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.


An employment objective for monetary policy: some survey results

Some link or other took me recently to the website of the University of Chicago’s Booth School of Business and, in particular, the IGM (economic) Experts Panel that they run.

Every few months, this outfit runs surveys of US-based academics on interesting economic questions.  Their panel is described this way

our panel was chosen to include distinguished experts with a keen interest in public policy from the major areas of economics, to be geographically diverse, and to include Democrats, Republicans and Independents as well as older and younger scholars. The panel members are all senior faculty at the most elite research universities in the United States. The panel includes Nobel Laureates, John Bates Clark Medalists, fellows of the Econometric society, past Presidents of both the American Economics Association and American Finance Association, past Democratic and Republican members of the President’s Council of Economics, and past and current editors of the leading journals in the profession.

You might not go to this group for “truth”. Academic economists have biases and blindspots, like everyone else (and tilt leftward politically), and sometimes the answers can look quite self-serving.  But a panel like this is likely to provide a fair representation of what US-based economics academics are thinking about issues.  They even provide two sets of answers: the raw responses, and a set in which respondents self-identify how confident they are of their views on the particular topic.

Flicking through the surveys from the last year or so, there were a couple of some relevance to the current review of the Policy Targets Agreement –  a new PTA is required in the next few weeks –  and of the Reserve Bank Act.

The new government has indicated its intention to add some sort of employment dimension to the Reserve Bank’s statutory objective for monetary policy, and they have often cited the (to me rather vague) wording in the US and Australian legislation.   In the US, the Federal Reserve is required by law to manage the money supply to grow in line with production, with the aim of thus contributing to

the goals of maximum employment, stable prices, and moderate long-term interest rates.

The Fed itself has reinterpreted this mandate –  without statutory authority although probably not unreasonably – as

The Congress has directed the Fed to conduct the nation’s monetary policy to support three specific goals: maximum sustainable employment, stable prices, and moderate long-term interest rates. These goals are sometimes referred to as the Fed’s “mandate.”

Maximum sustainable employment is the highest level of employment that the economy can sustain while maintaining a stable inflation rate.

One of the concerns some commentators here have expressed is whether any employment dimension added to our central banking legislation will have any real meaning or substance.  My own view, articulated here previously, is that it could do, but whether or not it does depends on how the provision is written, and what sort of reporting and accountability obligations are imposed on the Reserve Bank in respect of the employment dimension of the goal.   The Minister of Finance has not yet proposed any specific wording.

Against this background, it was interesting that the IGM Forum asked their panel members about the US wording.

employment IGM Weighted by the respondents’ individual levels of confidence, 55 per cent thought “maximum sustainable employment” was well enough defined to be used beneficially in policymaking.  22 per cent disagreed, and the remainder were uncertain.

This survey was done only a couple of months ago.  In that light, it is also interesting –  although not directly relevant to New Zealand –  that more respondents thought the US was still operating below “maximum sustainable employment” than disagreed.

At very least, these sorts of survey responses suggest that the government can come up with a formulation that might pass muster, as useful, among academic economists.  As a practical matter – and most of these respondents haven’t spent much time around policy –  I’m sure they can.    As I’ve noted previously, Lars Svensson – the leading Swedish economist who did a review of New Zealand monetary policy for the previous Labour government –  certainly believes some such framing is desirable and practically useful.

It isn’t yet clear whether the government wants a formulation that is practically beneficial and makes some difference to the conduct of short-term monetary policy, or simply wants something that looks different.   With Treasury, and the Independent Expert Advisory Panel (of questionable independence if the report on the back page of Friday’s NBR is anything to go by), due to report very soon, we should have some stronger indications before too long.

There was another recent IGM survey question of some relevance to New Zealand and other countries.  Last July, panellists were asked their view of the following proposition

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

Weighted by the confidence of the individual respondents 86 per cent agreed.

The panel was also asked their view of this proposition

If the Fed changed its inflation target from 2% to 4%, the long-run costs of inflation for households would be essentially unchanged.

A majority (51 per cent vs 29 per cent) disagreed, presumably thinking the costs of inflation would rise.

I’d agree with the majorities in both cases, and would answer the same way if the questions were posed for New Zealand.    I’d prefer not to have the target raised to 4 per cent –  actually meeting (or perhaps slightly overshooting) the 2 per cent target would do for now –  because there are (modest) welfare costs from a higher inflation target in normal circumstances.   But limitations on macro policy in the next serious recession is a real challenge, and there is little sign that the Treasury or the Reserve Bank have really engaged with them (eg it never appeared in the work programmes in Reserve Bank statements of intent).      And if there isn’t a willingness to address the practical constraint on taking interest rates much below zero, the Minister needs to be taking much more seriously the option of a higher inflation target.   Better to address the problem at source, but there is no sign our government – or officials –  have been doing so.

For those of a technical bent, in a Brookings newsletter the other day I noted a description of an interesting looking new paper tackling this issue from another angle.

Decline in long-run interest rates increases optimal inflation, but not one-for-one
If the decline in long-run real interest rates in advanced economies persists, nominal interest rates may be constrained by the zero lower bound more frequently. To counteract this, some economists have supported increasing the inflation target. Using a new Keynesian DSGE model, Philippe Andrade of the Bank of France and co-authors find that a 1 percentage point decline in the long-run natural rate of interest should be accommodated by an increase in the optimal inflation rate of about 0.9 percentage point—an estimate that is robust to various specifications that allow for uncertainty about key parameters in the model.

Hankering for normalisation

Really ever since the end of the immediate financial crisis in the first half of 2009 there has been a hankering –  often more than that –  among some central bankers, some former central bankers. and some agencies that associate with and support central bankers (ie the BIS –  Bank for International Settlements) for things to “get back to normal”.   What leaves these people particularly uncomfortable is the level of official interest rates, which in most of the major advanced economies (and quite a few smaller ones) have been very close to zero (sometimes modestly negative).    And it is now almost nine years since the end of that first intense crisis phase.   And, at least in nominal terms, there had been no precedent for such low official interest rates.

It was, perhaps, an understandable reaction in the immediate aftermath.  I certainly shared it then.  I was on secondment to The Treasury, and recall talking things over with a colleague who had previously been at the Reserve Bank.  We agreed that the Reserve Bank (Alan Bollard personally) appeared to have done a thoroughly excellent job in cutting the OCR aggressively during the crisis/recession, but that it seemed likely –  and appropriate – that many of those cuts should soon be reversed.  We welcomed early indications that that was exactly the Bank’s intention.  I also recall pointing out to colleagues that bond markets appeared to be pricing a reasonably prompt, and near-full, rebound in policy interest rates (not just in New Zealand but in range of advanced economies).

It all made sense at the time: very sharp cuts in policy rates had been appropriate in a sharp economic downturn accentuated by an extreme rise in uncertainty and liquidity preference, but once those fears eased (with time and various direct interventions) it didn’t seem obvious that anything very structural about economies had changed.  If so, it wasn’t obvious that future average interest rates would be much different from those of the previous decade or two.

That was then.  But now it is 2018.  And the median policy interest rate among OECD central banks (that have their own monetary policy) is about the same now as it was in the trough in 2009.   Some individual countries have lower rates now, and some higher (the US notably), some have tried to raise rates and had to reverse themselves (eg New Zealand twice, Sweden, and the ECB).   No OECD central bank has simply left its policy rate unchanged since 2009.

And throughout that period inflation (headline and core) has remained pretty quiescent. Here is an indicator of core inflation across OECD countries (well, monetary areas, so the euro-area is a single observation).

CPI ex OECD jan 18

Not all central bankers like to own up to paying any attention to (indicative) measures of excess capacity, but over the decade unemployment rates have typically dropped back quite slowly (as in New Zealand) and output gaps are still estimated to be around zero, often negative.  As a reminder, these outcomes have come about with interest rates very (historically) low.  They aren’t themselves an argument for much higher policy rates.

And yet the anguishing continues.    Some of it has become almost pro forma in nature.  The former Governor of the Reserve Bank used to regularly talk about how “extraordinarily stimulatory” he thought interest rates were and openly hankered for “normalisation” here and abroad.  His temporary successor (the “acting Governor”) throws in occasional references along similar lines.  I suspect it makes them more reluctant to lower the OCR than they otherwise would be but –  in fairness –  they do eventually seem to be led by the data rather than by their mental model of how the world should work.

Others seem to want to translate the model into action.  I noticed one example yesterday, in the form of a new column by former ECB board member (in effect he served as chief economist) and former Bundesbank Deputy Governor, Jurgen Stark.   Former BIS chief economist (and former Bank of Canada Deputy Governor) Bill White has had a succession of speeches and articles along similar lines, and his latest was published in the Financial Times a few days ago.

Stark opens his argument with the recent sharp dip in US share prices which, he asserts

revealed just how addicted to expansionary monetary policy financial markets and economic actors have become.

Possibly, but since the S&P this morning is still a touch higher than it was on 31 December 2017 –  a mere seven weeks ago – I’m not sure it is particularly compelling evidence.

He moves to a somewhat more macroeconomic argument

The fact is that ultra-loose monetary policy stopped being appropriate long ago. The global economy – especially the developed world – has been experiencing an increasingly strong recovery. According to the International Monetary Fund’s latest update of its World Economic Outlook, economic growth will continue in the next few quarters, especially in the United States and the eurozone.

I’m not sure we should be particularly encouraged that “economic growth will continue in the next few quarters”, but nor am I sure how it is relevant.  First, projections of continued growth –  even growth a bit faster than medium-term potential growth –  are, in part, reflections of –  and, at very least, consistent with –  the low interest rates.  And second, inflation –  or some other nominal variable – is supposed what central banks focus on first and foremost.

The US Federal Reserve has been raising interest rates, but it isn’t enough for Stark.

But the Fed’s policy is still far from normal. Considering the advanced stage of the economic cycle, forecasts for nominal growth of more than 4%, and low unemployment – not to mention the risk of overheating – the Fed is behind the curve.

It isn’t clear that “the advanced stage of the economic cycle” means much more than that it has been a few years now since the US had a recession.  Nominal GDP growth –  currently around 4 per cent –  shows no sign of racing away, and has averaged 3.8 per cent per annum since 2010.  And core PCE inflation –  the Fed’s target variable –  is currently 1.5 per cent, while the Fed’s self-chosen target is 2 per cent.  Yes, the unemployment rate is low, but as on the one hand some analysts suggest the headline number is underestimating residual labour market slack, and on the other the Fed is actually raising policy interest rates (and is expected to continue to do so), it is hard to find any backing for Stark’s claim that the Fed is “behind the curve”.    And even if, for example, the latest round of ill-judged fiscal stimulus does end up providing the boost that lifts inflation nearer target, it is hard to believe (and there is no obvious evidence for) that inflation expectations are so weakly anchored that a lift in inflation to target (after all these years) will destabilise expectations in a dangerous and damaging way.  This isn’t 1974.

But if the Fed is bad, on Stark’s reckoning, many other advanced economy central banks are “even worse”

The ECB, in particular, defends its low-interest-rate policy by citing perceived deflationary risks or below-target inflation. But the truth is that the risk of a “bad” deflation – that is, a self-reinforcing downward spiral in prices, wages, and economic performance – has never existed for the eurozone as a whole. It has been obvious since 2014 that the sharp reduction in inflation was linked to the decline in the prices of energy and raw materials.  In short, the ECB should not have regarded low inflation as a permanent or even long-term condition that demanded an aggressive monetary-policy response.

The ECB’s policy is also out of line with economic reality: the eurozone, like most of the rest of the global economy, is experiencing a strong recovery.

I think there is quite a bit to argue about over the way the ECB interjected itself into the euro crisis, and one can mount arguments –  as Stark did –  about the appropriateness of the quasi-fiscal policies the ECB ended up adopting.   But what about inflation –  the macro variable the ECB says it targets, under its treaty mandate to pursue price stability?

euro area CPI

The ECB targets something “below, but close to, 2%” (in practice something like 1.9 per cent).   Headline inflation certainly fluctuates –  there (as Stark notes) and other places fluctuations in oil prices make a big difference in the short-run.   But the last time euro-area wide core inflation was at 1.9 per cent was the end of 2008.   And there hasn’t been any obvious sign in the last 12 or 18 months that core inflation is picking up strongly again.  Now Stark is German, and activity and demand in Germany have done better than in the rest of the euro-area.  Inflation in Germany is also higher than in the euro-area as a whole but on neither headline nor core measures is it as high as 1.9 per cent –  and monetary policy is supposed to be set for the region as a whole, not just for the single largest national economy.

As for the “strong recovery”, things in the euro-area are certainly a great deal better than they were, but in its last published forecasts the IMF estimated that for the euro-area as a whole, there was still a negative output gap last year, and forecast one around zero this year.  And that with interest rates at (historically) very low levels.

The sort of argument that Stark uses might make a bit of sense if he wanted to argue that interest rates at these levels are having no effect (on demand/activity).  If they were having no effect, there might be no harm in having them higher again.  But that isn’t his argument.  Instead

One of those consequences is that the ECB’s policy interest rate has lost its steering and signaling functions. Another is that risks are no longer appropriately priced, leading to the misallocation of resources and zombification of banks and companies, which has delayed deleveraging. Yet another is that bond markets are completely distorted, and fiscal consolidation in highly indebted countries has been postponed.

This “misallocation of resources” line often pops up in commentaries like Stark’s (it is there is White’s FT article as well) although it is never clear quite what is meant.  It really only seems to make much sense if one can confidently assume that their model –  in which interest rates should be so much higher –  is correct, and thus relative to that benchmark choices are made differently than they would be in the alternative universe.  Perhaps it is right, but we have no very obvious means of knowing that it is –  after all these years.  If neutral rates are lower than they think, “misallocations” might just be “choices”.

And the claim seems to involve the suggestion that some real activity is now happening which wouldn’t happen if only interest rates were higher.   Stark actually states it more or less directly: in his view current policies have ‘delayed deleveraging”, and the “fiscal consolidation in highly-indebted countries has been postponed”.   But had a whole succession of governments actually been under more pressure to run lower deficits/larger surpluses, cutting their debt levels, where and how does he suppose the replacement demand might have come from?  It isn’t as if any monetary area in the advanced world has had consistent excess demand this decade.   There are, of course, standard responses about confidence effects, and private demand replacing public spending –  at times even the New Zealand experience in the early 1990s is cited –  but those offsetting adjustments typically take place in part through lower interest rates and a lower exchange rate (governments cut spending, central banks ease monetary policy, and additional private spending is crowded in ).  Stark’s model rules out that process almost by construction.  Much the same story is likely to hold for corporate or household deleveraging: the process by which it occurs usually involves (incipient) weaker overall short-term demand and activity.  Oh, and if Stark was right and the ECB raised policy interest rates in the current climate and it seems reasonable to expect that the euro exchange rate would be higher.  There is no guarantee about exchange rate effects, but (probabilistically) it is another channel that would weaken demand and activity further.

I’m not convinced there is a particularly good case at present for the ECB to still be buying large volumes of bonds.  But the case for higher interest rates –  across the whole euro-area, or even just for Germany –  seems threadbare in the extreme.

Stark ends his article this way, generalising beyond just the ECB.

Today, monetary policy has become subordinate to fiscal policy, with central banks facing intensifying political pressure to keep interest rates artificially low. As the recent stock-market turmoil shows, this is drastically increasing the risk of financial instability. When more – and more severe – market corrections take place, possibly affecting the real economy, what tools will central banks have left to deploy?

The evidence for these claims seems thin at best.  There has certainly been a huge increase in net government debt in some of the larger OECD countries in the last decade –  France, Italy the US, the UK, Japan, although not Germany –  but it isn’t obvious that monetary policy is playing out materially differently in those countries than in places like Switzerland, Sweden or Israel (where net debt has fallen as a share of GDP over the decade –  and where official interest rates are very low) or in places like New Zealand or Canada that have seen only modest increases, from low bases, in the levels of net public debt.

And what of the claim that “interest rates are artificially low”?  Well, that simply seems to impute far too much power to central banks.  Central banks set very short-term interest rates, and over those short-term horizons no one else can do much about it.  Central banks do not set long-term interest rates and typically have very little direct influence on extremely long-term interest rates.   The longest German inflation-indexed government bond matures in 2046: the current yield on that bond is negative.  Perhaps Stark would argue that the ECB bond-buying programme directly or indirectly influences those yields.  But in most countries, central banks aren’t engaged in bond buying programmes at all, and very long-term nominal and real interest rates are extremely low.   Swiss 10 year conventional bond yields, for example, are basically zero.  US 30 year inflation-indexed bonds (and the US currently has by far the highest interest rates among the larger economies) are currently around 1 per cent.  And even in little old New Zealand –  typically with the highest real interest rates in the advanced world –  our 22 year government indexed bond is yielding just slightly over 2 per cent (down from 5 per cent 20 years ago).  It is a global phenomenon, and it can’t just be down to the (misguided or otherwise) choices of central banks.   Rightly or wrongly, some mix of demographics, weak expected productivity or whatever, seem to be at work.  Central banks might not fully understand what is going on –  nor might anyone else –  but it would brave, nay foolhardy, for the central banks of the world to stake out a stance that relied on a completely different view (“interest rates should be much higher”).

Which, of course, brings us to that very last line in Stark’s article.  When things really go wrong, what tools will central banks have left to deploy?

That is, of course, a serious issue, and it is one that ever central bank, every finance ministry, every Minister of Finance should be worrying about.   After all, they’ve had years of notice of the issue now.    When the next serious recession happens –  and one will happen again –  it looks as if most central banks in advanced countries will have little or no room to cut interest rates, the typical counter-cyclical stabilising policy instrument.  Even countries like New Zealand and Australia will have far less room than typical (the Reserve Bank could probably cut the OCR by 2.5 percentage points, but had to cut by 6.5 percentage points after the last recession).     Markets know that constraint, which in turn risks exacerbating the severity of the downturn once it begins.    Most major advanced countries also have very little fiscal leeway left (whether as a matter of technical/market limits or political limits).

I’m all for growth-enhancing structural reforms.  They would benefit countries now, and in the future (both lifting demand and activity, and raising market assessments of neutral interest rates).  There are few signs of those sorts of reforms in most countries (indeed, often –  probably including New Zealand –  the reverse).  But what is the best path now, around macro policy, to provide greater leeway when the next serious recession comes?

On monetary policy, the standard prescription is pretty clear: higher inflation expectations are the only thing monetary policy can do to underpin higher medium-term nominal interest rates.  In other words, the best things central banks could have been doing in recent years was to aggressively pursue higher demand and inflation (there being no sign that weak inflation was a result, all else equal, of strengthening productivity growth).  Cut interest rates so as to later raise them by rather more (the opposite of the Reserve Bank strategy which turned out to be, in effect, “raise interest rates only to cut them more later”).    Few or no central banks have had the courage to adopt this course (or to openly consider higher inflation targets), partly (I suspect) transfixed by the desire for “normalisation”.   And what of fiscal policy?  In some of the countries with large deficits and high debt, it might well make sense to look to secure fiscal consolidation (giving, among things, more room for countercylical stimulus in the next recession).   For a country like the US, more or less back to a fully employed economy, that makes particular sense.   But it is far from obvious that the same logic follows in France or Italy  (still with negative output gaps): all else equal, fiscal consolidation will tend to worsen economic activity now, and yet euro-area monetary policy has all but reached its limits and can provide no offset.  Increasing the chances of a new recession now to slightly reduce the chances/severity of one five years hence is, to say the least, a difficult call (economically or politically).

At present, I’m reading one of the numerous books on my shelves about the politics and monetary policies of the inter-war period.  It is, I think, now widely accepted that monetary policy problems were at the heart of the seriousness of the Great Depression in many of the major economies (even New Zealand for that matter); in particular the way the Gold Standard had been run –  and patched back together (“normalisation”) during the 1920s after the extreme disruption of World War One.

Some of the abler observers in the late 1920s realised that problems were building up – including that perhaps two-thirds of the world’s monetary gold being held in France and the United States, without the natural stabilising mechanisms being allowed to work freely –  but there was never a sufficiently strong shared sense among policymakers that something needed to be done, and promptly.  In the US, for example, there was constant unease about the stock market boom, and thus a reluctance to allow the Gold Standard mechanisms to work as they should (when gold floods in interest rates fall, demand increases etc).   As I read through the book, I was reminded of the Governor of the Bank of England deliberately accentuating the risks to the UK peg to gold, to keep the pressure on British ministers to make large fiscal cuts (that were probably never substantively warranted).  And, even when the UK finally, reluctantly, went off the gold peg in September 1931, instead of embracing the opportunity, for some time all the great and the good (even Keynes) were focused on generating conditions that would warrant a return to gold.    Economic historians are now pretty clear that monetary expansionism –  made possible as countries slowly, and mostly reluctantly, broke the link to gold –  was a significant part of economic recovery in the 1930s.

Historical parallels are never exact but is hard not to see the constant hankering for “normalisation” –  and vigorous calls for it in some circles –   and even unease about asset prices, as akin to the well-intentioned policy mistakes of the late 20s and early 30s, leaving our world badly exposed when and if the next serious downturn occurs.

(And if –  as White and Stark claim –  financial stability is your real concern, use financial regulatory instruments and agencies to attempt to tackle those issues directly.  Sometimes monetary policy “mistakes”/shocks can be closely linked to subsequent financial stability problems.  Arguably that was the situation in Ireland and Spain in the 2000s – interest rates that suited German conditions but not Irish or Spanish ones –  but I doubt anyone can point to a single example today of an advanced economy dramatically overheating as those two did.)

Reserve Bank attempts to play distraction

A slightly strange story –  but one that rings very true – leads the business section of this morning’s Dominion-Post.  In the story, Hamish Rutherford reports on an interview with the Reserve Bank’s long-serving chief economist John McDermott.   If the interview is at all accurately reported, McDermott appears to have got himself into one of his periodic grumps with the private market economists.

I worked closely with McDermott for six years –  he was my boss, and we sat directly opposite each other.  He is mostly a pretty amiable guy, and in an earlier phase of his career had published a lot of research (a few years ago he was still, apparently, one of the New Zealand economists most cited in formal economics literature).   But he doesn’t react that well to people disagreeing with him, especially openly (some of my other concerns were outlined in this earlier post on one of his 2017 speeches).   There is often a testiness about his reactions –  combined with a condescending tone of a “you just don’t understand” type.

And yet, of course, together with his colleagues he has been consistently wrong about the inflation outlook (and, thus, monetary policy) for at least the last five years.   (In fairness, of course, except during the Bank’s very grudging series of OCR cuts in 2015/16, the median market economist has generally been even more wrong.)

But what of the latest interview?

A top Reserve Bank official has dismissed criticism from bank economists about his forecasts as “nonsense” saying the bank is ready to cut interest rates if growth lags.

On Thursday both Westpac and ASB accused the Reserve Bank of being too optimistic in its forecasts for economic growth.

But Dr John McDermott, the Reserve Bank’s chief economist for the past decade said the bank economists appeared to misunderstand the process creating Reserve Bank’s forecasts.

“Nonsense” is strong language.   And both the Westpac and ASB chief economists previously worked in the forecasting part of the Reserve Bank, albeit a few years ago now.

Here is Westpac

However, we still think the RBNZ is expecting too much of the New Zealand economy. In our view, the recent plunge in business confidence portends a slowdown in business investment that the RBNZ has not allowed for. Furthermore, we expect the Government’s upcoming changes to the tax treatment of investment housing, the foreign buyer ban, gradually rising fixed mortgage rates and lower net migration will slow the housing market later this year. A slow housing market would, in turn, lead to slower consumer spending than the RBNZ anticipates. Finally, we doubt that construction activity will accelerate in 2019 to the extent that the RBNZ expects, even with the KiwiBuild scheme in operation. Capacity constraints in the construction industry are just too binding.

Agree or not, they sound like plausible points on which reasonable economists might disagree, without resorting to name-calling.

But –  as he has often done in the past when his forecasts have been called into question – McDermott falls back on a claim of being misunderstood.

Rather than predicting what the economy will do, the bank worked out what kind of growth was needed to generate sufficient inflation. The variable in the equation is interest rates, which the bank can change.

In an interview in the Reserve Bank’s headquarters in Wellington, McDermott, repeatedly said if the economy was not growing fast enough to generate inflation, the bank will cut the official cash rate.

“It’s not about being optimistic or hopeful, it’s actually, if we don’t get that growth rate, we are going to lower interest rates because otherwise we won’t get the inflation rate.”

McDermott just shouldn’t be allowed to get away with this sort of special pleading  (even setting aside the fact that he and his bosses have actually delivered core inflation well below the target midpoint for years now).   He makes a partially fair point that one can’t just look at the Bank’s GDP forecasts in isolation.   But that is true of anyone’s forecasts.  While it is inflation targeting, the Reserve Bank will always show inflation coming back –  more or less slowly – towards the target midpoint.      And so, at very least, one has to read the interest rate and GDP forecasts together.

But in Westpac’s case they think GDP growth will be lower than the Bank is projecting, and that interest rates will be a (very) little lower than the Bank is projecting.  Against that backdrop it seems quite reasonable for them to say that the Bank is being too optimistic about how much GDP growth is likely over the next couple of years with interest rates around where they are now, or even a bit lower.

McDermott goes on

“Our inflation forecasts are always 2 per cent, it’s always 2 per cent.  [eventually]

“It is because we plan to succeed, and then you go, ‘well, how do you do this’. And so, the monetary policy statement’s objective isn’t an unadulterated forecast about what we think will happen, it’s what do we need the plan to look like to make it happen.”


The problem with McDermott’s story is that his forecasts today influence policy today.  Thus it is fine to talk  –  as McDermott often does –  about revising forecasts in light of developments.  But better still, how about getting them (more) right first time round?    The Bank believes that it will, with current interest rates, generate more demand and economic activity –  and thus more inflation –  than some of the private economists (eg Westpac and ASB) think likely.     The Bank is in that sense more “optimistic” than these private economists.  If the Bank is wrong, we will eventually find out, and (slowly, grudgingly) policy will be adjusted, but in the meantime we’ll have missed out on some growth (they expected) and inflation will have fallen short of the target (again).  If they are indeed too “optimistic” now, it matters.

McDermott goes on

McDermott said many bank economists did not appear to understand the process.

“They sit outside, they don’t get to influence policy. We get to move [interest rates]. Inflation has to be 2 per cent, and engineer backwards, what do you need growth to be, to engineer 2 per cent [inflation].”

So if growth starts lagging, you’re going to cut the OCR?

“Yes. That’s the game,” McDermott said. “So the fact that they think we’re being optimistic is a nonsense, because if it doesn’t eventuate, we get to alter interest rates.”

It is exceedingly unlikely that bank economists did not “understand the process”.  The process has been operating in basically the same way for more than 20 years now, it is extensively documented by the Bank in published material, and three of four main banks now have chief economists who started their careers in the Reserve Bank Economics Department.  What is going on here is that the Reserve Bank chief economist is on the defensive, and rather than defend the substance of his forecasts he attempts to muddy the waters with suggestions that the private economists just don’t understand.

Thus, we are told, McDermott

 would “remind” several chief economists of the process used

Which won’t change the fact that there is a difference of forecasts –  of views.

In a way, he even concedes the point.   The final sentence of the hard copy version of the article isn’t in quotation marks but here is what McDermott is reported as saying

McDermott said it would be a different situation if the banks were saying that the forecasts were too optimistic based on the OCR remaining at the current level.

So what was all the name-calling about?   As McDermott knows, neither Westpac nor ASB is forecasting an OCR cut, and the Reserve Bank isn’t forecasting an interest rate increase for some time.  The private economists and the Reserve Bank all have the OCR at 1.75 per cent throughout this year and well into next year, and thus their GDP forecasts for the next year or two are apples-for-apples comparisons.   It is quite reasonable to say that Westpac and ASB think that Reserve Bank is too “optimistic” (and they don’t need to state all their ancillary –  but rather obvious –  assumptions every time they make the point).

The article also contains this observation and comment

While economists have slowly come around to the Reserve Bank’s view that the OCR will stay at its current low for at least a year, none give a significant chance that the Reserve Bank will cut.

McDermott suggested they were wrong to do so.

“The market thinks ‘you guys are never gonna [cut]. They’ve been through almost a whole year of ‘there’ll be no chance you guys are going to cut interest rates’. Well, that’s not true.”

But again, this looks like a deliberate attempt to skew interpretations.   The Bank – rightly in my view –  has talked of the possibility of cutting the OCR, but in all its comments last week –  including from the “acting Governor” –  it came across as very reluctant.  And its published OCR forecasts don’t have a flat track as far as eye can see –  in fact the track starts edging upwards from the middle of next year.  And what of the market economists?   A couple of the more prominent ones are included in the NZIER Shadow Board exercise.  Here were their latest probability distributions for where they think the OCR should be.

shadow board feb 18

The chief economist of Westpac a few days ago thought there was 25 per cent chance that the OCR should have been lowered.   Indeed, in their post OCR commentary, Westpac explicitly said

If anything, we would put the odds of an OCR reduction this year as slightly higher than the odds of a hike

(Perhaps if the Reserve Bank really wants people to stop focusing on possible OCR increases they should, at last, drop the endless rhetoric about a “normalisation” of interest rates?)

I’m also a bit sceptical of the Reserve Bank’s growth projections.  As I’ve been pointing out for some time, in each set of quarterly forecasts they project a return to productivity growth.  In the latest numbers, after four years of basically zero growth in their “trend labour productivity” measure, they forecast a steady pick-up in productivity growth such that by 2020/21 they expect 1.2 per cent annual productivity growth.  In a single year, they expect as much productivity growth as the total productivity growth they show for the six years to March 2019.   Without any material productivity-enhancing micro reforms, and without any substantial reduction in the exchange rate, if that isn’t “optimistic” I’m not sure what is.   I really hope they are right, but it looks too optimistic at present.

No doubt the private bank economists will just grumble quietly, and their view of McDermott will be adjusted another notch downwards.    After all, they’ve seen what happens to those of their number who too openly criticise the Reserve Bank –  recall that McDermott was one of those deployed by Graeme Wheeler last year in his heavyhanded attempts to silence BNZ chief economist Stephen Toplis.

But we –  the New Zealand public – deserve better.    We need a reformed Reserve Bank, a properly independent statutory monetary policy committee, not simply staffed with bureaucrats, and we need quality senior staff of the Reserve Bank who are capable of engaging openly, and authoritatively, on the sort of issues and uncertainties we face in making sense of the economy, without resort to name-calling or rather desperate attempts to suggest that people who disagree with the Bank just don’t understand, and that they need to be called in and “reminded” of the process.




Inflation is – still – expected to rise

Inflation is expected to rise gradually towards the two percent midpoint of the target range.

That was what the then Reserve Bank Governor said in the press release for the March quarter Monetary Policy Statement five years ago.

And today Grant Spencer (the unlawful “acting Governor”) said

Overall, CPI inflation is forecast to trend upwards towards the midpoint of the target range

So much time has passed, and so little has changed.  I could probably compile a complete set of those sorts of quotes, drawing from every OCR review for at least the last five years.

And this is how the Reserve Bank’s preferred core inflation measure has actually been performing.

core inflation feb 17

December 2009 was the last time core inflation was at 2 per cent.  And there is little or no sign that –  despite all the Reserve Bank forecasts –  that the gap has been closing.

The Reserve Bank doesn’t publish core inflation forecasts, but since they also don’t typically forecast price shocks (the sorts of one-offs that get sifted out in the core measures), their actual medium-term inflation forecasts are a reasonable proxy.   On the numbers published this morning, it will be September 2020 before we could expect to see core inflation back to 2 per cent –   if so, core inflation would have been below the (explicitly highlighted) target midpoint for more than a decade.  Even though over that whole period our Reserve Bank has not once come close to exhausting the limits of conventional monetary policy.

And the worst of it is that neither in the published statement this morning, nor in the press conference could the Bank’s second XI (holding the fort until the new Governor takes office next month) offer any explanation for why they are more likely to be right this time than in those previous five years of statements affirming that inflation was heading back to the target midpoint.   In fact, there was no sign of them even attempting such an explanation.

Over the years core inflation has been below target we’ve had the big boost to demand from the Christchurch repair process, a material further step up in the terms of trade (albeit with a fair amount of volaility), a significant reduction in unemployment, and the demand effects of an unexpectedly strong and persistent rate of population growth.  We’ve seen the end of the fiscal consolidation phase too.  And there has been no sign of core inflation picking up much, if at all.    What, we should expect to be told, is likely to make things different over the next few years?   And why have they got things wrong – again – over the last couple of years?

The Bank claims the output gap is now near-zero, but on their own (inevitably imprecise) estimates those resource pressures are a bit less than they were, and haven’t changed much for several years now.

In the press conference, there were several questions about the case for an OCR cut, which the Bank sought to bat away (not remotely convincingly in my view).  The “acting Governor” acknowledged that there is a risk that the next OCR adjustment could be a cut –  if the downside inflation surprises continue –  but repeatedly sought to play down the significance of the 2 per cent target midpoint, which –  as a focal point – was explicitly added to the Policy Targets Agreeement in 2012.  Asked –  channelling lines run in this blog –  whether it might not be time to take some risks, after eight years of (core) inflation below target, Spencer could only fall back on observing that inflation had been inside the range, and that what mattered was to be patient and confident that inflation would be back to the target midpoint before long.  In other words, trust us, even though that trust has been misplaced for years now.

Asked then whether there was not also a case for acting now to push up inflation to create more policy leeway (in nominal interest rates) when the next recession comes, Spencer could offer nothing more than the limp observation that “we have to have a good reason to change policy”, and that they wouldn’t want to change rates until they could be confident the policy could be sustained (even though the whole point of this particular proposal is to use lower policy rates in the short-term to generate higher policy rates in the medium-term).

I suspect that much of what is going on is the same old line was used to hear repeatedly from Graeme Wheeler – the “normalisation” of interest rates which are currently –  in the Deputy Governor’s words –  “very stimulatory”.   A common way of judging whether policy is “very stimulatory” or not might be to look at inflation developments, which suggest –  for now at least –  that the neutral interest rate has fallen.   The siren call of “policy normalisation” has tantalised central banks for much of the last decade –  none more so than the Reserve Bank of New Zealand, with two unwarranted and reversed sets of OCR increases –  and isn’t helping the cause of good policy.  Perhaps –  perhaps even probably –  at some point interest rates will move up quite a lot and stay higher, but that hasn’t a helpful guide to practical policy at any time in the last decade.   Actual (core) inflation, by contrast, has been.   The Reserve Bank now seems tantalised by the official rate increases in the US and Canada, but there is little sign of that becoming a generalised pattern across advanced country central banks –  partly because there is little sign of generalised increases in core inflation.

There was one new interesting development in the Monetary Policy Statement.  Buried in a footnote was the report of a new point estimate for the NAIRU of 4.7 per cent (in the press conference, they added a range of 4.0 to 5.5 per cent), based on some as yet unpublished research work.  I welcome the publication of the estimate –  a step forward –  but I’m a bit sceptical about their number (which is actually higher than the NAIRU estimate the Bank had in its models a decade ago, and there are good reasons to think NAIRUs –  here and abroad –  have been falling over time).  But if they really believe the story that the output gap is zero and the unemployment gap is zero, and their own data show (see chart here) that there is nothing unusual about the current relationship between core tradables and core non-tradables inflation, then it raises some questions they don’t seem to have attempted to answer.  Given that actual core inflation has been persistently low, it would suggest that inflation expectations are also well below the target midpoint.  As I’ve illustrated again recently, that is certainly the case in bond market indicators (unlike say the case in the US), but the Bank continues to assert that there is no issue and that inflation expectations are securely anchored at 2 per cent.  Something in their story doesn’t seem to add up.

In a way, today’s Monetary Policy Statement doesn’t matter much:

  • Spencer himself retires in six weeks or so, just after the next OCR review,
  • a new single-decisionmaker Governor will take office, and we have heard as yet nothing from him about his approach to the role,
  • there will be a new PTA, which the government has not yet given us any details (although there have been some suggestions that the 2 per cent midpoint reference might be removed),
  • the statutory goal of monetary policy is to be amended later this year (presumably also requiring a new PTA), but with no details yet, and
  • a statutory Monetary Policy Committee is to be put in place shortly, including with outside members.

In other words, what Grant Spencer thinks today about future policy isn’t that important and obviously isn’t binding.  But there is no reason why the analytical part of the document could not have been a lot more persuasive –  if in fact the existing senior management team has a compelling story to tell.  As it is, they don’t seem to.

At the end of the press conference, Bernard Hickey invited Grant Spencer to reflect on his involvement with many Monetary Policy Statements over the years (going back to the very first one in April 1990 –  which I drafted most of, and Grant was my boss).    He offered only two brief thoughts: flexible inflation targeting had proved to be a good framework, and the (slightly cryptic) patience is a virtue.   I wasn’t sure if that latter observation was as close as we were going to get –  from a thoroughly decent senior public servant –  to an acknowledgement that the 2014 tightening cycle, driven by a combination of conviction that inflation was about to take off (above 2 per cent) and repeated talk of “policy normalisation”  –  had been a mistake.

If so, we should be grateful, but it is still important that the Bank shouldn’t be so paralysed by its previous mistake –  an inevitable human tendency –  that it fails to do its job.  It is increasingly difficult to see why we should confidently expect core inflation to get back to 2 per cent on current policy, or what harm might be done from signalling more strongly the possibility of a lower OCR.  After all, as both the “acting Governor” and the chief economist said, the aim isn’t to be exactly at 2 per cent each and every quarter, and if anything a period of inflation a bit above 2 per cent –  not sought, but if it happened –  might actually help to rebuild confidence that the target really was centred on 2 per cent, not operating as a ceiling of 2 per cent.

As non-transparent, and obstructive, as ever

Just when you think there are the occasional promising signs that the Reserve Bank might, perhaps, be becoming a little more open…….they come along and confirm that they are just as secretive as ever.

At the last Monetary Policy Statement, the Reserve Bank indicated that it had made allowance for four (and only four) specific pieces of the new government’s policy programme.   They provided no details, beyond the barest descriptions, even though these assumptions fed directly into their projections and to the “acting Governor’s” OCR decision.  In one specific example, they indicated that they had assumed that half the planned Kiwibuild houses would displace private sector housebuilding activity that would otherwise have taken place.   That assumption directly feeds into their forecasts of resource pressures, but is also quite politically sensitive.  You might suppose that in an open democracy, a public agency that came up with such estimates would publish their workings, at least when a formal request was made.

You’d be quite wrong.  I lodged a request a few weeks ago, asking for “copies of any analysis or other background papers prepared by Bank staff that were used in the formulation of the assumptions”.  I wasn’t asking for emails back and forth between staff, and I wasn’t even asking for the minutes of meetings where these papers were discussed.  I certainly wasn’t asking for copies any other government department or minister might have supplied them.  Just the analysis and related background papers the Bank’s own staff had done.

In response –  having taken several weeks of delay –  they didn’t redact particularly sensitive items, they simply withheld everything (down to an including the names of the papers concerned).   This is, it is claimed, to “protect the substantial economic interests of New Zealand”, a claim which is simply laughable.  Protecting senior officials of the Reserve Bank from scrutiny is not, even approximately, the same thing as protecting the “substantial economic interests of New Zealand”.  It might even be less intolerable conduct if they had laid out the gist of their reasoning in the MPS itself.  But they didn’t.

Of course, it is par for the course from the Reserve Bank.  They consistently refuse to release any background papers related to the MPS, no matter how technical they might be, or how high the degree of legitimate public interest (I did once get them to release such papers from 10 years ago).  They simply have no conception of the sort of open government the Official Information Act envisages.

Reform –  including opening up the institution –  is long overdue.  I do hope that the Minister’s review of the Act is going to address these issues seriously.

And in the meantime you and I –  citizens, taxpayers, who paid for this analysis –  are left none the wiser as to why, say, the Bank thinks a 50 per cent offset is the right assumption for Kiwibuild.  Perhaps it is, perhaps it isn’t, but the debate –  including around monetary policy –  would be better for having the workings in the public domain.

I was tempted to reuse my “shameless and shameful” description from yesterday, but that might a) overstate slightly the true importance of this particular issue, and (b) is a description better kept today for the Prime Minister and her willed blindness to the issues around China’s interference in the domestic affairs of New Zealand.  Anything for an FTA extension, nothing for protecting the democratic institutions and values of New Zealanders.

Full letter from the Bank below.

Dear Mr Reddell

On 16 November you made an Official Information request seeking:

copies of any analysis or other background papers prepared by Bank staff that were used in the formulation of the assumptions about the impact of four specific policies of the new government (minimum wages, fiscal policy, immigration, and Kiwibuild), as published in last week’s Monetary Policy Statement.

The Reserve Bank is withholding the information for the following reasons, and under the following provisions, of the Official Information Act (the OIA):

  • section 9(2)(d) – to avoid prejudice to the substantial economic interests of New Zealand;
  • section 9(2)(g)(i) – to maintain the effective conduct of public affairs through the free and frank expression of opinions by or between officers and employees of the Reserve Bank in the course of their duty; and
  • section 9(2)(f)(iv) –  to maintain the constitutional convention for the time being which protects the confidentiality of advice provided by officials.

You have the right to seek a review of the Bank’s decision under section 28 of the OIA.

Yours sincerely

Roger Marwick

External Communications Adviser | Reserve Bank of New Zealand | Te Pūtea Matua

2 The Terrace, Wellington 6011 | P O Box 2498, Wellington 6140

  1. + 64 4 471 3694

Email:  |