Some thoughts on the Monetary Policy Statement

First, some more kudos (albeit slightly ambivalent) to the Governor.  As of this Monetary Policy Statement they have started publishing a spreadsheet with detailed quarterly forecasts for about 30 variables.  I remain unconvinced of the value of such forecasting (especially up to 3.5 years ahead) –  which has a non-trivial opportunity cost – but if they are going to do such forecasts it is only right that we should have access to them.  The forecasts won’t be right but they will shed a little more light on how the Bank is thinking about how the economy is (or might) work, and the usefulness of the table will increase as a time series of such forecasts is built up.     And one day perhaps they’ll develop sufficient confidence to release, with a lag, the staff background papers that contributed to the forecasts.

Watching the webcast press conference, it was curious to see the Governor introduce his chief economist with the description “the wisest man in the Reserve Bank”, just a few days after the Governor had stripped the same individual of his Assistant Governor title and demoted him –  by putting another senior manager between McDermott and the Governor.   Perhaps wisdom isn’t greatly valued at the the top of the Reserve Bank?  More probably, it was just another cheap Orr line.

As I’ve noted previously, McDermott often isn’t that convincing in speeches and press conferences.  We had another example yesterday.   The Bank seemed to be a bit on the defensive over recent very short-term forecast errors, and this time I was mostly inclined to sympathise with them: there are significant uncertainty margins in how things are even measured, and you get the sense reading the SNZ commentary that (for example) even they don’t really believe the size of this week’s reported fall in the unemployment rate.  But McDermott went on to over-egg things claiming, as if his name was really Pangloss, that “the outcomes for monetary policy are as good as it gets”, asserting that things were turning out just as planned.  They had cut the OCR in 2016, we were told, and what we see is what you’d expect having done that.

I doubt the Governor was particularly taken with that line of argument.  He –  rightly –  pointed out several times that inflation is still below the target midpoint, and their job is still to get it back up.  They need considerable capacity pressures to achieve that.

Of course, there is a modicum of truth in what McDermott had to say.  Having stuffed things up in 2014, raising the OCR when it wasn’t needed (with the full support of McDermott, as yesterday’s chart on the advice to the Governor confirms), they had to cut the OCR, by quite a lot in the end.  Do that and of course you should expect inflation to pick up gradually –  take your foot off someone’s throat and they start breathing more freely again too.

But, of course, the Bank has been telling us for years that they are aiming to get inflation back to 2 per cent, and it was the year to December 2009 that their (often preferred) sectoral core factor model measure of inflation was at 2 per cent.

The Bank doesn’t publish forecasts of core inflation, but the medium-term inflation forecasts they do publish are good proxies (since two years out one doesn’t usually know about petrol price or tax shocks that throw headline inflation around).  Two years ago, at the end of the Bank’s OCR-cutting phase, they forecast that (core) inflation would be back up to 1.9 per cent by now.  In fact, it was only 1.7 per cent in the year to September.   A year ago, in the November 2017 MPS, they were forecasting inflation would be either 1.9 or 2.0 per cent in all their medium-term horizons.   But in the latest projections they don’t seem to see (core) inflation back to 2 per cent until mid-2020, long enough that they will have been below the target midpoint for more than a decade.

Perhaps one shouldn’t cavil too much about current outcomes, but it has been an awfully long time coming, and the wait needn’t have been anywhere as long if the Reserve Bank’s senior managers had been doing their job better.  Oddly, I also heard the Governor twice suggest that “only six months ago people were suggesting we weren’t doing our job [and should have cut]”.  I’m not sure who he is referrring to here –  I don’t recall a groundswell of calls for rate cuts six months ago –  but if I’m among those he is responding to, I hold to my view: we would have had better inflation outcomes (the primary job of the Bank) had the OCR been lower in 2016 and 2017. (That isn’t the same as saying I’d cut right now.)

And eight or nine years into this economic expansion, it isn’t as if the Bank is well-positioned should another serious recession come along soon.  The Governor was asked again about this yesterday, and gave his (now customary) complacent response.   There was, we were told, nothing to worry about.  The OCR didn’t really matter that much, because it was not much more than happenstance that that was the instrument currently being used.  There was lots of handwaving, and (still) not a lot of convincing argumentation.  And never an acknowledgement that if other countries are even somewhat constrained (or feel they are) that will markedly worsen the environment we face.   Perhaps one day the Governor could devote a speech to the subject, or is he not ever going to do a speech on what is, still, his primary statutory responsibility?

There was reference again to a Bulletin article the Bank published a few months ago, which I wrote about here.   I stand by my conclusion

In summary, I welcome the fact that the Reserve Bank has begun to talk more openly about the potential limitations in its response to the next recession, but it is disconcerting that they still seem to be trying to minimise the potential severity of the issue.   In that, they aren’t alone.  I’m not aware of any central bank that has yet laid out credible plans to minimise the damage (although senior officials of the Federal Reserve have been more willing to talk about the issues openly).  In that, they are doing the public a serious dis-service, and risking worse outcomes than we need to face –  repeating the sort of reluctance to address issues that saw the world drift into crisis in the early 1930s.  Fortunately for the central bankers perhaps, it won’t be central bankers personally who pay the price.  That won’t be much consolation for the many ordinary people who do.

Since politicians, and not central bankers, are accountable to the voters, the Minister of Finance should be taking the lead in requiring a more pro-active (and open) set of preparations to be undertaken by the Reserve Bank and The Treasury.

(There was also a brief exchange –  not entirely audible on the webcast – about a peculiar episode in the last recession when it appeared that the Bank had convinced itself the OCR couldn’t safely be cut below 2 or 2.5 per cent.  I was at The Treasury at the time and when we heard of this stance, it struck us as distinctly odd.  The argumentation  –  repeated yesterday –  apparently was that if they cut further the exchange rate could fall very sharply.  And yet in an open economy, with well-hedged foreign debt, a fall in the exchange rate is a natural and normal part of the stabilising transmission mechanism.  I mention it here mostly as an example of the sort of central bank caution –  here and abroad –  that has contributed to such weak inflation over the last decade and (at the margin) at muted recovery.  Even if the specific floor has changed, it isn’t clear how much the mindset has.)

Perhaps one of the most interesting aspects of the projections yesterday was the inflation numbers. Usually –  for decades now – the published projections for inflation have involved a gradual return towards the midpoint of whatever the inflation target range is at the time.   Sometimes that return path looked rather slow –  in the Bollard years when core inflation was around 3 per cent, Alan was happy enough to publish projections showing inflation only back to 2.5 per cent at the end of the forecast horizon – but it was, almost without exception, a convergent process.  If you were starting from 3 per cent with a target midpoint of 2 per cent, the end-point forecasts were 2 or a bit above, not (say) 1.8.  And the same when, as in recent years, the starting point has been below the midpoint.

But not now.    Here are the medium-term inflation projections (those two and more years ahead), which monetary policy can do a lot about if it chooses.

med term projections

Mostly –  and the more so the further out –  above 2 per cent.    Looking back a couple of years I did find an MPS where the final projections were at 2.1 per cent, but it was clearly a case where the then-Governor had chosen to portray a dead-flat OCR track.  By contrast, in these latest projections the OCR has risen by 66 basis points by the end of the forecast horizon.

The Bank doesn’t seem to have explained quite why it (well, the Governor) is making this choice, which is clearly a conscious and deliberate one.  There seem to me to be two possibilities:

  • the first is that, given the new employment dimension to the mandate, and that they had expected unemployment to stay around 4.3 or 4.4 per cent for the next 18 months (prior to this week’s HLFS numbers), the Governor was deliberately choosing to prioritise further reductions in unemployment over meeting the midpoint inflation target, or
  • alternatively, given the risks going into the next recession he is deliberately aiming for inflation in the upper half of the inflation target range to pull inflation expectations up more securely, and provide more leeway in the next recession.

There were hints of something along these lines in the reports of the off-the-record speech Orr gave on such matters a few months ago, but we’ve had nothing open and official.  That isn’t good enough.

(I’m quite comfortable with leaving the OCR unchanged at present –  relative to the alternative of signalling an early tightening –  as I’d still be surprised if, between domestic pressures and external threats, we saw anything like the growth the Bank is forecasting over the next year or two.  But the actual policymaker owes us a more considered explanation for the choices and tradeoff he personally is making with our economy.)

And whatever the explanation, the Governor clearly has some way to go to convince people putting their money on the medium-term inflation outlook.  Here is the chart of the breakeven inflation rate from the government bond market for the second half of this year.

breakeven 2018

The data are up to yesterday, so include both the unemployment and MPS news.  Expectations of medium-term inflation, as reflected in market prices, remain stubbornly low.

As I said at the start of this post, the new table of forecast data the Bank is releasing enables to illustrate a little more clearly how the Bank thinks things are working.   For example, this chart shows their projections for quarterly growth in potential output and for annual net immigration (working age population) –  the latter being a series we won’t even have on any sort of timely basis in another month or so.

productivity

Population growth (of working age) is one of the biggest single contributors to any sense of what potential output growth might be. But the Bank expects the net migration inflow to more than halve, while potential output growth is barely changed. (And for anyone who responds “but isn’t that what you say we should expect”, the Bank’s forecasts have no further reduction in the exchange rate and has, in time, increases in real interest rates.)   Using their GDP and employment forecasts, productivity growth (GDP per person employed) averaged 0.6 per cent per annum over the last decade, has been non-existent over the last couple of years, but is expectedly to rebound strongly to around 1.5-1.6 per cent per annum in 2020 and 2021.    Without any real sense of the channels at work that might bring about this startling rebound, it feels like little more than wishful thinking.  That isn’t new –  I’ve highlighted in repeatedly, under both Wheeler and Orr.  It might even be convenient for the government, but only until  –  most probably – the outcomes again disappoint.

 

What to make of the inflation data

The CPI data were released a couple of days ago.   There was, inevitably, a lot of commentary around higher petrol prices, although most commentators noted that the Reserve Bank was likely to “look through” what we are seeing, and not adjust monetary policy just because of higher petrol prices.  That would, indeed, be consistent with the Bank’s mandate –  and practice –  over almost thirty years of inflation targeting.

One can have all sorts of debates about what sorts of effects should be “looked through”.  We used to have lengthy discussions attempting to distinguish between petrol price effects themselves, indirect effects (eg higher airfares or courier costs directly resulting from higher fuel prices) and second-round effects –  the real worry, if changes in oil/petrol prices came to affect the entire inflation process, including medium-term expectations of inflation.   Those risks were real, and realised, back in the 1970s oil shocks, and that set the scene for much of the subsequent discussion and precautionary debate.

SNZ only has a CPI ex-petrol series back to 1999.  In this chart, I’ve shown the headline CPI inflation rate, the CPI inflation rate ex-petrol, and the Reserve Bank’s preferred core inflation measure, the sectoral factor model.

petrol price inflation

I’ve highlighted four episodes in which petrol price inflation was much higher than overall CPI inflation, and one (quite recent) when it was much lower.

In the first of those episodes –  around 2000 –  the surge in petrol prices coincided with quite a lift in core inflation.  Bear in mind that the economy was recovering from the brief 1998 recession, and the exchange rate had fallen sharply.

In the second episode –  2004 and 05 – the surge in petrol price inflation coincided with no change in core inflation.

In the next episodes –  2008 and 2010 –  the surge in petrol price inflation coincided with a fall in core inflation.  In the 2008, the Reserve Bank explicitly recognised some of this at the time, and talked of scope to cut the OCR soon, despite the high headline inflation.

And in the recent episode when petrol price inflation was very low, there was no fall in core inflation –  if you look hard enough, it may actually have increased very slightly.

There is talk that, if oil prices persist, headline inflation could get as high as 2.5 per cent before too long.  The experience of the last couple of decades suggests that will tell us nothing useful about underlying/core inflation trends, or about the appropriate stance of monetary policy.  And the preferred core inflation measure remains below the target midpoint, as it has been for almost a decade now.

Here are a couple of other series worth looking at.

other infl measures

The blue line is a fairly traditional sort of exclusions-based core inflation measure: excluding volatile items (food and fuel) and (administered) government charges (altho not tobacco taxes), and the orange line is non-tradables inflation excluding government charges and cigarette and tobacco taxes (which, you will recall, have been raised relentlessly each year, in a political non-market process).  There is no sign in either of these series of underlying inflation moving higher in the last year or two.  Core non-tradables inflation of under 2.5 per cent is not consistent, typically, with core (overall) inflation being at 2 per cent.

Having said all that the financial markets appear to have taken a slightly different view of this week’s inflation data.  Here is a chart of the breakeven inflation rate from the government bond market –  the difference, in this case, between the 10 year conventional bond rate and the 2030 indexed bond (real) rate.  I’ve highlighted the change since the inflation data were released.

IIBs oct 18 2018

At 1.4 per cent, the gap is still miles off the 2 per cent target midpoint (or than the comparable numbers in the US), but the latest change does look as if it is worth paying at least a bit of heed to.  Perhaps it will dissipate over the next few weeks, but if not it wouldn’t be a cause for concern, but some mild consolation that –  after all these years –  there was some sign of market implied inflation expectations edging a little closer to target.

What about a longer run of data?   We only have a scattering of inflation indexed bonds, in this case one maturing in September 2025 and one maturing in September 2030.  The 2030 bond was first introduced five years ago this month.    Creating a rough constant maturity 12 year indexed bond series –  the 2025 bond had 12 years to run in 2013, and the 2030 one has 12 years to run now –  and subtracting the result from the Reserve Bank’s 10 year conventional bond series produces this (rough and ready) chart.

iib constant maturity breakeve

A clear rebound from the lows of 2016, but implied breakeven inflation rates still much lower than they were five years ago.

There still seems to be quite a long way to go for the Reserve Bank to really convince investors that, over the decade ahead, they will do a better job of keeping inflation averaging near target than they have done this year to date.

Continuing to talk down the risks of the next serious recession, and the limitations of policy here and abroad to act decisively to counter such a recession and the likely deflationary risks, is cavalier and irresponsible.  It might (seem to) help confidence in the short-run, but if those risks crystallise –  and central banks should focus on tail risks in crisis preparedness –  the Bank will bear a lot of the responsibility if the economy performs poorly, and inflation ends up so low as to vindicate (and more) the evident lack of confidence among people putting real money on a view about the average future inflation rate.

 

What is the Reserve Bank’s monetary policy?

I’ve been banging on a bit about how the new(ish) Reserve Bank Governor has been enthusiastically talking about everything under the sun (mostly modish left-wing causes) in speeches and interviews, but six months into his term of office we still haven’t had a considered speech from him on any of the things he is, by law, exclusively responsible for, notably monetary policy and banking and insurance prudential regulation.  It is quite an extraordinary omission.  It is almost as if he isn’t overly interested in monetary policy and financial stability, which can be pretty dry but need to be done well and accounted for rigorously, preferring to use the pulpit his office provides to pursue personal political and policy agendas.   The appearance of that is bad enough, let alone the reality.  And then, of course, there are his meanders after the forest gods.

I stumbled yesterday on an example of what is lacking around monetary policy when a reader in the financial markets pointed out this line in a Bloomberg interview done by one of Orr’s senior managers, chief economist John McDermott, just after the last Monetary Policy Statement in August.

In current circumstances, the bank would need to see core inflation above 2 percent before it considered raising rates, he said.

I’d seen the interview when it was first published, but somehow overlooked this line.  As far as I’m aware, it didn’t get much –  or any –  attention anywhere else either, although who knows whether in the private briefings the Bank provides to select market economists they may have explained themselves.

As it stands, it looks like –  but perhaps isn’t – quite a change in the way the Bank thinks about monetary policy, but with no explanation and no elaboration.

Under the previous Governor –  on whose watch, and in agreement with the Minister, the 2 per cent target midpoint was explicitly made the focus of monetary policy –  the Bank’s approach would have been described as something like the following: adjust the OCR so that, allowing for the lags, a couple of years ahead (core) inflation would be around 2 per cent.

It was a forecast-based approach, and of course forecasts are often wrong.  Over the last decades, forecast errors were mostly one-sided, so that core inflation ended up consistently undershooting the target midpoint. The approach recognised that the midpoint could never be achieved with 100 per cent certainty, but envisaged departures from it arising only by (less or more) inevitable accident.

The approach the chief economist is reported as articulating in that interview seems quite different on two counts:

  • it isn’t forecast-based (they would need to actually see core inflation above 2 per cent before moving –  bearing in mind that the lags from policy to core inflation outcomes are probably 18-24 months), and
  • they would be relaxed about seeing inflation settle above the target midpoint, and not just by accident.

If that is the Bank’s new approach to policy, I would have considerable sympathy with it  (although many probably wouldn’t).   I’ve argued for some time that, given the limited scope to cut the OCR in the next recession, it would have been desirable to get inflation up, perhaps even a bit beyond 2 per cent, and with it inflation expectations.  That, in turn, would have supported higher nominal interest rates, and provided more room to move in the next serious downturn.   Given the evident difficulties of forecasting, I’ve also argued that for the time being the Bank should put relatively greater weight on what they can see now –  actual core inflation outcomes –  not on quite distant forecasts.  Doing so would seem a rational response to the evident uncertainty about the model (how the economy and inflation process are working).

(I’d have “considerable sympathy” if this were the new policy reaction function, but would have even more sympathy if such an approach had been reflected in the Policy Targets Agreement, ie with explicit ministerial support.)

But is this really the Bank’s policy approach?  We don’t know.  McDermott seems set to become a member of the new statutory Monetary Policy Committee next year, but for now he is just an adviser to the Governor, and only the Governor’s view finally matters.   There was no hint of such a policy approach in the last Monetary Policy Statement, or in the OCR announcement this week.  And, of course, the Governor talks about everything under the sun, but has provided no sustained analysis of how he thinks about the monetary policy process.

We don’t know, and that knowledge gap matters to anyone trying to make sense of how the Reserve Bank might respond to incoming information.    If core inflation now is at, say, 1.7 per cent rising gradually on current policy to 2 per cent over the next 18 to 24 months,  any upside economic surprise should be expected to take the Bank close to tightening, on the old forecast-based approach focused on the 2 per cent midpoint.   But if it takes actual core inflation to be above 2 per cent before they think about moving, near-term surprises would have to be very large –  with direct and immediate core inflation implications –  to make much difference at all to policy judgements.

If the new Governor has made such a change of approach, he’d have my full support – for the little that matters.   But whatever his actual approach, we are well overdue receiving a proper explanation from him as to how he –  in whom so much power is vested by law –  is thinking about monetary policy and the appropriate reaction function.

As part of that, we are overdue a good sustained explanation about how he is thinking about handling, and preparing for, the next serious downturn (beyond rather complacent, even glib, answers about there being lots of tools at his disposal).

It might all interest the Governor less than climate change, the (alleged) failures of capitalism, or idly lecturing people on the insufficiently long-term perspective they take to this, that or the other issues.   But it is the job he has taken on, and the Bank has liked to boast (not very credibly or convincingly) about how transparent it is.  A clear statement about how he thinks about monetary policy, not just as this or that particular OCR review, but in general, and in the context of the longer-term risks around the next downturn, would actually rather nicely fit with his emphasis on more long-term thinking.  Or is that lecture just for other people?

Ten years on

It is the season for books and articles reflecting on financial crises of a decade or so ago, the aftermath, and whatever risks might –  or might not –  be building today.  The collapse of Lehmans –  and the wise decision of the US authorities not to bail it out –  was 10 years ago this month, and although the US crisis had been underway for at least by a year by then, the Lehmans moment seems set to take a place in historical memory around the Great Recession rather parallel to the sharp falls in US share prices in October 1929 (the ‘Wall St crash’) and the Great Depression.  Not in any real sense the cause of what followed, but the emblematic moment in public consciousness nonetheless.

I’ve just been reading the big new book, Crashed: How a decade of financial crises changed the world, by esteemed economic historian Adam Tooze.  I might come back to it in a separate post, but for now would simply caution people that it is less good than his earlier books (around the Nazi economy, and the economic history of the West after World War One running into the Great Depression) had led me to hope.

But on a smaller scale, I picked up the Listener the other day and noticed on the front cover ’10 years after the GFC, former Reserve Bank governor Alan Bollard warns of new risks’.  Conveniently, I see that the article is freely available online.  The sub-heading tantalises potential readers

Former New Zealand Reserve Bank governor Alan Bollard warns that, although lessons were learnt from the global financial crisis, new risks have emerged that could trigger a repeat contagion..

Alan Bollard writes well, and often quite interestingly.  Extremely unusually (and in my view quite inappropriately), he actually published a book on his perceptions of the previous crisis in 2010, while still very fully-employed as Governor, a senior public servant.  There were quite severe limitations as to who, or what, he could be critical of (as I was reminded last night rereading my diaries of some crisis events I was closely involved in, and the Bollard published perspective on those events).     The Bank’s early reluctance to take seriously the emerging issues, as they might impinge on New Zealand, is not, for example, something you find documented in the book.

He must be in a somewhat similarly difficult position now.  He is Executive Director of the APEC secretariat, that grouping of Asian and Pacific (loosely defined) countries and territories, that includes China, Russia, the United States, Indonesia and so on.  I dare say Xi Jinping and Donald Trump won’t be watching nervously to see what Alan Bollard is saying, but the Executive Director knows that there are quite severe limits to what public servants can say while in office.

And, thus, much of the Listener article is a bit of a, perhaps slightly rose-tinted, rehash of some of the policy responses here and abroad (I will come back to deposit guarantee schemes on the tenth anniversary, next month).  There is some loose descriptive stuff on various developments in parts of the APEC region.  There was the suggestion that some countries (actually “much of the region”) in Asia is “anxiously worrying” about whether they could face a Japan-like low productivity future but to me, Japan still looks pretty attractive by regional standards.

japan

(New Zealand, for example, is at 42.)

In fact, I looked in vain for the promised analysis or description of the “new risks” that might “trigger a repeat contagion”.   Perhaps that was never Bollard’s intent, but the Listener had to attract readers to a fairly tame advertorial for APEC somehow.  The most we get is

We need to remember that the global financial crisis was originally triggered by a building bubble, and that is still on the minds of regulators throughout the region.

and

Meantime, we are very worried about the likely effects of the growing trade wars. It is too early to judge, but the stakes are high – trade growth has been the big driver behind the immense improvement in living standards through the Asia-Pacific region ……We are now on the alert for signs that these trade frictions could weaken exchange rates, hurt commodity prices, hit stock markets or cause financial volatility, against an unusual background of tightening monetary policy and loose fiscal policy in the US.

But then what more could a serving diplomat, not hired to be a high-profile problem solver (unlike, say, the head of the IMF) really say?

And it all ends advertorial style

As a big trader, New Zealand has always been susceptible to these tensions. But one international platform where they play out is coming closer: in just over two years, New Zealand will commence its year of hosting Apec. The organisation is a voluntary, consensus-driven one, where for 30 years we have promoted regional economic ties and tried out new ideas for trade and investment. As the upcoming chair of Apec, New Zealand will have to contend with continuing antiglobalisation pressures, big-economy tensions, climate-change damage and financial risks in the region. It sounds daunting, but there are many positives: We have learnt some of the lessons of the global financial crisis; banking regulation is tougher; banking chiefs are more cautious; economic demand is still growing; and the Asia-Pacific region is tied ever more closely by its trade flows.

It could have been a paragraph from a speech by one of his political masters.   I guess one wouldn’t know that one of his members (the People’s Republic of China) poses an increasing political and military threat to another (Taiwan) or –  closer to his own territory –  that few major economies have very much effective macroeconomic firepower at all when the next crisis or severe recession hits.  And really nothing at all about financial sector risks.  His final sentence –  “September 2018 should be a month much better than September 2008” –  is almost certainly true (at least outside places like Turkey and Argentina) but not really much consolation to anyone.

In his column in the Dominion-Post this morning, Hamish Rutherford touches a theme of various recent posts here: the limited macro capacity of many countries.  He rightly highlights how low global interest rates are, and the much higher levels of government debt in many countries.

To make matters worse, interest rates are already so low that some economists are speculating that if the Reserve Bank was to respond to a slowdown by slashing interest rates, in a bid to stimulate the economy, it may find that little of the money finds its way to households.

Debt levels among the world’s leading economies are, by and large, far higher than they were a decade ago. In the US, as well as threatening to kick off a global trade war, President Donald Trump’s administration is running the kind of deficit that would be wise in a recession, but at the late stage of a long economic growth cycle appears reckless.

But there was one point I wanted to take issue on.  He argues

Back in 2008, New Zealand benefited from its largest trading partner, Australia, avoiding recession and having almost no debt. This time Australia’s debt is climbing and there are doubts as to whether Canberra will have the discipline to return to a surplus, as the political state becomes more populist.

I don’t think that is true about either the past or the present.  We didn’t get any great benefit out of Australia’s fiscal stimulus in 2008/09, largely because if fiscal stimulus hadn’t been used, the Reserve Bank of Australia would probably have cut their official interest rates further.  Fiscal policy can be potent when interest rates have the effective lower limit, but they hadn’t in Australia (or New Zealand).  More importantly, and for all the New Zealand eagerness to bag Australian politics and policies, here is the OECD’s series of the net financial liabilities of the general government (federal, state, and local) for Australia and New Zealand, expressed as a share of GDP.

debt govt au and nz

Australia’s net public debt has been consistently below that of New Zealand for the entire 25 years for which the OECD has the data for both countries.  The gap is a little smaller now than it was a decade ago, and (on a flow basis) the New Zealand budget is in surplus but Australia’s isn’t.  But if there is a desire to use large scale fiscal stimulus in the next serious downturn, debt levels themselves aren’t likely to be some technical or market constraint in New Zealand, and even less likely in (less indebted) Australia.

And finally in this somewhat discursive post, a chart I saw yesterday from the BIS.

real house prices BIS

A story one sometimes hears is that low interest rates have driven asset prices sky-high setting the scene for the next nasty crisis.  Even if there are elements of possible truth in such a story, the story itself mostly fails to stop to ask about the structural reasons why interest rates might be so low.   All else equal, had interest rates been higher asset prices probably would have been lower – and CPI inflation would have undershot targets even further.  But as this particular chart illustrates, across the advanced economies as a whole real house prices now are much same as they were at the start of 2008.  That isn’t true in New Zealand (or Australia for that matter).  Interestingly, even in the emerging markets –  centre of current market unease –  real house prices are still not 15 per cent higher than they were at the start of 2008, when interest rates generally were so much higher.

But then only rarely is the next major economic downturn or financial crises stemming from quite the same set of financial risks as the last one.

Orr off the record on major policy matters

A reader mentions news that Reserve Bank Governor Adrian Orr was in typically loquacious form at a finance industry “networking event” held in Wellington last night.

Typically loquacious but, so the report suggests, perhaps going rather beyond the Bank’s public lines on monetary policy as articulated in the August Monetary Policy Statement, in a very dovish direction.     And weighing in on what sort of person he wanted (and did not want –  economists apparently not wanted) on the new Monetary Policy Committee –  the one where the Minister supposedly makes the appointment, the one where the legislation has not yet been dealt with by the relevant select committee.

Central bankers need to be very cautious in their communications around monetary policy.  The standard approach has been to communicate primarily via Monetary Policy Statements, where everyone has access to the same information (although I gather the Bank still holds confidential debriefs for bank economists as a group after each release, and if that isn’t potentially market sensitive it is hard to imagine what would be).  That approach is sometimes supplemented with speeches: on-the-record ones where there is anything at all interesting, important, or potentially sensitive being said, and off-the-record ones where it is just repeating the same lines previously made public.

The speeches themselves are not without their problems as the Reserve Bank of New Zealand handles things.  For instance, although the Governor has been in the role for five months now, there has been no on-the-record speech at all.  And even when Governors have spoken in the past, there is often considerable potential for nuance or shades of information in the Q&A sessions afterwards.  At the Reserve Bank of Australia, it is common practice for those Q&A sessions to be recorded and made available on the RBA website.  There is nothing comparable here, and the Bank has often refused to allow media access to events where the Governor –  a senior public official – is speaking.  If you are lucky enough to be there you get information that the market as a whole doesn’t have.  That simply shouldn’t be acceptable.

Perhaps some journalists might like to find out from participants, or from the Governor, what he actually said last night, complete with (potentially market-moving) nuances.  Any other readers who were there who want to flesh out the account I’ve heard feel free to get in touch or comment (anonymously if you like) below.

But as it was relayed to me, it doesn’t sound like the sort of approach we should expect from any serious person holding a major public role.

Options for the next serious recession: fiscal policy

I’ve run various posts over the last few years urging the authorities (Reserve Bank, Treasury, and the Minister of Finance) to get better prepared for the next serious recession (and lamenting the relative inaction on this front in other countries too, many of whom are worse-positioned than New Zealand is).

As a reminder, we went into the last recession with the OCR at 8.25 per cent, while the OCR now –  years into a growth phase, with resources (on official assessments) fairly full-employed –  is 1.75 per cent.  In that last recession, the Reserve Bank cut interest rates a long way, the exchange rate fell a long way, there was really large fiscal stimulus cutting in as the recession deepened, and there were lots of other interventions (guarantee scheme, special liquidity provisions) and it was still as severe as any New Zealand recession for decades, and took years to fully recover from (on official output and unemployment gap estimates perhaps seven or eight years).   Lives were blighted, in some cases permanently, in an event where there were no material constraints on the freedom of action of the New Zealand authorities.  In fact, our Reserve Bank cut the OCR (over 2008/09) by more than any other advanced country central bank.

Next time, whenever it is, it seems very unlikely that the Reserve Bank will have that degree of freedom, particularly around monetary policy.  On current policies and practices around bank notes, it seems unlikely that the OCR could be usefully cut below about -0.75 per cent.  Beyond that point, most of the action would be in the form of people shifting from bank deposits etc to physical currency, rather than buffering the economic downturn.

Our Reserve Bank has long appeared disconcertingly complacent about this issue/risk.  The latest example was comments by the new Governor and his longserving chief economist following the latest Monetary Policy Statement.    They talk blithely about the unconventional policy options other countries have used, but never confront the fact that almost no advanced country could have been comfortable with the speed of the bounceback from the last recession.   Output and unemployment gaps of eight or nine years (the OECD’s estimate for advanced countries as a whole) aren’t normal and shouldn’t be acceptable.

Quite why the Reserve Bank is so complacent is something one can debate.   My hypothesis is that it is some mix of assuming we will never face the problem (recall that they have spent years hankering to get the OCR back up again) and of noting that other people/countries will most likely face the problem before New Zealand does.   They also like to remind us that New Zealand has a floating exchange rate as if this somehow differentiates us (as a reminder so do Australia, Canada, Norway, Sweden, the US, the UK, Japan, Korea, Israel, and even the euro-area as a whole).  Whatever the explanation,  robust contingency planning, and building resilience into the system, is what we should be expecting from the Reserve Bank (and Treasury).  There is no sign of it happening.  Meanwhile, the Governor plays politics in areas (eg here and here) that really aren’t his responsibility.

In my post on Saturday, I touched again on the desirability of doing something –  specific and early, consulted on and well-signalled –  about removing the effective lower bound on nominal interest rates.   That would tackle the issue at source.    Monetary policy has been the primary stabilisation tool for decades for good reasons.  Among other things, it is well-understood and there is a fair degree of (political and economic) consensus around the use of the tool.  And confidence that the tool is at hand in turn proves (somewhat) self-stabilising, because people expect –  and typically get – a strong monetary policy response.

Perhaps the other reason why authorities –  perhaps especially in New Zealand – have been so complacent is the view that “never mind, if monetary policy is hamstrung there is always fiscal policy”.  After all, by international standards, public debt here is low (on an internationally comparable measure from the OECD, general government net financial liabilities, about 1 per cent of GDP, which puts us in the lower quartile –  less indebted – among OECD countries.)

The implicit view appears to be that, with such modest levels of debt, if and when there is another serious recession, New Zealand governments can simply spend (or cut taxes) “whatever it takes” to get economic activity back on course again.   After all, the upper quartile of OECD countries have net general government liabilities in excess of 80 per cent of GDP.

I’m sceptical for a variety of reasons.

One of them is the experience of the last recession.  For this, I had a look at the OECD data on the underlying general government primary balance as a per cent of potential GDP:

  • general government = all levels of government
  • underlying = cyclically-adjusted (ie removing the impact of the fluctuating business cycle on revenue (mostly), and adjusted for identified one-offs (eg recapitalisations of banking systems)
  • primary balance =  excluding financing costs, so that comparisons aren’t affected by changes in interest rates themselves
  • as a per cent of potential GDP =  so that a temporary collapse in actual GDP doesn’t muddy the comparison

The numbers aren’t perfect, and there are inevitable approximations, but they are the best cross-country data we have.  Changes in this balance measure are a reasonable measure of discretionary fiscal policy.

Here is how those underlying primary balances changed from 2007 (just prior to the recession) over the following two or three years.  I’ve taken the largest change I could find, and in every case that was over either two years to 2009, or over three years to 2010.

fisc stimulus

Some countries (Hungary, Estonia) were engaged in severe fiscal consolidation from the start.  Several others experienced almost no change in their structural fiscal balances.

Quite a few countries saw 5 percentage point shifts in their underlying fiscal balances.   Spain –  a country with no control over its domestic interest rates –  is recorded as having gone well beyond that.  I don’t know much about the specifics of Spain, but for those who are upbeat about the potential scope of discretionary fiscal policy I’d take it with at least a pinch of salt – on the OECD numbers, the Spanish primary deficit dropped again quite sharply the next year (and Spanish unemployment didn’t peak until several years later).

Note that both Australia and New Zealand are towards the right-hand end of that chart.  In Australia’s case, most of the movement resulted from deliberate counter-cyclical use of fiscal policy (the Kevin Rudd stimulus plans).  In New Zealand, by contrast, the change in the underlying fiscal position was almost entirely the result of discretionary fiscal commitments made by Labour government at a time when Treasury official forecasts did not envisage a recession at all.  From a narrow counter-cyclical perspective, those measure might have been fortuitous, but they were not deliberate discretionary counter-cyclical fiscal policy measures.  In fact, at the time they were seen in some quarters as exacerbating pressure on the exchange rate, and limiting the scope of any interest rate reductions.

Perhaps it is worth stressing again that in not one of the OECD countries did the reduction in structural fiscal surpluses (expansion in deficits) last more than two years.  In every single country, by 2011 structural fiscal policy (on this measure) had moved –  sometimes modestly, sometimes quite sharply –  into consolidation phase.  In most countries, either conventional monetary policy limits had been reached or (as in individual euro area countries) there was no scope for conventional monetary policy.  And it was to be years before output and unemployment gaps closed in most of these countries.

What is my point?   Simply, that it looks as though the political limits of discretionary fiscal stimulus were reached quite quickly, even in countries where there was no market pressure (any of the established floating exchange rate countries other than Iceland), and even though the economic rebound in most was anaemic at best.   That is why so many countries needed more conventional monetary capacity than in fact they had (and QE in various forms was not much of a substitute).

The OECD table on underlying primary balances only has data going back a few decades.  No doubt experiences in wartime were rather different –  in those circumstances huge shares of the nation’s resources can be marshalled and deployed in ways which (incidentially) stimuluate demand and activity.  But looking across the OECD countries over several decades, I couldn’t any examples of discretionary fiscal policy being used as a counter-cyclical tool materially more aggressively than happened over 2008 to 2010.  In Japan, for example, the structural fiscal balance worsened by about 6 percentage points over seven years after 1989.

So from revealed behaviour patterns, I’m sceptical as to just how much practical capacity there is for fiscal policy to do much, and for long, in the next serious recession, even in modestly-indebted New Zealand.    The limits aren’t technical –  they mostly weren’t last time –  but political.   Perhaps people will push back and run some argument along the lines of “oh, but we’ve learnt the lessons of unnecessary premature austerity last time round”.     To which my response would be along the lines of “show me some evidence, or reason to believe that things would, or even should, be much different next time”.   When – outside wartime –  has it ever happened?  And what about our political systems makes you comfortable that it is likely to happen next time?     We could probably run large structural deficits for a year or two, but pretty quickly the pressure is likely to mount to begin reining things back in again (especially if, for example, the next recession is accompanied by heavy mark-to-market losses on government investments –  eg NZSF).

And recall that here in New Zealand we had almost as much fiscal stimulus last time as any country, and even supported by huge cuts in interest rates (and without a home-grown financial crisis), we had a nasty recession (even a double-dip in 2010) from which it took ages to recover.

And all of this is without even examining how effective realistic fiscal policy is likely to be.    The easiest fiscal stimulus is a tax cut (or even a lump sum cash handout).   You can do clever ones, like the UK temporary cut in GST, which not only put more money in people’s pockets, but actively encouraged them to shift consumption forward –  only to then create problems as the deadline for raising the value-added tax rate loomed.   But putting money in people’s pocket –  in a recession, and often explicitly temporarily –  doesn’t guarantee they spend much of it.  The most effective demand-stimulating fiscal policy (supply side measures are another issue –  but lets just agree that deep cuts in company tax and related rates will not happen in the depths of a recession) is direct government purchases of goods and services.  Most talked of is government capital expenditure, infrastructure and all that.

But, approve or otherwise, no government has a reserve list of projects, designed and consented, just waiting to get starting the moment it is apparent the next deep recession in upon us (that moment usually being several months after the recession has begun).  It is almost certainly politically untenable for them to do so –  if the project is so good, so the argument will run, why not do it when times are good?  And so realistic government fiscal stimulus through the capital expenditure side will take months and years (more probably the latter) to even begin to get underway.   Faced with the actual physical destruction in Christchurch, look how long it took for major reconstruction to get underway.

What of income tax cuts?   Either the cuts are focused on those who pay the most taxes (in which case there is quickly one form of political pushback) or perhaps they take the form of a tax credit paid as a lump sum to everyone (in which case there is likely to be pushback of another political type –  ideas around “everyone becoming a welfare beneficiary).  I’m not attempting to defend either type of response, just to anticipate the risks.

By contrast, monetary policy –  the OCR –  can be adjusted almost immediately, and often begins to have an effect before the central bank even announces its formal decision (market expectations and all that).  And if monetary policy changes don’t affect everyone equally, they affect the entire country –  a borrower/saver/exporter in Invercargill just as their counterparts in Auckland.  In the line from a US Fed governor, monetary policy gets in “all the cracks” (although he was contrasting it with regulatory interventions).  Government capital expenditure is, by its nature, very specific in location.  There probably isn’t a natural backlog of major (useful) capital projects in Invercargill or Dunedin.

I’m not saying fiscal policy has no useful place in the stabilisation toolkit –  although my prior is that it is better-oriented towards the medium-term, with the automatic stabilisers allowed to work fully –  but that we should be very cautious about expecting that it is any sort of adequate substitute for monetary policy in the real world of politics, distrust of governments and so on, in which we actually dwell.    It is well past time for the Reserve Bank and the Treasury, led by the Minister of Finance, to be taking open steps towards ensuring that New Zealand has the conventional monetary policy capacity it would need in any new serious recession.

 

Towards a (physical) currency auction

A week or so back, at the Monetary Policy Statement press conference, veteran Herald economics journalist/columnist Brian Fallow asked the Governor about how well-situated New Zealand was to cope with the next recession, given how low the OCR is now (1.75 per cent, as compared with 8.25 per cent going into the previous recession).

As I recorded in a post the same day, the Governor and his offsiders responded with a degree of confidence that wasn’t backed by much substance.  It all smacked of a worrying degree of complacency.

Fallow also apparently wasn’t persuaded, and returned to the issue in his weekly Herald column yesterday.  I wanted to pick up today on just one of the topics he touched on in that column.

The key issue is the effective lower bound on nominal interest rates.  The Reserve Bank has indicated that it believes the OCR probably couldn’t usefully be taken lower than -0.75 per cent (I agree with them, and that assessment of the effective lower bound is consistent with the lowest any other country has set its policy interest rate).  Beyond that point, it seems likely that an increasing proportion of holders of short-term financial assets would transfer into holdings of physical cash.  There is no direct cost of conversion, although there are storage and insurance costs for physical cash (which is why large scale conversion doesn’t occur at, say, -5 basis points).

When official interest rates were dropped below -0.75 per cent it still probably wouldn’t affect very much much (or how) little cash you hold in your wallet/purse.  If you hold much cash at all, it is probably for convenience (or privacy), balanced against (say) risk of loss/theft.  And a secure physical storage facility for even $10000 of cash would be much more inconvenient –  and probably expensive – than holding a short-term bank deposit.  You might well, grudgingly, live with an interest rate of -2.0 per cent per annum (as it is, since the last recession, marginal term deposit rates have been well above the OCR anyway).   Or you might seek to shift your money to riskier (potentially higher-yielding assets) –  in which case the lower policy interest rate would still be somewhat effective.

But the big issue here isn’t so much what the ordinary householder does.  Most don’t have that many financial assets that could be converted directly to cash anyway.  The bigger issue is institutional investors (resident and foreign, including –  for example –  Kiwisaver funds).   The funds management market is pretty intensely competitive, and (risk-adjusted) yield-driven (as an example, I was in a meeting yesterday where we looked at a restructuring option to save perhaps 3 basis points).     So if the Reserve Bank tried to cut the OCR to, say, -2.0 per cent (and it was expected to remain at least that low for a couple of years), there would be big incentives to find alternative assets yielding a less-negative (or positive) return.  The most obvious example is physical cash.   And if there are incentives for fund managers to find such alternative options, there are incentives for trusted operators to provide them (secure physical storage for large quantities of physical currency).   Willing buyers and willing sellers usually find a way to get together, at least if regulators don’t come between them (in this case the regulator –  the Reserve Bank –  actually creates the problem.  People sometimes talk about a lack of secure storage facilities, but $1 billion in $100 bills doesn’t take much space (nor, really, does $100 billion).  (On US note dimensions, the calculations are here.)  If conversions of this sort happened on a large scale, a lower OCR won’t have any material effect –  other than encouraging remaining asser holders to convert to cash.  It wouldn’t lower retail interest rates (much) and wouldn’t lower the exchange rate (much).

These sorts of conversions wouldn’t happen overnight.  Probably most funds managers and the like won’t have physical cash in their list of approved assets.  Some will be able to change that faster than others. Those that can will be able to offer better returns than those that don’t.   And such conversions would be much more likely in the next recession precisely because the starting point –  initial low interest rates –  is so bad.  It is quite likely that official rates could be negative for years.  Or perhaps the conversions will just never happen because central banks (here the Reserve Bank) just don’t lower their official rates far enough to make conversion economic.  But, if so. they will have made the point: conventional monetary policy will have very quickly exhausted its capacity.

And so various people, including me in the New Zealand context, have been arguing for some years now that something needs to be done –  and needs to be done early, to condition expectations about the next recession –  about the effective lower bound.  Brian Fallow refers to this in his article

Overseas experience suggests that at most, a negative policy rate might move the effective lower bound for interest rates 75 basis points into the red. Moving it lower still would require, economist Michael Reddell suggests, imposing a fee on banks switching from virtual to physical cash.

It wouldn’t be difficult.  There are more complex models on offer –  see Miles Kimball or Citibank’s Willem Buiter – but the desired results looks to me to be able to achieved quite simply by setting a cap on the regular holdings of physical currency (say 10 per cent above current levels).  It might need to be a seasonally adjusted cap (currency demand rises around Christmas and the summer holidays, and then falls back again).  The cap would need to rise through time (currency demand rises with the size of the nominal economy).  But the key point is that any net issuance beyond that level would be auctioned (perhaps fortnightly or monthly).   Any creditworthy entity –  the sort of institutions the Reserve Bank deals with routinely –  could participate in the auctions, and the marginal exchange price between settlement cash and wholesale volumes of physical cash would then be established quite readily, and could alter through time.  If the state of the economy and inflation meant the Reserve Bank needed to cut the OCR to -5 per cent (and in the US context, there are estimates that such a – temporary –  rate would have been desirable in 2009), there would be a lot of demand for physical currency, and no more supply.  The market-clearing price would rise, perhaps sharply.

Of course, banks supply currency to retail customers on demand, mostly through ATMs.   Banks would be free to respond to the rise in the marginal cost of obtaining new notes by passing those costs onto customers (retail or wholesale).   A (say) 5 per cent conversion cost of obtaining cash would encourage retail customers to economise on cash holdings (using EFTPOS etc instead), while allowing those who put most value on having physical currency to pay the price.  These days very few domestic transactions strictly require much cash.

Perhaps there are pitfalls in such a scheme.  If so, now is the time to be identifying them, not in the middle of the next serious recession.  Now is the time to be socialising –  including with the public – possible solutions, not in the middle of the next serious recession (when putting a premium price on physical currency suddenly announced might actually be seen as a negative signal about the soundness of banks –  ie discouraging people from holding cash).   Perhaps there even legislative obstacles – I’m not aware of any, but all sorts of obscure issues can arise when one looks into anything in depth. But, again, now is the time to identify those issues and fix them, not in the middle of the next serious recession.  There would probably need to be an override mechanism to cope with a genuine financial crisis driven run to cash.

And if there are better, workable, models, now is the time to identify them, and to test the alternative models in open dialogue, to ensure things are easily pre-positioned to cope with the next serious downturn.

Unfortunately, there is no sign of any of this sort of preparation occurring.  Certainly, nothing has been signalled by the Reserve Bank or by the Treasury or by the Minister of Finance.  If they aren’t doing the work, it is (complacent) negligence.  And if they are, but simply aren’t telling us, it would be quite unwise.

After all, as I noted in the earlier post, a key consideration the authorities need to be addressing is expectations (about inflation and policy).  In a typical serious downturn, inflation expectations fall but not too much, as all market participants expect that the downturn will be relatively shortlived, partly because of aggressive cuts to official interest rates.  But going into the next recession –  whenever it happens –  it seems increasingly likely that few central banks will have the interest rate adjustment capacity they would like.  And all economists and market participants will recognise the constraint, and are likely to factor it into their expectations are seen as a downturn in underway.  A rational response would be to cut inflation expectations (actual or implicit) much more sharply than usual  –  in turn, driving up real interest rates (for any given nominal rate), worsening the downturn, and worsening the reduction in inflation.  This issue doesn’t seem to get the attention it deserves even in the international discussions of these lower bound issues, but it looks to me like a pretty straightforward implication of the current situation.

Since none of us knows when the next severe recession will hit –  it could be years hence, but it could be next year –  this isn’t the time to let the issue drift.  Too many people paid the (unemployment) price of central bankers reaching their limits last time around to contemplate with equanimity going into the next recession starting from a situation where current low official interest rates are still only consistent with inflation at or below target in most countries, including New Zealand.  Dealing with the lower bound issue should be treated a matter of urgency.

(For those who are quite relaxed because of fiscal policy options, I might do a post next week on why it shouldn’t be very much consolation at all.)