is not alone it seems in playing distraction, to divert attention from what little monetary policy is doing given the self-imposed (wholly self-imposed) constraints.

(All of which said, even relative to the RBA, our MPC is not doing as much as they could.  As noted above, they could explicitly target and securely anchor government bond yields.  They could also still cut the OCR, even without going negative: the headline rates in both countries are 0.25 per cent, but in New Zealand that is the rate we pay banks on deposits at the Reserve Bank, while in Australia the deposit rate is lower again.   These are small differences, of course, but there is no sound analytical or systems reasons for not using all the leeway even their self-imposed constraints allow them.

Of course, the much more immediate huge issue is what the government is going to do to underpin the credit system and support a willingness of banks to lend and firms to borrow.  The only secure foundation for that remains some mix of grants and income guarantees (which will become grants).  I can only repeat that the most useful way of thinking about these thing is as the national pandemic economic policy we would have adopted twenty years ago if we’d thought hard enough, been serious enough, about what could happen: undertake to underpin all net incomes at 80 per cent of last year’s for the first year (reducing after that if the issue is still with us).    The fiscal costs are easily manageable for New Zealand: if guaranteeing 80 per cent of incomes than even if full year GDP fell 40 per cent, it would still only be a fiscal commitment of 20 per cent of GDP, and we are starting with net government debt (properly defined) of zero per cent.   It isn’t the exact dollars that really matter at this point, let alone trying to distinguish good and bad firms, but the certainty such a guarantee –  ex post insurance policy –  would provide in capping the extreme downside risks, individually and collectively for the first year.  It wouldn’t stop all exits –  some have already happened, some firms are likely to think it not viable to come back even with a grant/guarantee –  but it is the best option to help stabilise the economic damage, and to ensure that banks are able and willing to play a strongly facilitative part.

On Q&A yesterday the Minister of Finance suggested more announcements very shortly. I hope so but what worries is that once again whatever they do will be inadequate and not really get ahead of the issue. There is an opportunity now, but time is running down fast.

Reserve Bank still behind the game

There was a new announcement from the Reserve Bank this morning.  The two key elements, as summarised by Westpac are

       A Term Auction Facility. The RBNZ will lend to banks for up to 12 months, taking Government bonds, residential mortgage-backed securities, and other bonds as collateral. This basically ensures banks will be well-funded for the foreseeable future. This will prevent an increase in the cost of bank funding, which in turn will help ensure that short-term interest rates for businesses and households remain low.

–       FX swap market funding. Banks sometimes borrow money from offshore and swap the debt back to New Zealand dollars. In recent days the cost of performing this swap has exploded. Left unchecked, this could have caused an increase in the cost of funding New Zealand banks, which in turn could have led to higher interest rates in New Zealand. The RBNZ has essentially offered to facilitate some of those swap arrangements, which will keep the cost of overseas funding contained.

Both initiatives seem sensible, as (for that matter) does the rest of the statement (although the new Fed USD swap line is surely of symbolic significance only, recognition that we are a real advanced economy, since New Zealand banks tend not to have an underlying need for USD.

I’m guess the fx swap market activity will make a useful difference. But I wonder how much difference the Term Auction Facility will make though.  I recall conversation with bankers at the height of the 2008/09 crisis who observed that their boards simply would not look at Reserve Bank funding –  however reasonable the term –  as a particular secure foundation on which to maintain, let alone expand (as it hoped for this time), their credit.  Time will tell, but the Reserve Bank of Australia announced a much more aggressive package yesterday afternoon, including provisions explicitly allowing banks to borrow more –  at very low fixed rates –  to the extent they increase business credit this year.

There were also indications in the statement that the Bank has been dabbling in the government bond market

Supporting liquidity in the New Zealand government bond market

The Reserve Bank has been providing liquidity to the New Zealand government bond market to support market functioning.

But, as Westpac notes,

However, the amount of liquidity provided seems tiny so far, and has had little effect on longer-term Government bond rates.

Funding rates through the fx swaps market aren’t transparent to you and me.  But bank bill yields are readily observable.  As I noted in yesterday’s post they had moved much further above the OCR than one we normally expect (especially when the Bank has committed not to change the OCR itself).    On this morning’s data, that gap is still 42 basis points (a more normal level might be around 20 basis points.   When the goal is supposed to be abundant liquidity and interest rates as low as possible (consistent with MPC’s self-imposed floor on the OCR), there is simply no need or excuse for these pressures.  Surely they aren’t worried about some spontaneous outbreak of inflation?

Similarly, here is the chart for the 10 year bond

il

In other words, barely below the levels at the start of the year, before any of us had heard of the novel coronavirus, let alone had our economies shredded by it.   The 10 year rate appears to have dropped a little further this afternoon, but it is still well above where it probably should be.

The Reserve Bank of Australia yesterday announced a significant bond purchase programme designed to cap three year government bond yields at 25 basis points (with flow through effects on the rest of the curve.  Our Reserve Bank has still done nothing of substance on that front –  and our shorter-term government bonds yields are well above 25 basis points.  Why not?  Well, there is no obvious reason for the lethargy –  inflation isn’t about to be a problem –  other perhaps than that Orr and Hawkesby went so strongly out on a limb with their complacency about the situation, as recently as last week and this, and Orr has never been one to be willing to concede he might have got things wrong (despite being in a game where such errors are, from time to time, inevitable).

Ah, but perhaps inflation and inflation expectations are just where we want them.  But no.  These are the New Zealand inflation breakevens (difference between nominal and indexed 10 year government bonds.

breakevens mar 20

Recall that the target is 2 per cent, and these are 10 year average implied expectations.  Things were not that great anyway –  not averaging much above 1 per cent in the last couple of years –  but now we are down to 0.65 per cent.  (It isn’t quite as precipitate as the fall seen in the US, but hardly comforting even if the data are harder to interpret than usual.)   This risk –  inflation expectations falling away, raising real interest rates all else equal –  used to worry the Governor.  Nothing has been heard of the line from him or his offsiders since it became a real and immediate threat.

There isn’t really much excuse for the MPC’s sluggishness and inaction.    After all, they talked about bond purchases being next cab off the rank, and then markets went haywire, their peers in Australia acted, and they did nothing.  Of course, it doesn’t help that it seems the Reserve Bank was seriously unprepared.  You’ll recall that as recently as Tuesday last week, we had 19 pages of high level stuff on alternative instruments from the Governor, with the clear message he thought we were well away from needing them.  We were promised a series of technical working papers “in the next few weeks” but despite the crisis breaking upon them almost two weeks later we’ve seen nothing.  All those years they had to prepare, and it seems all too little serious preparation was actually done (as we now know –  because they told us so –  despite all the talk of negative interest rates as an option, it now turns out they’d taken now steps to ensure banks’ system could cope).

But none of that need stop the Reserve Bank launching a large scale bond purchase offer (or auction programme).  It isn’t operationally complex.  The Bank transacts these securities in the normal course of its business, and each year buys back bonds approaching maturity.    There won’t be any systems implications.

I wonder if one other reason they are reluctant to act is a sense that then people would see how little the alternative instruments they favour actually offer.  While they don’t act, there is a pretence that there is a big bazooka.   But only while they don’t act.

As I’ve noted previously, I think there is fair consensus on the last decade’s unconventional policies in other countries: at times there were some real and significant benefits in case of specific market dysfunctions, but beyond that the beneficial effects were relatively limited.  Asset purchases, with a policy-set OCR floor, have no mechanisms that would lower interest rates to bank customers.  They’ll cap government bond rates, probably with some benefit to interest rate swaps rate, but the biggest effect will simply be to flood bank settlement accounts with a lot more settlement cash.  And since that is a rock-solid asset (now) fully remunerated at the OCR itself, it won’t prompt material behavioural changes.

You needn’t just take my word for it.  Last Friday in the Herald  the Bank’s chief economist (and MPC member) Yuong Ha (who had spent some years monitoring financial markets in his previous role), was talking about alternative instruments (bond purchases, intervention in the interest rate swaps market and so on).   He was quoted this way

yuong ha

These tools “give you a little more headroom, a little more time and space”.  In some circumstances “a little” might be all the situation demands.  In these circumstances it is grossly inadequate and simply no substitute for failing to act on interest rates.

That is part of why I think they should get on now and do the large scale bond buying, or even buying foreign exchange assets.  With an interest rate (OCR) floor in place it just won’t make much macro difference, the emperor’s new clothes will be exposed for what they are(n’t), and perhaps we might finally get some focus on the crying need to get retail interest rates lower.

Recall the Bank’s claim that bank systems aren’t ready.  For a start, this should be challenged, and some naming and shaming should go on.  Apparently some banks aren’t ready, but others are.  Name them.  Second, at least for wholesale products all the big banks must be finel –  lots of financial products abroad have had negative interest rates for several years, and our own inflation-indexed bonds were trading at negative yields at times in recent months.   Perhaps as importantly, actual retail rates –  and it is probably the retail components of some banks’ system that are the issue –  are still well above zero, both term deposit rates and retail lending rates.  If the OCR –  a wholesale rate – could be set to, say, -2.0 per cent (without triggering conversions to physical cash on a large scale), term deposits might still be only around zero, and retail lending rates higher again.  There is a lot of space the Bank could use to drive retail rates down without even having to envisage negative rates for the main retail products.  In times like the present every little helps. (As an example of the issue, the Australian banks today announced a scheme to freeze debt repayments for SME borrowers for six months, which is fine, but those borrowers are still paying an interest rate of perhaps 6 per cent, in a climate where time –  which is what an interest rate is mostly compensating for –  currently has no, or perhaps negative, value.)

Perhaps the Bank, The Treasury and the Minister of Finance are now cooking up some decisive intervention to support the credit system as a whole  rather than just extending government loans to the iconic and politically connected Air New Zealand.  Such an intervention is sorely needed, and once again the government is behind the game.  The credit system is probably the most pressing point right now, but it is no excuse for the MPC, an independent operator, to be not doing its  job.  The times demand a large easing in monetary conditions, including in real interest rates.  The Bank is delivering almost nothing, all while playing smoke and mirrors with the suggestion that its next instrument offers much more potential than is really there.

Once more our key decisionmakers fall short.

There would be nothing to lose now by bold and decisive action.  Nothing.

Retail interest rates fall substantially in recessions…

I’m out of town today, so just something short.

I’ve noted in various posts recently that in past recessions in New Zealand since we liberalised in the 1980s the OCR (or prior to 1999, the 90-day bank bill rate) had fallen by around 500 basis points in a typical (median) recession.   Small sample and all that, but it was a reasonable stylised fact (and happened to around the same size adjustment as you see in the longer run of US data).

But, of course, the OCR isn’t a rate paid by anyone –  technically in fact it is the rate the Reserve Bank pays banks on their settlement account balances.   In thinking about the experience of firms and households one has to look at retail interest rate and how they changed.  In the 2008/09 recession, for example, there was quite a widening in the margin between the OCR and retail deposit and loan rates.

One can identify five reasonably material downturns in the interest rate data on the Reserve Bank’s website.  Here are the changes in floating first mortgage interest rates in each of them.

Floating first mortgage new customer housing rate Six-month term deposit rate
percentage point chg in downturn
post 87 crash -4.3 -4.3
1991 -6.2 -4.9
1998 -3.1 -3
2001 -1.8 -1.9
2008/09 -4.6 -4.6
Median -4.3 -4.3
Now -0.8 -0.1

Not all of those events were particularly significant for the New Zealand economy, and the 2001 interest rate falls combined the effects of the northern hemisphere economic slowdown that year and the precautionary cuts the Reserve Bank implemented after 9/11.

But across this sample, the median reduction in both deposit and residential mortgage rates was 4.3 percentage points.  For the two deeper recessions, 1991 and 2008/09 the changes were larger still.

I’ve also shown the adjustments we’ve seen this year to date.   The main banks all lowered their floating mortgage rates on Tuesday by the full 75 basis points of the Reserve Bank’s OCR adjustment.  But retail deposit rates have only just begun to fall.

And in even The Treasury’s view, this recession “could” be bigger than the 2008/09 one (more realistic would be to view 2008/09 as tiddler by comparison, even if one allowed for nothing more than the elimination of our international tourism industry).

And then there are two problems to ponder:

  • first, the MPC has pledged not to change –  raise or lower –  the OCR for at least a year.  So if one believes they will keep their word, what you see now is all you get.  Retail lending rates aren’t going any lower, and retail deposit rates will take a while to catch up but probably won’t fall more than 75 points either.  75 basis points is a great deal less than 430 points, and
  • second, while it was probably good PR for the banks to cut point for point on Tuesday, actually it looks as though they’ve ended up with squeezed margins.  Here is a chart showing the 90 day bank bill rate less than floating first mortgage rate, up to yesterday

bill rate

The 90 day bank bill rate is usually a bit above the OCR, and fluctuates mainly with shifts in sentiment re future OCR adjustments.  When the OCR is expected to be cut imminently the 90 day rate drops below the OCR.  That had happened recently. But note what happened after Tuesday’s cut: the margin between the bill rate and the OCR is now higher than at any time in the last two years.  That would usually only occur if the OCR was expected to be raised, but that clearly isn’t the story as the MPC just pledged not to change the OCR for at least a year.  In fact, it points to liquidity pressures in the local market (details not known to me).    The Reserve Bank’s liquidity operations would usually be able to ease such pressures, and it is a bit surprising they haven’t already done so.

But the key point remains: there is no prospect of further retail interest rate reductions in the middle of the most severe adverse shock of our lifetimes.  75 points is it.     It is a ridiculously small adjustment.  But that is what you get when (a) the Reserve Bank fails to do anything about removing/easing the effective lower bound, (b) fails to ensure banks’ systems were ready for negative interest rates, and (c) pledges not to cut the OCR any further anyway. It really is Alice-in-Wonderland stuff.

Even in circumstances like the present where we aren’t –  or shouldn’t be for now – trying to stimulate aggregate demand, low interest rates play an important role in managing economic downturns.  First, they help lower debt service costs, including for existing flexible rate borrowers (and most New Zealand debt reprices fairly frequently), and do so by transferring some prospective income from depositors to borrowers, consistent with the idea that time is temporarily less valuable.  Second, at a wholesale level they help to weaken the exchange rate, which also typically plays a significant part in buffering adverse shocks.  And third, the flexibility to adjust rate, actually exercised, helps to support and stabilise medium-term inflation expectations.

Did I mention the exchange rate?  In the 1991 recession, the TWI fell by about 10 per cent. In the 1998 recession, the TWI fell by 17 per cent, and in the 2008/09 episode the fall was in excess of 20 per cent.

And this time?  Well, the TWI yesterday morning was only 5 per cent lower than it had been at the end of December, despite the adverse shock being much greater than in any of those earlier events.    This week, we have had the extraordinary sight of the New Zealand dollar approaching parity with the Australian dollar.  I’m sure a variety of factors help explain that, but an unexpected commitment from the MPC not to lower the OCR further can’t have helped.  The TWI appears to have fallen overnight and perhaps before long panic and flights to cash/flights to home will mean the TWI will fall a long way, but monetary policy so far has been an obstacle in the road.

The economy is already in deep strife, and the problems are going to get a lot worse.  We shouldn’t settle for the complacency of central bankers talking up their adjustments, their alternative instruments etc, and all the while retail rates have barely moved, relative to the scale of change seen in most past (smaller) downturns.

The Minister of Finance should simply insist that the Bank sort it out, including getting bank systems fixed post-haste.  There is no conceivable way in which on OCR with a positive sign in front of it makes any sense in today’s New Zealand economy.  Retail deposit rates really should be negative, and retail lending rates probably should be too.

Game’s up

I may well have more to write about the Reserve Bank announcement this morning after the Governor’s press conference at 11am – which I hope begins with a formal apology from him and Hawkesby for their appalling complacency and minimisation of the issues as recently as a few days ago –  but these are some initial reactions.

I guess I have three key points:

First, a 50 basis point was warranted at the time of the last  MPS (and doing so would have been entirely in line with past practice of reacting to out-of-the-blue shocks) so 75 basis points now is seriously inadequate.   Everything has got a great deal worse since then including –  though not mentioned in the statement –  medium-term inflation expectations.

Second –  and this was the mindblowing bit to me –  was this extract from the minutes

Staff also advised that an OCR of 0.25 percent was currently the lower limit, given the operational readiness of the financial system for very low or negative interest rates.

This is simply inexcusable if true (which it may not be).  As just one small point, I lead a working group at the Bank in 2012 –  height of the euro crisis – which identified then the need to ensure, as a matter of urgency, that banks and the RB itself were able to operate with modestly negative interest rates.   And for years we have seen various other countries operating with negative policy rates, so if the Bank has not been taking action to ensure the system could operate, when needed with negative rates it is simply an inexcusable failure. For which, frankly, heads should roll.   Neither when they put out their Bulletin article two years ago nor in the Governor’s speech last week was there any suggestion that negative rates could not be used now.  Best surmise, they simply weren’t taking things sufficiently seriously until the last few days.

And, third, they have basically conceded that it is game over and that monetary policy has reached current limit  (which is so wholly because of their failures –  on this narrow point and, like most of their peers, dealing more decisively with the near-zero lower bound.

Note that as part of their statement they formally rule out any further changes –  including cuts –  for at least the next 12 months.  In other words, tbey rule out taking urgent action now to remedy their past failures.  Simply extraordinary.   I guess climate change and the like were taking priority for the Governor and his staff?

But the point I also wanted to focus on was this bit of the resolution.

Agree that Large Scale Asset Purchases of New Zealand government bonds would be the best additional tool to provide further monetary stimulus in the current situation – if needed.

I never got round to writing about the substance of the Governor’s seriously inadequate speech last week, but had I done so one of the points I would have made was that outside immediate financial crisis conditions –  not NZ now –  these asset purchase routes simply did not offer much.    It isn’t as if bond yields are now at the still-high levels they were in most countries in 2009 even after the OCR had been cut (even if they have been rising in the last few days as the global rush to cash has taken hold).

You might doubt my interpretation –  but you really shouldn’t as it is pretty widely shared, even if often in muted language –  but, as it happens, we have the word of one of the MPC members for it.  Again, I’d been meaning to use this in a fuller post this week.  I hadn’t seen this quote elsewhere, but in his column in Friday’s Herald Brian Fallow reported the RB Chief Economist Yuong Ha as saying, of the unconventional options,

“they give you a little more headroom, a little more more and space”

Precisely.  And “just a little more” is not what the occasion demands.

In effect, in this announcement it is a case of “one and done” –  not in sense of “we”ll be bold and not need to move again” –  sort of their justification for the 50 point cut last year –  but “we’ll move now, and then……well, we have to retire from the field and stare into the macro/monetary abyss….because we spent years just not doing our job, distracted by all sorts of pet things, always looking for rates to rise (as recently as the last MPS).

It really is inexcusable.   Personally I think there is a strong case for dismissing the Governor, and probably most of the MPC too –  including those externals we’ve never heard a word from to explain or justify their collective inaction and failure of preparedness.   I don’t suppose it will happen, but it is what often does –  and should –  happen after battlefield disasters and revealed gross failures of preparedness.   Then again, to act would be for the Minister of Finance to concede some of his responsibility –  he appointed them, he is supposed to hold their feet to the fire, hold them to account.  And only a few months ago in a letter to me he indicated how satisfied he was with the Governor’s stewardship.

I plan to have a fuller post this afternoon on some ideas for macro management now and in the months ahead.  As I’ve said in posts last week and on Twitter, now isn’t the time for stimulus per se –  new spending by the public isn’t the goal as the economies of the world deliberately de-power. The immediate focus has to be income support, the health system, and then some assurance about the framework to see us through the period –  perhaps protracted – until genuine stimulus becomes the appropriate focus.

 

 

Why the OCR should be cut substantially

I’ve seen a few people on Twitter, typically not economists, casting doubt on the case for an OCR cut.  Twitter isn’t really a suitable medium for serious engagement on the substance of such issues, so here is a short(ish) post, articulating a case that (I suspect) will seem pretty obvious, on most counts, to most readers.  I almost wrote the title to that post as “why the OCR should have been cut substantially”, but actually, and even though I thought the cut should have come in February, the actual announcement matters less than the confident expectation that the right thing will be done at the next scheduled opportunity.  Markets largely trade on expectations, even if short-term retail rates mostly move on announcements themselves.  Right now, it is the Bank’s talk –  see my last two posts –  that bothers me more than that the OCR is still at 1 per cent.

Why should the OCR be cut substantially?

  • because inflation expectations have already been falling (reflected in the bond market and in the ANZ business survey) leaving short-term real interest rates higher than those at the start of the year.   Faced with the facts of this year in early January, no one would have prescribed higher real interest rates as part of the appropriate policy mix.
  • almost certainly neutral short-term interest rates (consistent with being at the inflation target with full employment) have fallen considerably in recent weeks/months.  A useful way of thinking about monetary policy is that it needs to involve at least keeping pace with changes (estimated only) in the short-term neutral rate.   How large has that change been?  Well, one low-end estimate could be obtained by looking at the inflation-indexed government bond market.  Very long-term interest rates won’t be much influenced by how much markets think the Reserve Bank will do this month or next.  So take the 20 year indexed bond and the 10 year one, and you can back out an implied 10 year real interest rate for the ten years 2030-2040.   Even that yield has fallen by 30 basis points since the end of last year, and most everyone would expect coronavirus no longer to be much of a factor.  For the five years from 2025 to 2030, the implied real yield has also fallen 35 basis points.
  • add these sharp falls in long-term real rates to the drop in inflation expectations, and then bring the next year or two into the mix, and it is pretty easy to mount a case for a 100 basis point cut in the OCR.  (In fact, if we were starting with an inflation target centred on 5 per cent and an OCR of 4 per cent (instead of 2 per cent and 1 per cent) almost certainly that is what would have happened by now.  In periods when there is a very sharp fall-off in activity, or a huge surge in uncertainty, you cut the OCR early and decisively.  I suspect fear –  the limits of conventional monetary policy and a lack of conviction in the limited unconventional instruments –  is probably afflicting more than a few central bankers, not just in New Zealand, making them nervous of the limits being shown up.)  If the OCR was roughly in the right place at the last review pre-coronavirus, it is simply inconceivable it should now be anything like as high as it was then.  And yet it is.
  •  a common argument is that an OCR cut won’t do much to demand now.  And I agree. In fact, in some respects it isn’t even obvious we should want to boost some forms of domestic demand now –  more people going out socialising etc.  The scale of the disruption and dislocation we will face in the next few quarters is almost entirely independent of what monetary policy does (any monetary policy effects will be swamped by the scale of the real shock).  But it will, all else equal, ease debt-servicing burdens for both firms and households –  and you’ll have noticed that binding cashflow constraints is one of the prominent themes under discussion at present.   Consistent with the previous point, time has very little value now (materially less than a few months ago) and, at the margin, people (savers) shouldn’t be rewarded for that time, borrowers (on floating rates) shouldn’t be paying for it.   Will people say that is tough on retired savers?  I’m sure they will.  But, tough.  There is huge income loss underway, and “valid” returns to financial savings are just lower than they were for the time being.  It won’t last for even, but it is some of the loss-sharing that needs to happen.
  • looking ahead, whenever the worst of the crisis is over lower interest rates will do the usual job monetary policy does and support a recovery as fast as feasible.  And we shouldn’t wait and cut then for at least two reasons:
  • the first is the exchange rate.  All else equal a lower OCR will lower our exchange rate (failure to lower the OCR will tend to hold it up).  International trading conditions have become very hostile in aggregate and a lower real exchange rate is a natural and normal part of the buffering process.  And despite Christian Hawkesby’s claim (in his interest.co.nz) that the exchange rate is now low, the extent of the fall so far is small by the standards of typical New Zealand recessions: we aren’t getting any interest rate buffering and we aren’t getting much exchange rate buffering either.
  • the second is about inflation expectations.  Core inflation is likely to fall. Headline inflation is also likely to fall (oil prices).  Inflation expectations have already fallen and are likely to fall further.   When interest rates are getting near the feasible lows, the only prudent thing to do is to act aggressively to leave no doubt in anyone’s mind –  markets or public –  that the authorities are doing everything possible to keep core inflation near 2 per cent.  If they don’t convince people, the road to recovery will be harder and slower.  It was the very argument the Governor was using briefly last year when he noted that the risks were such he’d rather inflation ended up above 2 per cent than risk that downside trap.
  • we can still cut materially.  The ECB can’t do much on that score at all, and several other advanced countries are also very constrained.   But we can.  We need to for ourselves, and we also do our (little) bit for the world.
  • it is what you do with a significant adverse demand shock.  In fact, in a standard Taylor rule guidance, it is even what you do with supply shocks that raise the unemployment rate relative to the NAIRU (as this one certainly is) –  I thank an academic for reminding me of this further hole in the Bank’s reasoning.
  • other countries have.  Not all of them – even those who could –  but the UK, Australia, the US, and Canada have.  Perhaps they are wrong, but they are all experiencing very similar shocks, and it is a bit hard to see why Adrian’s judgement on this would be so much superior to those of his peers.  Wisdom of crowds and all that.
  • there is no conceivable downside to cutting the OCR aggressively now.  We aren’t starting with core inflation even at target, let alone above.  In fact, it hasn’t been at or above for a decade.  So at worst, the lower OCR has no effect at all on anything above (very unlikely, since at very least it will alter servicing burdens in a useful, slightly stabilising way).  Or, it works remarkably and astonishingly well, so much so that core inflation surges above 2 per cent.  After the record of the last decade and the threat to expectations, I can only really accentuate the Governor’s message from late last year and say “if so, bring it on”.
  • OCR cuts are easy to reverse when/if warranted, not relying to anything like the same extent as most temporary fiscal measures do on having a secure view of the period over which support will prove to be needed.  It should barely need saying, we have no idea of that now.

And I haven’t even mentioned tightening credit conditions, rising risk spreads, rising cost of equity capital etc.  It really is one of those times for “all hands to the pump”, even recognising that come what may the economic times ahead are going to be difficult and costly and any macro (or microeconomic) policies are going to make only a limited  – but better than nothing – difference for now.

I was just re-reading the post I wrote on the morning just prior to the last OCR decision, making a quick summary case for a cut then.   Most of it still reads pretty well, even if –  like everyone (well, certainly every economist) then, I was grossly underestimating the severity of just what was –  and is – still unfolding.

 

Yield curve indicators, monetary policy, and the case for action

Six months or so ago, shortly after a flurry of attention in the US around the 10 year bond rate dropping below the three-month rate (which had been something of a predictor of weaker economic conditions) I wrote a post here on yield curve indicators in New Zealand.    Once upon a time, we used to pay quite a bit of attention to the relationship between bond yields and 90-day bank bill rates although, as I explain in that post, it isn’t a great indicator of future New Zealand recessions (and wasn’t really used that way when we did pay attention to it).

In the post I suggested it might be worth looking at a couple of other yield curve indicators, using the (fairly limited) retail interest rate data the Reserve Bank publishes, comparing short-term retail rates with long-term goverment bond rates.  The absolute levels wouldn’t mean much, but the changes over time might.   Here is a version of those charts updated to today (using current retail rates from interest.co.nz)

yield curve 20 1

and the same chart for just the last two years.

yield curve 20 2

For what it is worth, the only times these lines have been at or above current levels a New Zealand recession has followed.  And although the Reserve Bank interest rates cuts in the middle of last year did reduce the slope of the retail yield curves, we are now sitting right back where we were at the peak last year.

The Reserve Bank is, of course, now strongly expected to cut the OCR this month –  as Australia did yesterday and the US this morning, and as they should have done last month.  But do that and they’ll only take those retail yield curve slopes back to around where we were late last year –  and that on the assumption that long-term bond yields don’t fall materially further.  By historical standards that will look like relatively tight monetary policy, at least on this indicator.    And all that with credit conditions that tightened last year, look likely to tighten further because of the ill-considered capital requirement increases (they were warned about the risks that the transition period would cover, and exacerbate, the next major downturn) and –  despite political rhetoric –  are only likely to tighten further under the cloud of extreme uncertainty and actual/potential income losses currently descending.

In this climate, with the evident sharp slowing in economic activity, it would be more normal to envisage hundreds of basis points of cuts.  But, through official lassitude and a decade focused more on hoped-for rate increases than on the next severe downturn, cuts of that magnitude simply aren’t an option.

The constant pushback against the idea of OCR cuts now (whether last month, right now, or later in the month) is that they won’t achieve anything much in coping with the immediate disruption and the (probable) rapid increases in job losses over the next month or two.   And, of course, that is quite correct.

One also sees pushback using the argument that central banks shouldn’t be responding to share prices, noting that world markets are even now not much off their peaks.  Whatever the merits of that argument abroad –  and in general I don’t stock prices should (directly) drive monetary policy actions –  it is pretty irrelevant here: in all my years of involvement in advising on New Zealand monetary policy, the only time share prices ever really entered deliberations was in October 1987, and even then it was only as a proxy for the serious problems developing just behind the scenes.

But the fact that monetary policy doesn’t have much affect in the very short-term, particular amid really disordered conditions, is really rather beside the point.  If what you care primarily about is the employees and firms directly disrupted, there are plenty of direct options the government can, and probably is, considering.  But that is simply a different issue, even if one that operates in parallel.  Even direct short-term assistance won’t do much to slow the deterioration of economic aggregates –  won’t summon up more tourists, won’t fill gaps in supply chains, won’t offset the decline in spending if/when social distancing becomes more imperative.  By and large, we are stuck with whatever deterioration in economic activity the next few months bring, most of which will be events almost totally outside our control (overseas economic activity and the spread of the virus abroad and here).   We can support individuals to some extent, and perhaps can do something to increase the chances firms will still be there when the pressures pass.

But in many respects, monetary policy is also about the second leg of that. It is about getting in place early –  and providing confidence about –  conditions that will (a) support the recovery of demand as and when the virus problems pass, or settle down, and (b) helping ensure against that the sort of precipitate fall in inflation expectations (in turn confounding the economic challenges) that I warned about in yesterday’s post does not happen.   The importance of early and decisive action is compounded by several things:

  • the physical limits to conventional monetary policy (can’t cut very far, so need decisive early action to keep expectations up),
  • the probable political limits to fiscal policy (see 2008/09 globally)
  • the extreme uncertainty about the course of the virus or the economic consequences (like any city/country, we could face northern Italy or Korean disruption at almost any time),,
  • reasons to doubt just how rapid a recovery in demand will be (perhaps especially in tourism) and the likelihood of some –  growing by the day –  permanent wealth losses

All supported by the fact that, unlike other possible programmes, monetary policy action is readily reversible if the best-case scenario comes to pass.

I find two other thoughts relevant to the discussion.   It seems almost certain that the price-stability consistent interest rate is quite a bit lower than it was just a few months ago.  In normal circumstances, the job of the central bank is to keep policy rates more or less in line with that short-term neutral rate.  It might well be –  but no one knows –  that the fall is temporary, but the Reserve Bank’s job isn’t to back a particular long-term view (they have taken to talking recently far too much about the long-term, when their prime job is really quite short-term, about stabilisation) but to adjust to pressures evident now.

(In the same vein, we also hear the objection that the virus issues are “short-term” and thus no action is warranted.  Quite possibly, perhaps even probably, they are short-term, but so are most of the pressures central banks deal with.  Most recessions for that matter, even most crises.)

And finally, it is worth bearing in mind that many commentators are already highlighting debt service burdens for businesses where activity has fallen away sharply,     There are no easy answers to what the appropriate policy response, if any, is to those issues. But it is worth pointing out that there are likely to be permanent income/wealth losses, even if in a year’s time the path of GDP is back on the pre-crisis course.  Income not earned this year is unlikely to be made up for by more income later.  In the extreme, if the economy largely shut downs in certain cities or regions for a short time –  or if certain sectors (eg foreign tourism) largely shutdown for longer –  those losses will not be made back, and the debt (business and household, bank and non-bank, lease commitments and loans) that was being serviced supported by those actual/expected income flows will still be there.   Those losses have to be (will be) distributed somehow and frankly it seems reasonable that part of that would be by adjustments to servicing burdens.     People will say –  commenters here have –  that 25 basis points is really neither here nor there.  And, of course, that is true.  They will also say that the OCR is “only” 1 per cent –  also true – but retail lending rates are over 5 per cent (floating mortgages) or 9 per cent (SME overdrafts), and in a climate like the present.    Those rates really should be a great deal lower –  at least temporarily –  as, of course, should the adjustable rates being earned by savers/depositors.

Pro-active macro policy would be doing all it can, as soon as it can, whatever additional firm-specific measures the government might also try.  To repeat, the point isn’t to fix the immediate situation –  there is no such fix, absent the magic fairy curing the world of the virus overnight –  but to limit the risk of longer-lasting damage and better position ourselves for what could still be a difficult recovery, with permanent wealth losses.  The Reserve Bank should be taking the lead –  it is conceivable that if they are going to wait until the scheduled review date that even a 100 basis point cut could be under consideration by then –  but there is sufficiently little the Bank can do –  even about that medium-term horizon, that we should have well-targeted and designed effective and prompt fiscal stimulus as well (again focused on the six to eighteen month horizon).  If anyone influential is reading, I commend again –  as one part of a response – the case for looking hard at a temporary cut in GST).

 

 

Preparing

In those distant days when world sharemarkets were still at or very near record highs –  actually, on Monday –  the Federal Reserve Bank of San Francisco released one of their short accessible Economic Letters summarising some research work done last year on the question “Is the Risk of the Lower Bound Reducing Inflation?“.   The views expressed are those of the authors, not the FRBSF let alone the wider Federal Reserve system, but the authors aren’t just fresh out of college either: one is the executive vice-president and head of research (one of the most senior policy positions) at the FRBSF, and the two authors are senior managers on the research side of the Bank of Canada.

Here is their summary

U.S. inflation has remained below the Fed’s 2% goal for over 10 years, averaging about 1.5%. One contributing factor may be the impact from a higher probability of future monetary policy being constrained by the effective lower bound [ELB] on interest rates. Model simulations suggest that this higher risk of hitting the lower bound may lead to lower expectations for future inflation, which in turn reduces inflation compensation for investors. The higher risk may also change household and business spending and pricing behavior. Taken together, these effects contribute to weaker inflation.

How does this work? Here is their description

If monetary policymakers are constrained by the ELB in the future, recessions could be deeper and last longer because central banks may be unable to provide sufficient stimulus. The greater decline in economic activity in this case would translate into lower inflation during such downturns relative to recessions when the policy rate is not close to the lower bound.

In addition, greater risk of returning to the ELB could also affect inflation during good times, when the economy is performing well and interest rates are above the lower bound. Investors and households often care about the future when making long-term investment decisions that are difficult to reverse, such as setting up a new production plant or buying a house. The possibility that recessions might be more severe in the future because of the ELB can affect their economic decisions today, prompting them to be more cautious to guard against this risk. For instance, households could start saving more in anticipation of possible harder times ahead. Similarly, businesses could engage in precautionary pricing by setting lower prices today if they anticipate a greater likelihood of deeper recessions in the future and do not review their pricing strategy frequently.

As something for the future –  perhaps the very near future –  it all seems a plausible tale, and is consistent with a line I’ve been running here for years, that when the next severe downturn comes markets (and other economic agents) will quickly focus on the limitations of conventional monetary policy and adjust their behaviour (for the worse, in cyclical terms) accordingly, deepening and lengthening the downturn.  But these authors go further and posit that people (real economy and financial markets) have already been factoring the ELB risks into their planning and decisionmaking, in turn directly contributing already to lower inflation and lower inflation expectations (than perhaps the current cyclical state of the economy might otherwise deliver).

I haven’t yet read their full working paper so can’t really evaluate the strength of their evidence on this point.  But if they are capturing something important about actual behaviour in the last decade or so, presumably those effects would be expected to have become larger the closer to the present we come.   Prior to 2007 the Fed (and other central banks other than Japan) had not reached the ELB at all. Immediately after the recession there was a pretty strong expectation that things would return to normal (including normal policy interest rates) before too long –  a view typically shared by markets and by central banks.    Only with the passage of time did those expectations gradually fade –  and perhaps more completely in Europe (where policy rates are still often negative, and pretty consistently lower than those in the US).

For New Zealand, of course, if there is anything to this story, it must be even more recent, having started with higher policy rates, and with markets and the Reserve Bank mostly looking towards higher policy rates until just the last couple of years.   The possibility of reaching the ELB in New Zealand has been a distinctly minority point (yours truly and perhaps a few others) for most of the last decade, in ways that leave me a little sceptical that the story will explain anything much of the inflation experience in New Zealand (or Australia) for the decade as a whole. In both countries, inflation has averaged materially below the respective target midpoints.

Whatever the case for the past, the FRBSF note ends with this point

These findings suggest that the puzzle of how to raise inflation to meet central bank goals may require new ways of addressing the risk of returning to the ELB and new ways of understanding how to set and meet inflation goals.

The problem is that there is a growing risk that it is now too late, and that central banks (and Ministries of Finance) have spent the last ten years not getting to grips with ensuring effective capacity for the next severe downturn, leaving things potentially almost paralysed when that severe downturn breaks upon us.  Which it could be doing right now.

Many advanced country central banks can now barely reduce the policy interest rate much at all –  the biggest problem with former Fed governor Kevin Warsh’s call yesterday for a coordinated international rate cut is that it would immediately highlight the limits, especially in Europe.  Even in a traditionally high interest rate country like New Zealand, there is perhaps 150 basis points of capacity, when the average recession in recent decades has involved 500+ basis points of cuts –  a point our Minister of Finance rather glossed over yesterday in his talk of the advantage of starting with relatively high interest rates.

As the FRBSF authors note

To compensate for this lack of conventional firepower, central banks can rely on unconventional policy tools, such as forward guidance or quantitative easing. While these tools proved effective during and following the crisis, it remains unclear whether they can fully compensate for the diminished conventional policy space and the more frequent encounters with the ELB

That is fairly diplomatic speak, as befits senior officials.  In reality, few really believe that unconventional tools under the control of central banks can adequately compensate for lack of conventional policy space.

In my view, those limits have not really been sufficiently focused on by markets, firms and households, or governments.  There has been quite a lot of wishful thinking around –  hankering for higher neutral rates, inability to spot an near-at-hand risk that might trigger an early severe downturn, or whatever.   But when people look at the looming coronavirus risks –  and markets will no doubt ebb and flow still, just as happened as the financial crisis unfolded a decade ago – and really begin to focus on what can, and will, be done, we are likely to see inflation expectations falling away much faster than in a normal downturn, in turn raising real interest rates and accentuating the problems, at a time when neutral interest rates are likely to be falling further (perhaps temporarily, but real enough for the time being).

To bring that back to the New Zealand situation, after ignoring the issue for a long time the Reserve Bank appears to have begun to take it more seriously in the last 18 months or so. But with little or no transparency and no apparent urgency.  We keep being told they are about to reveal their thinking –  I hope with a view to getting serious feedback etc –  but they’ve already mentioned enough that we can be sure that what they’ve had in mind simply will not make up for the limits of conventional interest rate capacity, even allowing for the likelihood that in such a severe downturn our exchange rate will fall a long way (as it did in most of those previous 500 basis point rate cut episodes).   There is also sadly little sign that the Minister of Finance has shown much leadership or urgency about seriously addressing this problem (again, nothing along those lines in yesterday’s speech –  good enough as far as it went, but it stopped short of the really serious issues/risks).

It would be easy for me to suggest that the Governor has been too much occupied with his tree gods, his climate change interests, his views on infrastructure or the distribution of income, rather than driving action urgently in this area of monetary policy capacity (core day job).  And that is no doubt true, but as a specific criticism it needs to be kept in perspective –  his predecessors had let the issue drift, and his peers at the top of many other central banks have also seemed to prefer to believe things would come right than to seriously prepare for the constrained alternative.  We risk paying the price now –  including with central banks paralysed by their own limitations and reluctant to act early and decisively to lean against (do what they can to buffer) the economic downturn (and downside risks to inflation and inflation expectations).

Quite possibly there is a place for fiscal policy in responding to a serious downturn, even one amid the chaos of a potential pandemic, but there needs to be a lot more realism about the likely constraints on how much, and how longlasting, any discretionary stimulus is likely to last.   There is no real excuse – even in a less fiscally constrained country like New Zealand –  for authorities not to have moved to greatly alleviate or remove the effective lower bound before now, and to have used relatively settled times to have socialised the case for doing so.

And even if the FRBSF authors are wrong about the influence of the ELB on inflation over the last decade, if it very quickly now becomes even more binding – starting from a lower initial level –  it will be front of brain for everyone through the next cycle.    It really needs to be dealt with now.  It isn’t technically hard –  there are various workable options –  but it needs leadership, will, and vision for something to happen, something which has the potential to limit the extremes (depth, duration) of that severe downturn whenever it finally strikes us.