Or so Vernon Small, the Dominion-Post’s political columnist would have us believe.  His article appeared yesterday under the heading “Reserve Bank rules need major rethink”, and then online as “Monetary policy is bust, so why are we still banking on it”.

I reckon he has rather overstated his case.  “Reserve Bank ‘rules’ need following” might be a more accurate assessment.

Start with the odd line that Small got from the Minister of Finance, claiming that “no one ever thought it [the inflation targeting framework] would be used to try to lift inflation”.  I’m not sure where the Minister got that idea from, but as a reminder New Zealand is the classical case where it has been used, successfully, that way.  In 1996, the National-New Zealand First government raised the target midpoint from 1 per cent to 1.5 per cent.  And in 2002 the Labour government raised the target midpoint to 2 per cent (the then Prime Minister wanted to raise it further, to match Australia, and to Alan Bollard’s credit he resisted).  As I’ve noted previously, right through to the2008/09 recession the Reserve Bank delivered inflation rates averaging higher than the successive (and increased) target midpoints.

Small does have some nice lines that had me nodding in approval

….Governor Graeme Wheeler’s rejection of a “mechanistic” approach that would see low inflation immediately trigger a cut to interest rate, currently at 2.5 per cent. It is hard to find any sophisticated analysts in the area who has made such a “mechanistic” call, but hey! Straw men have no say over what goes into their stuffing.

But he can’t quite seem to make up his mind whether, as he says, “the prime tool of monetary policy, cuts to the official cash rate, cannot achieve the target”. [my emphasis added] or whether it is more a matter that “the Reserve Bank appears reluctant to try”.

No one has advanced any evidence that, or even a strong argument why, New Zealand’s inflation rate could not have been raised, or could not now be raised.  And I’m quite sure the Reserve Bank doesn’t believe such a story.  In my post the other day, I set out a list of factors that suggested that keeping inflation up around target should be less hard here than in most advanced countries.  And we know, for example, that another small advanced commodity exporter, Norway, has managed.

In a New Zealand context, no one seriously doubts that –  all else equal –  if the Reserve Bank were to come out with significant OCR cuts and a convincing statement of their determination to do whatever it takes to get and keep inflation near 2 per cent, that the exchange rate would fall.  Prices of tradables would rise to some extent, and returns to tradables production in New Zealand would also rise.  That combination of factors would lift the inflation rate –  and, over time, the latter would be the more important channel.

New Zealand isn’t a surplus country –  so we don’t find capital flooding home to our safe haven when international fears rise.  We are a small remote net-borrowing country, whose currency foreigners mostly hold because of the yield advantages it typically offers.  All else equal, when those yield advantages narrow or disappear so does a lot of the interest in holding New Zealand dollar assets.   Stories about what, on occasion, may have happened to exchange rates in Japan or Switzerland or the United States just aren’t particularly relevant here.

For a long time, I don’t even think it was a case of the Reserve Bank being “reluctant to try” to get inflation back to target. At least while I was still closely involved there was a quite genuine and quite widely-shared belief in the Bank that there would be sufficiently strong economic growth that the inflation rate would soon lift back to around 2 per cent, and would have gone beyond that midpoint if interest rates were not raised.  They were persistently wrong –  and, over time, that should involve some effective accountability for the relevant decisionmakers and advisers –  but it was a quite genuine belief. 

But over the last 18 months, it increasingly seems as though “reluctant to try” has been a more apt description of the Bank’s approach.   This has been exemplified in some of the rather shaky arguments they have begun to run.  Last year, for example, we were repeatedly told that headline inflation would rise because the exchange rate had fallen, but there was hardly any emphasis on the underlying or core inflation trends that they should have been focusing on.  More recently, we’ve had a convenient fixation on a single measure of core inflation, which just happens to be the highest around, when previously they had told us what most other central banks say –  there is no one ideal measure, and one needs the information from a range of series to interpret what is going on. Oh, and claims that it is “all about oil” when the data clearly don’t reflect that.  And attacking straw men  – claiming that those who advocate further OCR cuts are just inappropriately focused on headline inflation.

I don’t even think it is a case of the Bank looking for inflation under ever stone. Rather strangely, they have changed their view on the short-term demand effects of immigration –  in a way that supports the dovish side of the story –  and yet even though it was a major feature of the last MPS they can’t, or won’t, tell us why or show us their research or analysis in support of their story.

Perhaps the 2.5 per cent “barrier” has been a factor.  The OCR has never been taken lower than 2.5 per cent, and there might be a psychological/mental barrier for the Governor and his advisers to taking it lower.  If so, it shouldn’t be.  Prior to 2008 the OCR had never been lower than 4.5 per cent, but Alan Bollard rightly blasted through that floor, lowering the OCR to 2.5 per cent in late April 2009 (by when the worst of the financial crisis itself had passed).  There were debates in the Bank at the time as to whether it would be safe to go any lower –  at Treasury at the time we found that rather frustrating  –  but that was seven years ago.  Since then not only have we seen many countries with official interest rates near zero for long periods, but an increasing number tentatively experimenting with negative rates.  Historical reference points are an obstacle to good policy at present, rather than being a useful anchor. If anything, they make people doubt that central banks will do enough, soon enough.  In the end I’m sure the Bank will cut further, but once again they’ll have been behind the game, when they could have got ahead of it and helped recreate a climate in which people believe that, whatever was going on abroad, inflation would average around 2 per cent in New Zealand.

Were they reluctant to try?  Well, probably latterly.  Certainly the evidence is that they haven’t tried.  There has been a lot of focus on last year’s OCR cuts, but recall that they only reversed the previous year’s unnecessary increases.  Here is a chart of the real (inflation adjusted) OCR.

 I’ve shown two versions.  One, which I prefer, deflating the OCR by the two year ahead inflation expectations from the Bank’s survey, and the second using the implied long-term expectations from the indexed bond market.  Whichever measures one uses, real interest rates have been rising not falling in New Zealand over the last few years.  In a climate of such persistently low inflation, that shouldn’t have happened.

It all adds up to a story of a central bank that has been poorly led and managed, and which has not managed monetary policy well.  It hasn’t been held to account well either.

But that doesn’t say the “rules” are wrong, it simply says they haven’t been followed well.  Perhaps we should try operating within the “rules” rather than rush to conclude that there is something wrong with the system itself.    There is no sign that delivering inflation near 2 per cent is impossible, or that it is undesirable, or that doing so would lead to otherwise weird outcomes. Protracted debates now about whether the framework is right is a distraction from the real, immediate, and easily remediable issues: even under the current framework, monetary policy has been, and is, simply too tight.

None of which is to say that we should not from time to time review the rules under which the Reserve Bank works.  I’ve been championing far-reaching governance reforms, to bring the Bank more into line with international best practice, and the way other government agencies in New Zealand are run.  And the Policy Targets Agreement itself expires with the Governor’s term in September next year (which creates timing problems I’ve noted earlier).  I’ve argued here previously that it would be a good idea to follow the lead of Canada, and announce now a joint (and open) work programme, involving the Reserve Bank and Treasury, and outside researchers and commentators, to review the issues around the best design and contents of the PTA.  The last PTA, and those before it, were done largely in secret –  even though the PTA is the main document governing short-term macroeconomic management in New Zealand –  and even now, three years on, the Bank refuses to release any material background papers relevant to that PTA.

We should advance work on both fronts –  governance reform, and open review of the PTA issues in advance of the next renegotiation.  I’m not convinced of the case for material change in the PTA –  or that eg nominal GDP targeting, or wage targeting, or adding an external balance consideration –  would make much practical difference anyway (points I’ve covered in earlier posts).  But the research should be done, and debated, openly, to test and explore the arguments and alternatives.

But the problem at present is not that inflation targeting is being followed too closely, let alone “mechanistically”, or that it is proving overly and inappropriately restrictive.  It is that isn’t being taken seriously by those – the Bank –  with a legal responsibility to do so.

An interview with the Minister of Finance on inflation, monetary policy, and the Reserve Bank was reported in NBR (for those with subscriptions) yesterday.  The story is headed “English drops heavy hint to Reserve Bank” (to cut the OCR).  That may, or may not, have been the Minister’s intention – I suspect it was probably more about getting coverage on the right side of the issue, now that opinion among local economists has started to shift again.  The reporter, Rob Hosking, has appeared to be on the “hawkish” side of the argument until recently, and even in yesterday’s article seems to want to play down how well-established the fall in inflation expectations has become. (The breadth and extent of the falls are illustrated in this post of mine, and in a very good piece put out yesterday by the Westpac economics team.)

But my eye lit on some other comments by the Minister. Perhaps playing distraction, he observed

“While there are these discussions about Reserve Bank performance, you need to think through what the problems and the benefits of persistently low inflation are.  I think it would be worthwhile if the economists articulated those pluses and minuses a bit better.”

In between devoting too much of the last day or so to complying with new regulatory imposts of this supposedly red-tape cutting government (see the Financial Markets Conduct Act), I’ve been pondering the Minister’s question/suggestion and jotting down some notes.  I’m sure he has advisers in The Treasury who can articulate all these points for him, but in case not, here are my perspectives.

Why do we want low inflation?  Because economies work better that way, when (in Alan Greenspan’s words) people don’t have to think too much about inflation in the ordinary course of life and business.  And the tax system assumes inflation away, so high inflation can lead to some really nasty tax effects.

Why do we want stable inflation?  Again, as a predictable backdrop against which people can proceed, negotiating contracts, saving and investing etc.

Why don’t we set the target inflation rate at zero (or even half a per cent to allow for index number biases)?

Two main reasons. The first is a recognition that wages and some prices can be “sticky downwards” so that a modern economy might function less well if we insisted on targeting inflation near zero.  And the second is the lower bound on nominal interest rates.  It isn’t zero, but for the time being it isn’t far below.  With a very low target average inflation rate, average nominal interest rates will also be very low.  If so, when bad things happen (eg the next recession), the central bank might have limited leeway to do much about it.  This argument is less compelling when productivity growth is strong –  since equilibrium real interest rates will be higher –  and more so when productivity growth is weak.

There is a third “reason” in a New Zealand context.  We started out with a target centred on an annual inflation rate of 1 per cent per annum.  Under significant political pressure, successive governments  – including one of which Mr English was himself a junior minister – revised the target upwards in two stages.  It is now centred on 2 per cent –  very similar to the targets in most advanced countries.

All that is by way of prelude.  But it is also to remind the Minister that he has (now twice) signed Policy Targets Agreements in which the Reserve Bank’s target is centred on 2 per cent.  He has statutory responsibilities to assess the Governor’s performance in pursuing the target.  But he also has other powers.  If he so chose, he could invite the Governor to renegotiate the PTA and lower the target range.  Or he could use the section 12 powers of the Act to override the current target and temporarily impose a lower one.  Thus far, he has done neither of those.

When might one be comfortable with inflation being materially below 2 per cent?  One set of circumstances might be those the PTA itself talks of.

For a variety of reasons, the actual annual rate of CPI inflation will vary around the medium-term trend of inflation, which is the focus of the policy target. Amongst these reasons, there is a range of events whose impact would normally be temporary. Such events include, for example, shifts in the aggregate price level as a result of exceptional movements in the prices of commodities traded in world markets, changes in indirect taxes, significant government policy changes that directly affect prices, or a natural disaster affecting a major part of the economy.

When oil prices fall sharply that temporarily lowers the headline inflation rate.  When government taxes and charges are cut that temporarily lowers the headline inflation rate.  In both cases, good economic analysis and the PTA tell the Bank to be content to see headline inflation temporarily dropping away?  Why?  Because these aren’t persistent medium-term pressures, and it is those medium term pressures the PTA rightly focuses on (the stable environment for firms and households).    We deal with these sorts of one-offs with core inflation measures.  There is no one ideal measure but at present, when headline inflation in the most recent year was 0.1 per cent, the median of the various possible core measures is probably not much above 1 per cent.

No one is criticising the Reserve Bank for not reacting to those one-offs (even though the Governor has suggested otherwise).  The debate is about how the Bank should (or should have) responded to low core inflation.

Are there any benefits from having core inflation around 1 per cent at present?  I can’t think of any.

Could there be circumstances in which there would be benefits?  I can think of some.  If, for example, New Zealand (and perhaps the world) was experiencing a period of extremely rapid productivity growth then, all else equal, that would tend to drive down inflation rates everywhere.    Rapid productivity growth would underpin strong investment growth, and support a high level of neutral real interest rates (the marginal product of capital and the real interest rate should be related).  In such a climate one might also envisage a buoyant economy and a low unemployment rate –  plenty of jobs to take advantage of the newly productive opportunities.  In such a world, the Reserve Bank could adjust monetary policy to get inflation back up to around 2 per cent.   But society might reasonably say “why bother”, and consider changing the Bank’s target.    After all, there is no obvious excess capacity or unemployed resources lying round in this example –  the unemployment rate in this fortunate economy might already be below estimates of the NAIRU, and wage inflation would be likely to be strong, supported by the high productivity growth.   Turbo-charging a booming economy might seem rather risky and the arguments for a target centred on, say, 1 per cent rather than 2 per cent might seem reasonably good.  In the same vein, deflation driven by really fast productivity growth is a lot less concerning than deflation simply resulting from weak demand (the latter was the Great Depression story).

But the scenario I discussed in the previous paragraph bears not the slightest resemblance to New Zealand’s current situation (or, as far as I can tell, to that of the rest of the advanced world).

Do we have high, and stronger than normal, trend productivity growth?  No, like almost all advanced countries we’ve seen a marked slowing in productivity growth (labour productivity and TFP) in the last decade or so.

Do we have abnormally low unemployment rates?  Again no, even at 5.3 per cent –  which the respondents in the Reserve Bank’s recent survey don’t expect to be sustained –  the unemployment rate is well above most estimates of NAIRU.  Consistent with the excess capacity and low productivity growth, wage inflation is low and is expected to fall further.

We are also adjusting to a significant adverse terms of trade shock.  For all the talk of cheaper goods and services from abroad, the terms of trade have been falling.  When the terms of trade are falling we would normally expect to see the exchange rate falling, and domestic prices rising as a result. Core inflation measures never manage to capture all that effect, so that if anything in a weak terms of trade environment one might expect to see inflation running temporarily a bit higher than target.  Our exchange rate has not fallen very much (see the comparison with Norway), but that is partly because the Reserve Bank has presided over rising real interest rates over the last couple of years,  rather than cuts.

And, although it is becoming less of an issue now, the exogenous large boost to demand and activity resulting from the Canterbury earthquakes is yet another reason why one might have been more comfortable with inflation a bit above target, rather than well below, over the past few years.  Lots of resources needed to be diverted to the repair and rebuild process, and changes in relative prices are typically part of getting those resources in place.  Changes in relative prices need not boost the overall price level –  monetary policy can simply act to counteract them.  But, within limits, it generally isn’t sensible to do so.  We wanted the economy pushed as hard as was prudent, to get the repairs done and as much other stuff still  happening as possible. That probably implied a one-off lift in the price level –  of the sort suggested by the PTA itself (see references to natural disasters in the quote above).

Recall that the New Zealand recovery in the last few years has been the weakest and most anaemic in modern history.  Had it been the other way  – really unusually strong sustained growth –  again one might have been content to have monetary policy lean a little against the boom.  But it has been nothing of the sort –  instead we’ve had weak per capita growth, weak productivity, lingering unemployment, all in the face of a huge exogenous demand shock.

Those are sorts of combinations of circumstances in which discretionary monetary policy should be doing its utmost, not looking for excuses to justify repeat inflation outcomes well below the agreed target.

What about house prices?  I’m sure that in some minds, high house prices –  and the risk of them rising further –  is a consideration in opposing OCR cuts.  I might even sympathise with that logic if there had been broad-based large increases in real house prices and rapid supply-led growth in credit.  But again, that isn’t the story. In most of the country, real house prices are no higher, or materially lower, than those at the peak of the last boom.  Credit to GDP or credit to disposable income ratios have not risen in almost a decade, and most housing credit growth appears to be an endogenous response to higher house prices themselves.  There are real and substantial affordability problems in Auckland, but there is no real mystery about what has gone on there: the government runs an immigration policy that channels tens of thousands of people into a city, and then does not have a legislative framework in place the allows the physical size of the city to grow commensurately with the rapid population growth.  That just isn’t a consideration that monetary policy should be driven by – it is a relative price change, and the cost to the rest of the underperforming economy of using monetary policy is just too high.  Past Reserve Bank research has shown, quite plausibly, that it takes potentially hundreds of points of OCR changes to have any material impact on aggregate house prices.

We have a 2 per cent inflation target.  There is simply no good reason for us (or the Minister) to be content for the Reserve Bank not to meet that target (in core or underlying terms).   As I noted yesterday, the shocks and pre-conditions New Zealand faced should have made it easier to have meet the target here than other countries may have found it.  And none of the circumstances that might make one relaxed about a persistent undershooting of the target are present here now. We’ve simply been the victims of a poorly run monetary policy.  Under the New Zealand legislation, the Minister is the public’s agent who is supposed to sort out that underperformance.

Finally, in case anyone doubts the slow productivity growth story here is chart of TFP, based at the point when the Conference Board’s data start in 1989.  I’ve shown here the median of the West European, North American, and Oceania advanced economies (a group for which there is data all the way back), and the line for New Zealand.

New Zealand’s performance has been pretty dire for a long time, but we’ve shared in the marked deterioration evident across the advanced world in recent years.  This is simply not a climate in which the wonders of human ingenuity are driving productivity strongly upward and driving prices more strongly down than usual. It is a climate in which monetary policy should do what it can, when it can. In New Zealand there are no material constraints, and neither we –  nor the Minister –  should be content with what has been being delivered.

There is a small OECD country whose export commodity prices surged prior to the 2008/09 recession, and again in the years after that recession.  It has grappled with high and rapidly rising house prices –  some of highest ratios in the world – and high and rising levels of household debt.  It wasn’t New Zealand I had in mind, but Norway.

There has been a lot of talk from those opposing further OCR cuts of how countries everywhere are struggling to get inflation up, as if meeting New Zealand’s inflation target was either (a) a lost cause, or (b) not something we should be bothered about anyway.

So I found Norway’s experience interesting.

The Norwegian government has set an inflation target for the central bank:

The operational target of monetary policy shall be annual consumer price inflation of close to 2.5 per cent over time

They have all the usual ‘outs’

In general, direct effects on consumer prices resulting from changes in interest rates, taxes, excise duties and extraordinary temporary disturbances shall not be taken into account.

So far, so conventional.  The precise words are a bit different, but the gist is no different from New Zealand’s Policy Targets Agreement –  ours focused on 2 per cent inflation, and theirs on 2.5 per cent.

And, much as the Reserve Bank used to, the Norges Bank recognizes that there is no one foolproof indicator of underlying inflation

There is no one indicator that provides a precise picture of underlying inflationary pressures in all situations. Different measures of underlying inflation are discussed in Monetary Policy Report.

In fact, they include on their website a nice summary table of four different measures

And here is how they’ve been doing.

Inflation indicators

The Reserve Bank’s quarterly survey of expectations results were released the other day.  As a reminder, it is a survey  of business people, sector leaders, and quite a few economists.  The vision has always been that the survey should capture some mix of informed people and people who might influence actual behavior – whether through their own business transactions, or through their commentary or advice to others.    There is a sample pool of about 100 potential respondents, and they typically seem to get about 65 or 70 replies each quarter.  Some criticize the survey for its small sample, but for what it is trying to do, in a small country, it has never seemed too bad to me.  It is, after all, asking for numerical answers to quite a bunch of macroeconomic questions.  I know that when I fill it in, I sometimes have to go back to the data to check what the latest reported numbers were –  not carrying QES wage inflation data in my head.

For inflation expectations specifically there are other surveys with larger samples.  ANZ provide their long-running Business Outlook survey, and their newer survey of household expectations, and the Reserve Bank will release its  latest survey of household expectations next week.  At the other extreme is the (inaccessible to the general public) AON survey, designed primarily to provide inputs for actuaries evaluating pension funds.  They ask about, inter alia, longer-term inflation expectations, but they ask only a handful (perhaps 7) economists.

I’ve never been quite sure what to make of inflation expectations measures.  Inflation expectations play  a significant, and quite plausible, role in conventional macroeconomic models.  The difficulties come with mapping the data we have available with the concepts in the models.  For a start, what horizon matters?  In principle, 10 or 20 year ahead expectations sounds interesting, abstracting from all the short-term noise, whether around taxes and government charges, petrol prices, or even swings in the exchange rate.  Then again, how many people sign up to 10 year nominal contracts?   No one sets wages or selling prices that far ahead.  And while plenty of bonds are issued with long maturities, when corporates issue them they typically seem to swap back to floating rates.  So 10 year ahead expectations probably provide some useful information about how confident people are that, say, the framework will hold or be delivered on, over 10 years, but I doubt they make very much difference at all to this year’s inflation rate, or the challenges a central bank faces in meeting its inflation target over the next couple of years.  I don’t know much about the politics of the next 20 years, but if forced to write down a number for average inflation over the next 20 years I might still write down 2 per cent.  But with huge error bounds….and grateful that nothing rests on it and that my pension is inflation indexed.

Shorter-term expectations matter more. But not too short.  Quarter or year-ahead expectations are influenced by specific stuff people know about –  relative price changes and administered taxes and charges.  In trying to make sense of inflation expectations, analysts are typically trying to look through those effects, to get a sense of the “norms” people have in mind when they set selling prices, negotiate wages, and make decisions to borrow or save.  If firms have in mind a benchmark inflation rate of, say, 1 per cent, then when they come to review their pricing schedules –  perhaps every six or twelve months –  pricing adjustments are likely to be different (lower) than if firms had in mind a benchmark or normal inflation rate of 2.5 per cent.  Same goes for wage negotiations.  And for how potential borrowers react to any particular nominal interest rate.   When those norms are above the inflation target, it can be hard to get actual inflation down to target –  more interest rate pressure is needed, than otherwise, to deliver the desired inflation rate.  And vice versa.  Two year ahead expectations have often been seen as a reasonable horizon to focus on for these purposes –  far enough that it gets beyond most (but not all) of the immediate noise, but close enough that it is more or less within the planning horizons of many.  In the latest RB survey, for example, the actual question asked in early February 2016 was about the annual inflation rate for the year to December 2017.  Halfway through that year respondents are asked to focus on is only 16 months away.   (Similarly, it was pleasing that when the ANZ launched a household expectations survey they asked about two year ahead expectations).

If, in principle, measures of two year ahead inflation might usually give one a steer on the “pricing norms” that firms and households are operating on (at least implicitly), there is still the matter of whether the answers to survey questions actually give us the information we really need.  As I’ve noted before, for example, the ANZBO survey and the Reserve Bank household survey measures have consistently, over decades, been materially above actual average inflation.    In the 20 years the RB household survey has been running, mean expectations have been just over 1 per cent higher than the average inflation outcome.  Does it mean households really didn’t believe the Reserve Bank would do it job?  Does it mean those are the inflation rates people implicitly contract on?  We simply don’t know (at least without a lot more formal research).  There is no incentive for people to invest any time or effort in responding to one question in a substantial telephone survey –  whereas they might well be when they ponder taking out a mortgage, or negotiating a pay increase.

All of which is a roundabout way of getting to the point that historically the Reserve Bank has put most weight on the two year ahead inflation expectations measure from the Survey of Expectations.  And it has done so because (a) there is now a good long time series (back to 1987), (b) it fits the prior that, typically, it will be horizons just beyond the immediate noise that matter, given that most contracts reprice at least every year or two, and (c)  because historically  it had a mean which seemed to align quite well over time with actual inflation.  One way to see this is to compare the two year ahead expectation with the Bank’s preferred sectoral factor model indicator of core inflation (remember what I said yesterday –  whatever the potential problems, for historical periods it is probably as reasonable as any measure, effectively smoothing through the noise in headline inflation).

So what actually happened in the most recent survey?  Two year ahead expectations fell by 0.22 percentage points to 1.63 per cent [1].  Relative to the midpoint of the inflation target, that is the lowest in the history of the survey.  That isn’t all a bad thing –  despite the rhetoric suggesting we were crazed mechanistic inflation zealots, actually under both Don Brash and Alan Bollard inflation had averaged higher than the successive target midpoints, and expectations (in this survey) seemed more or less consistent with that.  But we don’t have a price level target, and if expectations start undershooting the target that is pretty undesirable as well.

The size of the fall in inflation expectations wasn’t unprecedented, but it was pretty large for this (not overly noisy) series.  In the period since low inflation became the norm (say since 1992) the only materially larger quarterly falls were (a) in the depths of the 2008/09 recession, and (b) in March 2012, when (post GST) the headline inflation rate had just fallen, in a single quarter, from 4.6 per cent to 1.8 per cent.

So this fall will have got the attention of the Reserve Bank, its analysts and forecasters.  It can’t really have been expected  – only 2 weeks ago the Governor told us explicitly that “survey measures of inflation…are now consistent with inflation settling at 2 per cent in the medium term”.  That was arguable, at best, previously.  It doesn’t really wash at 1.63 per cent –  and the prospect of further falls from here.

In the internal debate in the Bank, some will try to dismiss the latest fall as “just about petrol prices”.  Inflation expectations measures do respond, to some extent, to headline inflation, some seem “excessively” responsive to petrol prices, and even this two year measure (of informed respondents) is a bit sensitive to headline movements.  But, as I have pointed out on several occasions, the latest annual CPI inflation rate excluding petrol was only 0.5 per cent.  The more internationally conventional ex food and energy measure of inflation was only 0.9 per cent.  So if headline inflation is influencing two year ahead expectations (a) that seems quite reasonable –  it looks as though there is some information in trends in the headline rate, and (b) nobody much seems to expect headline inflation (including or excluding petrol) to pick up soon.  It looks as though respondents are just gradually giving up on the Reserve Bank’s story that inflation is heading back to 2 per cent any time soon.    It should be doubly sobering for the Bank that this comes in a survey in which responses to the other questions are not uniformly bleak: large falls in inflation expectations have usually gone hand in hand with more pessimistic GDP growth expectations, but in this survey those expectations have actually risen a little.

If people more generally –  not just these respondents –  are giving up on the Reserve Bank story, that will make it materially harder to get inflation back to target.

In one sense, it often seems wrong and excessively “mechanistic” to put too much weight on a single survey, and of 65 people –  it often did to me, when I sat around contemplating the survey results and wondering what OCR advice to offer successive Governors.  And in isolation that would be fine.  But it isn’t the only information we have –  rather, if anything, it is somewhat belated confirmation that the persistent undershoots of the inflation target have changed how people are thinking about prospects for inflation in New Zealand.   I suspect the Reserve Bank, perhaps rather grudgingly, will come to the same conclusion.

Recall what Mario Draghi, head of the ECB, said in the speech I discussed the other day

… in a context of prolonged low inflation, monetary policy cannot be relaxed about a succession of supply shocks. Adopting a wait-and-see attitude and extending the policy horizon brings with it risks: namely a lasting de-anchoring of expectations leading to persistently weaker inflation. And if that were to happen, we would need a much more accommodative monetary policy to reverse it. Seen from that perspective, the risks of acting too late outweigh the risks of acting too early.

And it is not as if New Zealand monetary policy has somehow already got ahead of the problem.  If the two year ahead measure is a reasonable proxy for the inflation norms now abroad in New Zealand –  and it may yet prove too high – real interest rates have actually risen over the last couple of years.

The Reserve Bank lists three lending rates on its main retail rates page: a business lending rate, an SME rate, and new customer floating mortgage rate.  In nominal terms, all are almost exactly now where they were at the start of 2014 (just before the OCR tightening cycle began). Inflation expectations, by contrast, are 70 points lower than they were then.  With an unemployment rate above any measure of NAIRU, and inflation persistently below target, rising real interest rates  have not obviously been something this economy needed. Retail deposit rates are lower than they were two years ago – by even they are no lower in real terms.  And as funding spreads are rising –  as they appear to have been recently, reflecting market unease about banks internationally  –  all else equal, the pressure on retail rates over the period ahead will be upwards not downwards.

And all this is before we focus on the continuing high exchange rate, the continuing weak commodity prices, and the growing stress persistently weak dairy returns are going to be placing on demand and activity (even if they aren’t necessarily a threat to the soundness of our banks).  Let alone the worsening global situation.

And, of course, there are market measures of implicit inflation expectations (from the difference between indexed and conventional bond yields).  These are weakening everywhere, but a chart someone sent me yesterday highlighted that the fall has been particularly sharp in New Zealand.  As of yesterday, a 10 year conventional bond had a yield of 3.06 per cent, and a 2025 inflation indexed bond was yielding 2.12 per cent.  That gap is now less than 1 per cent (and look how far it has fallen this year so far).

These aren’t perfect proxies, and bond investors’ expectations don’t directly affect (CPI goods and services) pricing now, but I don’t think central banks –  ours in particular –  can afford to be indifferent to message from bond markets: people with money on the line are no longer acting as if they think inflation is going to be near target on average over the next decade.  They might be wrong, but why would central banks be so confident that those investors are wrong –  especially when central banks, ours foremost among them, have themselves been persistently surprised by how weak inflation has been.  In part, in turn, that  has been because central banks –  ours among them –  have been persistently focused not on doing “whatever it takes” to create confidence that inflation targets will be delivered, but on doing as little as they can away with, perennially focused on “normalization” and some long-term benchmarks of where, surely, interest rates have to get back to one day.

There is a story abroad  – I saw it in a commentary from one of the local banks yesterday –  that low inflation is good and inevitable.  It certainly isn’t inevitable here –  looser monetary policy would, for example, lower our exchange rate generating additional resource pressure over time.  And it isn’t good either.  The story seems to go that structural features are driving price levels down.  But remember that productivity growth rates globally have been falling, not rising.  And stories about global overcapacity tell you mostly about demand having failed to keep up with supply capacity:  discretionary monetary policy exists to influence demand.  The indifference to what is going on is hauntingly reminiscent of some of the discussion and debate during the Great Depression –  when there was excess supply capacity (reflecting, eg, past heavy investment in agriculture), even amid rapid ongoing productivity gains –  and a sense in too many circles, for too long, that nothing very much should be done about monetary policy and the monetary system.

[1]  For what it is worth, when I completed the survey I did not lower my two year ahead expectation from the one I recorded in the November survey. On both occasions, I wrote down 1.4 per cent.