We expect inflation to strengthen reflecting the accommodative stance of monetary policy, increases in fuel and other commodity prices, an expected depreciation in the New Zealand dollar and some increase in capacity pressures.

So said Graeme Wheeler in his MPS press release this morning.  I thought it sounded like a familiar line, so I went back and had a look.  This seems to have been the Governor’s 30th OCR decision.  Back in his very first OCR announcement in October 2012 he said this

While annual CPI inflation has fallen to 0.8 percent, the Bank continues to expect inflation to head back towards the middle of the target range.

And in all those 29 statements since then –  with perhaps just one exception –  he has been saying much the same thing: inflation will increase.  And actual inflation –  headline, and the range of core measures – just keeps on being below target.

At the Bank’s press conference, Bernard Hickey asked if the Bank could be regarded as having done its job, given that even on its own forecasts (persistently too optimistic) there would have been six years of inflation below the target midpoint by the end of 2017, when the Bank again expects headline inflation to be back to 2 per cent (the Bank doesn’t publish forecasts of the core inflation measures, but I doubt the picture would be any different if they did –  it has also been four or five years since the various core measures were clustered around 2 per cent).  There were a range of possible plausible answers to that question, but I wasn’t prepared for the one Assistant Governor John McDermott actually gave: he said “your timeframe is very short”.  Six years……when monetary policy generally works over perhaps a two year horizon, and when the Governor’s term –  in a system built on personal accountability –  is only five years.

Yes, it wasn’t a very good day at the Reserve Bank today.    Inflation is apparently expected to increase partly because the exchange rate is expected to fall.  At 8:59am, the exchange rate was already above what the Bank was assuming in the MPS projections,  and a few minutes later it was another per cent higher, and it rose a bit more in the course of the press conference.  I’m not sure why the Governor expects the exchange rate to fall back if his rosy domestic economic story is correct.  Perhaps he expects a lot more tightening in the US.  But, again, he has been expecting that almost since he took office in 2012.

Some of the other bits in that statement as to why he expects inflation to rise were a bit puzzling too.  The Governor apparently thinks “accommodative monetary policy” will do the trick, but in real terms the OCR is probably a bit higher than it has been for much of his term (certainly than in the year or so before the unwarranted tightenings), and the TWI this afternoon is only slightly lower than the average level for the Governor’s term to date.  Set aside for now the question of whether conditions are actually “stimulatory” or “accommodative” in absolute terms, but if they are more accommodative now than over the last four years, the difference isn’t large.  Core inflation didn’t pick up over those four years, and it isn’t obvious why it is going to do so now.

The Governor also apparently expects “some increase in capacity pressures”.  One would hope so, given that on the Bank’s own estimates we have had eight consecutive years of a negative output gap.  But it isn’t clear why the Bank expects capacity pressures to increase from here.  They are forecasting quite an increase in residential building, but we’ve already had four or five years of increasing residential investment activity, through two very large shocks to demand for residential investment –  the Canterbury earthquakes, and the large unexpected surge in immigration.  All of that, on top of buoyant commodity prices earlier in the period, wasn’t enough to turn the output gap positive or get the unemployment rate back to more normal levels, or lift inflation back to target.  It isn’t obvious why things should change now –  especially as, like other forecasters, the Bank expects the net migration inflow to fall away quite sharply.

The Governor could be right.  Macroeconomic forecasting is, in many ways, a mug’s game.  But he has been wrong for several years now, as his predecessor was in his last couple of years.  It isn’t obvious that he has a compelling story to tell as to why inflation pressures are finally about to pick up. But if he has such a story it isn’t in the Monetary Policy Statement.

Meanwhile, there is a great deal of complacency. I heard the Governor talk of significant real wage increases, strong tourism, strong immigration, significant building activity, and so on.  All without any sense that per capita income growth has remained disappointingly weak.  Neither the Governor in his comments nor the text of the MPS itself even mention an unemployment rate that lingers at 5.7 per cent, years after the end of the recession.  If anything, the Bank appears to believe that excess capacity in the labour market is already exhausted (see Figure 4.8).

The Governor also made great play of non-tradables inflation.  He is quite right that, over time, non-tradables inflation (or at least the core of it, excluding government taxes and charges) is what monetary policy can really influence.  Even exchange rate effects –  which the Governor weirdly tried to play down –  over the medium-term work by influencing overall pressure on domestic resources and thus non-tradables inflation.  But non-tradables inflation typically runs quite a bit higher than tradables inflation, even in a stable exchange rate environment.  That is partly about the labour intensive nature of many of the services included in non-tradables inflation (hair cuts are the classic example, where there is limited scope for productivity gains).  With an inflation target centred on 2 per cent, the common view among economists inside the Bank used to be that one might expect non-tradables inflation to average perhaps a bit above 2.5 per cent, while tradables inflation might average a bit below 1.5 per cent per annum.  Together, they would be consistent with medium-term CPI inflation (ex taxes etc) of around 2 per cent.

But here is what non-tradables inflation looks like in recent years.  This series excludes government charges (eg the cut in ACC motor vehicles levies) and tobacco taxes (which have been increasing sharply each year).  It doesn’t take out the effect of the 2010 GST effect, but it is easy enough to visually correct for that – it accounts for about 2 percentage points of the inflation rate over 2010/11.

There is a bit of variability in the series, but it has been years since this measure of core non-tradables inflation got even briefly as high as 2.5 per cent, let alone fluctuating at or above that level.  And this is the series that should have borne the brunt of the Christchurch rebuild pressures –  which probably explained the increase in this measure of inflation in 2013/14.  Non-tradables inflation is what the Bank can influence. It really needs to be quite a bit higher to be consistent with the target specified in the PTA –  and on current Bank policy, there is no particular reason to think it is going to happen.

I outlined again yesterday my take on how the Governor operates: he is really bothered about the housing market, and really doesn’t want to cut the OCR.  But he can’t afford to see core inflation drift much lower –  he can get away with it holding around current levels (somewhere, in the MPS words, in a 0.9 to 1.6 per cent range) –  so will cut if data surprises really force him to, but not otherwise.  Today was a classic example of that model in action.  In the run-up to the March MPS it was, he said, the expectations survey data that really rattled him.  There has been nothing comparable since and so, mediocre economic performance and weak inflation notwithstanding, there was no OCR adjustment.

Instead, today was all about housing, and financial stability.  Perhaps we were supposed to have forgotten that the FSR was released only a few weeks ago and in his press release on that occasion the Governor began by extolling the resilience of the New Zealand financial system.  Often enough the Governor has been reluctant to comment on financial stability issues in monetary policy press conferences, and it is only three months since I praised him for his response on house prices at the March MPS press conference

And when asked about the impact of a lower OCR on house prices, he succinctly observed “well, that’s just something we’ll have to watch”.  By conscious choice, house prices are not part of the inflation target, either in New Zealand or in most (if not all) inflation targeting countries.  It is one, important, relative price, influenced heavily by a range of other policy considerations.  And if bank supervisors should pay a lot of attention to house prices, and associated credit risks, it is a different matter for monetary policymakers.

All that was long gone today.  It was, in effect, all about house prices and the possible threat to financial stability.  I don’t recall hearing, or reading, anything about stress tests (they’ve been pretty positive), or capital requirements (they seem to have been quite – rightly –  onerous by international standards), or even about the Bank’s benchmarking exercise to better understand how individual banks are modelling similar risks.  High house prices can be a source of risk if they are financed with poor quality lending, backed with inadequate capital.  But there was none of that analysis today.  Instead, there was a regulator champing at the bit to impose even more controls, touting the LVR restrictions to date as “very successful”.  Apparently more LVR controls could be only weeks away –  although of course they will have to consult on any new controls, with a mind open to considering alternative perspectives and evidence –  while loan to income restrictions seem to be a bit further down the track (they are doing analytical work on them, rather than detailed instrument design, or so it seemed from the Governor’s comments).  The Governor really seems to have it in for people buying residential properties for rental purposes, and yet can never quite tell us why.  He reminded us again today that some 40 per cent of property turnover involves such purchasers, but never ever addresses the simple point that in a badly-distorted system where the home ownership rate is dropping towards 60 per cent, the remaining homes have to be owned by someone.

The Governor and Assistant Governor were at great pains to emphasise that monetary policy is required to have regard to “financial stability”.  The relevant phrase isn’t new –  it has been in the Act since 1989 –  but it isn’t quite what the Governor said it is either.  Section 10 of the Act requires that

“In formulating and implementing monetary policy the Bank shall have regard to the efficiency and soundness of the financial system”.

Efficiency is listed first, both there and in the Policy Targets Agreement.  And yet, puzzlingly, I didn’t hear anything today –  or in the FSR press conference a few weeks ago –  about the efficiency of the financial system.  New controls, ever more detailed controls, overlapping LVR and DTI controls, all imposed on some classes of lenders and not on others, some classes of borrowers and not others, are usually considered ways of seriously undermining the efficiency of the financial system.  But the Governor seems not to care.

Perhaps more importantly, in a discussion about monetary policy, neither financial soundness nor financial system efficiency –  nor the avoidance of “unnecessary instability in output, interest rates and the exchange rate” –  are equal objectives with the inflation target.  Price stability is the Bank’s primary statutory objective, and the inflation target centred on 2 per cent in the practical expression of that.  It doesn’t mean headline CPI inflation is, or should be, bang on 2 per cent each and every quarter.  But six years –  with no assurance that even six years will be an end of it –  below target really is too much.  It was, after all, the Governor who added explicit mention of the midpoint to the PTA.

The Governor also found himself on the backfoot over communications, coming on the back of the recent BNZ analysis and yesterday’s Dominion-Post article.  In some obviously-prepared lines, the Governor went to great lengths to argue that there was simply no problem.  For a start, he and his colleagues agreed, people simply hadn’t read his February speech carefully enough  (set aside for a moment that point that if people misread your carefully prepared communication, it probably says something about that communication itself).  Oh, and we shouldn’t be surprised that there had been quite a few surprises in monetary policy lately, because the OCR was actually changing.  He seemed to ignore the fact that, as I noted yesterday, in 2014 the OCR had moved quite a lot and there were no major communications problems.  It got worse when he then argued that if one looked at 2006 to 2010 there were similar surprises –  as if he thought we’d forget that 2008/09 saw one of the biggest global financial crises ever, and huge  –  unprecedented  – OCR changes.  It simply wasn’t a very convincing performance.  The Governor’s communications haven’t been good enough recently.

A journalist asked him about the sharp reduction in the number of on-the-record speeches. I hadn’t really noticed this, but when I checked it was certainly true.  In his early years, the Governor made much of how the Bank was going to do more on-the-record speeches. In 2013 there were 17 and in 2014 there were 18.  Last year there were only eight –  a fairly normal sort of level in pre-Wheeler years – and this year so far there have been only four, only one of which was given by the Governor himself.  The Governor could offer no particular reason for this, but then fell back on a rather petulant anecdote, citing one business journalist who the Bank had asked for comment on the Governor’s speeches.  This journalist had apparently described them as “too complicated and with too many ideas”.  The Governor’s plaintive response was “I hope they get read”.  It was a slightly sad performance.  Unfortunately, it is true that neither the Governor’s speeches nor those of his colleagues really match the standards of those of their peers at the RBA, the Bank of England, the Bank of Canada, or the Fed.  We should expect better –  considered reflections, expressed clearly.  Part of accountability often involves such speeches, especially when –  as with this Governor –  he is apparently so reluctant to give interviews.  Embattled, the Governor appears to have withdrawn to his fortress.

Oddly, John McDermott offered the thought that while the number of speeches had dropped, there had been a “massive increase” in the number of other publications: “we don’t just communicate through speeches”.  I was a bit taken aback by this claim  and went to the website to check.  There does seem to have been a small increase in the number of Analytical Notes (author’s own research, including the standard disclaimer that it doesn’t speak for the Bank) and Bulletin articles (although there the increase seems to relate mostly to financial markets and the regulatory functions).  But there has been a big increase –  perhaps “massive” is not too strong a word –  in the number of Discussion Papers.  This year, so far (five months in), there have been eight published, compared to a typical annual total of six each year in recent years.  But…again, Discussion Papers are authors’ own research, complete with the standard disclaimer. In most cases, DPs are intended as the basis for submissions to academic journals by the Bank’s research staff.  Sometimes they have interesting material, but often –  abstract and introduction aside – they are fairly incomprehensible to someone who is not a specialist in the particular area.  They don’t attract much attention outside academe, and have never –  to my knowledge –  been used as part of official policy communications.   If senior policymaker speeches have a role, publications like DPs aren’t a substitute for them.

All in all, neither the MPS itself nor the press conference were the Reserve Bank anywhere near its best.  They will probably get away with it because the domestic banks seem mostly unbothered about the persistent undershoot of the inflation target.  But they really shouldn’t.  The Board, the Minister and Treasury should be asking hard questions –  both about the substance of policy and its presentation.

Finally, the Reserve Bank’s “modelling” of long-term inflation expectations got elevated as far as the press release today.  We are assured that these expectations are “well-anchored at 2 per cent” (not even “around” or “near” but “at”).  For these purposes, the Bank uses a couple of surveys of a handful of economists.  It isn’t clear what useful information the results have for current policy, since respondents will reasonably assume that some other Governor, and some other chief economist, will be setting monetary policy before too long.  But it also gives no weight at all to the market-based measure of implicit inflation expectations we do have.

125 points of OCR cuts has still not been enough to convince people actually buying and selling government bonds to raise their implied 10 year expectations above 1 per cent.

People just don’t believe –  whether on this measure or in the other surveys – that inflation is going to settle back at 2 per cent any time soon.  They’ve been right to be skeptical.   That should trouble the Bank, and those paid to monitor it.    Expectations surveys aren’t an independent influence on inflation –  often they are a reflection of past actual outcomes –  but the way the Governor was talking today it sounded as though it might take another inflation expectations shock, or perhaps a GDP surprise, to bring about another cut.  The next expectations survey data won’t be available until after the next MPS.

Graeme Wheeler’s OCR decision this morning –  perhaps he will tell us how many of his advisers backed this one? – was the wrong decision.  Core inflation measures remain well below the midpoint of the inflation target, and there are few or no pressures taking inflation sustainably back to the midpoint, even though it is now almost 11 months since the Reserve Bank began unwinding the ill-fated 2014 tightening cycle.

Keeping medium-term inflation near 2 per cent is the monetary policy job that has been given to the Governor.    Nothing else matters very much in the Policy Targets Agreement.  There has been talk in some quarters that the inflation target should be lowered.  The Minister of Finance says he hasn’t found that case persuasive, and he sets the target.

But if it was the wrong decision, it perhaps wasn’t too surprising a decision.  Graeme Wheeler has been reluctant to cut the OCR all along.  He continues to talk of how “accommodative” monetary policy is, but that appears to be referenced against a view that the “neutral” interest rate is 4.5 per cent (their last published estimates, although one hears that they tell investors in private meetings that that estimate is now around 4 per cent –  perhaps reflecting the fall in inflation expectations?).  He thought he was getting things “finally” back to normal when he launched the 2014 tightening cycle, talking confidently then of the prospects of 200 basis points of tightening.   It would be better, frankly, if the concept of a neutral interest rate was largely excised from central bankers’ vocabulary for the time being, because neither they nor we have any good sense of what “neutral” actually is.  Any such estimates have too often been a dragging anchor, helping hold back central bankers from the sorts of policy adjustments that meeting their respective inflation targets would have warranted.

So the Governor has been consistently reluctant to cut the OCR –  and even more reluctant to admit his past mistakes – and has only done so when the weight of evidence has overwhelmed his preferences.  Last year it seemed to be some mix of further falls in dairy prices, the failure of inflation to recover,  and/or high unemployment.  As recently as the start of February, in his forthright speech, the Governor was again holding out against the prospect of further cuts –  never ruling them out, but making pretty clear where his inclinations lay.  But then the data overwhelmed him again.   The new inflation expectations data shook the Bank, and the deteriorating global economic outlook and rising financial market unease (including widening credit spreads) prompted a move in March, with the prospect (projection) of one more cut to come before too long.

But in the past six weeks, there hasn’t been that much news, and little to change anyone’s baseline story.  There hasn’t been any new labour market data, the CPI had something for everyone, there was no material new inflation expectations data, and if the global economic outlook still looks unpromising, financial markets have recovered somewhat (including credit spreads banks face) and oil and various hard commodity prices have been rising.  If your reference point is that the OCR “really should” be something more like 4 per cent, why would you take the “risk” of cutting the OCR now?  It might be different if your reference point was that core inflation measures have been persistently below target for years, and that that gap shows little or no signs of closing.

What of the housing market?  I explicitly commended the Governor’s approach to house prices at the time of the March MPS:  asked about the risks that a lower OCR could provide a big further impetus to house prices, he  had simply observed “well, that’s just something we’ll have to keep an eye on”.   It helped that, at the time, the Bank  noted that house price pressures in Auckland had been “moderating”.  Recall that house prices are explicitly not something the Reserve Bank has a mandate to use monetary policy to target.

Six weeks on and house price issues are all over the headlines again, given added impetus by the Prime Minister’s talk of land taxes for non-residents etc.   The Bank’s tone has changed, although it is still somewhat cautious: “there are some indicators that house price inflation in Auckland may be picking up”.  Frankly, it would be surprising if it were not –  new distortionary policies introduced by the Bank and the government late last year should only ever have been expected to have had short-term effects.  Nothing fundamental about the market has changed.  It still isn’t the Bank’s responsibility at all, and certainly not something that should be driving monetary policy.  But when all his inclinations seem to be against cutting, unless “forced” to by new data, and with a potentially awkward Financial Stability Report only a couple of weeks off, it would have been another reason to hold back.

Are house prices really taking off?  The Dominion-Post would have one think so, highlighting this morning a sharp rise in the price of a house in the sunny but unprepossessing suburb of Berhampore, perhaps a kilometre from where I sit.  In terms of activity levels, I run this chart of the number of (per capita) mortgage approvals from time to time.  There doesn’t seem anything extraordinary about current volumes of mortgage approvals (again, the x axis is weeks of the year, numbering 1 to 52/53).

Various people who talk to the Reserve Bank have been telling me since March that the Bank has finally “got it” and recognized that the overall domestic and economic climate is such that materially lower interest rates were needed.  I wish it were so, but I think today’s statement confirms my “model”, in which the Bank will cut only reluctantly, and only if  –  in effect – “forced” to.  The Governor just doesn’t seem worried about having the economy is a position where  the best guess of next year’s inflation rate would in fact be 2 per cent.  He seems content so long as (a) he can mount a semi-credible story that headline inflation gets back above 1 per cent before too long, and (b) so long as the measures of core inflation don’t consistently drop below 1 per cent.  Otherwise, house prices seem to play too large a role in his “reaction function” –  he can play them down and suggest they aren’t a consideration when they look a bit quiescent, but they act as quite a drag on good monetary policy at any other time.

I’m not overly keen on central banks reacting much to exchange rate movements in most circumstances.  Often enough, the exchange rate changes reflect something “real” or fundamental going on.   The Bank’s own research has suggested that falls in the exchange rate haven’t materially boosted overall inflation –  probably for exactly that reason.  But it is the Governor who keeps going on about the exchange rate and how uncomfortable or inappropriate or undesirable it is.  And yet the one thing he can do that make a difference to the exchange rate is the stance of monetary policy.  A lower OCR, all else equal, will tend to lower the exchange rate.  As it, the Governor must have gone into this morning’s announcement knowing that it was almost certain that there would be quite a bounce in the exchange rate.   Despite the absence of media lock-ups, there didn’t seem to be much uncertainty about the market reaction this morning.

Trade-weighted index measure of the exchange rate:

And so we are delivered an exchange rate a full per cent higher than the level the Governor considered inappropriately high at 8:59am. That seems unnecessary and unfortunate.

The disastrous New Zealand (especially Auckland) housing market is primarily the responsibility of elected central and local government politicians.  It is not something to be controlled or moderated, except incidentally, by good monetary policy (to be aimed at stability in the general level of prices) or regulatory imposts on banks (supposed to be used only to promote the soundness and efficiency of the financial system.    If the Reserve Bank thinks banks need more capital, let it make such a proposal, advance the evidence, and consult on it.   If it thinks  banks are making reckless lending choices, again let them lay out the evidence in the forthcoming FSR, and tell us about the conversations it is having with bankers, and any regulatory measures it is thinking about.  But it simply is not a matter for monetary policy.

Looking ahead, there is not much key New Zealand macro data due before decisions are made on the June MPS.  The quarterly labour market data are out shortly, but after the noise in  the unemployment rate recently, it may be difficult to get much very new from that data yet.  Perhaps as important might be the next Survey of Expectations, and particularly the inflation expectations results in it.  Today’s statement is quite relaxed about inflation, and adamant that “long-term inflation expectations are well-anchored at 2 per cent” (not “seem to be”, not “close to”, but “are”  and “at”).

That certainly isn’t the message from financial markets.  Yes, I know that the implied inflation expectations from indexed bonds aren’t a perfect indicator –  then again, neither are the other measures of expectations or core inflation –  but the current level, just above 1 per cent, seems pretty close to the average of the various core inflation measures the Reserve Bank highlighted in the last MPS.  The central view just doesn’t seem to be that we can count on 2 per cent average inflation any time soon.  That should be a mark against the Reserve Bank.

In closing, I should note a couple of small aspects of the Bank’s press release that I welcome.  I (and no doubt others) had lamented the Governor’s recent high profile focus on a single, complex, prone to end-point issues, measure of core inflation.  In this statement, that is replaced with a  simple “core inflation remains within the target range”.  Only just within, I would argue, but it is better than putting so much official weight on a single measure.

And in the final paragraph, I have noted for some time an unease at how much weight the Bank has been putting on recent and near-term headline inflation in these statements  –   in the near-term, headline inflation is thrown around by all sorts of things.  This time, they have gravitated towards something more (PTA consistent) medium-term in focus: “we expect inflation to strengthen as the effects of low oil prices drop out and as capacity pressures gradually build”.  One could reasonably question whether there is any sign that capacity pressures really are building, or are likely to over the next year or two –  after all, they have been relying on this “gradual build” for some years now – but at least it puts the emphasis in the right place: the factors that shape the medium-term outlook for inflation.

Once again the Reserve Bank and its Governor have started backing away from a view that interest rates are low enough to get inflation back fluctuating around the 2 per cent midpoint of the target range –  the focus the Governor and the Minister agreed on just over three years ago.

Two years ago, with the OCR at 2.5 per cent, they were gung-ho on the need to raise the OCR – quite openly asserting that they expected to raise the OCR by 200 basis points.  From the January 2014 review:

The Bank remains committed to increasing the OCR as needed to keep future average inflation near the 2 percent target mid-point.

As late as December 2014, with the OCR now at 3.5 per cent they still thought

Some further increase in the OCR is expected to be required

By June last year, they had belatedly started cutting the OCR, and then thought only perhaps 50 basis points of cuts would be required.

By last month, they had got to 100 basis points of cuts, fully reversing (at least in nominal terms) the 2014 increases.   While not totally ruling out the possibility of further cuts they observed of the target midpoint that

We expect to achieve this at current interest rate settings

Today, that optimism has gone and we are back to

Some further policy easing may be required over the coming year to ensure that future average inflation settles near the middle of the target range.

I guess that is their bottom line, and I suspect the forecasters are giving the Governor little reason for much optimism.  No doubt the “over the coming year” is designed to discourage people from focusing on the March Monetary Policy Statement, but as ever the data flow will determine that.  Most likely, the Governor will have to shift his ground yet again – as he continues, for year after grinding year, to be over-optimistic about the likely rebound in inflation and (indeed) about the strength of the (per capita) economy.

But he must be a bit torn.  Almost everything in today’s statement that deals with what has already happened would be pointing towards further OCR cuts (weaker global growth and rising uncertainty about it, falling international commodity prices, continuing weak New Zealand export prices, and weak inflation here and abroad).  Add to that the Governor’s continuing unease about the exchange rate –  when it weakens it is usually a sign of weakening economic prospects, but the Governor still thinks it is too high.

So he seems to rest his case on two arguments.

The first is that New Zealand’s inflation rate isn’t very low after all.

 Headline CPI inflation remains low, mainly due to falling fuel prices

But that just isn’t even factually accurate.  The target inflation rate is 2 per cent, and the latest headline inflation rate was 0.1 per cent.   But the inflation rate excluding petrol prices was 0.5 per cent.  Excluding all vehicle fuels and household energy costs it was 0.6 per cent.  And if we take something like the common international ex food and energy measure, SNZ tells us that inflation excluding food, household energy and vehicle fuels was still only 0.9 per cent last year.

And it isn’t government charges or tobacco taxes either –  as I noted last week, in highlighting that the inflation rate is the lowest in 70 years –  the impact of higher tobacco excise taxes and cuts in government charges totally offset each other in the last year.

Everything seems to rest on the Bank’s sectoral factor model measure of inflation –  which, as I noted last week, has increased somewhat to 1.6 per cent for 2015.   This has been the Bank’s preferred measure of core inflation over the last few years,  but it is quite unusual for a model estimate measure of core inflation to make it into the OCR press release.  Indeed, I went back quickly and looked at the OCR press releases since the start of 2013, and not a single one of them referred to a core inflation measure, let alone quoted a specific number.

The idea behind the sectoral factor model is sound, but it seems rather bold for the Governor to put so much weight on this particular measure when it seems to be at odds with the other indicators of underlying or core inflation.  I’ve already quoted some of the exclusion measures (the CPI ex petrol, or whatever), but the other core inflation measures on the Bank’s website have also been flat or falling.  At the other extreme, the trimmed mean measure of inflation was only 0.4 per cent last year.  Oh, and inflation expectations –  survey measures and market ones –  have been low and falling.

I’m not sure what the “true” measure of underlying inflation is –  and neither is the Governor –  but I don’t think the overall balance of indicators should be giving the Governor any reason for confidence about the current situation of the inflation rate relative to target.  It certainly isn’t all about petrol.

The Governor also apparently remains optimistic about a re-acceleration in economic growth in New Zealand:

growth is expected to increase in 2016 as a result of continued strong net immigration, tourism, a solid pipeline of construction activity, and the lift in business and consumer confidence.

But….even if immigration remains high, that only maintains growth  rates and doesn’t provide a basis for any acceleration (especially as the Bank in its most recent MPS announced its conversion to a view that immigration did not put any net pressures on demand, even in the short-term –  a change of heart which they have still not justified, or released any supporting papers for).  When I last looked, international guest nights growth looked to have levelled off quite markedly in the second half of 2015, and any lift in business and consumer confidence still looks quite modest (and certainly hasn’t taken any of the measures back above where they were earlier last year).  And all that is before we take into account the continuing weak international dairy prices (weaker than the Bank, and most producers will have been expecting), and the increasingly difficult international environment.    There is plenty of volatility in quarter to quarter GDP growth rates, and plenty of revisions too, but there doesn’t seem to be much there to give us confidence that economic growth in New Zealand will pick up materially, if at all, this year.   And inflation was already weak, and weakening, even when the economy seemed stronger, and income growth higher, 12 to 18 months ago.

Yet again, the Governor is behind the game –  grudgingly adjusting his line to barely keep up with the deteriorating flow of domestic and international data.  We might worry less if the weak inflation was the result of strong and resurgent productivity growth, but there is no sign of that either.  Instead, we’ve been left with an anaemic recovery and a high unemployment rate (rising over the last year).  Not everything is down to the Reserve Bank’s failures, but the Governor’s choices haven’t helped –  monetary policy is designed to deal with demand shortfalls.   The Bank should be held more forcefully to account for those choices.

In closing, I was sobered to look at the inflation rate ex food and energy.  New Zealand’s is 0.9 per cent.  That for the euro-area is 1 per cent.  The gap isn’t large, but with plenty of policy room at the Reserve Bank’s disposal, they really should have been able to keep inflation a lot closer to the target midpoint than the ECB –  grappling with the zero bound, and all the existential issues weighing on activity, demand and investment in much of the euro area.

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.

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.

Today’s OCR decision was good news (and a pleasant surprise).  The Reserve Bank has finally recognised just how persistently weak inflation pressures are in New Zealand and has cut the OCR.  It has foreshadowed the possibility of one more cut.  And at least for the next two years there is no hint of the OCR being raised back towards the unchanged  estimate of the “neutral interest rate”.

There is likely to have been an element of deliberate smoothing of the numbers to produce such a flat track for two years ahead.  If so that is something to be welcomed.  I have two  –  slightly contradictory –  reasons for welcoming it.  First, no one (ever) has any good idea what the appropriate OCR will be two years hence. But, second, easing cycles (or tightening cycles) rarely stop at 50 basis points.  In the 16 years of experience with the OCR, the only time the Reserve Bank has moved by only 50 points was when it prematurely raised the OCR in 2010, and then unwound those increases after the February 2011 earthquake.  As I noted yesterday, if the Governor was going to cut the OCR he was most likely to back into modest cuts rather than embrace a wholesale change of view at this stage.

The document does not give a sense of a central bank with a very strong sense of what is going on.  In a sense, that is a step forward.  Huge uncertainty is something all central banks always face, and so many central banks have got things so far wrong over the years since the recession (repeatedly thinking that tightenings will soon be needed)  that it is better to play things by ear, putting quite a lot of weight on actual developments in (core) inflation, rather than on stories about how future events might unfold.

I’m not going to comment in much detail on the numbers in the projections, but I did want to make a couple of points on them and then turn to slightly longer-term policy considerations.

The first point was around this chart from the MPS, showing the Bank’s output gap estimates 18 months ago, and those now.

In one sense, the levels of the two estimates are not hugely different.  And  when we look back five years from now neither might closely resemble the best historical estimates.  But the differences  matter because the Bank, and its forecasting staff, have for several years been putting a lot of weight on the notion that excess capacity was exhausted (and hence it was “time to tighten”).  But in this chart there is almost two years difference in the crossover point.   Other indicators –   notably the unemployment rate –  cast doubt on whether the economy is even now operating at potential.  The point is not that the previous precise estimates are wrong (that is inevitable), but that the Bank has been consistently wrong in its narrative about what has been going on.

The second was around the line, oft-repeated this morning, about the way the economy’s supply potential had expanded rapidly, enabling supply to accommodate growth in demand.   It was presented as a good news story.   But it just is not that good.

The labour supply has certainly increased rapidly, largely on the back of high (not record) net inward migration.  But in the short-term increases in population growth boost demand more than they boost supply –  always have done in New Zealand, and there is no sign of that changing.  As the tables in the MPS remind us –  and it is a point I’ve made here repeatedly –  productivity growth has been lousy (on the Bank’s measure 0.7 per cent per annum).  And even investment has just not been that strong.  Here is a chart of investment/GDP .

I’ve shown both total investment ex housing, and investment in “plant and machinery, transport equipment, and intangibles”.    Investment has been recovering, but on neither of these measures has investment as a share of GDP got back to the average levels seen in the decade prior to the recession,  even though employment has been growing quite rapidly (lots of workers need equipping).  And both measures (even though they exclude housing) will have been boosted by activity in Christchurch to replace lost capacity (think of that underground infrastructure work).  There is no easy way to strip those Christchurch effects out, at least until we get the annual capital stock estimates, but there is really nothing to suggest that underlying growth in per capita capacity has been strong.  A more likely story of what has gone on in New Zealand (as in many other countries) is just that there was quite a lot of excess capacity, which has been enough to accommodate even the demand pressures of a migration inflow without boosting inflation.

The press conference was striking for how little searching scrutiny there was of the Bank’s judgements and performance over the last year or two.  Perhaps FEC will do better this afternoon?  But Rob Hosking of NBR did ask whether the Bank had made a mistake in raising the OCR last year and holding it up for so long.  “Not at all” was the Governor’s response.  His argument was that no one 18 months ago could have anticipated the sharp fall in oil prices or the sharp fall in dairy prices  (which, incidentally, are offsetting effects in the Bank’s forecasts).  I’m not sure about “no one”,  but even if we grant the point, the Governor is surely not arguing the continued weak core inflation, and declines in non-tradables inflation that we have already seen in the data, are a reflection of either of those forecast errors?  Weak commodity prices are going to exert an increasing drag on spending this year, and perhaps beyond,  but weak wage and price inflation were well-entrenched before  the depth of the correction in dairy prices became fully apparent.  I think it is more accurate to say that the Bank misjudged the level of spare capacity at the end of 2013, it misjudged the underlying inflation processes, it misjudged the inflation implications of the resurgence in the housing market, and thus was far too ready to initiate, and carry on, a tightening cycle.  It was a mistake.

As I’ve said before, there is huge uncertainty in monetary policy. In a sense I can understand why the Governor would not want to openly acknowledge that he had made mistakes (he’s human too), but it is a shame that he did not use the opportunity to convey to journalists and the public more of a sense of the limitations of anyone’s knowledge, and the inevitability that central banks will from time to time get it wrong.   And if the Governor did not want to  acknowledge the mistake in the press conference, some more sustained critical self-examination in the Monetary Policy Statement itself would have been appropriate, and consistent with the spirit of the legislative provisions governing such documents.  Perhaps a scenario experiment, running through the Bank’s models the implications of having held the OCR at 2.5 per cent since the start of last year, would have been an interesting basis for a conversation, including with the Bank’s Board (the Minister’s agent in holding the Governor to account).

But perhaps my biggest concern about today was an issue that won’t get any headlines.  It was how the Governor and Assistant Governor dealt with a question about whether the inflation target should be changed.  The Governor noted that outgoing IMF Chief Economist Olivier Blanchard had [been among various others who had] proposed raising inflation targets, to help minimise the risk that the near-zero lower bound would be such a problem in future.  As the Governor noted, Blanchard [and one of his predecessors Ken Rogoff ] had not got a lot of support for his proposal.   But then the Governor went on to note that monetary policy was proving a lot harder than people had expected and that it was very difficult to raise very low inflation expectations.

As I’ve noted previously, for other countries –  already entrenched at zero interest rates –  there is no easy way in which raising the inflation target now would make much difference.  It is too late.   But New Zealand (and Australia) are different.  We still have materially positive policy interest rates.  That means we are both still exposed to the possibility of hitting the zero lower bound in the next serious downturn.  And yet the Governor seems indifferent  to –  or perhaps not even consciously aware of –  the possibility, and the implications for the economy (and for the people who would be unemployed).  Raising the inflation target is certainly not an ideal option, but as I’ve argued here previously unless governments and central banks are going to do something active about removing the near-zero lower bound (and neither the Governor nor the minister has given any hint of doing that) there should be a more serious discussion about whether our inflation target should be raised, as a pre-emptive and precautionary move.   At very least, inflation outcomes in the upper half of the target range would provide slightly better buffers than a continuation of outcomes below the midpoint.   There would be no excuse, given how much notice our central banks have had, if in the next serious downturn New Zealand or Australia become trapped for years with interest rates at some floor (a floor that arises out of policy and legislative choices, not as some force of nature).  Perhaps, at a pinch, it was excusable not to think much about the zero bound when the Governor was signing the PTA in 2012.  It can’t be excusable now.

The Assistant Governor’s response to the question about the target was even more disappointing.  I suspect he was trying to help his boss, by asking the journalist whether he meant to suggest raising or lowering the inflation target.   But it is difficult to believe that a serious senior central banker could, in the current climate of extremely low inflation (here and abroad), seven years on from a recession which took policy rates to their lower limit and has seen them more or less stuck there, could even toy publically with the idea of lowering the inflation target.  If the Bank were to convincingly sort out the zero lower bound issues, then perhaps it would make sense to have that conversation (to aim for “true” price stability, rather than 2 per cent annual inflation).  But the Bank has given no hint that it even takes these risks seriously.

McDermott concluded that “changing targets is a very risky thing to do”.  Well, perhaps, but the risks in considering raising the target need to be weighed against the risks of adverse shocks that deliver New Zealand another recession before  the unemployment rate has even fully recovered from the last recessions.  Those are people’s lives the Bank toys with. As even the Governor recognised, the risks of something very nasty around a Greek exit from the euro are far from trivial –  though how, in the same breath, he could assert that deflation risks had passed in Europe was something that eluded me.

And finally a reminder about the gaps in the Bank’s transparency around monetary policy:

• The forecasting models, developed at considerable public expense, are still not public
• We will not see, even with a lag, any minutes from the Governing Committee or the Monetary Policy Committee, and will see no hint of the advice provided to the Governor.
• Despite the Bank last week releasing 10 year old “forecast week” papers, we still have so sense as to how long a lag we might face before having access to the Bank’s forecasting papers for the last 18 months or so.
• We will not see any minutes of the Board discussion of monetary policy and the Bank’s adherence to the PTA.  Nor we will see the written advice prepared for the Board.

As I’ve put it previously, the Bank is quite transparent about the things it (and we) don’t know much about –  ie the future –  and not very transparent at all about the things it knows a great deal about (its own analysis and deliberations and debates that went into shaping the Governor’s decisions, both today’s and those of the last 18 months).

Tomorrow the Governor will announce his latest OCR decision and publish the Reserve Bank’s June Monetary Policy Statement.    Having been inside the Reserve Bank for so long, I don’t claim any great expertise in reading the tea leaves as to what the Governor will actually have chosen to do when 10 days or more ago, he sat down, took advice, and made his decision.  I think he probably will not cut the OCR, but if so that will, most probably, be a mistake, compounding the series of mistaken monetary policy judgements he has made since the start of last year.  I shocked some colleagues in the middle of last year when I opined that the Reserve Bank would cut the OCR before the Federal Reserve raised US policy rates.   It was a rather speculative call at the time.    I’m still sticking to it, but I’ll be surprised if confirmation comes quite yet.

One of the things about monetary policy (at least, active discretionary forecast-based monetary policy) is that there will always be considerable uncertainty as to just what the right OCR will be.  As I’ve observed before, with that level of uncertainty there is no particular shame in being wrong, provided one learns quickly from the mistake.  The Reserve Bank doesn’t seem to have been very good at that over the last 18 months.  It should have been apparent pretty quickly that there was little or no basis for the tightening cycle that the Governor initiated last year, when he boldly foreshadowed 200 basis points of OCR increases.  But any recognition of that point has been pretty slow and grudging. Mea culpa, mea culpa, mea máxima culpa it most certainly is not.   Too bad about the people who have lingered on unemployed for longer than was necessary.  Perhaps tomorrow’s MPS will contain some retrospective self-examination of how those mistakes came to be made, and what lessons can be learned from them.  If such self-examination is not strictly required by the section of the Act governing MPSs,  it is pretty strongly encouraged.

A journalist asked me the other day if it was just embarrassment that made the Governor reluctant to reverse course.  I don’t think so.  I think is about views of the world.  All of us have them, and need to have them to make sense of things at all.   And views of what is going on in the world –  paradigms, models – don’t change quickly.  There is a tendency (again, in all of us) to discount observations that might undermine our story, and focus on data, insights, or arguments that tend to support our story.    That makes it hard to get material changes of view, and all the more so when a single decision-maker, who does not set out to foster the contest of ideas and the open-minded examination of alternative views, is in charge.    A downside of the single decision-maker model is the tendency to assign too much weight to one person’s “model”.

In the Governor’s defence, of course, outside observers are still split on what he should do tomorrow.  Many of the market economists in 2013 and 2014 were even more hawkish than the Governor, and each of them faces the same challenge of revising their view of what is going on.

I’m just going to make three other quick points:

• I noticed the BNZ economics team out a little while ago picking that the OCR would not be cut tomorrow, but arguing that if the OCR was cut the Reserve Bank would signal a series of OCR cuts of perhaps 100 basis points or more.  I think that is very unlikely to be right.  Practically, there just is not much time between the previous OCR review and finalising the forecasts for this Monetary Policy Statement, and big changes in the whole direction of the forecast don’t seem very likely in that time.  But perhaps more important is the point about paradigms or views of the world.  It seems much more likely that the Governor would back reluctantly into any OCR cuts, treating them as little and precautionary.  He could do that within a world view in which he thought the future OCR would still have to be at least as high as it is now.  That seems much more likely than that he would –  with no foreshadowing – embrace a full-scale reversal of last year’s OCR increases.  It might happen, perhaps it even should happen, but it seems very unlikely at this stage.

• The data.  I know some market economists have changed their view, and their OCR calls, since the last OCR review at the end of April.  But to me, the data since late April don’t seem enough for a major change of view.  For those, like me, who think the OCR should have been lower there has been nothing to contradict that view.  There is no sign of inflation pressures building, and perhaps a little more sign of the building boom tailing off, a little more sign of excess capacity in the labour market, and a little more weakness in dairy prices.   It has been enough to shift a few people across the line, but if one had been a confident believer in the sort of story the Reserve Bank was telling in its last MPS, it would have been nowhere near enough to have prompted a radical revision of one’s view.    The same goes for the world economy.  To me the data flow, especially from the emerging world, looks weak and quite worrying, but that is the read of someone inclined to a pessimistic take.  The Governor, by contrast, has repeatedly articulated a story about the strength of global growth.

• I like the NZIER’s Shadow Board process, where a group of outsiders offer their views not on what the Reserve Bank will do, but on what it should do.  At times it has been interesting to watch divergences between what bank economists are telling us the Bank will do, and what they think it should do.    Those involved in the Shadow Board are asked to assign probabilities that a range of different possible OCRs will be appropriate, recognising the uncertainty most of us face.    I’m not sure if they are still doing it, but the NZIER innovation prompted the Reserve Bank to introduce such a system for the group advising the Governor on what he should do with the OCR.  We provided written advice (one page each) but also assigned probabilities.  It was designed to help foster debate, and to help recognise (and help the Governor recognise) that when one adviser was advocating one rate and others another rate, both recommendations were typically medians or means of a distribution of views.    The latest Shadow Board results, for tomorrow’s OCR decision, came out today.  Here is the chart of the individual respondents’ views.

Two things strike me about the chart.  The first is how tightly bunched the distributions actually are.  It is as if all of them have a difficulty with grappling with just how uncertain we should be about what the right level of the OCR will turn out to have been.  I wonder if they are answering “what would you do if you were Governor” rather than “what OCR will prove to have been right for New Zealand given the inflation target”?  But the second observation is how the two academics in the group –  Viv Hall and Prasanna Gai –  have the tightest distributions of them all.  Viv is 85 per cent confident that 3.5 per cent is right, and Prasanna is 100 per cent confident.    Academics usually remind practitiioners of the huge margins of uncertainty in any of this stuff.  Fan charts have not been popular in New Zealand , but they do help to illustrate the historical range of uncertainties.  Presumably, given the way the PTA is written, the appropriate OCR today depends on the things that will determine the trend inflation outcomes a couple of years hence.  Who can say that they know that with any confidence?

For what it is worth, my own distribution of probabilities for the appropriate level of the OCR tomorrow is roughly as follows:

OCR                                       Probability

1.5                                          5

2                                              5

2.25                                        10

2.5                                          10

2.75                                        12.5

3.0                                          15

3.25                                        12.5

3.5                                          10

3.75                                        10

4                                              5

4.25                                        5

My distribution is wider, and much flatter, than any of those in the Shadow Board grouping, and yet it still feels too narrow to really grapple with the huge uncertainty we – and the Reserve Bank –  all face.

There is a great deal of complex, and pseudo-sophisticated, debate around monetary policy.  But when:

• Core inflation has been below target midpoint for years
• Unemployment is still above any estimate of NAIRU
• Major commodity prices are falling
• The building cycle –  often a key element in business cycles, and more so than usually this time given the salience of Christchurch –  looks to be turning,
• And there is little or no sign of material demand or inflation pressures globally

the decision around the OCR really should be straightforward.  It should be cut.