Towards this week’s OCR review

The Reserve Bank’s MPC will deliver their next OCR decision on Wednesday. The consensus seems to be (quite strongly, and I have no particular reason to differ) that the Bank will raise the OCR by another 50 basis points. At 3.5 per cent, the OCR would then be at the peak level it was (inappropriately) raised to in 2014, at a time when core inflation was well below the target midpoint and the unemployment rate was lingering high.

I’m less interested in what the MPC will do than in what they should do, and on that count I’m less convinced that the consensus call would be the appropriate one. In times like the last 2-3 years, no one should feel overly confident about any particular assessment of what monetary policy stance will prove to be needed: there is inevitably an aspect of feeling your way, knowing that when all the relevant data are available there is a fair chance you will be wrong one way or the other.

It isn’t the easiest situation in which to be making an OCR decision. We aren’t at the very start of a tightening cycle, rather the OCR has already been raised by 275 basis points since last October, and if that cumulative increase isn’t overly large by historical standards, the cuts in 2020 were also much smaller in total than in most prior easing phases (that would be so even if one included the 2019 cuts in a calculation). And most of the OCR increases have been really quite recent – it was only in mid April that the OCR was raised above the 1 per cent it had been when Covid hit, and we all know that monetary policy works with lags, often quite considerable ones.

But here, in some respects, the MPC has made a rod for its own back. At present, the most recent inflation data we have are for the June quarter. The midpoint of the June quarter (where the CPI is centred) was mid-May, a point at which (although more was expected over time) the OCR had only just been raised beyond 1 per cent. We’ll have the next release of the CPI on 18 October, and it would seem a great deal more sensible to have held off making the next OCR decision until then.

The annual cycle of OCR/MPS review dates was set a long time ago, and there used to be a view that the latest CPI didn’t often matter much so there wasn’t a particular problem with setting review dates just before the CPI release. But that was back in the days when the inflation rate was pretty stable (and low), not when it was well outside the target range, having been rising strongly (at least in annual terms for some time). It was even worse in July when the OCR review took place less than a week before the CPI was released.

Policymaking is suffering too from decades of underinvestment in macroeconomic data. Even when we get the September quarter CPI, that will have been centred in mid-August, and by then (eg) the United States will have had their September monthly data. I gather the Reserve Bank has now come round to wishing there was a monthly CPI – belatedly, since this was the same institution that frowned upon the idea 20 years ago when the then independent review of monetary policy, undertaken for the then government, by a leading overseas economist, highlighted the omission and recommended remedying it. Same goes for most of the labour market data: the June quarter data (latest we have) is centred (again) on mid May (although the new monthly employment indicator does represent some improvement in the New Zealand data in this area). We really need to be spending a bit more to get good quality monthly CPI and HLFS data, as almost all other OECD countries have. As it is, combining poor data with a weak MPC is not a recipe for good, robust, and trustworthy monetary policymaking.

And not too far down the track we will face again the MPC’s extended summer holiday, with no review of the OCR at all in the three months from 23 November to 22 February. That long holiday last summer almost certainly contributed to the OCR being increased more slowly than it should have been.

If it were me, I would have been postponing next week’s OCR review until a few days after the OCR review, delaying the next MPS until early December, and scheduling an additional OCR review at the end of January (after the December CPI data are available).

As it is, on the data we actually have to hand, I’m sceptical of the case for a 50 basis point OCR increase right now.

Some of the straws in the winds?

First, there was the relatively weak nominal GDP growth for the year to June (most recent we will have for quite a while yet) – the June quarter was 5.9 per cent higher than the June 2021 quarter, among the very lowest growth rates facing advanced country central banks. Nominal GDP is considerably easier to measure than real GDP, and is a relevant consideration in thinking about appropriate monetary policy.

Second, asset prices have been falling quite considerably. I’m not a great believer in wealth effects from house prices, but materially lower house prices will blunt the incentives for developers to continue to put in place new houses, and residential investment is one of the most cyclical components of the economy. There is a stronger argument for wealth effects from share prices, and share prices have also fallen back (eg the NZSE50 is below immediately pre-Covid levels), also dampening incentives for firms to undertake new business investment.

Third, if international New Zealand export commodity prices aren’t exactly weak, they are nothing like as strong as those in Australia (ANZ and RBA series respectively in the chart).

And then there are the core inflation measures. Much of the media and political attention has been (perhaps understandably) on the annual rate of inflation (complete with petrol tax cut distortions). That annual rate may well have fallen back a bit in September (petrol prices and all that), but it shouldn’t really be the focus. Ideally, we want to look at quarterly core meaaures – indicators of what is happening behind the headline “noise”. (And here the Reserve Bank’s factor model measures aren’t very useful, since they work on annual change data and thus often in effect function as lagging indicators in the face of big changes, even if they probably often provide the best medium-term and historical view.)

Here are the trimmed mean and weighted median measures (note that you cannot just multiply these by four to get an annualised rate)

and here are a couple of SNZ exclusion measures (CPI ex food and energy is most often used for international comparisons, simply because of data availability)

and here is one I’ve quoted a few times over the years, focused more (at least in principle) on the more domestically-generated bit of underlying inflation

Remember that all of these series are capturing prices as they were in mid-April, just short of six months ago.

There are a few potentially useful official monthly series. I’ve long kept an eye on these two from the Food Price Index

and there is the monthly rental data

Every single one of these series show a (not unexpected) trough in quarterly inflation in the June quarter of 2020 (the first, out-of-the-blue, “lockdown”). But more than a few also suggest that the sharpest increases in the inflation rate were occurring a year ago (perhaps 12-18 months on from the biggest fiscal and monetary stimulus), and that since then the quarterly inflation rates have been (high but) fairly stable or, on some measures have already fallen back a bit. And most of the most recent observations date from a time when the OCR was only just getting past 1 per cent.

If any hawkish readers are wanting to jump down my throat, can I take the chance now to stress that none of these inflation rates – from months ago – should be considered remotely acceptable. They are miles above the 2 per cent annual inflation the Reserve Bank is supposed to focus on delivering. We want inflation much lower than is evident in the most recent data.

But, again, monetary policy works with lags. And those lags may be particularly important to keep in mind when, as this year (and of necessity given how slow all central banks were to start) policy rates have been raised so sharply and quickly. Perhaps also relevant was the point in this nice post from a few days ago by Maurice Obstfeld, formerly chief economist of the IMF, highlighting that many advanced countries have (belatedly) been doing much the same thing, and those effects are likely to be mutually reinforcing. Recessions now seem unavoidable in a wide range of countries, and it isn’t clear that most central banks are taking other countries’ pending recessions into account in their own domestic policysetting.

As I said at the start of this post, only a fool would be overly confident about what monetary policy will prove to have been required over the coming year. And successful policy at this point will probably prove to have involved tightening at least a little more than, with hindsight, was strictly necessary. But on the data as they stand in New Zealand – long collection/publication lags and all – and if forced to make a decision this Wednesday (and the MPC is not forced to, the date is their choosing), I reckon there is a better case for a 25 basis point increase than for a 50 point increase. The key thing, of course, is to convey a sense that the MPC will do what it takes to deliver something near 2 per cent inflation before too long. But at this point it isn’t obvious that aggressive further OCR increases are really needed in New Zealand (Australia, the UK, or perhaps even the US may be in different positions, between even more belated starts to tightening cycles and positive shocks to demand from (eg) commodity prices or fiscal policy).

A canary in the coalmine?

A couple of days ago, I put this chart and brief comment on Twitter

I added “I do not think nom GDP targeting is generally superior to inflation targeting for NZ, but recent outcomes (latest annual 5.9%) are at least one reason for a little caution about further aggressive OCR increases”.

There is a long history of people writing about nominal GDP targeting (it was being championed in some of the literature before inflation targeting was even a thing). I’ve written about it a few times (including here and here) and just this morning I noticed a new commentary from Don Kohn, former vice-chair of the Federal Reserve looking (sceptically) at some of the issues. No central bank has shifted to nominal GDP targeting (whether in levels or growth rates) but a fair number of people (including Kohn) will suggest that there may still be useful information in developments in nominal GDP – something to keep at least one eye on.

Almost every piece of economic data has been made harder to interpret over the last couple of years by Covid. In my chart, the eye immediately tends to go to the unprecedented fall (in 2020) and unprecedented rebound following that. But my eye next went to what wasn’t there: the most recent rate of increase (nominal GDP in the June 2022 quarter is estimated to have been 5.9 per cent higher than that in the June 2021 quarter) wasn’t at all out of line with typical experience in the last few decades. It is quite a different picture than we see with headline and core inflation measures. And although Covid has continued to affect economic numbers, last June quarter seemed relatively little affected by Covid here (the Delta outbreak was mid-August), and by the June quarter we were through the worst of the restrictions. Perhaps as importantly for what follows, the June quarter was pretty normal for most other countries too (and the June 2020 quarter was pre-Omicron disruptions).

One upside of New Zealand’s slow publication of macroeconomic data is that when our GDP numbers are finally published, pretty much everyone else’s are available for comparison. And although people often note (fairly) that nominal GDP numbers are published with a longer lag than inflation numbers, we are also now in the long New Zealand hiatus where it is two months since we last saw an inflation number, and another month until we get another one. The MPC makes its next OCR decision before that.

So how did New Zealand’s estimated nominal GDP growth for the year from the June quarter last year to the June quarter compare with the experience of other OECD economies? Here I’m focused on places having their own monetary policies, and so show the euro-area rather than the individual countries in that area. I’m also going to leave Turkey off my charts – mostly to keep them more readable, in a context where they are running a crazy monetary experiment and have recorded nominal GDP growth of 115 per cent in the last year.

Nominal GDP growth in (fairly low inflation) Norway went sky-high because the invasion of Ukraine etc has sent oil and (especially) gas prices very high.

But look at New Zealand: we had the fourth lowest rate of nominal GDP growth in that year among all the OECD countries (monetary areas). And two of those below us – Switzerland and Japan – had not only not eased monetary policy in 2020, but had spent years grappling with such low inflation they’d needed persistently negative policy interest rates.

Absolute comparisons like this can mislead a bit. Some countries have higher inflation targets than others – Chile, Costa Rica, Mexico, and Colombia for example target 3 per cent inflation, and have historically had somewhat higher nominal GDP growth rates consistent with those higher targets. But I could take the Latin American countries (poor enough that they are really OECD diversity hires) off the chart and it wouldn’t much change the picture as it affects New Zealand and the countries we often compare ourselves to. In Australia, for example, nominal GDP increased by almost 12 per cent in the year to June.

The last quarter before Covid was December 2019. Across the OECD as a whole (and in New Zealand) core inflation at the time was generally a bit under the respective (core) inflation targets, and many central banks had been cutting policy rates that year.

Here is nominal GDP growth (as now recorded – GDP revisions are a thing) for the same group of countries for the last pre-Covid year.

New Zealand’s rate of nominal GDP growth then was a bit higher than the median OECD country, perhaps consistent with the fact that our population growth rate was faster than those for most advanced countries. But our nominal GDP growth rate that year was also a bit higher than the average rate New Zealand had experienced in the previous decade or more. (Note Norway again; not even the staunchest advocates of nominal GDP targeting recommend it for countries with terms of trade shocks on that scale.)

The next chart shows annual growth in nominal GDP for the latest period less annual growth to the end of 2019. The idea is to see how much acceleration there has been (with the sort of lift in core inflation we’ve seen across most of the world all else equal one might expect to have seen quite a lift in nominal GDP growth).

Fair to say that New Zealand stands out somewhat. In the year to June 2022 New Zealand was the only OECD country to have had nominal GDP growth lower than in the immediate pre-Covid period. And if our terms of trade have fallen a bit in the last year, that was still in a context where (NZD) export prices were up 17 per cent in the most recent year, with import prices up even more.

I am genuinely not sure what to make of these pictures and the New Zealand comparisons specifically. If you look across that last chart you would have little hesitation in suggesting that a lot of monetary policy tightening (interest rate rises) has been warranted in the advanced economy world. For the median country, nominal GDP growth has accelerated by 6 percentage points. But in New Zealand, nominal GDP growth has slowed.

And if one were a champion of nominal GDP levels targeting, here is New Zealand’s nominal GDP over the last decade

Things have (inevitably) been bumpier in the Covid period, but there is nothing there suggesting things have gone off track in recent times (although the mix has changed, with less population growth and more inflation).

The usual fallback position when anyone invokes nominal GDP numbers is to note (entirely fairly) that revisions to GDP are very much to be expected. Perhaps we will find, five years hence, that nominal GDP growth in the year to June 2022 was really a couple of percentage points higher than SNZ currently estimate. That would be a pretty large change for a single year (as distinct from historical levels revisions as data collections and methodologies change). But – if every other country’s estimates didn’t change – one could revise up New Zealand’s rate of nominal GDP growth by 2 percentage points and we would still be equal lowest (with Japan – where they are still running avowedly expansionary monetary policy) on that chart showing the acceleration in the rate of nominal GDP growth.

Two other considerations are worth noting. It isn’t true that our Reserve Bank was particularly early in raising the OCR again – about six of these countries were ahead of them – but market interest rates had already risen quite a bit last year in anticipation and we had had one of the frothiest housing market during the Covid period, and are now somewhat ahead of the pack in seeing house prices and house turnover falling away. Even if – as I am – one is sceptical of house price wealth effects, housing turnover itself is one (modest) component of GDP. Either way, our subdued nominal GDP growth may be foreshadowing what could be about to happen elsewhere.

Monetary policy is avowedly run on forecasts – that would be true (or the rhetoric) even if one were targeting nominal GDP growth rather than inflation – and I guess it is always possible that we might see an acceleration of nominal GDP growth from here, that might support further Reserve Bank tightening from here. Perhaps, but it is difficult to see quite where this acceleration might come from.

I have been a little more sceptical than some in recent months of quite how much further the OCR is really likely to need to be raised, but I am not drawing strong policy conclusions from these data just yet. But they do seem like a straw in the wind that (a) warrants further investigation and (b) might make one somewhat cautious about championing further tightenings, especially in the absence of timely fresh inflation data. Subdued growth in nominal GDP is more or less exactly what one might expect to see if, with a lag, core inflation was already on track to slow, perhaps quite a bit.

The $9 billion dollar man

The Listener magazine this week reported the results of a caption contest they’d run for a photo of Reserve Bank Governor Adrian Orr.

I’d suggested what seemed to me a rather more apt caption.

One good thing about the Reserve Bank is that they do report their balance sheet in some detail every month, and yesterday they released the numbers for the end of August. August was not a good month for the government bond market: yields rose further and the market value of anyone’s bond holdings fell. And thus the Reserve Bank’s claim on the government, under the indemnity the Minister of Finance provided them in respect of the LSAP programme, mounted.

This is the line item from the balance sheet

A new record high at just over $9bn.

And that doesn’t seem to be quite the full extent of the losses the Governor and the MPC have caused. A while ago the Herald reported on an OIAed document from The Treasury.

I wasn’t sure quite what to make of that, but we know that from July the Bank has begun selling its bonds back to The Treasury. Over July and August they had sold back $830m of the longest-dated bonds (ie the ones on which the losses will have been largest) and presumably collected on the indemnity when the Bank realised the losses on those bonds at point of sale.

Presumably all the numbers will eventually turn up in the Crown accounts, but for now it seems safe to assume that Orr and his colleagues (facilitated by the Minister of Finance) have cost taxpayers around $9.5 billion dollars – getting on for 2.5% of New Zealand’s annual GDP (or about 7 per cent of this year’s government spending).

These are really huge losses, and to now the Governor’s defence seems to amount to little more than “trust us, we knew what we were doing”, accompanied by vague claims that he is confident that the economic benefits were “multiples” of the costs. But there is no contemporary documentation in support of the former claim (eg a proper risk analysis rigorously examined and reviewed before they launched into this huge punt with our money), and nothing at all yet in support of the latter claim.

Central banks should be (modest) profit centres for the Crown. Between their positions as monopoly issuers of zero-interest notes and coins and as residual liquidity supplier to the financial system there is never a good excuse for a central bank to lose money, and certainly not on the scale we’ve seen here (and in other countries) in the last couple of years – punting massively on an implicit view that bond yields would never go up much or for long (as they hadn’t much in the previous decade when other central banks were engaging in QE).

There are plenty of things governments waste money on, and plenty of big programmes that (rightly) command widespread support (through Covid you could think of the wage subsidy scheme). But this was just little more than a coin toss – low expected value, but with at least as high a chance of big losses as of any substantial gains. And seemingly with no accountability whatever. Orr has not apologised for the losses, nor have the other MPC members. No one has lost their job – but then this is the New Zealand public sector where hardly anyone ever does – and not a word has been heard from those charged with holding the Bank to account (the Board or the Minister of Finance).

Back when I was young the Bank ran up big (indemnified) foreign exchange losses in the 1984 devaluation episode. Searching through old papers I can’t find the precise number the Crown had to pay out, but between what I could find and my memory it may well have been of a similar order (share of GDP) as the LSAP losses. But the responsibility then rested directly with the Minister of Finance – the Bank was not operationally independent, and defending the fixed exchange rate under pressure was government policy. It was a rash policy – the Bank advised the government not to do it – and the large losses added to the obloquy heaped on Muldoon for his stewardship in his last couple of years on office. But the public got to vote Muldoon out, while there still appears to be a serious possibility that Orr – having cost New Zealanders perhaps $1800 each – will be reappointed (with just six months of his term to go if he is not going to be reappointed it will need to be announced soon to enable a proper search process for a replacement to occur). The LSAP losses may not even be the Governor’s worst failing, but no one directly responsible for that scale of taxpayer losses – on risks he simply did not have to take – should even be considered for reappointment, at least if accountability is to mean anything ever.

Of course, there have been bigger losses in New Zealand government history. I’ve just been reading John Boshier’s Power Surge on the Think Big debacle of the 1980s. As a share of GDP, total economic losses to the taxpayer from that series of projects were far greater than the LSAP losses, but I’m not sure that losing less in one punt than the worst series of discretionary public sector projects ever in New Zealand history should be any consolation or mitigation. And, for what it is worth, Boshier’s book suggests there was typically more advance risk analysis undertaken for the Think Big projects than we have yet seen evidence of for the LSAP.

I’m sure gambling appeals to some people, and I wouldn’t want to stop those minded punting on the bond market, the fx market, Bitcoin, equities or whatever. But if that is the sort of thing that takes Orr’s fancy – and it probably isn’t judging by his past financial disclosures – he could at least do it with his own money, not ours. And having rashly done it with our money, and lost heavily, have the decency to apologise.

Orr defending the LSAP

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

From the 10 page report

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

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

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

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

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

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

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

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

Reviewing Covid monetary policy – Part 2

In yesterday post, the first in this series, I tried to review and assess the Reserve Bank’s preparedness and its policy response to the Covid economic shock in the first 2-3 months (January to April 2020). They weren’t very well prepared, as it turned out, and this probably contributed to them rushing (and rushing The Treasury and the Minister) into some elements of the response that bore financial risks that were grossly proportionate to the likely economic or financial returns. But on the information they had at the time, and the way most other forecasters and commentators were thinking about the likely economic implications of Covid (and associated other policy responses), there wasn’t much doubt that a significant monetary policy response – easing monetary conditions – was well-warranted at the time. But there were mistakes – some perhaps not that consequential as it turned out (the pledge not to change the OCR, up or down, for a year come what may, but others (the LSAP, concentrated at the long end of the yield curve) much more so (in a variety of ways), and to a considerable extent foreseeably so on the information available at the time. And, as usual (but potentially mattering more in high stakes times) the Bank wasn’t very transparent.

A point I didn’t make explicitly yesterday, but should have, is that a stylised central bank (and among advanced countries there has never been one in recent decades) focused exclusively on inflation would have had no cause to have done anything different, given the data and the beliefs about (a) how the economy would behave, and (b) how the various possible monetary policy instruments would work.

Today I want to focus on the following year or so. Over that period, there weren’t a huge number of monetary policy initiatives (they really didn’t change the OCR at all, up or down, although did ensure that banks could cope with a negative OCR should the inflation outlook require such a rate in the future.

There were two significant policy announcements:

  • the extension of the LSAP (and the associated Crown indemnity) to a potential $100 billion of bond purchases, and
  • the establishment of the Funding for Lending scheme.

Inflation targeting has long been recognised as relying heavily on forecasts of inflation. Why? Because monetary policy actions don’t affect inflation anything like instantaneously. Prudent policy today will typically (but not always) be substantially informed by best view available on the outlook for inflation some way ahead. The lags matter.

Quite how long those lags are is a matter for some debate. The old phrase was “long and variable”. I had a quick look at the Monetary Policy Handbook the Bank likes to boast of, and which is supposed to give readers a good sense of monetary policy as the Bank sees it. The word “lags” appears only once, and that referring to implementation lags in fiscal policy. I also checked the Discussion Paper in which the Bank’s calibrated economic model, NZSIM, is described, and was a bit surprised to find this chart

which seems to suggest very short lags (compare the 90 day and inflation charts), shorter than most practical discussion assumes. It is likely that the length of lags depends a bit on the shock, and a bit on the circumstances, but most pundits seem to think of the biggest impact of monetary policy on inflation as taking perhaps 12-18 months.

(Note that if the lags were as long as is sometimes rhetorically asserted – two years or more – the June quarter 2022 inflation outcomes (most recent we have) would have been substantially influenced by shocks to monetary policy in the June quarter of 2020, and since there were few/no dissenters then on the information available then, most questions of holding the RB now to account for recent inflation outcomes would be rendered largely moot. But few if any observers act, or consistently speak, as if the lags – for the largest effects – are that long.)

Implicitly or explicitly, all forecasts of inflation (and especially those that incorporate recent or prospective monetary policy changes) have a view on the length of lags, and when the Bank or officials ever discuss lags you also get the impression they have something like 12-18 months in mind.

So what did the Bank’s forecasts look like during this period? (Here, for the record, I an going to assume – I hope uncontroversially – that the published numbers were the Bank’s – or MPC’s – best view at the time.)

Here are the Bank’s inflation forecasts for the three successive MPSs, May, August and November 2020

Note that Reserve Bank published inflation forecasts almost always come back to 2 per cent eventually – it is the goal set for the Bank, and the default way the models are set up is for monetary policy to adjust endogenously to the extent required to get inflation back to target.

But note that these forecasts appear to have embodied views about the shocks monetary policy was leaning against that were severely disinflationary. Even with endogenous monetary policy, in all three of these sets of forecasts the inflation rates 12-18 months ahead were around 1 per cent, the very bottom of the target range and well below the 2 per cent successive governments required the Bank to focus on achieving. By the February 2021 MPS – not shown – the inflation outlook 12-18 months ahead was for outcomes around 1.4 per cent.

The Bank usually has OCR forecasts, but during this period (a) they had pledged not to change the OCR, (b) they believed the OCR could not yet be taken negative, and (c) they believed (or said they believed) that the LSAP was doing, and would do, a lot of the adjustment . So they published forecasts of what an “unconstrained OCR” would look like if a hypothetical OCR were to be doing its usual job.

Here were those projections (the paths in the May and August MPSs were identical)

So each of the published sets of projections through this period – but particularly those in 2020 – implied inflation well undershooting the target midpoint, even with substantial monetary stimulus (whether coming from the LSAP – which the Bank believed to be effective – or the OCR or – later – the Funding for Lending programme).

On their numbers it was pretty clear cut. The case for an aggressively stimulatory monetary policy was strong, whether considered against some pure inflation target or the Remit the MPC was charged with working towards.

I haven’t mentioned the unemployment or output gap estimates. These were the unemployment rate forecasts, that take into account actual and endogenous future monetary policy

I don’t want to make much of them (in shocks like this most of the information is already in the inflation picture) but their best view through 2020 was the unemployment into 2022 would still be 6 per cent or thereabouts (well above any credible NAIRU estimate). By the Feb 2021 MPS there was a big revision downwards, but they reckoned then that this week’s unemployment number would be about 5 per cent (best guess a day out, something like 3 per cent).

The forecasts were, of course, wildly wrong. But (a) there is no reason to suppose they were anything other than the best view of the MPC/Governor at the time, and (b) on those forecasts, the purest of inflation targeters would have taken a similar view on how much monetary policy stimulus was required (arguably – it was an argument I made at the time – the projections argued for more).

It isn’t very satisfactory that an organisation we spend tens of millions of dollars a year on, and set up a flash new statutory committee to make the decisions, did that poorly. There is no getting away from the fact that they had the biggest team of macroeconomists in the country, and access to every bit of private or public data they would have requested.

But, they weren’t the only ones doing forecasts, putting their money and/or reputations on the line. Long-term bond yields, for example, were barely off their lows in early November 2020, when the Bank was finalising the last projections of 2020.

What were the published forecasts of other forecasters showing. Conveniently, NZIER each quarter publishes a collection in their Consensus Forecasts. Those numbers include projections from the five main retail banks, NZIER itself, the Reserve Bank and The Treasury. There are limitations to the comparisons – they report numbers for March years (as distinct from rolling horizons) – and each institution’s forecasts are finalised at different dates (and Treasury publishes numbers only twice a year). The data are slightly biased against the Reserve Bank, which typically finalises forecasts in the first or second week of the second month of the quarter, while the compilation is published in the middle of the final month of the quarter (so some will probably have updated their forecasts after the Reserve Bank publishes its MPSs).

But for what it is worth here are the comparisons for forecasts done in late 2020 and the first quarter of 2021.

In the September 202 comparison, the Reserve Bank’s numbers for both inflation and unemployment are very much middle of the pack (just a little less inflation and a little less unemployment than the mean response (NB: note to NZIER: medians are probably better)).

By the final quarter of 2020, the Reserve Bank had the lowest March 2022 inflation forecasts,,,,,,but not by much. 1.1 per cent – the mean response – was still a very long way below the target midpoint.

And in the March 2021 comparison – where those focusing on the Reserve Bank’s failures might have hoped to find them at odds with their peers, on the wrong side – the Bank’s inflation and unemployment forecasts sit right on the respective means (and the least-wrong forecaster – credit to them – still proved to be off on inflation by just less than 5 percentage points).

I think it is no small defence of the Reserve Bank, in making the monetary policy that was driving core inflation outcomes now, that it had very much the same sets of views as its local forecasting peers. There are other forecasters (eg Infometrics) but it isn’t obvious anyone doing and publishing forecasts was doing much better than the Bank when it mattered. If you disagree that it is “no small defence”, all I can really offer is “well, they’d be really culpable if the central tendency of private forecasters – each with fewer resources – had been materially less bad than them”.

Another comparison is with the NZIER’s Shadow Board exercise, which for each monetary policy review invites six economists (and a few others) to offer their views on what the Bank should (not “will”) be doing. Several of the bank chief economists are in the Shadow Board panel, as are Viv Hall (retired macro academic, and former longserving RB Board member), Prasanna Gai, macro professor at Auckland (and former overseas central banker/adviser), and Arthur Grimes (former chief economist of the RB and the National Bank).

Shadow Board members used to just be asked for an OCR view, with probability distribution, and given the chance to make comments (some take regularly, some occasionally, some hardly at all). So I look through each release starting with the June 2020 (non MPS) review. The question was posed about the degree to which respondents thought the RB should use (a) a negative OCR, and (b) further QE (ie an expansion of the announced QE programme) at each of (a) the upcoming meeting and (b) the coming 12 months.

In June 2020, of the six economist respondents two thought there was a strong chance that a negative OCR would eventually be required. Arthur Grimes thought there was a near-zero chance. Four of the six strongly favoured an eventual expansion of the QE programme. Prasanna Gai put that chance at 50 per cent. Arthur Grimes again assigned a near-zero probability. Sadly, neither Prasanna nor Arthur offered any comments in elaboration, so we don’t know whether they felt the LSAP would be ineffective, they had a more robust macroeconomic (inflation and/or unemployment) outlook, or what.

By the next review, enthusiasm for more stimulus had begun to fade somewhat (although Arthur – again with no comment – modestly increased his very low probability on more QE being appropriate.

By the September review the LSAP programme had been significantly expanded, but respondents views about the future hadn’t changed much. A couple thought a negative OCR quite likely to be required, but no one was keen on a further increase in the LSAP programme. Nothing much had changed in respondents’ views going into the November MPS (and one of the comments suggest a robustly different macro outlook).

By the February 2021 exercise, the question had changed. Respondents were now asked about the likely need for “tighter policy”, now and in the coming year. There was growing sense that a tighter policy stance would be required over the coming year, but only one respondent – Grimes – was confident that an immediate tightening was warranted.

Ah, you say “see, an academic who doesn’t even do monetary policy stuff these days bests the Reserve Bank”. Except for the awkward fact that this was the time Grimes chose to make comments and explain his stance. His explanation?

The RBNZ loosened monetary policy too much through 2020, causing soaring house prices (as well as other asset prices) which is very damaging for disadvantaged New Zealanders and for the next generation…..The tightening should continue until such time as house prices return to a much more affordable level provided the goods market does not enter deflation.  

In other words, whatever the merits of Grimes’s stance may or may not be, he wasn’t at all focused on the outlook for the CPI. Instead he favoured using monetary policy to target house prices, with the explicit proviso that deflation might be a risk for general consumer prices. But – whatever merits or otherwise there may be to his argument – the target he was proposing was not the one the government had charged the Bank with pursuing.

(To look ahead, in the April survey Grimes again focuses on house price inflation but does talk about a need to “head off incipient goods market inflation pressures).

Again, maybe someone to point to some other commentators who did better, but from among the usual range of suspects there was little or nothing marking out the Bank’s overall view on inflation or monetary policy in the second half of 2020 or even early 2021. What there had been of course was a huge kerfuffle over house prices – where at times the Bank didn’t help itself (the chief economist once suggesting rhe higher prices were good ands helpful), but where mostly I agree with Governor: house prices were not something the monetary policy arm of the Bank was supposed to focus on (construction costs are) and that it would be an inferior approach to monetary policy to make house prices a focus of monetary policy. It is not irrelevant that no other central bank does.

So there was massive forecasting failure, and a widely shared one. The good side of that was that the economy got back to capacity much faster than expected/feared. The (very) bad side is that the economy grossly overheated and substantial core inflation pressures compounded – in headline CPI terms – various one-off price levels shocks that orthodox monetary policy generally encourages central banks to “look through”. It wasn’t a forecasting mistake unique to New Zealand. it was, it appears, about how Covid, the resulting stimuli etc would work out – something for which neither central banks nor private forecasters had many useful precedents.

None of that means that there were not significant mistakes made by the Bank during the period in this post.

If –  as the forecasts suggested –  more monetary policy stimulus was warranted in August and November 2020, there was still no good reason for a massive expansion of the LSAP programme, still focused at the long end of the yield curve (where little borrowing occurred), still boosting the level of settlement cash (in a way that had next to no macroeconomic significance, given the settlement accounts paid a full OCR interest rate, but which fed a frenzy around “printing money” –  from both several journalists on the left, and a few economists on the right.  The Bank had the option of cutting the OCR further –  25 points isn’t nothing, even if perchance a modestly negative OCR might have created a few residual systems problems for a few banks.  Sure, some weren’t keen in the abstract on negative rates, but the beauty of conventional monetary policy (the OCR) is that it comes a little or no financial risk to the taxpayer.  Massively expanding the LSAP programme –  when even the Bank will acknowledge uncertainty about the strength of transmissions mechanisms –  opened the way to potential for further massive losses to the taxpayer, with no sign still (months on, crisis passed) of serious risk analysis or indications of the losses taxpayers might face in the worst case, if things went bad and bond yields (and then the OCR) rose sharply.  

(A common excuse (I even used it once or twice myself) is “well, it doesn’t matter too much if the economy is so much stronger”, except that (a) there is little serious evidence (and the Bank has published none) that the LSAP was what produced the strength, and (b) things have so overheated, that if the LSAP did contribute much there are now two strikes against it.  At worst, the Bank should have been much for focused on managing yields at the 2 and 3 year parts of the yield curve, where any potential good would have come at much less financial risk.)

And then there is the Funding for Lending programme.  There have serious issues around the fact that that crisis scheme is still lending now, but that is an issue for the next post.

Again, given the macro forecasts (see above, very similar to those of private forecasters), it isn’t unreasonable for the Bank to have been seeking to ease monetary conditions a bit further.  And that is what the Funding for Lending programme did –  helped (mostly in the announcement effect, more than in actual lending) to lower term deposit rates relative to the OCR.  It was conceived at a time when the Bank thought the OCR could not go negative, but was only finally put in place by a time when (so the Bank told us) those issues had largely been sorted out.

I wrote a post about the launch of the Funding for Lending scheme in November 2020 (“Funding for lending and other myths”). I stand today by everything in that post. The scheme wasn’t harmful, didn’t carry material financial risks, and probably helped ease conditions a bit (the Bank has claimed it is latterly equivalent to one 25 basis point OCR cut, which sounds plausible). But by the time it was deployed it simply wasn’t necessary – adjustments could have been made simply to the OCR (if the Bank had not been dogmatically wedded to the ill-advised March 2020 pledge not to change the OCR come what may). And, if you refresh your memory, the scheme fed narratives that somehow banks were settlement cash constrained (they had never been), and led to loud but futile arguments about whether access to the funds should be tied to expansions of particular favoured types of lending (when banks were more opportunity-constrained, were never cash constrained, and where if such access rules had been put in place the scheme would not have worked to the limited extent it did. The Bank itself was a significant part of the problem – it was the party that devised the misleading name, presumably in same wish by the Governor to be seen, again, “doing stuff”.

I’m going to stop this post here, and am not going to attempt a summing up except perhaps to suggest that in the broad thrust of monetary policy (stimulus provided) this period the Bank did no worse than anyone much else (and if that isn’t saying much, so many people inside and outside of government and of New Zealand misread how the economy would behave. Lags are a problem. A mechanical inflation targerer with that not uncommon view of the world might reasonably have counselled more. Where the Bank is more culpable during this period – both with hindsight and with perspectives available at the time – was in its use of unconventional instruments.

Reviewing Covid monetary policy – Part 1

After last week’s posts on the Reserve Bank’s handling of monetary policy, I thought it might be worthwhile to stand back and attempt a series of posts this week on how the Reserve Bank has handled things (mainly monetary policy) over the two and half years since, in late January 2020, Covid became an economic issue for New Zealand. In today’s post, I will look at the Bank’s preparedness and their responses over the first three months or so. In a second post, probably tomorrow, I will look at their handling of policy over the following year or so, and a third post will look at the more recent period. If it seems worthwhile, I might attempt a final post bringing it all together.

It is hardly a secret that I do not have a high regard for the Governor, but in this series I will be seeking to offer both brickbats and bouquets as fairly as I can, and to distinguish as far as possible between perspectives that were reasonably open to an informed observer at the time and those which benefit from hindsight. Both have their place. Even though every country’s circumstances differ, what was going on in other countries and central banks is not irrelevant to a fair assessment of the Reserve Bank’s handling of things. People with more time and resources are better placed to assess the variety of responses in other advanced countries, but I will draw on comparisons where I can and where I think it would be helpful. Finally, while my focus is on the people who mattered – the Bank and the MPC – I’m always conscious that I wrote a lot in real-time about how monetary policy was being and should be handled. Inevitably I’ve had to reflect on what I got right and wrong, and why.

One area in which the Bank does not score well throughout is transparency. The Bank often likes to boast about being very open and transparent – the Governor was at it again in his press release last week reacting last week to the Wheeler-Wilkinson paper – but it is anything but, and the gaps were more evident than usual over the Covid period. The Bank has been less willing than the government generally to release relevant background documents, nothing at all has been heard from most members of the MPC (despite it being one of the most difficult times for monetary policy in a decades), and there have been few serious and relevant speeches and little or no published research. In challenging and uncertain times when no one has any sort of monopoly on wisdom the stance the Governor has chosen to take – echoing the biases of successive Governors – is a poor reflection on the Bank. We are told that Bank staff are beavering away on their own review, but the Bank will not even commit to having that material available to the public before their consultation on the five-yearly review of the monetary policy Remit closes (and there is no sign, for example, of any sort of ongoing engagement with alternative views going on). Here it is always worth bearing in mind that the Reserve Bank has far more resources available to it (including the largest team of macroeconomists in the country) than any other relevant party in New Zealand. We should expect better. And the Governor’s assertion a couple of months back to Parliament’s Finance and Expenditure Committee that he regrets nothing is neither true to the limitations of human knowledge/understanding, nor exactly reassuring that we are dealing here with an open and learning organisation.

Preparedness

When the first news of Covid cases emerged from China at the very end of 2019, the OCR was 1 per cent and the Bank had been struggling for some years to get (core) inflation up to the 2 per cent that successive governments had told them to focus on. By the end of 2019, they were not far away, but equally the economy was pretty full employed, the growth phase had run for 8 or 9 years, and prudent central bankers needed to be thinking about how they’d cope with the next recession. The effective lower bound on the nominal OCR really wasn’t that far away and in typical recessions perhaps 500 basis points of interest rate cuts had been required.

In a couple of respects, the Bank doesn’t score too badly:

  • as long ago as 2012, then outgoing Governor Alan Bollard had set up a working group (I chaired it) to think about how we would handle the next serious downturn. That group recommended, and there was no dissent from senior management, that steps be taken to ensure that the Bank’s systems and those of the banks could cope with modestly negative interest rates (which had already become a thing abroad),
  • in 2018, shortly after Orr took office, the Bank published a survey of options for what they referred to as “unconventional monetary policy”, citing the need to have thought through the issues in case the need arose in New Zealand (I discussed the article here).
  • well into 2019 the Governor gave a substantive interview in which he expressed his view that a negative OCR was preferable to using large-scale asset purchases in a future serious downturn. They seemed to have been thinking about the issue quite a bit.

The problem was that it didn’t seem to have occurred to them until very late in the piece to check if their preferred option was workable. Documents released under the OIA confirm that it wasn’t until December 2019/January 2020 that they thought to check, and pretty quickly the feedback from banks told them that – for many if not all banks – there were systems problems (both computer systems and documentation) that meant negative interest rates could not be implemented in short order.

(To be honest, I am still mystified on two counts: the first is how the Bank never checked over all those years, but the second is how the banks – often part of banking groups with operations in countries/markets that had dealt with negative rates elsewhere over the previous decade – were sufficiently remiss as not to have prepared either. How insuperable these obstacles really were in still hard to tell, but what matters is that the Reserve Bank and the MPC treated them as so, and were foreced into last minute changes of plan.)

The Bank was pretty slow off the mark to recognise the potential severity of Covid. By late January, some New Zealand exporters of luxury food products to China (notably crayfish) were reporting real problems. At the very end of January, New Zealand temporarily closed the border to arrivals from China (China have already restricted outflows from China), threatening both tourism and foreign students, and lockdowns were a thing in one of the world’s largest economies. But through February, the Bank took a fairly relaxed approach (which, in fairness to them, seems to have reflected a fairly relaxed approach across much of government – the Secretary to the Treasury sits on the MPC, and there is no sign that she injected any great sense of urgency to the deliberations on the February MPS, and published papers reveal no urgent whole of government effort to get ready for what might be coming). I was among those calling for a precautionary (Covid) OCR cut in February – at the time, there was no doubt that the Covid effects we were experiencing were, from a New Zealand perspective, pure adverse demand shocks. The Bank didn’t act, but what surprised me more was a couple of weeks later when they took to social media to talk up economic prospects for 2020 (an OIA request revealed that this wasn’t some rogue social media person, but was initiated/cleared by the Bank’s chief economist).

The global situation deteriorated into March, and not much was seen or heard of the Bank. But then on 10 March the Governor delivered a speech to an invited audience on monetary policy at very low interest rates. The Governor was keen to stress that this was all in abstract, there were no immediate plans to use any of them, but also

There was an indication that they would shortly be publishing background technical papers on each option (papers which, if they existed, never actually were published).

Note the preferred order. Note the date.

A couple of days later the Herald briefly reported some comments by the chief economist also downplaying the potential of asset purchase options.

On Monday 16 March, the deteriorating situation (virus, markets, economic dislocations), finally prompted the Bank to act. The centrepiece of the day’s announcements was that the OCR was cut by 75 basis points immediately (other central banks were making similar moves). But there were other elements to the day’s announcements, notably:

  • a year’s delay in the commencement of the higher bank capital requirements,
  • a move to pay the OCR interest rate on all settlement cash balances (previously each bank had a quota – linked loosely to daily interbank settlement requirements – above which only below market rates were paid).

Both moves made sense.

The Bank also indicated that it had discovered – 6 days on? – that banks could not operationally cope with a negative OCR, and issued a pledge that seemed strange and inappropriate at the time and seemed only more odd later: no matter what happened, the OCR would not be changed for the coming year. It simply made no sense. On the one hand, even if a negative OCR wasn’t really technically feasible, there didn’t seem to be any obstacle to an OCR of zero (or 1 or 10 basis points). And in an environment that was moving so fast and was so uncertain (that, for example, emergency unscheduled MPC announcements were needed) how could anyone pretend to the level of confidence in the economic and inflation outlook implied by a pledge that, come what may, the OCR would not be changed – up or down – for the coming year? Since the Bank won’t release the relevant documents and has never really engaged on the issue, it is hard to know what was going on in their minds, or what issues/risks they were thinking about (or not).

All that said, on the day the broad thrust of the moves was fairly widely welcomed (as just one example, here is the “Whatever it takes” (and “more will be necessary”) press release from the NZ Initiative. This was the day before the government’s own first significant Covid fiscal package (which I described at the time as, at best, good in parts).

The Covid situation deteriorated rapidly over the following week, with New Zealand’s “lockdown” (not envisaged in either fiscal or monetary announcements the previous week) announced and implemented. Economic activity was clearly weakening, as (eg) domestic travel dried up. Global equity markets were very weak and pressures spilled over into bond markets, initially in the US, but increasingly globally. Cash was king and bonds could be sold.

And on 23 March, the Bank announced that they had lurched to launching a $30bn large-scale asset purchase programme. Read the statement and it is clear that there were two separate considerations: one about the immediate pressures in the government bond market (yields were rising) and the second – more important – about the deteriorating economic situation. In their words

The negative economic implications of the coronavirus outbreak have continued to intensify. The Committee agreed that further monetary stimulus is needed to meet its inflation and employment objectives.

The following day – the “lockdown” having been announced by then – the Reserve Bank, the government and the retail banks had a further announcement (not primarily about monetary policy) : a six month mortgage holiday for those with severe Covid income disruptions, an (ill-fated) Business Finance Guarantee Scheme, and (from the RB, and with monetary policy implications) an easing in the core funding ratio requirement on banks.

There were various other announcements over the following days/weeks, but perhaps the last in the initial wave (and I’d forgotten it came a month later) was a 21 April announcement that the Bank was planning to remove LVR restrictions for 12 months.

It seems to me that the Bank’s broad approach over the period from mid-March to late April 2020 was consistent with a pretty widely held view of severe downside risks to both economic activity and inflation – widely held among informed observers in New Zealand and those overseas (looking at their own economies). Of course everyone recognised that (for example) ordering people to stay at home for weeks on end represented a reduction in the economy’s capacity to supply (good and services) and that the liberal wage subsidies would maintain immediate purchasing power (at least for wage and salary earners), but that there were good reasons to suppose that adverse demand effects would outweigh supply reductions. If so, downside risks to inflation and inflation expectations were very real (risks to expectations soon became apparent in survey measures) and, well, inflation and inflation expectations were what we wanted the monetary policy arm of the Reserve Bank to focus on.

What sort of demand effects might we see? Examples included:

  • schools and universities unable to receive foreign students (significant export industry), and uncertain when those restrictions might ease,
  • tourism itself was a net export earner for New Zealand,
  • the borders being closed meant few if any new migrants could arrive (the demand effects of new migrants typically outweigh supply effects over the short-term horizons relevant to monetary policy,
  • the previous recession had seen a material fall in nominal house prices (despite much larger interest rate reductions) and between (a) reduced immigration, (b) limited interest rate cuts, and (c) significant reductions in business income (not protected by wage subsidies) house price falls and consequent reductions in building activity seemed likely (for those fond of wealth effects, them too)
  • big fiscal outlays upfront meant higher taxes later. That, together with lost GDP, meant we were actually/prospectively poorer, and might less keen on future spend-ups
  • huge additional risk and uncertainty had been added to the economic environment ( no one knew when normality would return, what it would look like, how many disruptions – or deaths – there would be in the intervening months/years. A standard prediction would be that heightened perceptions of risk and real inescapable uncertainty would mean firms and households would respond by deferring spending, and particularly (very cyclical) investment spending,
  • and if all this happened globally then our export commodity prices could be expected to fall (even as headline inflation was lowered by oil prices briefly approaching zero).

I held many/most of those sorts of views. So did many/most forecasters in those early days. A fairly aggressive macro policy response was warranted on those sorts of scenarios. If inflation and inflation expectations were to fall sharply it could prove very hard to get them back up again. against that sort of troubled economic backdrop. I am not aware of many (if any) mainstream commentators or forecasters taking a drastically different view in those early days (even as everyone recognised the huge uncertainty).

That doesn’t mean an automatic tick for everything the Bank did. For me

  • the big OCR cut, if a little late coming, was quite the right thing to do (including against a backdrop of significant fiscal income support and some other stimulus)
  • making available additional liquidity if required also made sense,
  • as did the easing of the core funding ratio, which helped enable lower term deposit rates relative to the OCR,
  • but the pledge not to change the OCR further for a year made no sense then, and makes no sense now.  The Bank knew it was entering a climate of extreme uncertainty, it knew it might need all the monetary support it could get. No one else anywhere in the economy had any certainty at all about anything, and yet the Bank pretended to.  
  • the move to pay the OCR on all settlement cash balances made little sense if the Bank was really serious about delivering as much stimulus as it could (that floor stopped market rates drifting lower) [UPDATE: altho it did support a more precise control of very short-ter market rates at/near the OCR itself, that might have been impaired otherwise if the Bank was injecting more liquidity.  This was probably the intention, althoguh a little later in ended up impairing one channel through which the LSAP might have worked].

My focus is on the remaining two strands of the package.

Perhaps one can mount a decent case for a week or two of stabilising intervention in the government bond market in late March 2020.   The pressures would have sorted themselves out anyway (after Fed intervention) but if the RB wanted to do its little bit that in isolation probably did little harm (if reinforcing future moral hazard risks).   But the case for the sustained LSAP itself (initially $30bn) was never, and has never compellingly, been made.  The Bank was right, just a few weeks earlier, to be wary of what the LSAP could offer outside the white-heat of financial crisis.  It seemed to have been too readily swayed by some mix of a need to be seen doing stuff (having ruled out more on the OCR), and false parallels with choices some other central banks had made over the previous decade.  The Bank rushed into the LSAP mainly purchasing long-term government bonds with ever, it seems, addressing either the fact that very little borrowing in New Zealand occurs at long-term fixed rates (so even if they affected those rates a bit, so what?) and with no serious financial risk analysis at all (if any such document existed it would surely have been released by now).   This latter failure has cost the taxpayer very dearly, and any serious risk analyst (in the Bank or The Treasury –  who seem quite culpable here, as advisers to the Minister on the indemnity)) would have identified those downside risk scenarios.   It was a failure of controls that, in a private bank, would rightly alarm a supervisor.     (While my view on the LSAP still seems to be something of a minority view in New Zealand, it is quite consistent with that of Professor Charles Goodhart, a UK monetary economist that the Bank has drawn on over the years, writing –  in a Foreword to a book on QE completed just prior to Covid “the direct effect on the real economy via interest rates, whether actual or expected, and on portfolio balance, was of second order importance. QE2, QE3 and QE Infinity are relatively toothless”).  I absolve the Bank of claims that the LSAP was later to do much to influence asset prices or the CPI, but that was on grounds that it was a gigantic speculative punt in the bond market, at taxpayers’ risk, for an expected economic return that was always derisorily small. 

If I have a minority view on the LSAP –  simply was not appropriate even at the time as a monetary policy tool –  I may also have on the LVR restrictions.  I see numerous people commenting, including on my Twitter feed, that “well, maybe the Bank had to do something with monetary policy in March 2020, but why do they do anything with LVRs-  that really was inexcusable”.

And on that I simply disagree.  I have never been a fan on LVR restrictions and in that sense would always –  including now –  welcome their removal, but even on the Bank’s own terms suspension of the restrictions was the sensible thing to do back then (ideally a few weeks earlier).  LVR restrictions were intended to lean against reckless lending against rapidly rising collateral values, and in discussions inside the Bank in the early days on LVRs the mentality was that sensibly controls would be lifted if asset prices were to be falling, or otherwise the controls would exacerbate falls and potential illiquidity in the market, while doing little/nothing for financial stability.  In this particular (Covid) crisis there was a further factor, cited by the Bank in its announcement: a six month mortgage holiday for those severely affected by Covid could have run smack hard into LVR restrictions had the latter been left in place [UPDATE: since interest deferrals in particular would have amounted to an extension of further credit to the borrower, at a time when collateral values –  which in principle would need to be reassessed at any fresh credit extension – appeared to be (and were expected to be) falling.]   One might quibble that the mortgage holidays really did pose increasing financial stability (loan loss) risks down the track, but the banks were already amply capitalised.  Between early indications that house prices would fall –  as they did for the first couple of months –  and tightening bank credit standards anyway (something the Governor regularly inveighed against) suspending the LVR restrictions was definitely the right call with the information, and the (widely shared) economic outlook the Bank had at the time.

This has, almost inevitably been a long post. I’m going to stop here, with just one final brief observation.  When, as is often done, people now talk about high inflation being a problem almost everywhere, it is sometimes (and fairly) pointed out that it isn’t quite all (advanced) countries: Japan and Switzerland being two examples of countries with much more moderate inflation.  They were also two countries that didn’t do anything much with monetary policy in 2020.  However, that doesn’t really tell as anything about what was right to do, with the information at the time, in early 2020.  After all, both Japan and Switzerland went into Covid with policy rates already negative, and unable to do very much more with monetary policy.  Had they been able to do more perhaps they would have done so. Or perhaps not.  But we have no easy way of knowing.  In early 2020 countries (central banks) like NZ, Australia and the US were openly quite glad to have the leeway they did, to take the steps they did, in a climate in which many argued “just do whatever it takes”.

Next stage in Covid monetary policy tomorrow.

 

Did it make a difference?

I’ll get back to some extensive original material next week, but I have been reflecting a bit on the attack on the Reserve Bank by Arthur Grimes, former chief economist of the Bank (and later chair of the Bank’s monitoring board). The most recent version ran on Radio New Zealand yesterday morning. As I noted on Twitter, there was a fair amount there I agreed with (notably the observations on the poor quality make-up of the MPC) and a fair amount I disagreed with.

Grimes has been critical of the Bank (and the government) for some considerable time, going back to the amendment to the statutory objective (adding a secondary element of “supporting maximum sustainable employment). Since the pandemic descended on us, his criticism has centred not on CPI inflation (actual or prospective) but on house prices.

Almost a year ago, he had an impassioned piece on these themes published in the Listener. I responded to it in a post, the relevant bits of which I reproduce below.

At which point in this post, I’m going to turn on a dime and come to the defence of both the Bank and the government. A couple of weeks ago the Listener magazine ran an impassioned piece by Arthur Grimes arguing that the amendment to the Reserve Bank Act in 2018 was a – perhaps even “the” – main factor in what had gone crazily wrong with house prices in the last few years. Conveniently, the article is now available on the Herald website where it sits under the heading “Government has caused housing crisis to become a catastrophe”.

Grimes was closely involved in the design of the 1989 Reserve Bank Act, and for a couple of years in the early 1990s was the Bank’s chief economist (and my boss). He left the Bank for some mix of private sector, research, and academic employment, but also spent some years on the Reserve Bank’s board – the largely toothless monitoring body that spent decades mostly providing cover for whoever was Governor. These days he is a professor of “wellbeing and public policy” at Victoria University.

However, whatever his credentials, his argument simply does not stack up, and given some of the valuable work he has done in the past, on land prices, it is remarkable that he is even making it.

There is quite a bit in the first half of the article that I totally agree with. High house prices are a public policy disaster and one which hurts most severely those at the bottom of the economic ladder, the young, the poor, the outsiders (including, disproportionately, Maori and Pacific populations). But then we get a story that house prices have been the outcome of the interaction between high net migration and housebuilding. As Arthur notes, immigration has hardly been a factor in the last 18 months (actually it has been negative, even if the SNZ 12/16 model has not yet caught up) and there has been quite a lot of housebuilding going on.

And yet in the entire article there is nothing – not a word – about the continuing pervasive land use restrictions (and only passing mention about the past). If new land on the fringes of our cities – often with very limited value in alternative uses – cannot easily be brought into development (if owners of such land are not competing with each other to be able to do so) there is no reason to suppose that even a temporary surge in building activity will make much difference to a sustainable price for house+land. Instead, any boost to demand will still just flow into higher prices.

Remarkably, in discussing the events of the last year there is also no mention of fiscal policy – the boost to demand that stems from a shift from a balanced budget just prior to Covid to one that, on Treasury’s own numbers, is a very large structural deficit this year.

Instead, on the Grimes telling the problem is a reversion to “Muldoonism” – not, note, the fiscal deficits, but the amendment to the statutory goal for the Reserve Bank’s monetary policy enacted almost three years ago now. Recall the new wording

The Bank, acting through the MPC, has the function of formulating a monetary policy directed to the economic objectives of—

(a) achieving and maintaining stability in the general level of prices over the medium term; and

(b) supporting maximum sustainable employment.

The main change being the addition of b).

Grimes has been staunchly opposed to that amendment from the start, but his assertion that it makes much difference to anything has never really stood up to close scrutiny. It has long had more of a sense about it of being aggrieved that a formulation he had been closely associated with had been changed.

He has never (at least that I’ve seen) engaged with (a) the Governor’s claim (which rings true to me) that the changed mandate had made no difference to how the Bank had set monetary policy during the Covid period, (b) the more generalised proposition (that the Governor is drawing on) that in the face of demand shocks a pure price stability mandate (and the RB’s was never pure) and an employment objective (or constraint) prompt exactly the same sort of policy response, or (c) the extent to which the New Zealand statutory goals remains (i) cleaner than those of many other advanced countries and yet (ii) substantially similar (as the respective central banks describe what they are doing) to the models in, notably, the United States and Australia. Similarly, he never engages with the straight inflation forecasts the Bank was publishing this time last year: if they believed those numbers, the purest of simple inflation targeting central banks would have been doing just what the RB did (and arguably more, given that the forecasts remained at/below the bottom of the target range for a protracted period).

Grimes seems to be running a line that the LSAP was the problem

The central culprit has been monetary policy that has flooded the economy with liquidity. This liquidity in turn has found its way into the housing market.

But there is just no credible story or data that backs up those claims. Banks simply weren’t (and aren’t) constrained by “liquidity”. The LSAP was financially risky performative display, but it made no material difference to any macro outcomes that matter, including house prices.

There is quite a lot of this sort of stuff.

Grimes ends on a better note, lamenting the refusal of governments – past and present – to contemplate substantially lower house prices, let alone take the steps that would bring them about (his final line “And no politician seems to care enough to do anything about it” is one I totally endorse). But in trying to argue a case that a change to the Reserve Bank Act – that had no impact on anything discernible as it went through Parliament or in its first year on the books – somehow explains our house price outcomes (especially in a world where many similar price rises are occurring, and where there was no change in central bank legislation), seems unsupported, and ends up largely serving the interests of the government, by distracting attention from the thing – land use deregulation – that really would make a marked difference and which the government absolutely refuses to do anything much about.

There is nothing much in that I would change today. In particular, in continuing to attack the change in the wording of the mandate (a matter on which reasonable people might differ, but which most economists would argue largely served to reflect how the Bank had been – and had been expected to be – running policy for the previous 25 years), he has not (that I’ve seen) been willing to engage with the points I’ve noted above which the Bank might reasonably be expected to mount in its defence.

Similarly, he never engages with the straight inflation forecasts the Bank was publishing this time last year: if they believed those numbers, the purest of simple inflation targeting central banks would have been doing just what the RB did (and arguably more, given that the forecasts remained at/below the bottom of the target range for a protracted period)

As Arthur correctly noted in his RNZ interview yesterday, monetary policy lags are quite long. The Bank has to be looking ahead in setting policy. Many estimates are that the lags for the main effects of monetary policy might be 18-24 months. Thus, June quarter 2022 inflation might be most affected by monetary policy choices in late 2020. Here is a summary of the key variables in the Bank’s November 2020 MPS projections (“baseline scenario” as they were calling it at the time)

If this was genuinely their best view at the time (and there is no obvious reason to doubt that) then a textbook pure inflation-targeter (which has never described the Reserve Bank under any of its inflation-targeting Governors) would have looked at these forecasts – inflation at about 1 per cent in mid 2022 – and might reasonably have concluded that more monetary policy stimulus was required.

It all just goes to my argument that the big problem (with hindsight) in the first year or more after Covid hit was a forecasting mistake – the Bank (and most other forecasters) proved to be using the wrong models for thinking about how Covid would affect key economic variables. For much of that time, the thrust of the Bank’s forecasts were not so different from those of other forecasters. Where, in my view, they become much more culpable is from the middle of last year when, with core inflation evidently rising beyond the target midpoint, they were slow to start tightening, and sluggish in the adjustments they did make. But, again, by then both inflation and unemployment numbers (actual and indications of the future) were pointing in the same direction.

A tidal wave of cash?

One thing in the National Party’s call for a public inquiry into monetary policy that I didn’t comment on yesterday was the framing. The press release is headed “Inquiry needed into impact of tidal wave of cash”. It is a framing I have never liked, whether coming from critics on the left or the right.

My point here isn’t to bag National. They ran with a catchy headline, but the body of their release talks more generally about the overall conduct of monetary policy. But it is a framing that isn’t uncommon (loose talk of “money printing”) so it is an opportunity to restate my view – probably a minority view, but I stand by it – of the macroeconomic irrelevance (to a first approximation) of the Reserve Bank’s LSAP programme.

Rather than write something fresh, here I’ve reproduced the relevant sections of a lecture I gave to some Victoria University masters students in December 2020. Probably no more than any other commentator, I won’t stand by everything I’ve written on monetary policy since the pandemic began. but this 20-month-old view (typos and all) is largely still my view today.

It was an asset swap that involved the central bank taking on a huge amount of risk, and there is little credible basis for supposing there was any material macroeconomic effects (lower short-term interest rates and fiscal policy did the stimulus). Banks are not, in aggregate, settlement cash constrained. Shorter-term rates are what mostly matter in New Zealand, and so even if the Reserve Bank’s purchases managed to have some sustained impact on long-term rates they just don’t matter much in the New Zealand transmission mechanism.

Oh, and that risk was taken on without any sign that any robust financial risk analysis was ever undertaken by the Bank, by the MPC, or by The Treasury. There is no sign the Minister of Finance ever asked for one. And so in something of a panic (LSAP hadn’t previously been their preferred instrument), wanting to be seen to be “doing something” they rushed into purchases, no doubt thinking they were doing good, but actually with little sustained prospect of doing so. And as the Minister of Finance put it in Parliament yesterday, in a set of answers that suggested some distancing from the Bank.

Interest rates have shifted since that time and, as with our fiscal response, there are costs associated with the measures that the Reserve Bank took. The latest estimates from Treasury of this cost is around $8.46 billion.

Or about $8000 per family of five.

The final couple of sentences in the extracts above might have raised some eyebrows. Here is what I went on to say about housing later in the lecture.

People today are quite free in attacking the Bank for lifting LVR restrictions in March 2020. I continue to believe that, in the context of other policies being adopted at the time, and the generally prevailing view at the time that a Covid economic downturn would be associated with falling house prices, lifting those restrictions was both right and inevitable. From the time LVR restrictions were first put in place in 2013 it had never been envisaged that they would be left on if house prices started falling: the original conception of LVRs was to lean against excessively liberal lending standards, not usually a problem when the underlying asset value is falling. The big change came later when the Orr Reserve Bank moved, wrongly in my view, to make LVR restrictions a permanent feature of the landscape – whether or not there was any sign of lots of poor quality lending, whether or not there were evident financial stability risks. Financial repression always sows seeds of future problems.

Not to start a lengthy new discussion, but for much of 2020 and early 2021 the problem proved to be a forecasting problem. The Reserve Bank and The Treasury, and most private forecasters, had the wrong model of pandemic economics. They (we) assumed there would be a larger element of an adverse demand shock than there proved to be. That was certainly a mistake I made: as just one example, my approach from March 2020 had been that the inevitable uncertainty (virus and policy) would act as a considerable damper on (highly cyclical) investment spending, all aggravated by the population shock wrought by the closed border. One can trace forecasts – official and private – from early 2020, and it is clear that until perhaps May/June last year the problems were forecasting failures. It was only from then, perhaps until about March this year, that the Reserve Bank’s failings were in how it responded to contemporaneous data and its own forecasts.

A public inquiry isn’t necessary

A few weeks ago in a post about what a new government might do about the Reserve Bank, I noted with some concern that the National Party had been very quiet on the issue.

I noted then that the process for reappointing (or not) Orr was likely to be getting underway very soon, and that if the Opposition thought it was inappropriate for him to be reappointed they needed to be raising concerns now (helping create a climate in which it would be more difficult for the government to push ahead) and not wait until (as required by law) the Minister has to consult other parties on the person he proposes to appoint as Governor (by when there would be considerable momentum behind any particular name).

So it was interesting and encouraging to see a press release yesterday from Luxon which appeared to raise serious concerns about Orr’s stewardship of monetary policy., apparently prompted at least in part by the Wheeler-Wilkinson (WW) note out yesterday morning, which has had considerably coverage. The centrepiece was a call for an independent public inquiry

tied to the issue of whether or not Orr is reappointed thus

Count me sceptical.

There have been a couple of earlier strands to calls for inquiries. The Green Party has for some time been calling for the Finance and Expenditure Committee to inquire into the conduct of both fiscal and monetary policy over the pandemic period. They have had support in that call from both ACT and National but the Labour majority (no doubt on instructions from above) simply refuses. It seems to me a natural topic for a serious select committee to look into, and even allowing for the partisan priors of all participants, it isn’t impossible such a review could shed some light.

The second, and more recent, strand is that inquiry into the RBA that the incoming Labor government in Australia has established (terms of reference here). But this inquiry isn’t really relevant to the issue here, and while pandemic responses aren’t out of scope the focus of the inquiry seems likely to be on policy frameworks more broadly and the governance model. On the latter, the current New Zealand government has only recently legislated for new models, for monetary policy specifically and the Bank more generally. As I’ve highlighted in various posts on this blog, there are a lot of problems with the new arrangements, but this government is hardly likely to revisit its own creations so quickly. That (I hope) will be a matter for a new government one day.

Note also that the RBA review, with reviewers already appointed, has to report by March next year. The question of the (re)appointment of a Governor here has to proceed on a much faster track than that, since Orr’s term expires in late March. As I noted in my earlier post, I expect that the question of the (re)appointment will be on the Board’s agenda very shortly, with a goal (Minister, Board, Bank – and probably markets) of having everything more or less settled by Christmas. Consistent with that, I saw this in Bernard Hickey’s newsletter this morning

Finance Minister Grant Robertson immediately refused yesterday to agree to a review and said he was in discussions with the Reserve Bank’s board about the re-appointment process. 

Robertson has ruled out a review, but even if he hadn’t I don’t think it would be a particularly good use of public money to have one. Apart from anything else, it is hard to think of anyone in New Zealand who knows the territory who is not conflicted or who has not already declared their hand (often in quite strong terms).

In other comments, the Minister has pointed out that the Bank’s Board is responsible for reporting and reviewing the Bank’s performance. Of course, there he is just playing distraction since he appointed both the old and new boards (and their chairs) and knows that the Board is on record (minutes released under the OIA) as having done no serious scrutiny or evaluation of the Bank’s monetary policy performance. Nor is there any sign that the Minister has ever asked for more. And, most recently, he has appointed a new Board that is manifestly underqualified for the statutory roles of holding the Governor and MPC to account, or recommending the appointment of a future Governor. Other OIAs show that the Minister just reappointed two of the MPC members – in the midst of a really troubling period for monetary policy – with no serious attempt to evaluate their performance at all.

In addition, The Treasury is now formally charged with a role monitoring the Bank’s performance. It is hard to be optimistic that will deliver much (the institutions are typically too close) but there is no sign Robertson has any serious interest in enhanced scrutiny or analysis. (In addition, of course, Treasury is more than a little compromised by their closeness to the Bank – including the Secretary as non-voting MPC member – and the advice they provided at the time, including recommending the Minister enable the LSAP programme.)

Finally, it is true that the Reserve Bank is working on its own evaluation of its handling of policy over recent years. We can expect this to largely be a self-serving self-congratulatory piece being done by staff (not even by the MPC) but even so when they eventually publish it it will still provide a basis for discussion and critique. The Bank tells us it has taken some independent overseas advice, but if that sounds reassuring it probably shouldn’t: they haven’t told us who they have sought advice from, and it is hardly a novel insight to suggest that the choice of overseas person is quite likely to be influenced by what the Governor already knows of that person’s views. One can always find a sympathetic commenter.

The real reason I don’t think an independent inquiry is warranted is that we already know pretty much all there is usefully to know. Defenders of the Bank/Governor will interpret the set of data one way, and others will contest a range of alternative interpretations. It is, and should be, a process of contest and debate. And the issues relevant to the question of whether Orr should be reappointed by not even close to limited to those around the pandemic response (in fact, I would argue that these later points should not be given too much weight at all). We know about things like:

  • Orr’s bullying style,
  • his lack of receptiveness to scrutiny, challenge, and criticism (most evident in the bank capital review process),
  • the high rate of turnover of staff, particularly senior staff,
  • the top-heavy management structure he has put in place, in which very few have much evident subject expertise (eg the deputy chief executive responsible for macroeconomics, monetary policy and markets, who has no background in economics at all),
  • the really big increase in the size of the Bank (with no material change in responsibilities), in many cases in non-core areas (notably the very large communications staff),
  • the distracted focus and politicisation of the Bank as Orr has pursued his climate change, indigenous network, tree god, and similar interests, for which he has no statutory responsibilities,
  • the absence of serious speeches from the Governor shedding light on his thinking or analytical frameworks around areas of his core responsibility,
  • the degrading of the Bank’s research and analysis capabilities (despite the massive increase in total staff) that has seen very few serious research papers published in recent years,
  • the insular monolith the Governor has helped create in the MPC, where outsiders with relevant ongoing expertise are banned from being appointed to the Committee, and challenge and dissent (let alone public accountability) appears to be actively discouraged.

All these speak of someone not fit for the job, someone who isn’t even that interested in developing a world-class small central bank or doing the core functions of the Bank excellently.   We don’t need an inquiry for any of that.

What of the pandemic response?    Perhaps there is case that could be made that any time core inflation gets so far outside the target range, the Governor and most of the MPC should lose their jobs almost automatically.   Such a regime might be better than one in which leading central bankers (globally) rarely pay much (if any) personal price for their mistakes, no matter what cost they impose on the public in the process.  $8 billion plus in losses on the LSAP speculative punt (with not even any evidence of a robust risk analysis before launching the scheme) isn’t nothing, and neither is the recession likely to be required for getting core inflation back down again.  They are serious failures.  Honourable people responsible might well choose to resign, or not seek reappointment.  They took the job, and the pay and prestige, and accept that there is a price to be paid when things go badly, if only to encourage others.

But what makes me hesitant is that these choices were not made in a vacuum.  Others, with incentives to get things right, had views at much the same time as the Orr-led Reserve Bank was making its call, and the middle-ground of expert opinion at the time was not, I assert, wildly different to the policy choices Orr and the MPC (and their peers abroad) were making.  I take seriously the idea that when central banks are targeting inflation, their forecasts matter hugely (given the lags, perhaps almost as importantly as outcomes).   At the times the Reserve Bank was making key choices, their forecasts –  which I will treat as their honest best effort –  either showed (core) inflation undershooting the target range (the case for most of 2020), or staying in the range based on policies similar to those they adopted.

I would accept that there was a good case for not reappointing Orr (and the MPC) if:

  • New Zealand’s Reserve Bank was the only one to have made the same mistake (thus, they ignored relevant perspectives from peers), and/or
  • the Reserve Bank’s forecasts and policy actions at the time they were made were seriously out of step (in what proved to be the wrong direction) with those of most serious observers, forecasters, commentators, and/or market prices

But as far as I can see that was not the case, on either count.   Sure, there were always people critical of some or other aspect of what the Bank was doing (I was an early critic/sceptic of the LSAP policy, although did not anticipate how large the losses they would run might be), and (of yesterday’s authors) Bryce Wilkinson was among them.  But often, at least I would argue, those who disagreed with some or other aspect of what the Bank was doing may have been right for the wrong reasons, and right analysis counts in making judgements about key policymakers.

People will, reasonably enough, point out that there are several advanced countries that have not seen the extent of the rise in core inflation New Zealand (and most others) have.  Thus, they suggest, there was wisdom our Reserve Bank could have followed and did not.  I’m not convinced.  The countries that have not seen much of a rise in inflation seem mostly to have been those that were already at the effective lower bound in early 2020.  They did not materially ease monetary policy because they could not.  It is unknowable at this point what they would have done if they’d had the capacity (and New Zealand and Australia and the US did have that capacity –  starting with policy rates still materially above zero).

It isn’t a common position for me to be defending the Bank, and in many respects I don’t (to me, there is a strong case for not reappointing Orr on things it is quite appropriate to directly hold him to account for –  his choices, his information).   But there is an element of the last 2.5 years that may have been simply unknowable with any great conviction or certainty.   Sadly, no one I’m aware of was (18 months ago) forecasting that New Zealand would soon see record low unemployment (similar outcomes in many other countries).  With hindsight, perhaps they should have, but it was an idiosyncratic shock –  pandemics, lockdowns, virus and policy uncertainty –  for which we (and central banks) had no real precedents.    I’m still happy to argue that the LSAP should have been stopped in the second half of 2020 when it was clear the world wasn’t ending, but….at the time the Bank still had very low inflation forecasts (and if others differed, no one I’m aware of differed to a huge extent).  I’m quite content to argue that the Bank –  and peers abroad –  should have started raising the OCR earlier and more aggressively last year but……given the lags it isn’t likely that any credible tightening started mid last year, even done at some pace, would have made a lot of difference to the inflation we have seen in the latest June quarter numbers (but would have brought it down sooner and faster). But again, who was openly calling for tightenings last May or June (for myself, the May MPC was the first time in almost a decade I’d been more “hawkish” than the Bank, but I wasn’t then calling for immediate OCR increases). 

Perhaps societies need scapegoats, but it isn’t self-evidently obvious that a reasonable human set of central bankers at the RBNZ would have been likely to have done better than Orr did in that particular set of circumstances.  The Bank is wrong to allow the suggestion to continue that they moved earlier by international standards (they were nearer the median of OECD central banks), but they were a bit earlier than the Anglo central banks we often default to comparing against.

Perhaps I’m just playing devil’s advocate here, but I don’t think so.  There is a real point about the limitations of human knowledge, and of what we might realistically expect from a typical (not exceptional –  you’ll rarely find them) central banker.    And a quickfire inquiry wouldn’t really help resolve that one.

It is encouraging that National is beginning to get down off the fence again (after Luxon initially shut down Bridges saying National had no confidence in Orr late last year).    But they probably need more confidence in their convictions (assuming they have found some) and be willing to back a case that the Governor should not be reappointed, and the external MPC members should be replaced as their terms expire.   Much of what Orr has done, and failed to do, has been done with the apparent approval, or even endorsement of the Minister of Finance (who thus shares some responsibility).  But in the end, Robertson has the choice to jettison Orr if he becomes a liability for the government.  An honourable Governor would probably walk away, expressing his regrets for the outcomes he has presided over.  So far, (per past select committee appearances and yesterday’s statement) Orr appears to regret nothing about policy, even with hindsight, and if he has regrets at all it is the empty and meaningless regret that Covid itself has intruded.

I regret that the Committee – and society at large – has been confronted with the COVID-19 pandemic, and other recent events that have caused food and energy price spikes. 

We should regret that Robertson appointed a Governor who has done so poorly, who has cost New Zealanders so much, and regret that Robertson has gone along with the Governor in barring the appointment of an open and excellent MPC, following that up with the appointment of a weak and inadequate board.

A voice from the past

Various media this morning have given quite a lot of coverage to the new paper released by the NZ Initiative, headed How Central Bank Mistakes After 2019 Led to Inflation. The authors are Bryce Wilkinson of the Initiative and former Reserve Bank Governor (2012-17) Graeme Wheeler – the coverage probably mostly because of the trenchant words from the former Governor, I think the first we have heard from him since he moved back to corporate board land in late 2017.

I’m not one of those who has any particular problem with former Governors and Deputy Governors commenting on what is going on with monetary policy. If it isn’t always common, well we have a fairly thin pool of commentators in New Zealand, and these are hardly ordinary times. The quality of the debate is only likely to be improved by hearing, and challenging/scrutinising, alternative perspectives. We can only hope that one day the Reserve Bank’s own Monetary Policy Committee will learn from that sort of example, instead of continuing to act as some impenetrable monolith, even faced with the inevitable huge uncertainties of macroeconomics and monetary policy. And if Graeme Wheeler was not, to put it mildly, known during his term as Governor for welcoming debate and dissent – internally or externally – I guess we can only say better late than never.

In some ways the Wilkinson/Wheeler collaboration is a curious one. They go back 45 years to when Wilkinson was Wheeler’s boss in the macro area of The Treasury, and have apparently been friends since. But whereas Bryce Wilkinson has long been sceptical of any sort of active monetary policy (I have various emails on file challenging me as to what evidence there is that central bank policy activism has accomplished anything much useful over the years), Wheeler chose to take on the job of central bank Governor under an entirely-standard policy target, put into sharper relief than previously with the addition that the Governor was to be required to focus explicitly on keeping future inflation close to the 2 per cent midpoint of the target range. And there was nothing very unusual or distinctive about the way monetary policy was run on his watch – conventional models, conventional judgements, and in many ways conventional errors. If there were distinctives, they were mostly that Wheeler proved more thin-skinned than your typical central bank Governor or Monetary Policy Committee members (the young or those with short memories may have forgotten Wheeler deploying his entire senior management group to attempt to silence criticisms from BNZ’s Stephen Toplis – several relevant posts here).

The (quite short) paper isn’t specifically focused on New Zealand and our central bank, and consistent with that the authors have secured a Foreword from Bill White, former deputy governor of the Bank of Canada, and then long-serving Chief Economist of the Bank for International Settlements, from which perch he irritated many with his warnings about system fragility in the years leading up to 2008. He is a really smart guy and what he writes is usually worth thinking about, and I’ve enjoyed various stimulating discussions/debates with him over the years. His views today, reflected in the Foreword, still stand out of the mainstream (rightly or wrongly). If he is keen on fiscal consolidation etc across the advanced world, he champions “significant tax increases, particularly on the wealthy”, and while suggesting this would be desirable but politically impossible then suggests that a heavy reliance on monetary policy may pose a threat to democracy itself. White appears to believe that we are on the cusp of a very substantial adjustment, as the public and private debt built-up over the last few decades is sorted out (“we must review carefully our judicial and administrative procedures to ensure the necessary debt restructuring, and there will be a lot of it, will be orderly rather than disorderly”. Perhaps, but it is a long way from debates about how monetary policy has been run in the last 2.5 years or so. (And, for what it is worth, New Zealand has low public debt, and (for ill) its housing debt remains underpinned by governments and councils that refuse to free up land use on the margins of our cities.)

But enough introductory discussion. What should we make of the substance of the note? There is 13 pages of it, but about half is itself scene-setting or largely descriptive stuff. There are bits I might quibble with, bits I strongly agree with (unexpectedly high core inflation is the responsibility of central banks and the results of mistake choices by them – given inflation targets that is close to being a tautology), five big charts. Oh, and this was good to see.

Wheeler and Wilkinson seem to think QE-type operations (including our LSAP) are more effective macroeconomically (for good and ill) than I reckon, but the sheer scale of the losses is a reminder that even if there are some potential benefits, those would need to be weighed against the potential downside risks.

But the heart of the note is in the six points under this introduction

The first is “Central banks became over-confident in their inflation targeting frameworks”.

Much of the discussion of this point could have been written 15 years ago, although even then if there was much to the story it wasn’t so in New Zealand. We grappled with needing interest rates higher than the rest of the world to keep inflation near target, as well as repeated political assaults on whether we had the right target or the right tools.

But the story of the decade prior to Covid, in New Zealand and most other advanced countries, was of central banks struggling to keep inflation UP to the respective targets. New Zealand went for a decade with core inflation never once getting up to the 2 per cent midpoint that Wheeler himself had signed up to target. Now, I think it is probably true that in 2020 and early 2021, many central banks and central bank observers were more focused on the previous decade and its (very real) downside surprises, and not perhaps alert enough to the possibility of (core) inflation rising sharply. But that seems to me to be an importantly different thing to what Wheeler and Wilkinson are arguing.

They end this discussion with this point

But for now I think the evidence is against them. With headline inflation as high as it is, what is striking is how low market-based measures of inflation expectations still are (around 2 per cent here and in the US). The Bank’s own survey of 2 year ahead expectations, at 3.3 per cent in May, is higher than it should be, but probably not disastrously so at this point (and I reckon there is a good chance that the next survey, just being finished now, will show slightly lower numbers). Central banks were slow to act last year, but for now evidence suggests some confidence that they have, and will, acted decisively to keep medium-term inflation in check.

I also reckon that Wheeler and Wilkinson don’t adequately grapple with complexities and uncertainties of the Covid shock. It doesn’t really excuse the slow unwind last year – as, for example, the unemployment rate was falling rapidly – but it certainly makes much more sense of the initial monetary policy easing in 2020. Wheeler faced nothing of the sort during this term.

I had to splutter when I read the second item in their list: “Central banks were over-confident in the models they use to base monetary policy decisions”. Several paragraphs follow making the widely-accepted point that it is hard to work out the size of the output gap at any particular time, or to know with confidence the neutral interest rate. All very true, but who is going to disagree with them on that?

Well, one person who might was Governor Graeme Wheeler over the period from about 2013. He was convinced – quite convinced – that the OCR was a long way below its neutral level, and that large increases would be appropriate to get things back in check. So much so that in late 2013 he was openly asserting (in public) that 200 basis points of OCR increases were coming (any conditionality was very muted). These were the 90 day/OCR forecasts the Bank published while Wheeler was Governor

He was convinced that inflation pressure were building and rate rises would be required. Overconfidently, he started out on his tightening cycle in 2014, got 100 basis points in, and then finally was confronted with the data. The rate increases had to be reversed in pretty short order (and later in his term, the Bank was much more modest in its assertions). Note that although there were a number of central bankers globally who were keen on eventually getting policy rates higher, Wheeler was one of the few to back his model with ill-fated policy rate increases.

And to be fair to today’s central bankers, I haven’t detected an enormous amount of confidence in comments over the last couple of years, but rather (a) a huge amount of uncertainty, and then (b) some really big (but widely-shared) forecasting mistakes.

In the podcast interview that accompanies the research note, Wheeler does show some signs of (belatedly) accepting that he made a mistake. But even then he continues to claim it wasn’t really his fault, that the domestic economy really had been overheating, and that it was all the fault of the inscrutable foreigner (ok, he calls it “tradable inflation”, from the rest of the world.

Very little of this stacks up:

  • core inflation (whether something like the sectoral core model that the Bank claimed to favour during the Wheeler years or the simple CPI ex food and fuel) was well below the midpoint of the target range throughout the Wheeler term.
  • Wheeler claims that non-tradables inflation was high but (a) non-tradables inflation always runs higher than tradables, and (b) if one looks at core non-tradables inflation it was at a cyclical low when Wheeler took office, was not much higher when he left office, and was never high enough to be consistent with 2 per cent economywide core inflation, and
  • Whatever the vagaries of output gap estimates, the unemployment rate lingered high (even at the end above most NAIRU estimates) throughout his term.

But read his press statement from early 2014 and you’ll see someone in the thrall of their model (at the time many people supported the broad direction of policy, but not all – whether outside or inside the Bank).

The third item on the Wheeler/Wilkinson list is “Central banks were excessively optimistic that they could successfully “fine tune” economic activity”. This is a longstanding Wilkinson theme, but is a curious one for Wheeler to have signed up to, given that he signed up to a tighter inflation target (focus on the midpoint) and after 2015 was more focused on getting inflation back up towards target. And, in fairness to our RB, their “least regrets” framework exploicitly recognises the huge amount of uncertainty that was abroad in the Covid era/

The fourth item is “Central banks took their eye of their core responsibilities and focused on issues that were much less central to their roles”. Of course, I agree with them that the Orr Reserve Bank has chased after all sorts of non-core hares (to the list WW provide one might add the “indigenous economies” central bank network), and I’ve been quite critical of that. But I just don’t think the case has compellingly been made that these fripperies really made that much difference to the conduct of policy. Take it all out and in the NZ context, Orr was still as he was, the MPC was weak and muzzled, and the Bank’s forecasts often weren’t that different from those in the private sector. Perhaps the (chosen) distractions made a substantive difference, but there needs to be a stronger case made than WW yet have (and central banks with much more talented Governors and MPC often seem to have made similar monetary policy mistakes to those of the RBNZ).

The fifth item in the list is “Dual mandates for monetary policy create conflicts”. In principle they can, in practice the case simply is not made as regards the last 12-18 months, when both inflation and employment limbs pointed the same way (here and abroad). Arguably they did so in 2020 too, at least on the forecasts/scenarios central banks, including our own, were working with. Forecasting was the biggest failure…….faced with a shock for which there was simply no modern precedent.

The final item on the list is “Did some central banks try too hard to support government political objectives in making judgements about monetary policy?”

The short answer is that WW offer no evidence whatever of anything of the sort, either in New Zealand or other advanced economies. They make this claim

which is probably true in some less developed countries, but do they have any examples in mind in advanced economies or New Zealand? I think not. In New Zealand, MPC members have been reappointed with no scrutiny, and politicians – government or Opposition – seem reluctant to focus on the central bank’s part on the inflation outcomes. There is no sign of any serious pressure on the Bank – not even much sign Grant Robertson cares much. Look at the underwhelming crew he just appointed to the Reserve Bank board – not evidently partisan, just deeply inadequate to the task (including holding the Bank and MPC to account).

And that is it.

In the end there simply isn’t a great deal there. It is good to have more voices sheeting home responsibility for high core inflation to the central banks. If you accept the assignment of responsibility for achieving an objective, you are responsible when things fall short (even if, as Wheeler argues was true of his own stewardship) you’ve done the best job possible with the information to hand at the time. How much that sort of explanation is sufficient to the current situation can and should be debated, but it probably needs much more engagement with data, and forecasts etc, than WW have room for in their piece.

Wheeler and Wilkinson end this way

I largely agree (although would put much more weight on top notch macro and monetary policy expertise, relative to financial markets). But what is noticeable throughout the paper is how little weight they appear to put on transparency or accountability. There is no call for diverse views and perspectives on the MPC, openly testing alternative perspectives, and individually accountable. But I guess – given his onw track record re dissent – such a suggestion would be too much for Graeme Wheeler even now five years safely out of office. It might after all have required more openness to stringent criticisms from people with a view different than the Governor’s

Incidentally I am pleased to see that his attitude to external scrutiny and challenge from former central bankers has moved on a little from his approach just a few years back when he claimed to believe that former staff – surely even more former Governors – owed some vow of omerta to the Bank and its mistakes, whether operational or policy.