Monetary policy

Glenn Stevens on monetary policy

Michael Reddell Australia, Monetary policy

I’ve long had a great deal of time for the Reserve Bank of Australia. It is an institution made up of human beings, so they make mistakes from time to time (for a while, for example, their relentless optimism about China reminded one of a sell-side analyst) but it has been a strong institution for decades, successfully developing successive generations of governors and senior managers. Successful organisations tend to promote from within. The RBA publishes thoughtful analysis, and the speeches of senior managers are usually well-worth reading. I don’t recall any major innovations originating at the RBA, but they’ve avoided policy debacles like the MCI experiment, or rapid policy reversals.  All things considered – and setting to one side the serious issues around Note Printing Australia – I think the RBA has had a reasonable claim to having been one of better advanced country central banks in recent decades. At times, no doubt, fortune has favoured them. And perhaps too, there is a little in the old proverb about the grass always being greener on the other side.

Anyway, I was reading Glenn Stevens’ most recent (and quite short) speech, “Issues in Economic Policy”, on some of the challenges the Australian authorities, and the Reserve Bank in particular, face at present. The Governor grouped his remarks under four headings:

  • Negotiating turbulence (the international environment)
  • Accepting adjustment
  • Maintaining stability, and
  • Securing prosperity (a rather general discussion of the place of microeconomic reform)

What struck me, and prompted this post, was how scarce references to inflation were in the speech.  The Reserve Bank’s primary policy responsibility is the conduct of Australia’s monetary policy.  As the (non-binding) Statement on the Conduct of Monetary Policy between the Treasurer and the Governor put it:

Both the Reserve Bank and the Government agree on the importance of low inflation.

Low inflation assists business and households in making sound investment decisions. Moreover, low inflation underpins the creation of jobs, protects the savings of Australians and preserves the value of the currency.

In pursuing the goal of medium-term price stability, both the Reserve Bank and the Government agree on the objective of keeping consumer price inflation between 2 and 3 per cent, on average, over the cycle. This formulation allows for the natural short-run variation in inflation over the cycle while preserving a clearly identifiable performance benchmark over time.

There are only two references to inflation in the speech.  In the main one he observes:

A period of somewhat disappointing, even if hardly disastrous, economic growth outcomes, and inflation that has been well contained, has seen interest rates decline to very low levels. The question of whether they might be reduced further remains, as I have said before, on the table.

But the thrust of what followed was a bit surprising:

But in answering that question, it is not quite good enough simply to say that evidence of continuing softness should necessarily result in further cuts in rates, without considering the longer-term risks involved. Monetary policy works partly by prompting risk-taking behaviour. In some ways that is good: in some respects, there has not been enough risk-taking behaviour. But the risk-taking behaviour most responsive to monetary policy is of the financial type. To a point, that is probably a pre-requisite for the ‘real economy’ risk-taking that we most want. But beyond a certain point, it can be dangerous.

Deciding when such a point has been reached is, unavoidably, a highly judgemental process. And that is after the event, let alone beforehand. My judgement would be that policy settings that fostered a return to the sort of upward trend in household leverage we saw up to 2006 would have a high likelihood, some time down the track, of being judged to have gone too far. That is not the case at present, given the current rates of credit growth and so on. But the point is simply that in meeting the challenge of securing growth in the near term, the stability of future economic performance can’t be dismissed as a consideration.

It was as if the authors of the BIS Annual Reports had managed to infiltrate the RBA’s speechwriting team. The point of this post is not to make the case for further cash rate cuts in Australia. On the surface, some further easing looks warranted to me, but I’m not close enough to the Australian data to be confident of that view. My point is that the Governor looks here to be risking taking his eye off the inflation ball, and downplaying short-term macro stabilisation for some ill-defined concern about the longer-term. In any economy adjusting to an investment slump a reasonable case might be made that insufficient risk-taking is going on. And since there are no reliable direct benchmarks for the appropriate degree of risk-taking, a simpler benchmark might be levels of excess capacity in the economy. An unemployment rate of 6 per cent – above any estimates of NAIRU that I’ve seen – might reasonably suggest a need for rather more risk-taking across the economy, if the people who are unemployed are relatively quickly to find jobs.

The Governor goes on to note that “policy settings that fostered a return to the sort of upward trend in household leverage we saw up to 2006 would have a high likelihood, some time down the track, of being judged to have gone too far”. Central bankers worry about periods of rapid growth in credit and asset prices, but it is a curious historical episode to cite. After all, Australia came through that period of leveraging up (which had more to do with the interaction of planning restrictions and rapid population growth as with anything to do with monetary or banking policy) rather well. And if some of that was down to the good fortune of the terms of trade, it isn’t obvious that countries like New Zealand or Canada suffered seriously from the aftermath of rather similar domestic credit booms (although of course, post-2007 growth has been weak almost everywhere). There was little or no evidence that lending standards became pervasively and seriously too loose in Australia (or New Zealand or Canada) during the pre-2007 booms

Perhaps I’m over-interpreting the Governor, but his comments have a bit of a feel about them of the Swedish Riksbank’s ill-fated experiment in using monetary policy to lean against household debt accumulation, rather than keeping their eye firmly focused on the medium-term outlook for inflation. Economists and central bankers don’t know that much about appropriate levels of debt or about what macro policy can do about them. By contrast, we have a stronger sense of when the numbers of people unemployed are above normal, and a rather better (although far from foolproof) sense of what monetary policy can do about that, especially in periods when core inflation pressures (domestically and globally) are pretty quiescent (core inflation measures in Australia seem to be at or below the midpoint). And in Australia, the Reserve Bank’s Act explicitly enjoins the Bank to run monetary policy in a way that best contributes to “the maintenance of full employment in Australia”.  For practical purposes that doesn’t override a medium-term focus on keeping inflation near-target, but it does rank rather higher in the statutory list of considerations than visceral unease about the possibility, at some point down the track of excessive risk-taking.

On an unrelated point, for any readers interested TVNZ’s Q&A programme yesterday pre-recorded an interview with me, to be shown tomorrow. The questions were mostly around the Reserve Bank of New Zealand: actions, inactions, and frameworks. Unless I said something I really didn’t mean to say, I don’t think there is anything in the interview that regular readers won’t have encountered before. One question – how worried should we be about the New Zealand economy – caught me a little by surprise, and I’ve been reflecting further on that. I might jot down some thoughts on that here on Monday.

The Shadow Board on tomorrow’s OCR

Michael Reddell Monetary policy, Reserve Bank

The NZIER this morning released the results of its Shadow Board exercise. They survey nine people (currently three market economists, three business people, and three with academic affiliations) and ask them to assign probabilities for the “most appropriate level of the OCR for the economy”. In principle, I suppose “the most appropriate level for the economy” could be different from “the most appropriate level to be consistent with the requirements of the Policy Targets Agreement”, although I suspect that respondents will typically be treating the two as the same. Note that, in principle, the information in the Shadow Board responses is different from the information in financial market prices (which are close to a direct view on what the Reserve Bank will do – as distinct from what people think it should do) or from ipredict, which runs direct contracts allowing people to bet anonymously on what they think the Reserve Bank will do. When I looked just now, the prices reflected an 84 per cent chance of a 25 basis point cut tomorrow

Launching the Shadow Board was a modest but useful initiative by NZIER. It helps spark a little more debate, and a little more scrutiny, about what the Reserve Bank is doing, and puts the results in a useable (and reportable) format. It was inspired by a similar exercise in Australia (which is slightly more (too?) ambitious in that it also asks respondents for probabilities for the right rate six and twelve months ahead).

But what the Shadow Board doesn’t really do is provide any additional information on what the Reserve Bank should do. As everyone recognises, there is a great deal of uncertainty around monetary policy. Central banks talk of trying to target inflation a couple of years out, and yet have no great certainty even as to what is going on right now, let alone what will be going on 12-18 months hence.

Here is a chart showing the actual OCR following the relevant review and the median view of the Shadow Board (thanks to Kirdan Lees at NZIER for sending me the historical data).

shadow board 1

They are all but identical, at least over this relatively short period. And yet the Reserve Bank has subsequently acknowledged that, with the benefit of hindsight they would have had the OCR lower in 2011 and 2012.   And most observers would now agree that the OCR did not need to have been as high as it was over the last year.

Perhaps the information is in the distribution of probabilities rather than in the median view?  Here is the mean of the views of the Shadow Board members. It does deviate a little from the actual OCR, and perhaps during last year the Shadow Board’s views were a little more cautious than the Reserve Bank was. The Shadow Board’s mean view was a little below the actual OCR, while the Reserve Bank itself was still stressing upside risks and the probable need for further rate increases.

shadow board 2

And here are the 25th and 75th percentiles. Respondents collectively put at least a 25 per cent chance on something at or below the 25th percentile being appropriate, and at least a 25 per cent chance on something at or above the 75th percentile.

shadow board 3

It is striking just how tight these ranges are. I noted back in June that most individual respondents’ views seemed excessively tightly bunched, given the huge historical uncertainty about the appropriate OCR. This time around there is a little more dispersion. The Shadow Board exercise has now been running for 27 reviews, and this is one of only three in which respondents collectively put a less than 50 per cent weight on one particular OCR (the other two were January last year, when the Reserve Bank was just about to commence raising the OCR, July last year which proved to be the last of the OCR increases).  I doubt, if I’d been assigning my own probabilities, if I would ever have put even a 40 per cent weight on any particular OCR in any particular review.

One other way of looking at the scale of the uncertainty around the OCR is the fan charts that the Reserve Bank published in the June MPS last year.  These were somewhat controversial, and are hedged around with lots of caveats in the technical notes, but the Governor presumably regarded them as a sufficiently useful device to run prominently in the main policy analysis chapter of a Monetary Policy Statement.   On the subset of shocks and uncertainties considered in that exercise, the 90 per cent confidence interval for the 90 day rate (proxy for the OCR) two years ahead was some 400 points wide. Perhaps a little embarrassingly for the Bank, that range did not even encompass an OCR of 3 per cent or less by July 2015.

fan chart

What do I take from all this?   I’d probably make only two points:

  • There is a huge amount of uncertainty in running discretionary monetary policy.  Some would argue that it is a mug’s game and only likely to introduce additional volatility.  That isn’t my view, but the uncertainty (across a range of different dimensions) is large enough that in general everyone should be a little cautious in taking a stand on a particular OCR (of course, under the current regime, the Reserve Bank must take a view, in actually setting the OCR). Mistakes won’t be uncommon –  whether by commentators or central banks – and that should be recognised, with appropriate humility, by all involved.  Of course, Reserve Bank mistakes matter more because they are charged with the power to take decisions that affects all of us in one way or another.
  • That very uncertainty highlights just how important it is that there is robust debate around a range of perspectives.  In this post, I haven’t looked at the diversity in the individual respondents’ views (partly because the panel of respondents has kept changing, and the sample is quite short), but looking through that data there hasn’t been much diversity of view across respondents either (with the creditable exception earlier in the period of Shamubeel Eaqub).    It is very easy for consensus views to form – both within the Reserve Bank – and in the wider New Zealand debate more generally.  And yet those consensus views will often be wrong.  Sometimes those looking at New Zealand from the outside have had a better take on things, but I doubt that has been consistently true (in the last year, HSBC in Sydney has been running the “rockstar economy” story, while other offshore players were rather more sceptical of the Reserve Bank’s continuing tightening cycle).  Encouraging that diversity of perspective is particularly important within the Reserve Bank, and yet it can be hard to maintain.  That is probably true in all central banks, but is a particular risk in our system, in which the Bank’s chief executive controls resources and rewards and is also single monetary policy decision-maker.  A very good single decision-maker would probably want as much debate and challenge as possible, recognising just how uncertain the game is.  A less-good one would find it too easy to discourage debate and challenge –  while never explicitly saying so, or perhaps even meaning to – preferring material that supports the decision-maker’s own priors and predilections.

Fiscal and monetary policy interactions: some New Zealand history

Michael Reddell Fiscal policy, Monetary policy, New Zealand economic history, Reserve Bank

The role of fiscal policy has been much-debated in recent years. I think the consensus view now is that discretionary adjustments to fiscal policy make little difference to GDP in normal times, because monetary policy typically acts to offset any demand effects. By contrast, if interest rates can’t go any lower (or central banks for whatever reason are reluctant to take them lower) then discretionary fiscal policy adjustments can have quite material impacts on near-term GDP behaviour.

These debates focus on demand effects. If the government spends less, without changing tax policy, spending across the economy as a whole is likely to be dampened to some extent, all else equal. But there are also stories about confidence effects. If the overall economic and fiscal situation is sufficiently fragile, then in principle tough and credible new fiscal initiatives could lift confidence sufficiently that the confidence effects overwhelm the demand effects.  This was the vaunted “expansionary fiscal contraction”. I’m not sure I could point to any examples in advanced countries, but others read the evidence and case studies a little differently. I’m not wanting to buy into debates about Greece here – but “credible” was perhaps the operative word in the previous sentence.

Before 2008, there was a variety of historical episodes that people often turned to when looking at the effects of fiscal contractions.  The UK experience in the early 1980s and the Canadian experience in the mid-1990s got a lot of attention.  I think the best read on the Canadian episode (with more extensive treatment here) was that substantial fiscal contraction did not have adverse effects on the Canadian economy because interest rates fell sharply,the Canadian exchange rate fell in response, and the United States – Canada’s largest trading partner – was growing strongly.

And then there was New Zealand’s experience around 1990/91. After several years of significant fiscal consolidation (which had been sufficient to generate material primary surpluses), new fiscal imbalances had become apparent by late 1990. In a major package of measures in December 1990, and in the 1991 Budget, substantial cuts to government spending were made. In combination with the earlier efforts (which were probably more important), these cuts helped lay the foundation for the subsequent decade or more of surpluses.

Former director of the Business Roundtable, the late Roger Kerr, was prone to argue that it was an example of an expansionary fiscal contraction. I’ve repeatedly argued that it wasn’t. Certainly, the recession troughed at much the same time as the 1991 Budget and the subsequent recovery was pretty strong. And, as Kerr noted, the academic economists who publicly argued that the fiscal contraction could only depress the economy further and would prove largely self-defeating ended up looking a little silly.     But the recovery had much more to do with the very substantial fall in real interest rates – as inflation was finally beaten – a substantial fall in the exchange rate, and with the recoveries in other advanced economies than with any confidence effects resulting from the tough fiscal policy measures.   By mid-1991, the new National government’s political position was so fragile that no one could have any great confidence that the fiscal stringency that was announced would be sustained (and, indeed, several of the higher profile measures were subsequently reversed). The rest of the macroeconomic policy framework, including the Reserve Bank Act, were in jeopardy. Elected in October 1990 with a record majority, the National party was 15-20 points behind in the polls only a year later, and only scraped narrowly back into government in 1993.

A few years ago, there was renewed debate here around the appropriate pace of fiscal consolidation. At the time, the government had large deficits, and the exchange rate had risen uncomfortably strongly from the 2009 lows. Some argued for a faster pace of fiscal consolidation, arguing that to do so would ease pressure on interest rates and the exchange rate. It had been the thrust of Treasury advice, and some outsiders were also making the case. Among them was then private citizen Graeme Wheeler, who had had a meeting with John Key and Bill English and had reportedly cited the experience on 1991, noting that monetary policy could offset any demand effects of faster fiscal consolidation.   Reports of this conversation had been passed back to the Reserve Bank.

Not many people at the Reserve Bank knew much about that earlier period. Newly-returned to the Reserve Bank from a secondment to Treasury, I wrote an internal paper discussing the interplay between fiscal and monetary policy over 1990 and 1991, including addressing some of the “expansionary fiscal contraction” arguments. It drew extensively on previously published material, on the now-archived files I had maintained during the late 1980s and early 1990s (as manager responsible for the Bank’s Monetary Policy (analysis and advice) section, and from my private diaries.

The Reserve Bank finally released this paper yesterday, with a limited number of deletions (I have appealed these deletions to the Ombudsman, given that they relate to events of 25 years ago, and in some cases involve deleting quotes from my own private diaries). The Bank is obviously uncomfortable about the paper. Despite the fact that the paper draws extensively from contemporary records – most of which are in the Bank’s archives – and was run past (in draft) several of senior people from the Reserve Bank in the early 1990s, the Bank has included a disclaimer on each page suggesting that the paper is primarily based on my memories, which it can’t vouch for. But, to be clear, it draws primarily on contemporary records, trying to document and explain historical events, and then to interpret them to an audience used to different ways of conducting monetary policy. Different people may read the same evidence in different ways, and access to a fuller range of records could alter some perspectives. As an example, while my files had copies of many Treasury papers, and records of many meetings with Treasury officials, I did not have access to a full set of Treasury papers comparable to the collection of Bank papers I used. As background, Graeme Wheeler was the Treasury’s Director of Macroeconomics in 1991.

A copy of the paper is here (two separate links, as that is how I got it from them).

Memo to MPC – Fiscal policy, monetary policy and monetary conditions part 1

Memo to MPC – Fiscal policy, monetary policy and monetary conditions part 2

This was an extremely tense period. The Reserve Bank Act had come into effect on 1 February 1990, and although both main parties officially supported it, it was contentious in both caucuses. In the National Party caucus, Sir Robert Muldoon and Winston Peters had been the leading sceptics. The Labour Party was almost equally split, and Jim Anderton had left the party over the direction of economic policy. Going into the 1990 election, no one knew which wing would dominate the (probable) new National government, nor which tack the Labour Party would take once it was in Opposition. Economic times were tough, and patience with the Reserve Bank was wearing rather thin as the disinflationary years dragged on. It wasn’t helped by the system for implementing monetary policy that we were using (documented here) which at one point led to our efforts being described by Ruth Richardson in Parliament as comparable to those of Basil Fawlty in the comedy classic. (Treasury and the Bank were actively at odds over the implementation arrangements – they variously hankered after money base targets or, on occasion, exchange rate rules[1]).

Last night I reread some of my diaries from the period, and dipped into Ruth Richardson’s book, and Paul Goldsmith’s biography of Don Brash, and was reminded just how fraught the period was. We spent most of 1991 not knowing whether, or how long, the monetary policy framework would last, and whether the senior management would survive. Ruth Richardson records that even at the end of 1991 when the worst of the pressures were beginning to ease, the Prime Minister Jim Bolger, in a meeting of senior ministers, canvassed the possibility of changing the Reserve Bank Act to provide an impetus to growth.

The Bank had for some time publicly argued that there was no problem with the exchange rate. As a result the Bank’s position with the new government was not helped by a change of stance quite late in the piece: the new view was that a lower real exchange rate was likely to be required to rebalance the New Zealand economy. This was an important theme in the Reserve Bank’s 1990 post-election briefing, and took the incoming Minister of Finance quite by surprise. The Reserve Bank openly making the case for a lower exchange rate seemed to provide ammunition for some of her caucus and Cabinet colleagues who were less convinced of the overriding importance of macroeconomic stabilisation.

She would have been more aghast had she realised that until the very eve of the election the Reserve Bank had been planning to recommend stepping back from the 0-2 per cent inflation target itself. This had been the outcome of some mix of unease over how (excessively) mechanical the first Policy Targets Agreement had been, and a wish to allow room for the desired depreciation in the exchange rate. The suggestion had been to keep a medium to longer-term focus on a 0-2 target, or perhaps redefine it to 1-2 per cent, but to add a 0-4 per cent “accountability range”, within which inflation could fluctuate without triggering severe accountability consequences. We stepped back from that recommendation at the last minute, in large part because of the view that to have recommended that sort of change would have left Ruth Richardson out to dry, as the only defender of a 0-2 per cent target, exposing her to (in the words of my diary two days before the election) “Peters’ and Muldoon’s ridicule and Bolger’s incomprehension”.

In terms of the fiscal policy dimensions, one of the Reserve Bank’s deletions in from this extract from my diary a couple of days after the election:

We had a marathon session in Don’s office (from 8-11) going thru para by para agreeing on a text with DTB finally showing his impatience with the last minute chaos. Changed fiscal tack in favour of a tough stance now, to help cement-in any exchange rate depn and, as important as anything it seemed, to help the Richardson faction in Cabinet.

What this captures is the somewhat uncomfortable extent to which the Reserve Bank (and Treasury, as we shall see) in this period were focused on supporting, or at least not undermining, those political players supporting the sorts of frameworks and reforms that the Bank and Treasury favoured. In the Bank, senior management came to a view in 1991 that saving the framework (the Act) was, for now, more important than price stability itself (as least in the short-term). Sceptics of this stategy – I was one – caricatured it as “the Reserve Bank Act is more important than price stability”.

Even with the benefit of long hindsight, I’m not sure what to make of the approach taken at the time. On the one hand, it is somewhat distasteful – neither the Governor nor the rest of us were elected – but on the other hand, perhaps it is just what inevitably happens in any fraught and controversial period. As it happens, we probably gave quite unnecessary ammunition to the opponents of reform through this period. In small part this was because we communicated badly and ran an implementation system that – with hindsight – was pretty bizarre. But more importantly, we held monetary policy too tight for too long – not to make any points, or reinforce any positions, but simply because we misread how strong the disinflationary forces were by then. In a serious recession, that was black mark against the Bank (and I was one of the more hawkish people on the Reserve Bank side).

During 1991, the Treasury became very focused on supporting the political position of Ruth Richardson as Minister of Finance. Some of this is captured in the paper. But much of I didn’t include, since the focus of the paper had been on the fiscal/monetary interplay. On page 15 of the paper, the Bank seems to have deleted some of this extract from my 4 September diary”

David [Archer] and I had lunch with Graeme Wheeler and Howard [Fancy][2] and were treated to a litany of gloom, of how we needed to be supporting the macro policy mix and helping get the recovery going and being very concerned about the political risks. As GW said “I wouldn’t want history to look back on me as a policymaker and say that in my confidence about the framework I hadn’t taken adequate precautions” – referring to the Bank. He was going on about how we had a “near-perfect” mon pol framework for the medium-term but that at the moment we needed to be more flexible. Both were concerned to play down 0-2, with vacuous waffle about “best endeavours” but taking the view that, in effect, 2-4% inflation wouldn’t worry them. ….. Apparently Bolger is getting worried about 1981/1932 re-runs: mass demonstrations, violence in the streets etc.

Only a few months previously the Treasury had been openly sceptical that macro policy was sufficiently tight.  It wasn’t always clear how well Treasury was reading the politics either – I had a very good relationship with Ruth Richardson’s own economic adviser, Martin Hames, and on the evening of the deleted extract above I recorded a long conversation with Martin in which “he still claims there are no real threats: says things were a lot worse at times in Oppn”.

This has been become rather a long post. It is partly about providing some context for those who think about reading the whole paper. Here are a few of my bottom lines:

  • Had we been running a now-conventional system of monetary policy implementation, many of the less important of these tensions and ructions would not have arisen.  When demand and inflation ease –  whatever the source –  the OCR is generally  cut.
  • While, with the benefit of hindsight, New Zealand was probably always going to settle at a low inflation rate (all other advanced economies did) that wasn’t remotely clear at the time.  In particular, the initial passage, and the survival, of the Reserve Bank Act was a much closer-run thing than is generally recognised. Infant mortality was a real threat
  • Neither the Reserve Bank nor the Treasury covered themselves with glory through this period in their macroeconomic analysis and policy advice.

[1] Murray Sherwin presciently argued that we should adopt an OCR. I’m still embarrassed by the note I wrote in response to that suggestion.

[2] David was the Bank’s deputy chief economist, and Howard was Treasury’s macro deputy secretary.

The zero lower bound and Miles Kimball’s visit

Michael Reddell Monetary policy, zero lower bound

One of my persistent messages on this blog has been that central banks and finance ministries need to be much more pro-active in dealing with the technological and regulatory issues that make the near-zero lower bound a binding constraint on how low policy interest rates can go, and hence on how much support monetary policy can provide in periods of excess capacity (and insufficient demand).

I’ve found it surprising that the central banks and governments of other advanced economies have not done more in this area. In most of these countries, policy interest rates have been at or near what they had treated as lower bounds since 2008/09. A few have been plumbing new depths in the last year or so, but half-heartedly (the negative rates have not applied to all balances at the central bank), and no one is confident that policy interest rates could be taken much below -50bps (or perhaps -75bps) without policy starting to become much less effective. The ability to convert to physical currency without limit is the constraint. There are holding costs to doing so, but for all except day-to-day transactions, the holding costs would be less than the cost of continuing to hold deposits once interest rates get materially negative. For asset managers and pension funds, for example, that shift would look attractive.  I would certainly recommend that the Reserve Bank pension fund (of which I’m an elected trustee) transferred much of its short-term fixed income holdings into cash if the New Zealand OCR looked likely to be negative for any length of time.

I’ve been surprised by the lack of much urgency in grappling with this issue in other countries. I suspect there must have been a sentiment along the lines of “well, getting to zero was a surprise, and inconvenient, but we got through that recession, it is too late to do anything now, and before too long policy rates will be heading back up to more normal levels”.     But they haven’t, despite false starts from several central banks. And each of these countries is exposed to the risk of a new recession, with little or no macroeconomic policy ammunition left in the arsenal. Interest rates can’t be cut, and the political limits to further fiscal stimulus are severe in most advanced countries.

If the rather sluggish reaction of other advanced country central banks (and finance ministries) is a surprise, the lack of any initiative by the New Zealand and Australian authorities is harder to excuse. Neither country hit the zero bound in 2008/09, or in the more recent slowdown (Australian policy rates are now at their lows, and commentators increasingly expect that New Zealand’s soon will be).  The period since 2008/09 should have shown authorities that the zero lower bound is much more of a threat that most of us previously realised (not just, for example, a Japanese oddity). It should have suggested some serious contingency planning – as, for example, the Reserve Bank of New Zealand had done as part of whole of government preparedness for the possibility of a flu pandemic. Both countries have had years to get ready for the possibility of the zero lower bound. It is not as if the experience of the countries who have hit zero is exactly encouraging – slow and weak recoveries and lingering high unemployment.

But neither New Zealand nor Australia appears to have done anything about it. Indeed, in the most recent Reserve Bank of New Zealand Statement of Intent these issues don’t even rate a mention. I’m not suggesting it is the single most urgent or important issue the central banks face. Contingency planning never is, but that does not make doing it any less important. I’m also not suggesting that New Zealand is as badly placed as some – if we were to get to a zero OCR, our yield advantage would disappear and the exchange rate would probably be revisiting the lows last seen in 2000. And we have some more room for fiscal stimulus than some other countries. But no central bank or finance ministry should contemplate with equanimity the exhaustion of monetary policy ammunition.  Nasty shocks are often worse than we allow for.

My prompt for this post is the visit to New Zealand this week of Miles Kimball, Professor of Economics at the University of Michigan (and an interesting blogger across a range of topics). Kimball has probably been the most active figure in exploring and promoting practical ways to deal with the regulatory constraints and administrative practices that make the ZLB a problem. They are all government choices. I’ve linked to some of his work previously. I noticed Kimball’s visit through a flyer for a guest lecture he is giving at Treasury on Friday, on a quite unrelated topic. I presume he will also be spending time at the Reserve Bank, addressing some of the monetary issues. This would seem like a good opportunity for some serious and enterprising journalist to get in touch with Kimball – whether directly, or via the Reserve Bank or Treasury – for an interview on some of his work in this area, and the reaction he is getting as he promotes his ideas, and practical solutions, around the world.

I’ve suggested previously that if our authorities are not willing to start on serious preparations to overcome the ZLB then the Minister should think much more seriously about raising the inflation target. I’d prefer to avoid a higher inflation target – indeed, in the long-run a target centred nearer zero would be good – but current inflation targets (here and abroad) were set before people really appreciated just how much of a constraint the zero lower bound could be. Better to act now so that in any future severe recession there is no question as to ability of the Reserve Bank to cut the OCR just as much as macroeconomic conditions warrant.

Here are some other previous posts where I have touched on ZLB issues:

On the physical currency monopoly, and thus block to innovation, held by central banks.

On a sceptical speech on these issues by a senior Federal Reserve official

A severe commentary

Michael Reddell Monetary policy, Reserve Bank

Plenty of commentaries have remarked on the very low inflation numbers out this morning.

None (that I have seen) has highlighted what a severe commentary these numbers are on the Reserve Bank’s conduct of monetary policy over the last few years.

Reciting the history in numbers gets a little repetitive, but:
• December 2009 was the last time the sectoral factor model measure of core inflation was at or above the target midpoint (2 per cent)
• Annual non-tradables inflation has been lower than at present only briefly, in 2001, when the inflation target itself was 0.5 percentage points lower than it is now.
• Non-tradables inflation is only as high as it is because of the large contribution being made by tobacco tax increases (which aren’t “inflation” in any meaningful sense).
• 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.
• Both trimmed mean and weighted median measures of inflation have reached new lows, and appear to be as low as they’ve ever been.

This wasn’t the way the Bank told us it was going to be. And more importantly, it wasn’t the basis on which they held interest rates up through 2012 and 2013, and then raised them last year. As late as December last year, they were still talking of raising the OCR further. Real interest rates never needed to rise, and as a result of the misjudgement they rose even further than the Bank intended (inflation expectations fell away).

It has been a sequence of cumulatively severe misjudgements. The word “mistake” keeps springing to mind, although of course the Governor rejected that characterisation at the time of last month’s MPS. Perhaps he is rethinking now? As I’ve pointed out previously, inflation outcomes so far weren’t mostly the result of unforeseeable external economic shocks. And if core inflation measures are this weak now, we have to start worrying what will happen to them as economic growth slows further, construction pressures ease, and the deepening loss of income from the declining terms of trade bites. Wage inflation has been very low, and more recently wage inflation expectations have been falling.

The Reserve Bank has belatedly recognised the need to modestly change direction. The Governor cut the OCR by 25 basis points last month, and foreshadowed that at least one more cut was likely. But the problem is that they are still well behind the game. The data are weakening faster than they are cutting, and the OCR was already too high right through last year. Difficult as it might be to make a large move at an intra-quarter review next week, the substantive case for a 50 point move is certainly strong. If not next week, then at the latest it should happen at the September MPS. There also needs to be a recognition that there is nothing wrong or inappropriate even if the OCR goes to new lows. The OCR simply needs to be set consistent with a realistic appraisal of the inflation outlook (not the upwardly biased one that has guided too many central banks in recent years). An apology, and a heartfelt mea culpa, from the (single decision-maker) Governor would also be appropriate.

As inflation expectations measures are likely to keep falling, this mistake is also increasing the risk that the zero lower bound will end up being binding in New Zealand. But, if we take the Reserve Bank’s Statement of Intent seriously, this is not something they worry about. They should.

But questions also need to be asked about the role of the Bank’s Board as agent for the public and the Minister of Finance. Inflation outcomes now are reflecting policy choices made last year. But here is all the Reserve Bank Board has to say about monetary policy in their latest Annual Report, published only nine months or so ago. In introducing the document, they note that:

Our formal review of the Bank’s performance is included in the Bank’s Annual Report.

And when they get to monetary policy

In the last year, we have considered the Bank’s decisions to hold the OCR at a record low of 2.5 percent for an unprecedented three-year period, and to increase the OCR four times from March to July 2014.

The level of disclosure in monetary policy was very high. We considered that the Bank’s policy decisions were appropriate, initially taking into account the need to provide support for the economic recovery after the disruptions of recession and earthquakes, and lately the need to ensure that the recovery is sustainable, by restraining emerging inflationary pressure.

This was a “formal review”? I still find it astounding that, less than a year ago, the Bank’s Board – the independent agency responsible for scrutinising the Bank – made no mention at all of the continued undershooting of the inflation target. I’m not suggesting they should have read the data better than the Governor – they are paid as ex-post monitors, not as monetary policy decision makers – but there is little sign of any serious scrutiny at all. It reinforces my view that the governance model is inappropriate in a wide variety of dimensions, and that the Board in particular plays little useful or effective role as agent for either the Minister or the public. By construction, it is simply too close to the Bank, and thus is more prone to act as defensive cover for the Governor, than as a source of serious scrutiny and challenge in the public interest. At very least, we should expect something much more substantive from the Board in its next Annual Report.

The Minister of Finance has commented a couple of times recently about the Bank undershooting the inflation target midpoint (which was added explicitly to the PTA by him in 2012). Such “shots across the bow” seem both understandable, and quite appropriate. The Minister initiates the inflation target, but has no say in individual OCR decisions. But he is responsible to the public (and Parliament) for having the target met by the Governor. Whether with hindsight or foresight, monetary policy has been too tight for probably five years. Partly as a result, New Zealand’s economic recovery has been anaemic – much more muted than in a usual recovery, despite the huge boost to demand provided by the Canterbury repair and rebuild process. The unemployed pay a particularly severe price for that, but they aren’t the only ones.

The real question is whether the Minister is willing to do more than talk. My impression is that his instincts are often in the right direction, but there is often a reluctance to follow through (one could think of housing supply issues as a prime example).

I’ve touched previously on some of the options the Minister has to show that he takes these issues seriously. In May I noted:

The Minister could seek a report from The Treasury on their view of how well the Governor was doing consistent with the Policy Targets Agreement, could let it be known such work was underway, and could arrange for such a report to be published. The New Zealand Treasury offers independent professional advice to the Minister of Finance and would have to take seriously such an exercise. It might be expected to consult externally (but confidentially) to canvass opinion. At present, for example, most financial market economists – not the only relevant observers but not unimportant either – in New Zealand seem quite comfortable with the Governor’s handling of monetary policy.
The Minister could also seek formal advice from the Bank’s Board, and let it be known that he was doing so. This would be a totally orthodox approach – the Board exists as a monitoring agent for the Minister – and it was, for example, the approach taken in the mid-1990s when inflation first went outside the target range. The Board has a number of able people on it, but as an effective agent for accountability risks being too close to management. The Governor sits on the Board, the Board meets on Bank premises, it has no independent resources, and it has been chaired exclusively by former senior managers of the Reserve Bank. It was striking that last year’s Board Annual Report (which is just embedded in the Bank’s Annual Report document) had nothing substantive on the deviation of inflation from the policy target.

Those are both still serious options. I suspect that it might be timely to exercise both of them.

Longer-term, it is now only just over two years until the Governor’s term expires. There must be real questions as to whether Graeme Wheeler could credibly be reappointed (recommended by the Board or accepted by the Minister) after his succession of overconfident monetary policy misjudgements, and in light of the poor quality analysis he has used to support his over-reaching policy initiatives in the regulatory areas. Perhaps Graeme will make it easy and conclude that, at his age, one term is enough?

The mistakes of the last few years don’t result primarily from the governance model, but the governance model – with too few checks on the Governor, as decision-maker and chief executive responsible for all the supporting analysis – is likely to have contributed. The mistakes –  an exaggerated version of those made in various other countries – highlight the material weaknesses in our most unusual system. The start of a new gubernatorial term is a good opportunity for the Minister to take the lead in reforming the Reserve Bank Act to bring governance of this powerful agency more into line with international practice and with governance standards in the rest of the New Zealand public sector. Treasury recommended doing something in 2012, and the Minister refused. He should take the lead this time. If he did, I suspect he would find pretty widespread support – from other political parties and from market economists. Perhaps even from the Reserve Bank itself.

PS.  Following on from earlier commentary, SNZ has altered how it is doing seasonal adjustment of the non-tradables inflation series.  The cost of doing so, is quite a short series, but for what it is worth, seasonally adjusted quarterly non-tradables inflation last quarter (0.3 per cent) was about half what it had been each quarter for the last 2-3 years.

It isn’t time to shift the fiscal stance

Michael Reddell Fiscal policy, Monetary policy

The media have been reporting a suggestion from the ANZ Economics team that New Zealand’s fiscal policy might be made more stimulatory in response to the actual and expected slowdown in growth that is underway.  When I heard this story reported this morning, I wondered if ANZ had been misreported, but on checking their weekly Market Focus document, it appeared not.

In a piece headed “Time to shift the fiscal stance” here is what they argue

Monetary policy is generally expected to do theheavy lifting when growth slows. However, fiscal policy and local authorities have stabilising roles to play too. Both the government and local authorities have large balance sheets, which allow them to absorb swings in the business cycle more easily than SME’s. It goes against human nature for fiscal policy to be run in a counter-cyclical sense (i.e. crank things up in bad times and wind things back in the good times), but it is sound economics. Of course there are relatively long lags involved, which can make the pursuit of such an approach difficult. But that shouldn’t stifle the concept altogether. 

Fiscal policy could move to a more neutral stance – or even an expansionary one – next year if thinking-caps were put on now. The sacrificial lamb would be nascent operating surpluses. But with net debt sitting around 27% of GDP, delaying or deferring the achievement of surpluses for a year or two is trivial – and as discussed below, the accounts are still running ahead of expectation anyway. Local authorities in rural (dairy) aligned regions could also be pulling forward investment projects. And there is room for rates relief, or at least limiting the magnitude of increase. There shouldn’t be a fear from officials to use the balance sheets at their disposal. The Government sector has a role to play just as monetary policy does, particularly when growth is below trend.

Frankly, I’m still puzzled by the case they are making.  Here’s why:

  • If the OCR were at zero, or very close to it, I would probably endorse their call.  Discretionary fiscal policy can play a useful stabilisation role when monetary policy is reaching its limits.  But the OCR is at 3.25 per cent.  ANZ expect it to be cut to 2.5 per cent, and I think there is a pretty good chance of even deeper cuts.  But even if the OCR gets to 2 per cent (probably not until early next year) there is still a material buffer above zero.  When buffers like that exist, looser fiscal policy tends to be approximately fully offset by tighter monetary policy (in the jargon, the multiplier is basically zero).  That is what happened in the years leading up to 2008, and would no doubt happen here again, given that, on the evidence of its comments and actions, the Reserve Bank would probably prefer to avoid plumbing new lows on the OCR if at all possible.
  • We have the highest real interest rates in the advanced world.  Of course, they are low by historical standards, but higher than other advanced country governments are paying.  Why would I want the government to take on even more debt, at my (future) expense at such relatively high interest rates?
  • Sometimes overseas enthusiasts for more fiscal stimulus argue for more infrastructure spending, citing the allegedly poor state of infrastructure in, say, the United States or Germany.  But the New Zealand government has been spending very heavily on infrastructure for the last decade. Indeed, at the last election I went to a session with David Parker, then Opposition spokesman on Finance, who declared his view that quite enough had now been spent on public infrastructure.  He may have had a variety of reasons for saying so, but when the finance spokesman for a left-wing party makes the case for not increasing public infrastructure spending we should probably listen.
  • How comfortable are we about the likely quality of any new government spending?  Do I need to go much beyond mentioning the economics of Transmission Gully, Kiwirail, and cycle-ways programmes?  Many of the projects governments actually spend money on simply fail to cover their costs.
  • I was left open-mouthed in astonishment at the suggestion that local government could play a part in securing a fiscal stimulus.  I’m sure many councillors would be delighted, but what sort of return do voters and the country get?  The talk of is “pulling forward investment projects”, but the investment project wishlist in often pretty questionable.   Another Dunedin Stadium for some other city?  Or a Wellington Airport runway extension?   Or even more spent on cycle-ways (I live in Island Bay where the Wellington City Council is just pouring money down the drain in a particular pointless (and controversial) “cycleway to nowhere”).
  • It is always easier to increase spending than to cut it later.  We are still living with the aftermath of the 2005 to 2008 fiscal easing.  Why put ourselves through that again if we don’t (yet?) need to?   (And did I mention Australia under Kevin Rudd?)

I can envisage a scenario in which fiscal stimulus could be useful (although if our OCR gets to zero the exchange rate will be much much lower than it is now, with a TWI still above 70) but let’s keep the powder dry for that time.  General government debt in New Zealand is not extraordinarily low (as a per cent of GDP), and even if it turns out that a modest operating surplus was recorded in 2014/15 –  made possible by record terms of trade – the prospects for the coming year are probably worse than they were when the Budget forecasts were done.  There are distinct political limits to how much fiscal stimulus any government can do, even in a crisis, so why fritter away the capacity now?  By all means, have Treasury working up some options, but don’t lose sight of monetary policy as the primary cyclical stabilisation tool.  It works.  And it probably needs to be used more aggressively now,  after being  headed in the wrong direction last year.

ANZ don’t mention it as a reason, but perhaps they are uneasy that further cuts in the OCR will fuel the house market. Perhaps, but if the outlook really is as  gloomy as they suggest it might become, then  income growth will be taking a hit as well (wage expectations are already falling), and New Zealand will be increasingly less attractive to migrants.  Real interest rates are hundreds of basis points lower than they were in 2008, and in most of the country real house prices are still lower than they were then.  The OCR is generally cut for a reason – that demand is weakening at any given interest rate.

Towards a new Policy Targets Agreement

Michael Reddell Monetary policy, Reserve Bank

The Reserve Bank continues to obstruct, at least as far as they legally can, Official Information Act requests. Some time ago, I recounted my experience with a request I lodged for older papers I had written while at the Bank. To cut the story short, I eventually did get the handful of papers I had written in the second half of 2010, with the exception of one which they had missed going through their document management system. So I put in a specific request for that paper. It was a paper, for the Bank’s internal Monetary Policy Committee, which I had written on fiscal and monetary policy interactions in 1990/91. To be clear, this is a five year old paper, about events that are now almost 25 years old. As it happened, the paper had been prompted by a meeting Graeme Wheeler, then still a private citizen working at the World Bank, had had with the Prime Minister and the Minister of Finance, but my paper was about the historical events and interactions. It drew from public documents, my contemporary Bank files, and my personal diaries. Doing the paper was an interesting reminder of the tensions in that period, and of just how difficult the political environment was, both for reforming ministers and for the Bank. Treasury officials on occasion exerted pressure on the Bank to ease policy specifically to assist the political position of the Minister of Finance.

It was no real surprise that this week the Bank once again extended the time for dealing with my request, citing the need for consultations to occur that could not – it asserted – take place within the statutory 20 working days. About a single document that is five years old, about events quarter of a century ago.

But a couple of weeks ago I did get a response to my request for background papers to the 2012 PTA. Having been threatened with a large bill in response to my first request, I took the Bank’s suggestion as to how to narrow the request, and they did subsequently release that handful of papers. As it happened, the papers covered by the revised request proved not to be very interesting. The one paper of interest was a six page letter to the Minister of Finance on 2 May 2012 outlining the outgoing Governor’s thinking on PTA issues. This was well before Graeme Wheeler’s appointment was announced (or probably confirmed). For the record, a copy of that advice is here:
2012 PTA Papers Bollard advice

The revised OIA request captured nothing of any interactions between the Bank and the Treasury, or between Graeme Wheeler and either Bank staff (including Alan Bollard) or the Minister. Given my experience with the Bank’s document management system, it does not greatly surprise me that this material did not get into the folder for issues relating to the new PTA. I might, in time, lodge some further requests. But the original background to this request had been a point about the relative lack of transparency around many aspects of the Reserve Bank and monetary policy. A genuinely transparent Reserve Bank, or a Minister committed to open government, would have pro-actively released the papers around the new PTA at the time it was released. Had that slipped their mind, a request like mine might have prompted a fuller release now. As it is, we still know little about the considerations that were taken into account in settling on the new PTA – even though it is the major instrument governing macroeconomic stabilisation policy, for five years at a time. Was there any discussion, for example, of the possible relevance of the zero lower bound for New Zealand? What pros and cons of adding the explicit reference to the target midpoint were considered? What debates happened around so-called macro-prudential policy,  And so on.

In some respects, this material is now of mostly historical interest. The PTA is what it is. The Governor is responsible for implementing policy consistent with the PTA, and the Minister is responsible, on behalf of citizens, for holding the Governor to account for doing so. But the background papers would help provide insights on what the parties thought they were signing up to, and why. And they would also shed some light on just how satisfactory (or otherwise) the current process is – in which a nominee as Governor must agree a PTA before he or she is even appointed, or necessarily has any exposure to (for example) staff advice.

But the lack of openness around the historical documents also reminds us that, without process changes, that is how the next PTA is likely to be handled. The clock is ticking on the Governor’s term, and it is only two years now until a new Policy Targets Agreement will need to be agreed – before a Governor is appointed or reappointed. Issues and risks around the zero lower bound have not gone away. If anything they have come into sharper focus since 2012, as countries have been cutting interest rates again. In New Zealand, the prospect of the OCR falling below the previous low of 2.5 per cent, even on the macro data as they stand today, reminds us that zero interest rates are far from impossible here either, if events turn nasty at some point.

Discussions around these issues should not just be occurring behind closed doors. It would be preferable if the Minister – the initiating agent in things around the PTA – and the Treasury would commit to a more open process of consultation and debate. For example, by the middle of next year perhaps some issues papers could be released for discussion, and a consultative workshop held to discuss and debate the issues and risks, as they affect New Zealand. Perhaps there would not be support for a higher inflation target, even if nothing is done about the ZLB, but at least we should understand the costs, benefits and risks of eschewing that option. Given that 2017 is election year, it would be good to have those discussions relatively early

When the key parameters of a major arm of macroeconomic policy are set only every five years, and implementation power (and associated wide discretion) is then handed over to a single unelected official, it becomes particularly important that there are opportunities for adequate scrutiny and debate at that five year review point. I noted recently that when the Bank’s five year funding agreement is put through Parliament there is no more transparency around expenditure plans than there is for the SIS. The situation is not really much better for the PTA, which probably matters rather more. Yes, outside parties can debate and analyse the issues themselves, but none of them have the analytical and research resources that the Treasury and the Reserve Bank have.

BOE chief economist on policy reversals

Michael Reddell Monetary policy, OCR

The Bank of England’s chief economist Andy Haldane had a stimulating speech out overnight.  I find almost everything Haldane writes is worth reading –  he stimulates thought, and sends me off chasing down references, even if I often end up not quite convinced by a particular argument he makes.

This speech, titled simply “Stuck”, explores some of the reasons why interest rates, around the advanced world, have been so low for so long.   Much of his story uses insights from psychology literature to try to explain behavioural responses across the advanced world in the years since the 2008/09 crisis.  I don’t find the application of the psychology literature entirely compelling, partly because Haldane does not attempt to differentiate between countries that did, and did not, directly experience a financial crisis.  For example, I would have expected different behavioural responses in places such as Ireland or the United States, on the one hand, and countries like New Zealand and Australia on the other.  For New Zealanders, I’d assert, the experience of 1987 to 1991 was much more frightening, and prone to have induced behavioural change, than anything we directly experienced in 2008/09.  And yet within 2.5 years of the trough of the 1991 recession, interest rates needed to rise here.  By contrast, in mid 2015, we are six years on from the trough of the recession, with no sign that the OCR needs to be higher than it was in 2009.

As it happens, New Zealand gets a mention in Haldane’s speech, in somewhat unflattering company. I did a post a few weeks ago on Policy interest rate reversals since 2009 looking at the 10 OECD countries/areas that had raised their raised their policy rates and then lowered them again.  Writing about the New Zealand policy reversal I commented:

it is difficult not to put this episode –  the increases last year, now needing to be reversed – in the category of a mistake.  It is harder to evaluate other countries’ policies, but I would group it with the Swedish and ECB mistakes.    Monetary policy mistakes do happen, and they can happen on either side (too tight or too loose).  But since 2009 it has been those central banks too eager to anticipate future inflation pressures that have made the mistakes and had to reverse themselves.  …..it should be a little troubling that our central bank appears to be the only one to have made the same mistake twice.  It brings to mind the line from The Importance of Being Earnest:

“To lose one parent may be regarded as a misfortune; to lose both looks like carelessness.”

Haldane includes in his speech a table with an “illustrative list of countries which have pursued the latter strategy – tightening during the post-crisis recovery and then course-correcting”.  New Zealand’s 2014/15 experience makes the list, as do the Swedish and ECB reversals noted in my quote above.  Somewhat provocatively, Haldane includes in the same list the US experience in 1937/38, where some combination of  fiscal and monetary policy tightenings (the role of active monetary policy is much debated) badly derailed the US recovery from the Great Depression, generating another severe recession.
haldane2
Haldane uses this illustrative material (and not all of the cases seem overly well chosen) to argue a case for an alternative monetary policy strategy:

The argument here is that it is better to err on the side of over-stimulating, then course-correcting if need be, than risk derailing recovery by tightening and being unable then to course-correct.  I have considerable sympathy with this risk management approach.

He goes on to say

Chart 19 shows the average path of output either side of the tightening. Most of these countries experienced several years of robust growth prior to the tightening, suggesting the economy was primed for lift-off. Yet when lift-off came, annual output growth weakened by around 2 percentage points in the following year, in the US by much more. Lift-off was quickly aborted as the economy came back to earth with a bump. In trying to spring the interest rate trap, countries found themselves being caught by it.

Why did this happen? One plausible explanation is the asymmetric behavioural response of the economy during periods of insecurity. Dread risk means that good news – such as oil windfalls – is banked. But it also means that bad news – 9/11, the Great Depression – induces a hunkering down. It risks shattering that half-empty glass. A rate tightening, however modest, however pre-meditated, is an example of bad news. Its psychological impact on still-cautious consumers and businesses may be greater, perhaps much greater, than responses in the past. Or that, at least, is what historical experience, including monetary policy experience, suggests is possible.

Another way of illustrating this point is to imagine you were concerned with the low path of the yield curve and the limited monetary policy space this implied. And let’s say you were able to lift the yield curve to a level which, for the sake of illustration, equalised the probabilities of recession striking and interest rates being at a level at which they could be cut sufficiently to cushion a recession.

With monetary policy space to play with, this might seem like a preferred interest rate trajectory. But it comes at a cost, potentially a heavy one. The act of raising the yield curve would itself increase the probability of recession. If we calibrate that using multipliers from the Bank’s model, cumulative  recession probabilities would rise from around 45% to around 65% at a 3-year horizon. These ready-reckoners are, if anything, likely to understate the behavioural impact of a tightening in a nerve-frazzled environment.

This suggests that a policy of early lift-off could be self-defeating. It would risk generating the very recession today it was seeking to insure against tomorrow. In that sense, the low current levels of interest rates are a self-sustaining equilibrium: moving them higher today would run the risk of a reversal tomorrow. These self-reinforcing tendencies explain why the glue sticking interest rates to their floor has been so powerful.

Haldane concludes that, in his view, current very low UK policy interest rates are still needed, to secure “the on-going recovery and the insure against potential downside risks to demand and inflation”.  Even at such a low policy rate, Haldane observes that he has no bias –  the next move the policy rate could be up or down, and might well be a long time away.

It is certainly refreshing to have a speech of this depth and quality from a senior policymaker, just one among many of those on the Bank of England’s Monetary Policy Committee.

But how convincing is his argument?  I’m not entirely convinced about the mechanism he proposes, but in practical terms, experience is on his side.  Almost all the advanced countries that have raised rates since 2009 have had to lower them again, in New Zealand’s case twice.  Personally, I’m inclined to think that psychology might offer more insights into the behaviour of central banks  and markets –  which, as Haldane notes, repeatedly expected early lift-offs and were repeatedly proved wrong.  In addition, as a nice piece on the Bank of England’s new blog recently illustrated, the “probability of deflation is raised further, and the likely duration of any deflation increased, if one thinks that there are limits on how far the Monetary Policy Committee (MPC) could loosen policy in the face of new shocks.” (ie as policy rates get near zero).

In the current climate, the safest approach for monetary policymakers is to hold off on the rate increases until there is hard evidence that actual measures of core inflation have risen to some considerable extent.  And if you have a central bank that made the mistake of moving too soon, hope that they recognise it quickly, own up quickly, and quickly act to reverse the mistake.  With data like the ANZBO survey results out this afternoon, those wishes seem increasingly apposite in the New Zealand case.

Policy interest rate reversals since 2009

Michael Reddell Monetary policy

I had a look at ten OECD countries/areas whose central banks have since mid-2009 raised their policy interest rates and subsequently lowered them again.  I was curious as to how quickly those reversals came, and what else was going on.

The overnight interest rates for these countries are shown below.  Overnight rates aren’t the same as policy rates, but the OECD has these data readily available.

call1

call2

A couple of cases we can fairly quickly set to one side.  The Bank of Canada began raising its policy rate in mid 2010, and only in late 2014 did it make a single subsequent cut.  Iceland raised rates in 2011, and did not cut again until mid 2014.  Given the turbulent circumstances of Iceland, the stability in policy rates is quite surprising.

Australia and Chile both benefited hugely for a time from the late phase in the hard commodities price boom that peaked in 2011.  In both cases the increases after the 08/09 crisis seemed pretty well-warranted, and in Chile’s case the peak rate was held for two years before some cuts were put in place.  In neither country’s case has inflation been uncomfortably low relative to the target.

I don’t know much about Israel, but the very shortlived nature of the post 2009 peak interest rate, combined with the fact that the policy rate has subsequently been cut to new lows, and that CPI ex food and energy inflation has been running well under 1 per cent for some time suggests a policy mistake.

The Swedish policy mistake has been well-documented by Lars Svensson (and only rather grudgingly accepted by the Stefan Ingves, the Governor of the Riksbank).  Both Sweden and Norway will have been affected by the unforeseen severity of the euro crisis, but in Sweden’s case in particular there was a clear misjudgement by the policy committee.

The ECB’s policy tightening in 2011 proved to be extremely shortlived.  I’m not aware of anyone who would call it anything other than a mistake.  There is probably a variety of factors that influenced the ECB at the time, but they acted too soon, under no (inflation target) pressure, and quickly had to reverse themselves.

Finally, we have the Reserve Bank of New Zealand, the only one of our ten central banks to have reversed itself twice in five years.  The 2010 increases took place at a time when a variety of other central banks were raising policy rates.  There was some reason to think that the recession was behind us, and that it would be prudent to begin raising rates.  I wasn’t involved in the Reserve Bank’s 2010 decisions –  I was on secondment at Treasury –  but from memory I thought they were sensible moves.  As it turned out, by the time the rate increases were being put through the economy was already turning down again, and had a  shallow “double-dip recession”  The February 2011 earthquake was the catalyst for cutting the OCR again.  Initially, it was sold as a pre-emptive step, but we fairly soon realised that the level of interest rates  actually needed to be lower even once the initial shock had passed.

And then the Reserve Bank did it again.  I’m not going to rehearse the ground I covered this morning, but it is difficult not to put this episode –  the increases last year, now needing to be reversed – in the category of a mistake.  It is harder to evaluate other countries’ policies, but I would group it with the Swedish and ECB mistakes.    Monetary policy mistakes do happen, and they can happen on either side (too tight or too loose).  But since 2009 it has been those central banks too eager to anticipate future inflation pressures that have made the mistakes and had to reverse themselves.  As a straw in wind, in a country with an unusual governance model, it should be a little troubling that our central bank appears to be the only one to have made the same mistake twice.  It brings to mind the line from “The Importance of Being Earnest”:

To lose one parent may be regarded as a misfortune; to lose both looks like carelessness.”

Was a mistake made?

Michael Reddell Monetary policy, OCR, Reserve Bank

Both the Dominion-Post and the Herald this morning devoted their editorials to monetary policy and yesterday’s announcement by Graeme Wheeler.  The Herald, somewhat oddly, commends the Governor on “seeking to get ahead of the curve”.  In principle, I suppose that is always what he is trying to do –  it is, after all, forecast-based inflation targeting.  But I’m not sure that too many people would regard one OCR cut, just beginning to reverse last year’s increases, as “getting ahead of the curve” when core inflation has been so persistently low, and the unemployment rate has remained troublingly high.  A belatedly awakening might be a better description.

But I was more interested in the Dominion-Post’s thoughtful piece.  Here is the heart of it:

This is more than just an abstract number. It is a signal that more was possible. It suggests that, even though growth has been robust for the past couple of years, it might have been higher, with few costs, had the bank kept rates lower. That, in turn, might have meant more jobs and lower unemployment – which, at 5.8 per cent currently, is still too high.

Was it possible to sense any of this earlier? Monetary policy is a difficult business, and reasonable people can disagree. Certainly the plunge in global oil prices, a key factor behind low inflation, was a surprise to most observers. The slump in dairy prices, too, which will likely weigh heavily on the economy, has been steeper and more prolonged than anticipated.

But other factors were perhaps not so shocking – the slow progress of the global economy, the large influx of migrants to New Zealand (in train before last year), the persistence of low wage growth and local unemployment.

Much hinges on the opaque question of the economy’s “capacity” – essentially how hot it is running. It is always difficult to tell at any given moment; the truth gets clearer in the rear-view mirror.

The bank moved swiftly last year when dairy prices soared, the housing market surged, and the economy began hitting its straps. In hindsight, it moved too fast; it turns out there was more capacity – more labour and resources – to go round than it thought.

At the least, bank governor Graeme Wheeler and his team will need to consider if they were too quick to jump then, and too slow to reverse course.

Still, they have done it now, and rightly so.

I happen to agree with the editorial, but that isn’t really my point.  I’m hardly alone in lamenting the quality of a lot of public debate and media coverage of policy issues, but I was impressed that a newspaper editorial in this country could, in a calm way, highlight the uncertainties that monetary policy makers face, and the scope for reasonable people to disagree on the outlook for the economy.    And that the paper could suggest, in a very moderate tone, that it might be time for some critical self-examination by the Governor and his team .  It was the sort of balanced perspective that, say, those charged with holding the Reserve Bank to account, such as the Bank’s Board, might have read with profit, or which their advisers might have written.  (Of course, it is an open question whether it is the sort of piece that sells more newspapers.)

I noticed media accounts of the Governor’s appearance at FEC yesterday report him again denying that he made a mistake last year, whether in raising the OCR so much or holding it up for so long.  I’m not quite sure what he hopes to gain by this stance.  The Governor used to tell staff that his aim was for the Reserve Bank to be the “best small central bank in the world”.  One of the marks of a successful, learning, organisation is the ability to acknowledge mistakes, learn from them, and move on.  I suspect that there is a more chastened attitude internally than is evident publically, but this is a powerful public organisation, and we should reasonably expect to see more evidence of an ability to acknowledge mistakes.  A misjudgement  about monetary policy is not the worst thing in the world  –  it is in the nature of the game.   If anything, a refusal to acknowledge the misjudgement is more worrying, and detrimental to our ability to have confidence in the Governor, or in the single decision-maker governance framework.  It might, for example, be easier for a committee to acknowledge a mistake than for an individual to do so.

But was it a mistake?  The Governor appears to put a great deal of weight on the high dairy prices at the start of last year.  Even then, the Bank’s forecasts did not have export prices staying up indefinitely.  But the Bank’s optimistic forecasts for dairy prices back then required something quite out of the ordinary.  In the last decade, since EU policies began to change and dairy stockpiles were exhausted, global dairy prices have been much more volatile than previously (and production is much more responsive to changes in output prices and input costs).  At the start of 2015 a reasonable person might not have forecast dairy prices falling quite as low as they have or for long, but they would not have assumed the persistence of anything like the WMP prices seen in 2014.

wmp

This is what the Governor had to say in the March 2014 Monetary Policy Statement as he initiated the tightening cycle

Overall, trading partner growth has seen demand for New Zealand’s goods exports remain robust. Increasing rates of urbanisation and protein consumption in China are supporting demand for many of New Zealand’s commodity exports

Consequently, global prices of New Zealand’s commodities are extremely high, particularly for dairy. Dairy prices increased substantially in the first half of 2013 and remain at those high levels.

Rising demand in New Zealand’s trading partners, and particularly China, will result in continued growth in demand for New Zealand’s exports over the projection. Export prices are expected to remain high relative to history, though ease by about 3 percent over the next year due to an assumed moderation in global dairy prices.

The Bank –  and the Governor –  seemed beguiled by China.  A rather more reasonable approach would have been to have assumed that large fall in dairy prices were likely, even if the Bank could not be quite sure when they would occur.  Forecasters have to have a specific track.  Policymakers need to exercise judgement.

And context matters greatly.  When the first OCR increase was put in place, the unemployment rate was still above 6 per cent, less than one percentage point off the peak during the 2008/09 recession.  The recovery had not (and still has not) ever achieved the sorts of real GDP growth rates seen in earlier recoveries. And, of course, headline and core inflation were both (still) below the midpoint of the target range.  Private sector credit growth was running at around 5 per cent per annum, less than the (then) rate of growth in nominal GDP.

There just was no urgency[1].  There was slack in the economy,  continuing low inflation, modest credit growth.  Reasonable people might have been able to differ about the first OCR increase –  for what its worth, I advised against it, but I was a minority voice –  but the Governor went on tightening, moving at each of four successive reviews, even as dairy prices started falling sharply and core inflation just kept on staying low.  As late as December last year, the Governor was talking about the likely need for further OCR increases.

But he was wrong.  His approach last year was a mistake.  It appeared to be driven, at least in part, by a belief that there was something anomalous about the OCR as low as it had been, and that getting interest rates nearer the Bank’s estimate of neutral would be “a good thing”.

In one sense it shouldn’t be a great surprise that such mistakes are made. The single decision-maker system system is not well-designed to minimise the risk of mistakes (some of Alan Bollard’s early moves were also mistaken, as he later acknowledged).  And the Governor does not have a strong background in monetary policy or macroeconomics, and had not worked in New Zealand for 15 years when he took up the job.  Last year’s OCR adjustments were the first OCR changes he had made.

It would be better if the Governor simply acknowledged that he had made a mistake.  They happen.  It would be better for him, for the organisation (externally and internally –  learning organisations have to create room for staff to make mistakes), and for the country which entrusts so much power to the Governor.  If he is so unwilling to acknowledge a pretty clear-cut mistake, how willing is he to engage in critical self—scrutiny (or encourage it among staff) in areas where there might be rather more shades of grey?

[1] And, thus, the situation was quite different at the start of 2007 when, with unemployment already very low and core inflation very high, a lift in dairy prices, from relatively low levels, prompted Alan Bollard to raise the OCR four times in successive reviews.