Some thoughts on the Monetary Policy Statement

September 10, 2015September 10, 2015 Michael Reddell Monetary policy, Reserve Bank

What to write about the Monetary Policy Statement?

The Governor continues to deny that any mistakes were made last year. I’m not sure why. As I’ve said before, perhaps the first OCR increases were defensible (certainly lots of onshore economists thought so), but to keep on hiking and then take a year to start cutting, quite grudgingly, even as core inflation stayed very low, was just indefensible. The Governor and his staff are human, so they will make mistakes. They should acknowledge this one and then move on. Unfortunately the continuing reluctance to admit any mistake, perhaps even to themselves, is colouring how they are running policy now. The OCR is still higher than it was at the start of last year – the only OECD country of which that is true – even as inflation expectations have fallen further. What is it about a situation of rising unemployment, near-zero per capita GDP growth, and well-below-target inflation makes them think we’ve needed higher real interest rates?

I was disappointed, if not overly surprised, by the questioning of the Governor at the press conference this morning. Here are a couple of questions I think we should expect the Governor to provide straight answers to:

Governor, the Reserve Bank – like its peers abroad – has been telling us for years that core inflation is just about to pick up, and it hasn’t. If anything, it has kept drifting down, and with the unemployment rate still rising it is likely to fall further. In the very first paragraph of your Annual Report last year you once again told us that inflation was heading back to the midpoint. Again it hasn’t done so. . How have you corrected for this persistent bias, and why should we (or the public) have any more confidence in your inflation outlook now?
Governor, given the Bank’s persistent forecasting bias – shared, of course, by local market economists – why not adopt a strategy that aims to get core inflation to something nearer 3 per cent. Given the (unintentional) biases you’ve shown to date, that might give us a good chance of actually getting core inflation up to 2 per cent. If inflation really looked to be rising strongly – to something well above 2 per cent – surely you have plenty of time to correct when you actually see the material increases in inflation?.

There was, as far as I could see, no particular basis in the document for a belief that core inflation is about to head back towards 2 per cent. Indeed, there is almost an attempt to sweep those awkward measures under the carpet, and to focus instead on headline inflation. Yes, headline inflation will probably pick up to some extent, and perhaps it will even creep over 1 per cent early next year. The evidence for that proposition isn’t great, and the Bank’s own past published research has cast doubt on it. Some tradables prices will no doubt rise – some already have – but exchange rates fall for a reason and are often accompanied by falling non-tradables inflation. It is those core or domestic components of inflation that really matter, and there was nothing in the Governor’s July speech or in this document to think the downside surprises have come to an end. Indeed, the Bank acknowledges that non-tradables inflation is likely to fall further (partly for one-off reasons), and as they are projecting the unemployment rate to carry on rising it would be surprising if their favoured core inflation measure did not fall further.

I’ve gone on quite a bit over the last few months about the apparent indifference to the unemployed. No one thinks that a 5.9 per cent unemployment rate is New Zealand’s NAIRU, the rate has been rising for several quarters already, and the Reserve Bank is now forecasting that the unemployment rate will rise even more. There is, conveniently, no chart of the unemployment rate in this MPS, but the tables at the back show them forecasting an unemployment rate up to 6.1 per cent next March, and only back down to 5.9 per cent a year later in March 2017. The unemployment rate was only 6.2 per cent in March 2010, just after the 2008/09 recession ended. Seven years on they expect no material inroads will have been made on the unemployment rate.

That March 2017 unemployment rate of 6.1 per cent is well within the sort of window that monetary policy can do something about. But the Governor is doing next to nothing more about it (these unemployment forecasts are after taking account of today’s cut and one more OCR cut). Lest I upset some economists, I should be clear that I’m not suggesting that monetary policy has very much impact on the longer-term average unemployment rate, but it has a considerable influence on fluctuations around the normal or natural level (itself determined by some mix of regulation, demographics, and so on). If core inflation was already 2 per cent and clearly rising, higher short-term unemployment might be an unavoidable price of keeping inflation in check. But core inflation is now 1.3 per cent, and probably falling. There is really no excuse for the OCR still to be so high. This is one of those times when there is no nasty trade-off: looser monetary policy would raise inflation (which we need, to get back to target) and lower the unemployment rate. Targeting house price inflation in Auckland isn’t part of the Reserve Bank’s mandate.

I don’t really understand why this high unemployment rate doesn’t seem to bother more people. I don’t hear market economists talking about it, or business journalists. I don’t hear business lobby groups doing so. The libertarian economist Bryan Caplan wrote a nice piece a couple of years ago about the grave evil of unemployment, and the way that people on the right tended not to take the problem seriously. But curiously, I also don’t hear the political Opposition talking much, or with much intensity, about unemployment.

And, as I’ve noted before, I really wonder what the Governor says to the unemployed people when he runs into them? How does he justify the Bank having run monetary policy in ways that delivered years of above-trend unemployment, scarring permanently the prospects for some of the people concerned. Mistakes happen, but the minimally decent thing to do is to acknowledge them and apologise. And how does he justify not adopting a more aggressive policy now, a stance that might get more of the unemployed back to work sooner? The Chief Economist gave us a little lecture about the neutral interest rate having fallen 3 basis points a quarter for the last decade, but whatever neutral is – and no one knows – there is no sign that keeping medium-term trend inflation near 2 per cent requires an OCR as high as it is now.

I was encouraged by one aspect of the Governor’s press conference. He seems to be becoming slowly more uneasy about the situation in China. In answer to one question he uttered the dreaded d word – deflation, observing that if there was a substantial depreciation of the yuan that would export deflation around the world. He actually sounded worried. Given that almost every emerging market currency has depreciated markedly against the USD in the last 12 months or so, and that the Chinese are rapidly running through their foreign reserves, he probably should be worried. But if he is worried, he should be doing some preparation, focusing on keeping inflation expectations up, and on removing the obstacle that the near-zero lower bound poses for monetary policy. We still have some way to go to get to zero, but that space is steadily diminishing, and if the Bank’s Statement of Intent is any guide, he is doing nothing pre-emptive about managing the risk.

I wonder how the Bank’s Board and the Minister of Finance feel about this Monetary Policy Statement. Is the Minister yet asking for advice from the Board and/or Treasury on just what is going on?

Does anyone believe core inflation is about to rise?

August 26, 2015August 26, 2015 Michael Reddell inflation, Monetary policy

The next Reserve Bank Monetary Policy Statement is scheduled for 10 September. Unless they’ve materially changed the timetable, this will be the week in which the Governor, his staff and advisers will be in long meetings, working their way through the data from the last few months and the draft economic forecasts. The forecasts are finalised to be not-inconsistent with the Governor’s preliminary OCR decision (which is usually made at this stage of the process, but can be revised very late in the piece).

One set of data was released only yesterday (although the Bank will have had it last week). That is the results of the Reserve Bank’s two expectations surveys. The household survey, of around 1000 people, asks only about CPI and house price inflation, while the other one, the Reserve Bank’s Survey of Expectations asks quite a wide range of questions about financial and macroeconomic variables. I’m not sure how many respondents they now have, but it used to be around 70. Respondents were a mix of people from business, the labour market, the financial sector, and economists (I’m now one of them). We used to treat this survey as the responses of an “informed” group, even if not many were experts in each of the areas on which they were questioned. The surveys have both been going for quite a long time now, and complement the quite different sorts of information available from business and consumer confidence survey. For some years, we ran a staff version of the Survey of Expectations, which occasionally raised interesting question when it showed up material differences between staff and respondents’ expectations.

Of all the questions in the two surveys, only one tends to get any media coverage (or even much market economist coverage). That is the question in the Survey of Expectations about what respondents expect the annual inflation rate to be in two years time. It gets focus because it is the variable that the Reserve Bank pays most attention to, and relatedly because it appears in many of the Reserve Bank’s formal models of the inflation process. The two year ahead measure gets the focus because it should largely “look through” most of the short-term fluctuations in inflation (oil prices ups and downs, tax changes, and so on, which can have a large effect on short-term inflation, but shouldn’t normally affect medium-term inflation). And, empirically, the two year measure seemed to do reasonably well (together with some measure of excess demand) in equations explaining (core) inflation; or at least it did until the last few years.

You may recall that in the July OCR review, and the Governor’s subsequent speech, the Bank affirmed its view that although current headline CPI inflation is still very low (0.3 per cent in the year to June), it would soon be back to around the 2 per cent middle of the target range. They talked in terms of inflation being back near the midpoint by early-mid next year. I and others have previously made the point that, even if so, this would be just a one-off lift in the inflation rate, as prices adjusted to a lower exchange rate, and would not represent a lift in core inflation pressures.

Respondents to the Survey of Expectations seemed only partly convinced by even this element of the Bank’s story. Year-ahead inflation expectations picked up from 1.32 per cent to 1.46 per cent, and two year ahead expectations also rose slightly, up from 1.85 per cent to 1.94 per cent. Among households, year ahead expectations rose, while five year ahead expectations were unchanged. The Reserve Bank is likely to take some comfort from these results, reinforcing the Governor’s bias (at least at the time of his speech) that the OCR didn’t need to be cut much more. But I think they would be wrong to take any comfort from them. As I dug through the numbers, I was staggered at how weak they were (and as I say that as one who is more pessimistic than the mean response on most, but not all, questions).

Let’s deal with households first. The numerical expectations that respondents reported did increase, but the survey also has a question – which, from memory, gets a better response rate – as to whether the respondent thinks the annual inflation rate will rise, fall, or stay the same over the coming year. Households have always – every quarter since 1995 – reported a net expectation that inflation will rise over the coming year, but this quarter’s response was one of the lowest ever.

The only time a smaller proportion of people expected inflation to increase over the coming year was at the end of 2008, when the actual annual inflation rate was peaking at just over 5 per cent ($150 oil prices and all that). Quite reasonably, and in the middle of a severe recession, not many expected the inflation rate to increase from there. The Reserve Bank apparently expects inflation to rise from 0.3 per cent to something around 2 per cent by the middle of next year. That is a really large increase to publicly project – and it got a lot of coverage – but households don’t believe it. They don’t expect inflation to rise much at all. They might be wrong, of course, but they don’t seem to believe the Bank at present.

What about the more informed group, the respondents to the Survey of Expectations? Here we have the luxury of getting a bit more of sense of how respondents (collectively) are thinking, since we get answers to a whole variety of macro and financial questions (although perhaps the Bank might think of adding a house price inflation question to this survey).

Respondents are asked a number of inflation questions. They are asked for their expectations for each of the next two quarters (in this case, September and December) and for their year-ahead expectation. That means we can back out an implied expectation for the second six months (in this case the first half of next year). There isn’t much sign that respondents expect inflation to rise. They are expecting inflation of 0.67 per cent for the second six months of this year (still one of the weakest six month ahead expectations ever), and 0.78 per cent in the first six months of next year. In other words, there is hardly any pick-up in near-term inflation even following one of the sharpest three month falls in the exchange rate we’ve seen since the float thirty year ago. It is exactly the same extent of pick-up, from the first half of the year ahead period to the second half, as the average expected in the surveys done over the previous two years.

Like the Reserve Bank’s projections, the Survey of Expectations respondents take account of any changes in monetary policy they expect over the survey horizon. We get a direct steer on that from the questions about the expected 90 day bank bill rate in a year’s time. In this survey, that expectation fell sharply, down by 92 basis points – and the only time there has been a larger fall than that was at the height on the financial crisis in 2008/09. Respondents expect that the OCR next June will be around 2.5 per cent – probably not a lot different than the Governor had in mind in his speech. Even with these big cuts in interest rates, respondents don’t see the rebound in expected inflation.

The survey also asks respondents about their perceptions of monetary conditions (actual and expected). “Monetary conditions” isn’t defined, and respondents may be influenced by factors such as interest rates, exchange rates, share prices, and credit conditions. Respondents think conditions at present are (quite considerably) on the easier side of neutral, but what caught my eye is that this is the first quarter in the history of the survey when respondents have both thought current conditions were loose now, and expected them to get looser still over the coming year.

Survey respondents’ GDP growth expectations have also fallen Expected growth rates of around 2.3 per cent for the year ahead and two years ahead would barely even match potential growth over that period, suggesting little prospect of an increase in core inflation. Consistent with this story about potential, unemployment rate expectations have risen notably, and are expected to stay at around 5.8 per cent for the next two years. If anything, medium-term expectations are getting more pessimistic – for the first time since 2009, the unemployment rate two years hence is not expected to be below that in one year’s time.

And finally, the one question where respondents were even more pessimistic than I was. Wage inflation expectations picked up coming out of the recession back in 2009/10 (and recall there are more business-affiliated respondents in this survey – it wasn’t just household aspirations), but have been going sideways, or falling, for the last few years. The survey asks respondents about expected wage inflation one and two years ahead. In big booms one expects to see the two year ahead expectation below the one year ahead one – intense pressure on wages now, but they will abate as the market equilibrates. And in deep recessions, one expects the reverse: very weak wage pressures in the near-term but some recovery in the medium-term as the market equilibrates. You can see that pattern in the chart, both pre and post 2008.

But what is striking is what has happened in the last year or so. As actual wage inflation has been falling, expectations of future wage inflation have been falling, but the two year ahead expectations that have been falling faster than the one year ahead expectations. In the more than 20 years these questions have been run, medium-term wage inflation expectations have been lower only once – that in the middle of a recession in 1998, when the inflation target was 0.5 percentage points lower than it is now. Respondents to this survey seem to have just given up on the idea of any labour market pressures in the foreseeable future. There is barely any real wage inflation expected: nominal wage inflation – before allowing for productivity growth – is expected to only barely above 2 per cent.

The respondents to these surveys might be quite wrong. But the sorts of people who fill in the Survey of Expectations are the sorts of people the Reserve Bank should be wanting to convince. Some of them are real decision-makers. Others might be, in Nigel Lawson’s memorable phrase, “teenage scribblers”, but they are the sort of people who pay more attention than most to this stuff. And they do not see any inflation pressures out there, at present or in prospect over the next couple of years.

Which brings us back towards monetary policy. Even after the first two cuts, the OCR is still around 50 basis points higher than it was at the end of 2013, even though inflation expectations – business and household – are probably 50 basis points lower than they were then. In other words, the Reserve Bank has substantially raised real New Zealand policy interest rates, over a period when markets tell us that real New Zealand long-term rates – the market’s view of what will be required over the next 15-20 years – have been falling. Perhaps that would have made sense if core inflation had been getting away on the Bank and it had needed to act fast to bring it under control. In fact, core inflation has just kept on being very low, surprising the Bank, and well below the target (and accountability) midpoint.

After the Governor’s speech, I posed the question of how the Bank hoped to get core inflation back to around 2 per cent, given its current very cautious approach to lowering interest rates. Add in the lack of any confidence the Survey of Expectations respondents appear to feel, and the question is redoubled now. It seems most unlikely that another 25 or 50 basis points of OCR cuts will be anything like enough – cuts of that sort are already factored in to these survey responses, And all this in a survey completed 2-3 weeks ago. I suspect a survey done today might be a little more pessimistic still.

Monetary policy transparency US style

August 20, 2015 Michael Reddell Monetary policy, Transparency

I opened the Wall Street Journal website this morning and noticed a prominent piece of advocacy (and here) , making the case for not increasing the Federal funds rate target yet. Plenty of market and other commentators openly run either side of that argument. But this column was from Narayana Kocherlakota, President of the Minneapolis Fed, and rotating member of (and permanent participant in) the Federal Open Market Committee, which takes monetary policy decisions in the US.

This is no, “on the one hand, on the other hand” treatment, but an article that begins with the rather bold statement

I’m often asked by members of the public about the biggest danger facing the economy. My answer is that monetary policy itself poses the biggest danger.

In his view, raising interest rates in the near-term would “create profound economic risks for the US economy”.

I happen to mostly agree with Kocherlakota’s conclusion – since core inflation remains very low, and there is little or no sign of a quick return to the target rate – but that isn’t my point. I drew attention to the article because of the refreshing contrast it represents to the way in which monetary policy deliberations and debates occur in New Zealand (and, to a lesser extent, in most other advanced countries).

I’ve highlighted previously that the Reserve Bank of New Zealand is just not that transparent about monetary policy. Their formal model remains under wraps, written advice to the Governor on OCR decisions is kept secret, and no minutes of the Monetary Policy Committee or the Governing Committee are published. The Bank was recently forced to release background papers for an OCR decision and Monetary Policy Statement from 10 years ago, but experience suggests they would fight very hard to avoid releasing rather more recent papers. And that is even though all this material is official information, generated at the cost of your taxes and mine.

But one of the key features of forecast-based discretionary monetary policy (what the Fed, and the Reserve Bank and most other central banks try to practice) is how little any of us knows with any certainty. Reasonable people can reach quite different views, not just on the outlook but on where the economy and inflation pressures are right now. Reasonable people can also differ on how the Policy Targets Agreement should be best interpreted and applied. And views inside central banks are typically no more monolithic – if perhaps equally prone to herd behaviour – than views outside.

So what is gained by maintaining the secrecy? In some areas of public life there might be a real need for temporary secrecy. Shaping negotiating positions, and identifying bottom lines, in trade negotiations might be an example. But monetary policy deliberations aren’t like that. The reputation of the Federal Reserve system doesn’t suffer because Kocherlakota runs a dovish line right now, or James Bullard runs a hawkish line. If anything, the reputation of the system is enhanced, because people can see able people grappling with the range of issues and evidence that need to feed into monetary policy decisions, and can test and evaluate the arguments those people are making.

Of course, it is much easier to adopt such a model in the US system, where FOMC members are independently appointed, and are not dependent on Fed system chair for pay or resources or the like. It would be much harder to do in the New Zealand system at present, where all those who have a formal say in the system are senior staff, appointed by and accountable to the Governor. But that only goes to highlight the weakness of our system, and why it would not be appropriate, when Parliament reforms the Reserve Bank Act, to simply give all decision-making powers to a group of senior managers and insiders. Monetary policy issues like those we – and the US, and most other countries face – need robust and searching debate, and especially in a small country much of the expertise is tied up inside government institutions. We need to create a culture that can encourage debate, and can live with differences of perspective. I’m not suggesting that all debate should take place in public, but that there is a place for those actively involved in the decisionmaking process to participate openly in debate on these important issues, as happens in the United States or Sweden (and to a lesser extent in the UK)

Even now, if, for example, Deputy Governor Geoff Bascand opposes OCR cuts, we – and not just the Governor – should hear his case. Perhaps, with hindsight such an argument might prove right, or perhaps not. In the nature of these things, no one is ever going to have the answer right all the time, and so in a collective decision-making model, of the sort other countries have, we should be holding participants to account not so much for any particular call, but for the quality and tone of the arguments and judgements each participant brings to the table. Under the current system, perhaps a start might be made by publishing the written OCR advice the Governor gets prior to each OCR decision, and the minutes of the Governing Committee, when – straight after the MPS – that information goes to the Bank’s Board. But that is no more than a start: we need to move towards a system where an independent committee makes monetary policy decisions. Under such a model, the Governor and staff would still have a crucial role, but their primary role would be advising the decision-makers.

In the next few days I want to come back to the much more severe problems of lack of transparency around the regulatory and supervisory functions of the Reserve Bank.

Can Steven Joyce’s confidence be taken entirely seriously?

August 17, 2015August 17, 2015 Michael Reddell Current New Zealand data, Monetary policy

I watched Q&A’s interview yesterday with Minister of Economic Development, Steven Joyce. He was resolutely upbeat, rather beyond the point where his case could be taken entirely seriously.

The Minister tried to reassure us by observing that he’d taken a look at New Zealand’s previous four recessions and we weren’t facing anything like that. In particular, he assured us, the world economy was different.

I’m not sure which recessions the Minister had in mind. But here is the chart of six-monthly growth in real GDP back to the start of the official series. Six-monthly because of the popular lay definition of a recession as two consecutive negative quarters of GDP growth. It has never been entirely clear why that measure enjoys such popularity. Apart from anything else, it means something quite different in all those European countries or Japan with flat or falling populations than it does in, say, New Zealand, with 1.9 per cent estimated population growth in the last year. Two quarters of zero or negative GDP growth in New Zealand is a quite material hit to per capita GDP.

My first observation about past recessions, or marked growth slowdowns, is that they almost always take officials (and probably ministers) by surprise. I reflect sadly on having been in policy/analysis roles in the Reserve Bank in each of the episodes in this chart where growth got to zero or negative. I’m pretty sure we didn’t expect or anticipate a single one of them. To take just the most recent examples:

The 2010 double-dip recession was such a surprise that the Reserve Bank had raised the OCR twice just as it was happening.
It wasn’t until several months into 2008 that the Reserve Bank recognised even the initial domestic recession

But you could go through published material from the Bank around each of these episodes and the story will be much the same. And I’m not trying to pick on the Bank. I’m pretty sure Treasury’s record would have been no better, and nor (consistently) would that of any of the market forecasters/economists. There would be nothing very unusual if, by the time the September or December national accounts numbers came out, it turned out that real GDP had been going backwards for some time, even as ministers and senior officials had been running the usual upbeat story.

My second observation is that while severe world downturns are bad for New Zealand, we haven’t needed global recessions to have a downturn in New Zealand. Our 1991 recession and our 2008/09 recession were part of common global (or advanced country) events, but our 2010 double-dip recession, our 1997/98 recession, and our 1988 recession were largely home-grown. The Minister wanted to take comfort from the state of the world economy, but I’m not sure why. World growth rate estimates are no better than mediocre, and they rest on estimates of China’s growth which few people now take seriously. Growth in many other emerging market countries has been slowing, as their credit-booms exhausted themselves, and there is no sign of acceleration in the anaemic growth in most of advanced world. Commodity prices have been falling very sharply, and monetary authorities in many countries have been easing policy in the last 18 months. Perhaps the US Federal Reserve will raise interest rates next month, but if so it seems to be as much as response to the siren call of getting back to (questionable estimates of) a neutral interest rate, rather than because demand growth is putting much upward pressure on inflation.

There has been plenty of talk of New Zealand maintaining growth at around 2 or 2.5 per cent. But remember that in the last six months for which we have official data, real GDP rose by only 0.8 per cent. And that was the six months to March, when sentiment was still pretty upbeat, employment was growing strongly, and so on. It is hard to believe that “true” growth in the rest of this year – and we are now half way from March to the end of the year – will have been stronger than it was in the six months to March. If it is only as strong, that produces an annual growth rate of not much more than 1.5 per cent. With building activity starting to go sideways, unemployment rising, and consumer and business sentiment down – and as the sharp fall in the terms of trade has grabbed the consciousness of many people – a much safer bet would seem to be lower growth. It isn’t clear to me why, say, one would bet on an average of anything more than zero growth for the next few quarters.

There has been talk of the “automatic stabilisers” working. Perhaps, but lets look at them. Fiscal automatic stabilisers are not particularly strong in New Zealand – which just reflects the fact that our maximum marginal tax rates are low, and our unemployment benefits are modest and at a fixed rate. Interest rates are falling, but they probably shouldn’t have been raised last year, and so far only half the increase in the OCR has been unwound. As I’ve noted previously, by the standards of past cycles in short-term interest rates, even a cut in the OCR to, say, 2 per cent by early next year would not be remotely aggressive. And it is quite possible that medium-term inflation expectations are still falling – there have been suggestions of that from the bond market, for example. If so, real interest rates aren’t falling much at all.

And, of course, the exchange rate has fallen. As I noted last week, the fall over the three months to July was one of the largest short-term falls we’ve seen in the floating exchange rate period. But we’ve had one of the largest falls in commodity prices (and probably the terms of trade) on record, and I don’t think anyone would regard the TWI at just over 70 – where it has been for the last month or so – as particularly stimulatory. It is back at around the levels prevailing in 2010.

So combine subdued world demand growth, very deep falls in commodity prices, a levelling off in one of the biggest construction booms in modern times, continuing modest fiscal consolidation, subdued credit growth (except among distressed dairy farmers), real interest rates that remain very high by world standards, and a real exchange rate that has only dropped back to around the average level of the last 15 years, and it isn’t clear what is likely to hold up growth in New Zealand this year.

Of course, that migration-driven 1.9 per cent population growth helps boost demand. But since even at the peak of the migration inflows there was barely any real per capita GDP growth (and the level of the real per capita measure of income (ie allowing for the terms of trade) peaked in the March last year), that might be cold comfort. And the influx of people (especially the non-citizens) may well start to wane if the labour market conditions facing prospective employees keep on deteriorating.

Here’s one final chart. It shows annual growth in nominal GDP: already down to 2 per cent in the year to March, before this year’s fall in the terms of trade has been reflected in the national accounts. Only in previous recessions has annual growth in nominal GDP got any lower than it is at present.

With the combination of mismanaged monetary policy, ebbing activity in one of the world’s largest economies (and major source of demand growth in recent years) and the very deep fall in commodity prices, it might be better to ask not “can we avoid a couple of negative quarters” – the technical recession question – but to ask instead what makes us confident we are not already in a renewed recession (real, as well as nominal), perhaps already deepening? I don’t purport to do quarterly GDP forecasts, and would be happy to be wrong on this one, but presented with the raw New Zealand data it looks like the sort of conclusion a visiting analyst from Mars might easily reach.

Downturns, recessions, corrections don’t last for ever. And they don’t, in the end, make that much difference, to the longer-term (rather disappointing) performance of the New Zealand economy. But for individuals – particularly the 148000 unemployed, and the others likely to be joining them – and business owners they can matter a great deal. Some variability is natural and unavoidable (the two aren’t the same thing) but macroeconomic management should have been able to have prevented unemployment rising again before it ever quite recovered from the last two recessions, and to have avoided any new recession. It looks to have failed already on the first count, and the outlook doesn’t seem promising on the second.

Wheeler and his critics

August 7, 2015August 7, 2015 Michael Reddell Governance, Monetary policy, Reserve Bank

The print issue of today’s NBR has a double-page feature on “Wheeler and his critics”. It includes – with a few transcription errors – the heart of an interview I did with Rob Hosking in early July.

There are few broad issues touched on in the article:

The first is monetary policy. Hosking correctly points out that market economists’ forecasts of inflation have been even less accurate than those of the Reserve Bank. That doesn’t reflect well on the market economists, who in 2013 and 2014 were also often even more “hawkish” on policy than Graeme Wheeler has been. The same results are reflected in the survey results of the NZIER’s Shadow Board.

Being less wrong than market economists is convenient defensive cover for the Reserve Bank. During the 2003-2007 boom, we used the argument on the other side. We (the Bank) let inflation drift too far up, and tightened too slowly. But, on average, the markets (pricing and economists) were more dovish – constant looking for the first easing.

And if the Governor has to make mistakes – and inevitably every central bank will from time to time – it is better to be in good company than out on his own. But only one agency – in New Zealand, one individual – is charged by law with keeping inflation near target. And the Governor has been given a lot of public resources to do the analysis and research to support his policy decisions. In this cycle, our Reserve Bank wasn’t doing that well in 2013 – core inflation was below the target midpoint (although 2013 outcomes were largely a result of Alan Bollard’s choices). But then they tightened policy – at a time when no other advanced country central bank was doing so – and kept on tightening. And core inflation just kept edging lower (and unemployment began to rise again). They were bad calls – increasingly clearly so with hindsight – and should be acknowledged as such, by the Governor – and by those paid to hold him to account, the Bank’s Board, and the Minister.

So I’m not one of those arguing that the Governor has put too much focus on inflation. Instead, he seems to have put far too little focus on actually keeping the medium-term trend in inflation on target. And that focus on the 2 per cent midpoint was one that Graeme Wheeler and Bill English added to the PTA less than three years ago. He seems to have been distracted by Auckland house prices – a serious issues, for political leaders – and by beliefs about what “normal” interest rates should be.

The second issue is around governance, and particularly the decision-making structures Parliament set up for the (rather different) Bank back in 1989. I get the sense that no one is really now defending the current system, which has no counterpart anywhere else in the advanced world. A single unelected individual is responsible for all the Bank’s analysis, and for all its decisions – not just on monetary policy, but on banking supervision, insurance supervision, note and coin designs, housing finance regulation, foreign exchange intervention, and so on. No other country does it that way. No other New Zealand public agency I’m aware of does it that way. The Greens have been raising concerns (and do so again in this NBR article), the Treasury has been suggesting changes, market economists have favoured change. In this article, now-independent economist Shamubeel Eaqub calls for change. And, of course, I’ve argued that it is past time for change. Actually, I suspect Graeme Wheeler favours change – although his preferences as to how are likely to be different from those of most others. This is not an ideological issue. It is common-sense one where reform is needed to bring the governance structures up to date. There are important discussions to be had about precisely what alternative model to adopt. I’ve made the case for something like the model the British government has recently adopted for the Bank of England, but there are reasonable arguments for other possible solutions. Unfortunately, the obstacle to reform now is the current government. I’m not quite sure why.

The third issue is around LVR controls. Shamubeel worries that active Reserve Bank involvement in housing finance restrictions invites, over time, a more direct political involvement in future Bank decisions, perhaps including around monetary policy. I think that is a risk. My points about LVR restrictions are twofold. These are really the sorts of decisions that should be made by politicians, if anyone is to make them. Direct controls of that sort, that impinge of so many people’s finances and businesses aren’t the sort of thing unelected officials should be deciding, But, in a sense, that is a decision Parliament needs to make, to take back (and then take) responsibility for such decisions.

But perhaps more importantly, the Bank – the Governor – has still not made a compelling case that the soundness of the New Zealand financial system requires such controls. They have not made a clear and convincing public case that investment housing lending is riskier than owner-occupier lending. More importantly, even if such lending is a bit riskier, there is no sign that lending is growing rapidly, or that even very major falls in house prices and rises in unemployment would threaten the health of New Zealand banks. The Reserve Bank did the stress tests, not me – and they seem to be very demanding tests. My response to their consultative document is here. In the meantime, they are now hiding behind provisions of the Official Information Act, and highly questionable provisions of the Reserve Bank Act, to keep from the public the submissions people have made on the proposals. Here are the submissions on some of the government’s housing initiatives. But where are the submissions on the Governor’s planned direct controls? The provisions the Bank rests on to keep them secret were never designed to shelter public submissions on major new macroeconomic policy initiatives. I’ll come back to this issue next week.

The interview reports a few areas where I have been critical of the Governor. In particular, I noted that he seemed very reluctant to engage in serious or robust debate on any of the policy or analytical issues. That was certainly the case internally, but I think it is true externally as well. Various people have made the point to me that the Governor seems uncomfortable with the media, or with the sort of scrutiny that inevitably should go with the sort of power he wields. I’m not sure that we’ve yet seen a serious and searching interview about his proposed new LVR restrictions, or about his conduct of monetary policy over the last 18 months or so. (Incidentally, I’m reported as calling the Governor “Action Man” – in fact, the credit for that description, emphasising action rather than analysis and reflection, belongs to one of the Governor’s own current direct reports.)

Finally, Rob Hosking highlights the issue of possible comparisons between the Governor and the late former Minister of Finance, Sir Robert Muldoon. As I noted, I did not make such a comparison, and I don’t think it would be helpful to do so. There is a sense in New Zealand debates that the first person to invoke Muldoon comparisons loses. And Sir Robert was Minister through some of the most difficult years New Zealand faced, and his record in response was a mix of the good and the rather less good.

But through the post-war decades, we had an extraordinary piece on legislation on the books, the Economic Stabilisation Act. It was introduced by a Labour government, and used and abused by both Labour and National governments over the decades. It gave ministers the power to impose wide-ranging economic controls (in Geoffrey Palmer’s words) “without resort to Parliament in ways that were unique in the western world”. It was finally repealed by the Labour government in 1987.

But it is worth noting that these decisions had to be made by a committee (the Governor General by Order in Council) and perhaps more importantly had to be made by people with an initial electoral mandate to hold office: Cabinet ministers are elected MPs, and can be tossed out again.

By contrast, Parliament just a few years later (in the original 1989 Reserve Bank Act and subsequent amendments) passed legislation allowing an unelected official to single-handedly (not even by Order in Council) impose far-reaching controls on almost any aspect relating to banking, which has potentially pervasive influences on whole classes of economic activity. The scope is, of course, nowhere near as wide as the powers under the Economic Stabilisation Act, but there are even fewer checks and balances, in an age that typically puts much greater weight on openness and transparency.

Graeme Wheeler is not responsible for having passed the Reserve Bank Act. That was Parliament’s choice. But the Governor has choices about whether, and how, he deploys those powers. Without a much stronger case, establishing the serious prospect of a threat to the soundness of the financial system, simply banning people from using banks to finance their residential rental businesses, when the initial exposure would exceed 70 per cent, seems unwise, and a step too far. Several serious people have argued to me that the Governor’s proposals are ultra vires. I’m not a lawyer, and issues of that sort can really only be resolved in the courts. But when banks are willing to lend, and customers are willing to borrow, and there is no evidence of any serious deterioration in credit standards, we should be wary about the prospect of a single public servant telling them they just can’t.

Oops

August 5, 2015August 5, 2015 Michael Reddell Monetary policy

As readers know, I have been putting a lot of weight on the unemployment rate. It isn’t a perfect measure of excess capacity, but it has lingered at uncomfortably high levels since the recession. Very uncomfortable for those who are unemployed, no doubt. But particularly when inflation has been persistently well below the agreed target midpoint, those unemployment numbers should also have been very disconcerting for people with responsibility for short-term economic management.

The Reserve Bank Governor began an OCR tightening cycle at the start of last year, and was still talking about further OCR increases as late as last December.

The red line in this chart is what the Reserve Bank thought was going to happen to the unemployment rate last March – the numbers from the March 2014 MPS projection. The blue line, by contrast, is what actually happened.

The first OCR increase was announced in March 2014. It takes a little while for monetary policy changes (even expected ones) to have much of an effect on the economy. By the September quarter of 2014, the unemployment rate had reached what now appears to have been a trough. Even by them, the unemployment rate hadn’t been falling as fast as the Reserve Bank expected. And since then, the divergence has grown materially. The Bank had expected the unemployment rate would be 4.9 per cent by now. In fact, SNZ tell us, it is 5.9 per cent. That is a difference of around 25000 people. And unemployment doesn’t just affect the people who are unemployed, but their spouses and families as well.

Is it all down to the Reserve Bank’s misjudgement? Probably not – and there is noise in the series – but monetary policy is our principal macroeconomic stabilisation tool. Mistakes on this scale, when there was no pressure to tighten in the first place, have to be sheeted home to those responsible. That is, very largely, the Governor.

Optimists have told stories about the unemployment rate holding up mainly because of rising participation rates. But participation rates have been rising in much of the OECD, and since September New Zealand’s participation rate has risen by only 0.2 percentage points. It doesn’t explain the difference. The Reserve Bank seems to credit surprisingly high immigration with boosting unemployment, in defiance of all the evidence (and its own research) that shocks to population affect demand more than they do supply in the short-term.

The HLFS is a sample survey, and occassionally it does seem to give slightly rogue steers (notably the increase in the unemployment rate in 2012), but this time it doesn’t seem inconsistent with most of the rest of the labour market data, and in particular the absence of any resurgence in wage inflation. The uncomfortable truth seems to be that after rising more than 3 percentage points during the recession, the unemployment rate at 5.9 per cent is only about 0.5 percentage points below the average level for 2009 to 2012.

This is no small failing. Among all the OECD countries, the only ones whose current unemployment rates are higher, relative to pre-recession lows, are a group of countries in the euro-area with no ability to adjust monetary policy at all.

Sometimes a rise in unemployment is unavoidable. And forecasting is a mug’s game. But with what was always an anaemic recovery (by historical standards), with very weak price and wage inflation, and no external constraints (eg ZLB) on macroeconomic policy, there was no pressure on the Reserve Bank to tighten when it did. They could have held their hand, and let the numbers unemployed continue to fall. But they didn’t.

As I noted last week, I wonder how Graeme Wheeler explains this to the, now, 148000 unemployed people when he meets any of them? I really do.

In Fran O’Sullivan’s column in today’s Herald there is a report of the recent Minter Ellison Rudd Watts’ 2015 Corporate Governance Symposium in Auckland on Monday, attended by, inter alia, a number of “leading independent directors and chairs”. Participants were addressed by various independent directors, and O’Sullivan notes:

It was said that while the regulatory and social pressure on major organisations mounts, the 24-hour news cycle is shrinking to 24 minutes and accountability is increasing.

Where, the unemployed might wonder, is the accountability for the Governor?

What legislation used to require of monetary policy

August 3, 2015August 3, 2015 Michael Reddell Monetary policy, New Zealand economic history

This was what section 8 of the Reserve Bank Act, and associated provisions, replaced. It is easy to forget – and for many younger readers, never to have been aware – just how different things were. Of course, we had a singe decision-maker back then too, although as Minister of Finance and an elected MP, the single decision-maker could be (and often was) tossed out of office.

8. Primary functions of Bank—

(1) The primary functions of the Bank

shall be—

(a) To act as the central bank for New Zealand; and

(b) To ensure that the availability and conditions of credit provided

by financial institutions are not inconsistent with the sovereign right of the Crown to control money and credit in the

public interest; and

(c) To advise the Government on matters relating to monetary policy, banking, credit, and overseas exchange; and

(d) Within the limits of its powers, to give effect to the monetary policy of the Government as communicated in writing to the Bank under subsection (2) of this section, and to any resolution of Parliament in relation to that monetary policy.

(2) For the purposes of this Act, the Minister may from time to time

communicate to the Bank the monetary policy of the Government, which shall be directed to the maintenance and promotion of economic and social welfare in New Zealand, having regard to the desirability of promoting the highest level of production and trade and full employment, and of maintaining a stable internal price level.

(3) The Bank shall, as directed by the Minister, regulate and control on behalf of the Government—

(a) Money, banking, banking transactions, any class of transactions of financial institutions, credit, currency, and the borrowing and lending of money:

(b) Rates of interest in respect of such classes of transactions as may from time to time be prescribed:

(c) Overseas exchange, and overseas exchange transactions.

(4) The Bank shall make such loans to the Government and on such conditions as the Minister decides from time to time, in order to ensure the continuing full employment of labour and other resources of any kind.

For those interested in the history, and how the functions/objectives/powers provisions changed (as they repeatedly did – this was the 1973 formulation) there is an interesting Bulletin article here by Christie Smith and James Graham. In case anyone thinks my post this morning was a recantation of a commitment to monetary stability (which it certainly wasn’t) I remain proud of the fact that my grandfather’s cousin was the Minister of Finance who introduced the concept of a stable internal price level to the Reserve Bank Act, and removed the formal power for the Minister of Finance to direct the Bank. Those changes didn’t last long.

Should the statutory objective for monetary policy be changed?

August 3, 2015August 3, 2015 Michael Reddell Monetary policy, PTAs

Since 1989, section 8 of the Reserve Bank of New Zealand Act has read as follows:

The primary function of the Bank is to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices.

That provision was widely seen as one of the centrepieces of the new Reserve Bank Act in 1989. It does not directly guide day-to-day monetary policy, but rather it should constrain the Minister and the Governor in negotiating Policy Targets Agreements (PTAs). PTAs must, by law, be consistent with section 8: as the Act puts it, the targets are “for the carrying out by the Bank of its primary function”.

The wording raises a variety of geeky questions. Should, for example, the Act really describe monetary policy as the Bank’s “primary function”, or just treat monetary policy as one of a variety of functions Parliament assigns to the Bank? Is it really sensible to talk of stable levels of prices, when neither the Bank (nor ministers, nor Treasury) has ever shown any interest in stabilising the level of prices, as distinct from the rate of change in those prices (“the inflation rate”). More troublingly, perhaps, can a medium-term trend inflation rate of 3 per cent (which we had got up to prior to the 2008/09 recession, and which would double prices every 24 years) really be described as “price stability”?

I’m not going to try to answer those questions today. But they illustrate that there is no particular reason to think that the current specification of section 8 should be treated as sacrosanct. My impression over many years at the Reserve Bank was of a tendency (I may have shared this attitude at times) to treat section 8 as the battle standard of orthodoxy, such that any change would be akin to allowing the barbarians to overrun the fortress.

Going into last year’s election, each of the Opposition parties (Labour, Greens, New Zealand First, Internet-Mana) was campaigning to change section 8 of the Reserve Bank Act. Of course, typically they were looking for rather more change than just a change of overarching statutory objective, but two parties were quite specific in what they were looking to do with section 8 itself

In Labour’s case, as I noted a couple of weeks ago, they came up with this formulation

“The primary function of the Bank with respect to monetary policy is to enhance New Zealand’s economic welfare through maintaining stability in the general level of prices in a manner which best assists in achieving a positive external balance over the economic cycle, thereby having the most favourable impact on the stability of economic growth and the level of employment.”

And New Zealand First has sought to introduce legislation amending section 8 to read as follows:

The primary function of the Bank is to formulate and implement monetary policy directed to the economic objective of maintaining stability in the general level of prices while maintaining an exchange rate that is conducive to real export growth and job creation.”

In both cases, it would appear that the framework of a Policy Targets Agreement would continue. Labour was quite explicit about maintaining the inflation target.

In fact, looking around the world’s advanced economies there is a wide variety of ways in which countries have written down what they are looking for from their central bank and monetary policy. In a fairly short issue of the Reserve Bank Bulletin published late last year, Amy Wood and I looked at the wide variety of ways legislation is written in 18 advanced countries (or regions in the case of the euro) that now use inflation targets as the day-to-day centrepiece of monetary policy.

There are big differences across countries. Some of those differences are about the age of the legislation. Old legislation looks quite different from newer legislation. Some is probably about the preferences of legislative drafters in different countries. And one important difference that became apparent is that in some countries they have written a limited statement of what a central bank can directly achieve, while in others they have written more about the longer-term desired outcomes that might flow from good monetary policy. And while acts of Parliament are one part of the mix, they often aren’t the only place in which society’s aspirations for monetary policy are set down.

At one extreme, in Sweden the only formal document – the central bank act – simply states that the goal of the Riksbank’s monetary policy is “price stability”. There are no other formal or binding documents (although there are plenty of Riksbank texts on what current governors interpret the Act as meaning).

The US legislation, by contrast, is a mix of medium-term objectives (things the central bank might more directly affectl) and desired outcomes from good policy. The Federal Reserve Act requires the Fed to “maintain long-run growth in the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production”. Stable money growth was the thing the Fed could directly influence. But the Act goes on to state that this is to be done “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”. Congress didn’t care about money supply growth for its own sake, but for the things that are thought to flow from it.

The Bank of Canada operates under very old legislation. The Bank is required to “regulate credit and currency to control and protect the external value of the national monetary unit” (this dates back to before the era of floating exchange rates), but again it does not do this simply for its own sake. Rather, Parliament goes on to explain that the desired outcome of monetary policy is “to promote the economic and financial welfare of Canada”

I could go on. Even the ECB, established by treaty rather than by national legislation, operates under provisions which state that while the primary objective is “price stability” a variety of good things that should flow from the work of the ECB specifically and the EU more generally (eg “…stable prices, sound public finances and monetary conditions and a sustainable balance of payments”). When I first stumbled on that last clause, about a sustainable balance of payments, I wondered if the Labour Party people were aware of it.

In many countries, even with quite recent legislation, there is an explicit obligation on the central bank to work together with, or support, other government economic policies, at least so long as doing so does not threaten the primary price stability goal,

What about the New Zealand situation?

Section 8 of the Act is pretty clear and succinct about what monetary policy is for, but nature tends to abhor a vacuum. Trace through the evolution of the Policy Targets Agreements since 1990 and you will more and more stuff written down, that was previously unwritten and somewhat taken for granted. But political pressures and criticisms of the Bank saw more and more details added in. The 1992 PTA was perhaps the most cut-down approach.

Price Stability Target Consistent with section 8 of the Act and with the provisions of this agreement, the Reserve Bank shall formulate and implement monetary policy with the intention of maintaining a stable general level of prices

But in late 1996, a revised PTA was signed as part of the National-New Zealand First deal. It moved beyond just writing down the direct stuff the Bank could manage, to articulating what the point of pursuing price stability was. The ‘so that” language that Winston Peters introduced here paralleled the “so as to” in the Federal Reserve Act.

Price Stability Target

Consistent with section 8 of the Act and with the provisions of this agreement, the Reserve Bank shall formulate and implement monetary policy with the intention of maintaining a stable general level of prices, so that monetary policy can make its maximum contribution to sustainable economic growth, employment and development opportunities within the New Zealand economy.

In 1999, in the wake of the MCI debacle, Michael Cullen added this provision.

In pursuing its price stability objective, the Bank shall implement monetary policy in a sustainable, consistent and transparent manner and shall seek to avoid unnecessary instability in output, interest rates and the exchange rate

It isn’t in the Act, but it is no less binding on the Governor (and successive Governors who have signed it). Unfortunately, as I noted last week, it is a somewhat troublesome clause, in that no one has ever been sure quite what the practical import was. At one level it was uncontroversial – avoid “unnecessary instability” – but quite what is “necessary”?

In 2002, Michael Cullen and Alan Bollard reformulated clause 1, restoring a clean focus on price stability in a), which just mirrors section 8 of the Act, while adding a separate sub-clause outlining what the government’s economic policy was looking for, and a sense of how price stability contributes.

Price stability

a) Under Section 8 of the Act the Reserve Bank is required to conduct monetary policy with the goal of maintaining a stable general level of prices

b) The objective of the Government’s economic policy is to promote sustainable and balanced economic development in order to create full employment, higher real incomes and a more equitable distribution of incomes. Price stability plays an important part in supporting the achievement of wider economic and social objectives.

With a change of government in 2008 there was a change in economic policy goal

The Government’s economic objective is to promote a growing, open and competitive economy as the best means of delivering permanently higher incomes and living standards for New Zealanders. Price stability plays an important part in supporting this objective.

And finally in 2012, the words – already present in section 10 of the Reserve Bank Act since 1989 – about having regard to the efficiency and soundness of the financial system in conducting monetary policy were added. Quite what these words mean in practice is also less than clear – even after 26 years.

No other countries have a binding legal arrangement akin to the Policy Targets Agreement.

There is a wide variety of ways in which countries, with very similar practical monetary policies, write down what they want from their central banks. So the current wording of section 8 should not be sacrosanct – the only possible way sound money could be preserved. Personally, I would have no great objection if the wording introduced to the PTA in 1996 were to be translated in an amended section 8 of the Act. I’d probably have slightly more problem with the Labour Party’s version from the manifesto last year, but ultimately it is for politicians to lay out higher level objectives for the Reserve Bank, and monetary policy.

But, and in a sense this is the point of the Bulletin article, those sorts of alternative formulations would not, on their own, be likely to make any material difference to the way monetary policy was run. Practical differences flow from different Governors and different Policy Targets Agreements. If political parties want actual practical differences in how monetary policy is run, they need to look to what they are negotiating in the PTA, and with whom. As it stands, although the Reserve Bank has made more than its fair share of policy mistakes, evidence suggests that in normal times it has responded to incoming data in much the same way as central banks in Australia, the US, or Canada do. And legislatures in each of those countries have written things down in rather different ways, to each other and to New Zealand.

There is no harm in amendments that may have little practical impact. Symbolism matters, and since few would argue that price stability should be sought for its own sake, there should be no strong objection to writing down in statute what it is hoped that good monetary policy will help contribute to. Indeed, I would argue that it is better to write it down in statute than to keep fiddling with the Policy Targets Agreement. PTAs can be signed in the dead of night, perhaps involving two people only, as part of bundles of post-election negotiations. The first the public know about the new terms is when the parties publish the signed document. By contrast, even in New Zealand, the legislative process is usually much more open and transparent. Bills typically go to select committees, which invite submissions and review the arguments from outsiders before making recommendations. And the hurdle of making changes in law is higher than for the PTA – which has become something each change of government feels obliged to change.

I would favour amending section 8. We need to face the fact that New Zealand is probably the only advanced country in which monetary policy has been repeatedly an election issue. There has not been an election since 1987 in which one or other party was not campaigning on changes to the Act or the PTA. That is no passing discontent.

Changing section 8 isn’t the biggest issue to address is reforming the Reserve Bank, but it shouldn’t be treated as of no importance either.

Since I’m not a die-hard inflation targeter either, I would favour something along these lines

Monetary policy shall be formulated and implemented towards the economic objective of maintaining medium-term stability in the purchasing power of the New Zealand dollar, so as to maximise the medium-term contribution monetary policy makes to full employment and to the economic and social welfare of the people of New Zealand.

With such a clause, clause 4b – the troublesome clause about avoiding unnecessary variability – should be able to be junked. Parliament will have made clear that the whole point of the Bank is to promote good economic outcomes, and the longer-term interests of New Zealanders. But don’t lose sight of the fact that New Zealand’s real medium-term economic failures have little or nothing to do with the conduct of monetary policy, or the way the Reserve Bank Act is written.

Of course, there still will – and should – be vigorous debates about what intermediate targets the Bank should be required to pursue. Many will favour the status quo, others might favour NGDP targets, and some might come to favour wage growth targets. Some might favour a more active role in exchange rate smoothing. But those debates too should be carried on openly. As I’ve argued before, the Minister of Finance and the Treasury (with or without the cooperation of the Bank) should already be planning an open process for consideration of issues before the next PTA will be due in 2017. As 2017 is election year, the earlier the better really.

Of course, there is probably another debate to be had, before the Act is next comprehensively reviewed, as to whether there should be a single overarching objective for monetary policy and financial regulatory policy. I think that would be a step in the wrong direction. They are two quite different functions, just as monetary policy and fiscal policy are quite different. But perhaps that is a topic for another day.

How is core inflation going to get back to 2 per cent?

July 30, 2015July 30, 2015 Michael Reddell Monetary policy

No doubt I should find something more useful to do, but out walking by the sea in the sun, one aspect of Graeme Wheeler’s speech, and story, was still puzzling me. How, except perhaps by chance, does he expect to get core inflation back up to the target midpoint again in the remaining two years of his term?

Recall that:

core inflation, at around 1.3 per cent, is a long way from the midpoint of the target range
the PTA mandates the Governor to focus on the “medium-term trend in inflation”, and on keeping “future average inflation” (not one year’s headline rate) near the 2 per cent target midpoint.
The Bank reckons real GDP is currently growing at an annual rate of around 2.5 per cent
And its best estimate of the rate of growth in potential GDP is around 2.6 per cent
Inflation expectations are quite close to the target midpoint – and lower, relative to target midpoint, than they have been at any time in the history of inflation targeting.
The Bank’s current estimate of the output gap (June MPS) is around zero.
And, although not mentioned in the speech, the unemployment rate is above any reasonable estimate of the NAIRU.

There is nothing in that mix that would tend to raise core inflation from where it is at present.

A conventional model would suggest that to lift core inflation, quite substantially, from around 1.3 per cent to around 2 per cent would take some combination of a lift in medium-term inflation expectation (what people are treating as “normal” rate of inflation when negotiating contracts, and borrowing and lending), and a period in which some fairly material pressures build up on resources (“excess demand”). Increased pressure on resources would require a period, looking ahead, in which growth runs faster than potential and, probably, where the unemployment drops below the NAIRU.

Perhaps any temporary increase in headline inflation, on account of the lower exchange rate, will boost inflation expectations a little, but any lift would be unlikely to be sustained without some new resource pressures

But where is this faster growth going to come from? I searched the speech in vain. The Governor talks of a few factors that might “support” economic growth. He lists “continued high levels of migration and labour force participation, ongoing growth in construction and continued strength in the services sector”. But note the repeated word: “continued”. We’ve had all these things over the last 12-18 months, and they generated “a little below trend growth”. Big increases in immigration boost growth rates, but steady high rates of immigration just, at best, maintain them. Construction activity had stepped up a long way over the previous couple of years, but few commentators (or indicators) suggest the rate of growth will be sustained. And all this is before the decline in the terms of trade – which easier monetary conditions may or may not adequately offset – has had its full effect, on the farm or in the wider economy.

If the rate of potential growth really is around 2.6 per cent, then it increasingly looks as though New Zealand needs two or three years of perhaps 4 per cent growth to be confident of getting core inflation to settle back around 2 per cent. If the NAIRU is 5 per cent, perhaps we need a couple of years with unemployment down around 4.5 per cent to lift core inflation back to around the target midpoint.

These are the sorts of outcomes we might have had in a more normal recovery. But – partly because monetary policy has been kept too tight – our recovery has been anaemic. At present, these sorts of outcomes seem likely only if the OCR is cut quite a bit more than the Governor currently seems to envisage.

But in a sense the ball is in his court. Perhaps he could tell us how he expects to see core inflation reverse the seven or eight years of decline, and get back to around the midpoint of the target range What will boost growth sufficiently, and cut unemployment rate sufficiently, to put sufficient additional pressure on resources to achieve a substantial lift in the “medium-term trend in inflation”?

And all this assumes that the Bank is correct that growth is still around 2.5 per cent. We only have March quarter GDP data, and it is now almost half-way through the September quarter. I have seen some commentators suggesting that the June quarter may already have been weaker than would be consistent with 2.5 per cent growth. I have no idea if they are correct, but, if so, the challenges facing the Governor in getting core inflation back to target will be even greater than those I have outlined here.

In the speech, the Governor put quite some emphasis on the troublesome clause 4(b) in the PTA, and especially the highlighted words

In pursuing its price stability objective, the Bank shall implement monetary policy in a sustainable, consistent and transparent manner, have regard to the efficiency and soundness of the financial system, and seek to avoid unnecessary instability in output, interest rates and the exchange rate.

I describe the provision as troublesome because ever since Don Brash and Michael Cullen added it to the PTA no one – Bank, Minister, Board, markets – have ever known quite how to apply it. I’d just make two observations:

The medium-term price stability objective is paramount, and the medium-term trend in inflation is currently a long way from the mandated target midpoint.
Against that backdrop, more (upside) variability in output growth looks to be necessary. Few people object to extra growth, especially when the starting point is one of no apparent pressures on resources or core inflation and lingering high unemployment..

Falling commodity prices and the unsettled world environment mean that it would be difficult for the Bank to deliver a couple of years of 4 per cent annual GDP growth even if they set out now to try. But as things are heading at present, the risks of something rather closer to 0.4 per cent growth are rising. Better to aim for 4, and perhaps deliver 2.5. If 4 per cent growth actually happened, inflation would start heading back to target and more of the people currently unemployed would be in jobs. And if only 2.5 per cent growth was achieved it might be enough to stop unemployment rising again. From where we stand right now, it is far from obvious what is lost, or even risked, by a more aggressive stance.

PS: As it is, in pondering the Bank’s record on inflation in recent years – it just isn’t there when they think it will be – the old rhyme came to mind:

Yesterday upon the stair

I met a man who wasn’t there

He wasn’t there again today

I wish, I wish he’d go away

When I came home last night at three

The man was waiting there for me

But when I looked around the hall

I couldn’t see him there at all!

Go away, go away, don’t you come back any more!

Go away, go away, and please don’t slam the door

Last night I saw upon the stair

A little man who wasn’t there

He wasn’t there again today

Oh, how I wish he’d go away

What does the Governor say to the unemployed?

July 30, 2015July 30, 2015 Michael Reddell Monetary policy, Reserve Bank

Graeme Wheeler yesterday gave a speech on current monetary policy issues and challenges. It was accompanied by an unusually long press release, and is probably best seen as a commentary, and elaboration, on the brief OCR statement released last week. I commented on that statement here.

I thought it was a very disappointing speech.

There is still no sign that the Governor recognises that he made a mistake in raising the OCR 100 basis points last year, in talking of further rate hikes as late as last December, and only beginning to cut rates in June. The fact that a mistake was made really should be blindingly obvious, even to him, by now. It should have been acknowledged and serious steps made to reverse it, and then we could move on. Instead, reluctance to acknowledge the mistake seems to have locked him into a mind-set in which he is now willing to cut the OCR as new weak data emerge, probably 25 points at a time, but is unwilling to unwind the excessively tight conditions he put in place last year. He repeatedly talks of GDP growth rates around 2.5 per cent as if these are good outcomes, but New Zealand’s population is estimated to have grown by 1.8 per cent in the last year. After an anaemic recovery, New Zealand is already experiencing weak per capita growth, before the full impact of the sharp fall in international dairy prices (let alone any threat from a weakening Asia) has been felt. And it is idle to talk repeatedly of the “need” for a lower exchange rate when he is personally deciding to hold the OCR at levels higher than the inflation target would appear to require.

Far too much weight in the speech is given to headline CPI inflation. As the Policy Targets Agreement has put it for years:

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.

The Governor has stated very explicitly in this speech that the Bank’s preferred measure of core inflation is the sectoral factor model measure. That measure it has its weaknesses, but it has the longest time series of any of the measures the Bank publishes, and it tends to be the measure I use most often too. As it happens, estimated sectoral core inflation over recent years has been being progressively revised downwards. And at 1.3 per cent now (and having been below 2 per cent for five years now) it is not just a “bit” (the Governor’s word) below the midpoint. For a very persistent slow-moving series, this is a huge deviation. “The medium-term trend of inflation” is nowhere near the 2 per cent target midpoint the Bank is required to focus on.

The Governor downplays this in two ways.

First, he explains away current low headline inflation mainly by reference to the fall in international oil prices and the rise in the exchange rate last year. Which is fine, and no serious observer is focused on headline inflation. But the Governor doesn’t mention tobacco tax increases, which have “artificially” and substantially boosted headline inflation in recent years. The Governor quotes the PTA to the effect that headline CPI inflation might deviate from the medium-term trend because of “shifts in the aggregate price level as a result of exceptional movements in the prices of commodities traded in world markets” [ie oil prices], but doesn’t mention that the next reason listed in the PTA is “changes in indirect taxes”. As I noted last week:

• Even with the rebound in petrol prices, CPI inflation ex tobacco was -0.1 over the last year – this at the peak of a building boom.
• CPI ex petrol inflation has never been lower (than the current 0.7 per cent) in the 15 years for which SNZ report the data.

We develop core inflation measures to adjust for these sorts of effects. Five and a half years with core inflation (on their own preferred measure) below the target midpoint, by slowly increasing margins, is a sign of a Bank that has got monetary policy repeatedly wrong. And that matters more under Graeme Wheeler, because he explicitly signed up to the focus on the target midpoint. Alan Bollard, by contrast, could (and did) point out that the midpoint had no special status in his PTAs.

And then the Governor tells us that he expects inflation to be back to target midpoint by the middle of next year. But here he is not talking about the “medium-term trend of inflation”, but about headline inflation. All else equal, if oil prices and the exchange rate stay around current levels, headline inflation is likely to pick up somewhat over the next 12 months. But the speech says nothing at all about the expected path of core inflation, or medium-term inflation measures more generally. A lower exchange rate provides a boost to the domestic price level, all else equal, but that just means the headline inflation rate rises for a year or so. What happens after that? As the Governor acknowledges, the Bank has overestimated medium-term or core inflation in recent years, but he offers us nothing, at all, to give us reason to believe that that situation has changed. There is no sign of any correction to what has led them astray for the last few years.

For the last 15 years or so, the Bank has generally sought to “look through” the direct price effects of exchange rate changes, precisely because they usually tell us little about the underlying state of inflation pressures. Doing anything else – putting much weight on those direct effects in setting policy – risks the Bank holding the OCR higher than the medium-term trend in inflation would warrant. Not just the PTA, but plenty of good economic theory also, encourages the Bank to focus on the stickier prices, captured in (for example, and imperfectly) non-tradables or core measures.

In fact, some of the Bank’s own quite recent research suggests that we might not see even much of an increase in headline inflation. Here is one of their researchers, Miles Parker, in a paper published last year:

The net impact of a fall in the international prices of the commodities New Zealand exports on the consumers price index (CPI) has been to lower New Zealand consumer prices, even though the exchange rate has tended to fall when export commodity prices fall. Falls in export commodity prices leave New Zealanders as a whole poorer and so domestic spending, and pressure on domestic labour and capital, tends to ease. For exchange rate depreciations caused by other factors there appears to have been little net effect on aggregate consumer prices, since a rise in tradable CPI inflation has been broadly offset by a fall in non-tradable CPI. For each of these classes of exchange rate changes, the inflation outcomes implicitly include the average response of monetary policy to such exchange rate movements over the period.

In other words, falls in the exchange rate happen for a reason, and have often been accompanied by such a significant weakening in economic conditions that they have often been associated with further falls in non-tradables and core inflation measures. That has to be a real risk now, as falling real (terms of trade) incomes and slowing growth in construction activity take hold.

What else is there to say? A few scattered observations:
• The Governor rightly observes that “in most advanced economies, policy interest rates are at historic lows”, but one could go further. In all OECD countries, except New Zealand, policy interest rates are lower (or no higher) than they were at the start of last year. New Zealand has seen no sign of the sort of medium-term inflation pressures that would have warranted – or warrant now – such a stance. The Bank thought such pressures would emerge, but they were wrong. Mistakes happen, but they need to be acknowledged and corrected for.
• I find it extraordinary that the Governor continues to articulate a view that high immigration has eased inflation pressures (outside the Auckland house market presumably). Until the last 12 months or so, the Reserve Bank has for decades consistently operated on the assumption, well-supported by data, that (whatever the possible long-term benefits) the short-term demand effects of immigration dominate the supply effects. Indeed, that result is apparent in the Bank’s own quite recent published research. Here is a picture from a 2013 Analytical Note

• It is puzzling that there is no mention of unemployment in the speech at all. It isn’t a fool-proof indicator by any means, but is probably better estimated and more easily interpreted that output gap estimates which the Bank continues to rely on (despite the inability of the Bank’s existing models to explain inflation). At 5.8 per cent, New Zealand’s unemployment rate is still disconcertingly high. It is all very well to laud rises in the participation rate, but there is no evidence that New Zealand’s NAIRU is anywhere near as high as 5.8 per cent. Many real people – with lives currently blighted by unemployment – would have been back in jobs if the Reserve Bank had not set the OCR so high over the last 18 months. What, I wonder, does the Governor have to say to these people when he meets them?

• This passage in the speech seemed particularly ill-judged:

Central bankers have found the post Global Financial Crisis (GFC) years to be a very challenging time for conducting monetary policy. High expectations have been placed upon central banks at a time when the economic, financial and political interlinkages in the global economy seem more complex, and where monetary policy has become the fall-back policy to promote a strong global recovery.

Few people will have much sympathy with highly-paid powerful officials bemoaning how difficult their job has been in recent years, as the Governor seems to. He has options.

Many of the problems central banks in other countries have faced relate to running into the near-zero lower bound on nominal interest rates. New Zealand (and Australia) have not yet got anywhere near that floor. There is no evidence of “high expectations” having been placed on the Reserve Bank of New Zealand – indeed, the dismal inflation track record, with no obvious adverse consequences for the Bank, might suggest a central banking equivalent of the “soft bigotry of low expectations”. The Governor complains that “monetary policy has become the fall-back policy to promote a strong global recovery”. Most New Zealanders would have settled for a strong domestic recovery, but we just have not had one. It has been the weakest domestic recovery for many decades, despite the record terms of trade, and the boost to demand from a Christchurch-led building boom.

In a sense, the whole point of discretionary monetary policy is to allow monetary policy to promote strong bounce-backs when demand falls away and recessions happen. With hindsight it is clear that lower policy interest rates over the last five years would have given us both a stronger recovery, and a medium-term trend in inflation nearer the inflation target. There were no policy obstacles to doing so. I’m not suggesting there are no puzzles in the global events of the last few years, but if you have trouble reading the future, just look out the window and respond to the best estimates of the medium-term trend in inflation. Core inflation has been below target midpoint since December2009, and not once – not for a single quarter – has the OCR been cut below the level that prevailed back then.

• The Governor repeats a claim that “our economy has generated better growth…than many other advanced economies”. As I have documented on several occasions, and in several ways, while our total GDP growth has been relatively high, that is only because our population growth has been much faster than most. Growth in GDP per capita, or in any of the productivity measures, has been no better than mediocre, even relative to other countries’ weak performances. Quite why we have done so badly is still a bit of a puzzle, but endless repetition of an alternative wished-for story does not make it true.

• Somewhat puzzlingly the Governor claims that “some local commentators have predicted large declines in interest rates over coming months that could only be consistent with the economy moving into recession”. Actually, it isn’t only local commentators, but set that to one side. With core inflation measures so low, and no evidence adduced that core inflation measures are about to rise materially, it would be quite easy to make the case for a 2 per cent OCR right now. There was never any need for the OCR to have been raised at the start of last year (from 2.5 per cent) and core inflation pressures and measures are weaker now than they were then. At present, with the threat from a weakening Chinese economy increasing, the risk is that having held the OCR too high for too long materially increases the chances of a couple of quarters, or more, of negative GDP growth. And the Governor needs to get some perspective on the scale of short-term interest rate falls that tend to happen in real recessions: 700 basis points over the 1991 recession, 550 basis points in the mild 1997/98 recession, and 575 basis point OCR cuts in 2008/09. Against that background, arguments as to whether the OCR gets to 2.5 per cent or 2 per cent, from a recent (ill-judged) peak of 3.5 per cent, are interesting but bear no relationship to what any serious recessionary threat might require.

There are many more points I could make. There are puzzling sentences like “having the scope to amend policy settings, however, is a key strength of the monetary policy regime”. I’m not sure when anyone last suggested a regime in which policy settings could not be amended, but perhaps I missed something. But I’ve probably taxed readers’ endurance enough already.

New Zealand deserves a lot better than this: better policymaking and better quality analysis and communication of the issues. And, of course, it is increasingly past time for reform of the governance of the Reserve Bank, to put considerably less power in the hands of one imperfect individual, the Governor (any Governor).

Meanwhile, what does the Governor say to any of those 146000 unemployed people he meets?

croaking cassandra

Economics, public policy, monetary policy, financial regulation, with a New Zealand perspective

Monetary policy