OCR cuts as plausible as increases

The CPI data for the September quarter were released yesterday.  They were the last for the period Graeme Wheeler was Governor of the Reserve Bank –  charged with targeting inflation – although of course the lags mean that policy choices Wheeler made will still be influencing inflation through next year.    The target Wheeler willingly signed up for five years ago was 2 per cent CPI inflation.  In his time in office, he saw annual inflation that high only once (of 20 observations).  On his preferred core measure –  which is probably the best indicator of the underlying trend in inflation –  September 2009 was the last time core inflation was as high as 2 per cent.

In fact, here is that (sectoral factor) measure of core inflation back a decade or so.

core inflation

There are various readings one could put on that chart.  On the one hand, core inflation (on this measure) has been astonishingly stable in the last six years or so.   That would normally be to the credit of the Governor concerned.   Then again, the same Governor explicitly signed up for a focus on 2 per cent inflation, and there has been no sign that the trend in inflation is any closer to fluctuating around 2 per cent than it was in 2012.

On the other hand, at the start of chart, back in 2006/2007 at the peak of the last boom, inflation was clearly too high (relative to the target the government had given us).   Partly for that reason, I continued to recommend OCR increases throughout most of 2007.  With hindsight –  but probably only in hindsight – those increases weren’t needed.  But my point here is to recognise that the gap between actual core inflation and the target midpoint (2 per cent) was materially larger then that it is now.  As it happens, we didn’t have this particular core measure in 2007, but when we sat around the table debating what Alan Bollard should do with interest rates then, we knew a best estimate of core inflation was around 3 per cent (we were also pretty confident that the unemployment was well below a sustainable level).  In fact, at the time the Bank’s Board was asking uncomfortable questions as to quite how 3 per cent annual core inflation squared with the statutory mandate of “a stable general level of prices” (I wrote a, from memory, slightly casuistical paper in response.)

So, if there are legitimate questions about the conduct of monetary policy right now –  the Bank having already undone its 2014/15 mistake –  they pale in comparison with those that should have been being asked in 2007.  (As I recall it, Stephen Toplis was raising such questions then, and attracting the ire of the then Governor).

What do yesterday’s inflation data show?

I’ve previously shown a table of six core inflation measures

Core inflation, year to Sept
CPI ex petrol 1.8
Trimmed mean 2
Weighted median 2
Factor model 1.8
Sectoral factor model 1.4
CPI ex food and energy 1.5

A couple of those measures are actually bang on 2 per cent.  On the other hand, the Reserve Bank has been consistently clear in recent years that its favoured measure is the sectoral factor model (a statistical exercise that searches of underlying common trends in the disaggregated components of the CPI), and international comparisons often use a CPI ex food and energy measure (it is the one core measure the OECD reports for its member countries).

Hawks might be inclined to dismiss the Bank’s preference for the sectoral factor model as just “cover for a reluctance to raise the OCR to where it ‘should’ be”.  I think they would be wrong to do so.  It isn’t that long since the median core inflation measure was running materially below the sectoral factor model number, and the Bank was then asserting that the core inflation measure was a better guide.   I wasn’t fully convinced at the time, but it seems that they were probably right.

We only have consistent data for all six core measures back three years or so, but even that is enough to illustrate the point.  In this chart I’ve shown the sectoral core measure and the median of the other five measures.

core inflation measures oct 17

The gap between the two lines was larger a couple of years ago than it is now.  I don’t think many observers will find it that credible that in the sort of economy we’ve experienced in the last couple of years “true” core inflation has picked up as strongly as the blue line suggests.  The general understanding of how inflation works, in settled and stable economies, is that there is lots of short-term noise, but that the underlying trend –  the bit monetary policy should usually focus on –  is pretty sticky and slow-moving.   Personally, I find it more convincing to believe that core inflation has been pretty consistently low for several years than to suppose it has gone through the quite large cycles some of the other measures suggest.  In support of this proposition, over the almost 25 years for which we have estimates from the sectoral factor model, it is easy –  with hindsight –  to tell a persuasive story about what was going on in that series.  Less so with some of the other measures.

One other way to illustrate the point is to compare the sectoral factor model numbers to a couple of the other core inflation indicators for which there is a long run of data.    This compares the sectoral factor model and the factor model (an earlier iteration, using a similar class of filtering techniques).

core measures

Or in this one a comparison of the sectoral factor model with the CPI ex food and energy (in the latter I haven’t manually excluded the 2010 GST spike).

core measures 2

You will struggle to find an economist who thinks that, in an economy like New Zealand’s, the underlying trend in inflation is anything like as noisy as those other measures suggest.

We don’t have a formal Policy Targets Agreement at present, but for some years now PTAs have included this phrase

For a variety of reasons, the actual annual rate of CPI inflation will vary around the medium-term trend of inflation, which is the focus of the policy target.

There isn’t much sign either that the medium-trend of inflation is fluctuating around 2 per cent –  where it supposed to have been –  or that it has been increasing and getting any closer to target.

Here is another way of looking at the issue.   Headline inflation is thrown around by changes in taxes and government charges, and although SNZ don’t (unfortunately) publish a series of CPI inflation excluding taxes and charges (as many other countries’ statistical agencies do), they do publish a series of non-tradables inflation excluding government charges and the cigarettes and tobacco component (the latter having been the subject of repeated large tax increases in recent years, which have nothing to do with the underlying inflation process).  The data only go back 10 years or so, but here is what that chart looks like.

NT ex govt charges and tobacco oct 17

This measure of core non-tradables inflation is off its lows (in 2010, 2012, and 2015) but shows no sign of racing away.    Construction cost pressures play a big role in this series, but even with the pressures in that sector, this measure of non-tradables inflation is currently running at only around 2.25 per cent.   The 2014 peak was (a bit) higher. (Consistent with this story, wage inflation –  although quite high relative to productivity growth –  has also been showing no signs of acceleration).

I saw one commentary yesterday suggesting that if non-tradables inflation was above 2 per cent that was grounds for thinking about tightening –  after all, 2 per cent is the inflation target midpoint.  Actually, for decades non-tradables inflation has averaged well above tradables inflation.  Our benchmark in discussions at the Bank was often along the lines of “a 2 per cent inflation target means tradables inflation averaging about 1 per cent and non-tradables inflation averaging about 3 per cent”.  As it happens, for the 17 years the Bank has data on its website, tradables inflation has averaged 1.0 per cent, and non-tradables inflation has averaged 3.2 per cent (CPI inflation averaged 2.2 per cent).

If the Reserve Bank is serious about ensuring that core inflation fluctuates around  per cent, they will need to be seeing quite a lift in non-tradables inflation from here.  There is nothing in the data suggesting that lift is already getting underway.  And, of course, that is largely why their own projections haven’t shown any OCR increases for some considerable time.

Against this backdrop, the troubling question remains why every commentator (I’ve seen) has been focused on the timing of a potential OCR increase (even if all agree it is probably still some time away).    Core inflation is persistently below target, the best measure of core inflation shows little or no sign of picking up, and –  not irrelevantly – the unemployment rate is still above any credible estimates of the long-run sustainable rate.  It is not as if rapid productivity growth is driving prices downward either –  some sort of “good low inflation”.  Instead, there is no aggregate productivity growth.  And few commentators seem to envisage GDP growth (headline or per capita) accelerating from here.  Even if there are some encouraging signs in the world economy at present, it isn’t at all clear to me why one would think the next OCR change was any more likely to be an increase than a cut.

I wouldn’t be pushing for an OCR cut at present, but it isn’t hard to envisage how we might be better off if the OCR was a bit lower than it is now.   I’ve resisted the argument that house price inflation should be an additional factor in OCR decisions, and I’m not about to reverse that stance just because house price inflation is (temporarily?) subdued, but for those who did want to give house price inflation some extra weight even that argument against further OCR cuts probably has to be put to one side for now.

In conclusion, I noticed this paragraph in the BNZ commentary on yesterday’s numbers

What is peculiar to New Zealand, however, is the very confused governance picture we have at the moment. Not only do we have a caretaker governor but we also don’t know who the incoming government is or what its expectations are for future fiscal stimulus, the Policy Targets Agreement and the Reserve Bank Act itself. Until these questions are answered it is very difficult to make any meaningful comment on future RBNZ action with any degree of certainty.

I’d largely agree with all that. It remains possible that the Bank could be operating under a different PTA as soon as next week (it happened to varying degrees in each of 1990, 1996, 1999 and 2008), and even then the (unlawful) caretaker Governor has little or no effective mandate to do anything much, minding the store until a permanent appointee is in place.  Of course, even when all those uncertainties are resolved –  Governor, and any (or no) changes to the PTA or Act – it will still be hard “to make any meaningful comment on future RBNZ action with any degree of certainty”.   Doing so would require a degree of knowledge about future inflation pressures not gifted to central banks, or to private forecasters.  We (more or less) know what we see now, and not much beyond that (ever).




Still unconvincing

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.

nt ex govt charges and tobacco

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.

iib breakevens to june 16

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.


Expectations measures still warrant further OCR cuts

The Reserve Bank’s Survey of Expectations (of some reasonably “informed” respondents) came out the other day.  It was one of the last significant pieces of New Zealand macro data likely to emerge before the Bank finalizes the forecasts for next month’s Monetary Policy Statement and the Governor makes his OCR decision.

As ever, there wasn’t that much media attention on these numbers, and arguably not much changed in this survey from the previous one.    But in a sense that in itself should be newsworthy.

For a year now, the Reserve Bank has been reluctantly cutting the OCR, more or less reversing the ill-judged aggressive tightening phase the Governor undertook in 2014.  I say only ‘more or less’, because although the current OCR is lower than the 2.5 per cent that prevailed for several years until the start of 2014, inflation expectations have also fallen.  Using the two-year ahead survey measure, the real OCR was about zero at the start of 2014, but it is around 0.6 per cent now.  And, as the Bank reminded us in the FSR last week, the margins banks face, over the OCR, in tapping wholesale funding markets have also increased.

But the Bank has been cutting nominal rates for a year now, and still respondents to the survey don’t take very seriously the chances of the Bank getting inflation back to the 2 per cent midpoint of the target range, an explicit target that Governor himself had added to the PTA.  The last year or so is the first time ever that two-year ahead expectations have been below the target midpoint.  But despite 125 basis points of OCR cuts, there is no sign of medium-term expectations picking up again.

infl expecs and target midpoint

Some reporters noted that one year ahead inflation expectations had increased but (a) that shouldn’t have surprised anyone given the rise in world oil prices, and (b) there is no sign of the lift in expectations for the next couple of quarters flowing beyond that.  The survey provides expectations for each of the next two quarters, and for the year ahead, which enables us to derive and implied expectation for the second six months of the year ahead (which shouldn’t be much influenced by eg changes in oil prices).  Here is that chart.

implied 6mths ahead

I wouldn’t want to make much of a single observation, but the latest fall just continues a trend that has been underway ever since the 2008/09 recession.  There is no sign of growing confidence that inflation will soon be getting back to target (note that the annualized rate of inflation for the second six months is only 1 per cent, at the very bottom end of the target range).

And these inflation expectations are based on expectations that monetary conditions will be eased further.  In the history of this survey, respondents typically only expect monetary conditions to ease over the coming year when they are already judged to be quite tight.

monetary conditions

For example, over the period from 2004 to 2008 respondents thought conditions were tight (the red line) and expected that they would ease over the year ahead (the blue line).  At present, they think conditions are quite easy, but they still think conditions will (have to) ease further over the coming year.  The size of the expected future easing isn’t large; it is the fact that they still expect further easings at all that is striking.  Even with that expected easing, inflation expectations remain subdued.

If the Reserve Bank is keen to get these medium-term inflation expectations back up to around the target midpoint –  as a marker of how much confidence people have in the seriousness with which the target is being pursued –  there are broadly two ways to do that.

The first is through credibility/confidence effects.  In other words, a substantial programme of interest rate cuts could, of itself, be enough to raise expectations of future inflation.  People think along the lines of “gee, inflation has badly undershot the target, but I see the Bank is moving decisively now, and accordingly I’ll adjust my responses in the survey”.  As already illustrated, there is no sign –  a year into the easing cycle –  of that sort of behavior at work.

If not, then they need to rely on the second channel: actually boosting economic activity, putting more pressure on scarce resources, and raising actual core inflation, leading people to revise up their forecasts of future medium-term inflation.  This is probably usually the more important channel –  people more often revise their forecasts/expectations in the light of actual experience with inflation.

The survey enables us to see whether respondents expect additional pressure on resources.     Take the question about GDP growth, for example.  In this survey expectations of GDP growth for the next one and two years actually fell.  In the case of the two year ahead expectations, this fall reversed a rise in the previous quarter, but left expectations as low as they’ve been since the end of the 2008/09 recession.   The survey doesn’t ask respondents for their population growth estimates, but at present the population is growing by almost 2 per cent annum, and if that continued then the expected 2.33 per cent GDP growth wouldn’t put much pressure on resources, or give much reason to expect inflation to rise.   Perhaps respondents to the survey are just wrong, and will be surprised by how much growth actually happens.  But at present there isn’t much evidence of a growth acceleration that might lift the core inflation rate.

The survey also asks about unemployment rate expectations.  Respondents are asked what they expect the unemployment rate to be in a year’s time and in two years’ time.

expec rise in U.png

The chart shows the expected increase in the unemployment rate between one and two years ahead.  When the unemployment rate is very low, and monetary conditions are tight (see chart above), as in the pre-recession period respondents typically expect that the unemployment rate will rise in future.  After the 2008/09 recession, for several years respondents expected material falls in the unemployment rate.  But now. with the actual unemployment rate at 5.7 per cent, they still expect it to be 5.53 per cent two years from now.  There is simply no sign that these respondents expect capacity pressures to intensify from where they are.  And, thus, they see no reason to expect underlying inflation (abstracting oil and tax changes etc) to head back to 2 per cent any time soon.

Who knows what the Reserve Bank will make of the recent data, including the Survey of Expectations.  On their past track record, the expectations survey might provide them cover to not cut the OCR in June (“look, two year ahead expectations stabilized”).   Given the Governor’s apparently strong bias to focus on the housing market whenever possible –  for which he has no mandate –  and avoid cutting unless the other data overwhelm him, it might make a plausible story for some.

But it would be the wrong message to take.  The Governor’s mandate for monetary policy is to keep inflation near the 2 per cent target midpoint.  Almost four years into his term, he has consistently failed to do that.  Reasonable people might differ on quite how much responsibility he bears for that failure –  what was forecastable and what wasn’t  –  but right now there is almost nothing suggesting (a) that informed observers have any confidence that inflation will settle at 2 per cent, or (b) that growth will accelerate and capacity pressures will intensify, in a way that might raise actual inflation and lead survey respondents to reassess the outlook for inflation itself.   The succession of grudging OCR cuts over the last year has probably eased the disinflationary pressures a little, but the evidence suggests they have been nowhere near enough to address the problem of inflation persistently undershooting the target the Minister of Finance (on behalf of the public) has given the Governor.

If we look back over the last five years, there were various factors that have, and should have, supported demand/activity at any given interest rate.  The terms of trade rose strongly on the back on high dairy prices, boosting domestic incomes.  The Christchurch repair and rebuild process was a big boost to demand  –  didn’t boost productivity, but it sucked up real resources that couldn’t be used for other things.  And at least on some readings, the world economy was providing some support to domestic activity –  both the sluggish recovery in the West (about as sluggish as New Zealand’s) and the buoyant demand in many emerging economies.

None of those things is supporting any sort of intensified pressure on resources now.  The terms of trade have fallen quite a lot, and while world dairy prices might be stabilizing (a) we can’t just assume that they will soon rise very much, and (b) the full effects on domestic spending etc of current weak payouts probably haven’t yet been seen.  The Christchurch process has a long way to go, but there is no sign of the level of repair/rebuild activity rising from here (and the recent cement sales data actually showed a large fall in Canterbury sales).  And there are very few bright spots in the world economy at present.

Perhaps the hope rests on a domestic (non-Canterbury) construction boom?  Given the population pressures that might be welcome, but it remains much more of an aspiration than a forecast –  respondents to the RB survey, expecting only very subdued GDP growth, seem to think so too.

Much better now for the Reserve Bank to move decisively to finally get on top of the downward drift in people’s expectation of future inflation, and the persistent undershooting of the target midpoint.  At present, I reckon the Governor’s reaction function is one in which (changes in) house price inflation dominate, unless other data suggest to his forecasters a material risk of inflation staying below 1 per cent.  That isn’t the target he has been given, but if that is something like the way he is operating, it is no wonder respondents to this survey see no reason to expect inflation to head back towards 2 per cent any time soon.  The Governor has only 16 months left in office –  just enough time, if he really took the issue seriously, to get underlying inflation settling back to around 2 per cent.


A wrong decision, but perhaps not too surprising

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).

weekly mortgage approvals

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.

iib breakevens

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.


Grudging adjustment – yet again

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.

BOE chief economist on policy reversals

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.

“We didn’t get it wrong: Wheeler”

I’m getting tired of the subject, and readers probably are too, but I noticed that in today’s Herald Brian Fallow had reported Graeme Wheeler’s case that the Reserve Bank had not made a mistake in raising the OCR so much last year, and holding it up for so long.

I’m sure Graeme had no say in the headline “We didn’t get it wrong: Wheeler”, and perhaps Brian Fallow didn’t either.   But actually the article is a compilation of individual items where the Bank did get it wrong over the last 18 months.  Some of those mistakes were probably quite pardonable (in full or in part), but they were mistakes:

  • The Bank did not forecast a material fall in dairy prices
  • It did not forecast the fall in oil prices
  • It did not forecast the extent of the net migration inflow (or, apparently, the proportion of those arriving who were (a) students, or (b) young workers.
  • It did not forecast the extent of the increase in the labour force participation rate.

As I noted yesterday, dairy prices have been volatile for the last decade.  Faced with dairy prices as high as they were at the start of last year, it was imprudent of the Bank to have acted on the assumption that they would stay anywhere near that high for long.

The Governor seems to have in mind some sort of version of the world where GDP growth had been around 3.5 per cent, and yet labour force growth had been much lower than it was.  That would, almost certainly have been a more inflationary economy than the one we have seen.  And in fact it was what the Bank was forecasting at the start of last year.  But we now know that GDP growth would not have reached anything like 3.5 per cent without the growth in the population and the labour force we’ve seen.  Demand just wasn’t strong enough otherwise.  And, on the other hand, population growth surprises add a lot to demand.

I was also puzzled by the claims around migration.  Fallow reports:

The bank says the composition of the immigrants – more single workers recruited for the Canterbury rebuild and more students – has meant that the boost to the supply-side capacity of the economy has been faster and stronger, and the effect on demand weaker, than headcount alone would historically have indicated.

This sentence seems internally contradictory.  More single workers [or presumably married ones without children] certainly have the direction of effect the Bank talks about, but more students goes in the opposite direction.  Foreign students add to demand (for accommodation, for education, and for other consumption items) but generally add very little to labour supply.  This chart shows permanent long-term arrivals for those in the age group 15-29.  If anything, over the last year or two, the rate of increase in those of student visas has been even greater than the increase in the number of young foreign workers.


The article also reports

Combined with capital investment by business it means that it has taken a couple of years longer for the slack in the economy to be taken up and the output gap to turn positive than the bank expected when it started tightening last year.

But as I noted the other day:

  • The Bank’s view of the level of excess capacity that existed 18 months ago, at the start of the tightening cycle, has been revised materially.  Judging spare capacity isn’t easy, but they now think they were wrong about the earlier view that excess capacity had already been fully absorbed.
  • The level of investment since then just has not been very strong.  Growth in hours worked has been quite rapid over the last year, even by the standards of the previous boom, and yet investment did not reach previous boom levels.  (And, of course, when the previous rates of investment were occurring there was still a lot of inflationary pressure). As our best estimate is also that productivity growth has been lousy, this story of an unexpected growth in supply capacity just does not wash.

Economic forecasting is hard, and mistakes will happen.  With the possible exception of the over-optimism about dairy prices, I wouldn’t be very critical of the Bank on any of those forecasting errors.  They are the sort of thing that happens.

But what I think translated the events of the last 18 months into something a little more serious (and again, it isn’t the worst monetary policy mistake ever, by a long shot) is that the Reserve Bank was under no pressure at all to have acted at all last year:

  • Core inflation, on the estimates available to the Bank at the time, was around 1.6 per cent, and had been for several years
  • The unemployment rate was still 6.1 per cent, not far below the sort of level it have averaged in the recession years
  • Credit growth was modest

And inflation had stayed low, to that point, despite the very big and concentrated increase in residential building activity that had already occurred in Christchurch.  For several years, the Bank had (quite reasonably) cited the rebuild as one of the forthcoming major pressures on resources and inflation.  For that matter, there was no sign that commodity prices –  which had been high for a year, while inflation stayed low – were about to rise further.

When inflation is high and resources are demonstrably stretched it is quite understandable when central banks are a little jumpy about new inflationary pressures.  As I noted yesterday, Alan  Bollard raised the OCR four times in succession in 2007 when dairy prices were soaring.  With hindsight, those increases weren’t necessary –  the 2008 recession took care of the inflation, and reversed the dairy price increases –  but I wouldn’t call those 2007 increases a policy mistake.

But in 2014 the Reserve Bank did not need to act.  There were no new inflationary pressures, and the Bank was under no pressure to raise rates, other than the pressure it imposed on itself.  Having started raising the OCR, it was under no pressure to carry on increasing rates.  It was under no pressure, as late as December last year, to be talking of further rate increases.

It was a policy mistake.    They happen.  They have occurred in the past, here and abroad.    And policy mistakes will happen again.

Here’s roughly how, in Graeme Wheeler’s shoes, I  would have answered the question “did you make a mistake?”

Yes, we did.  Monetary policy aims to keep inflation over the medium-term at around 2 per cent.  Doing so means we make extensive use of economic forecasts –  trying to make sense of where we are now, and where things are likely to head over the next couple of years.    Our forecasts were not so very different from those of other economists and agencies     But we misjudged just how much pressure there was (and was going to be) on resources, and as a result we raised interest rates sooner, and further, than was really warranted.

One of the lessons people should take away from this episode is that monetary policy isn’t a precise or surgical tool.  We have to make judgements about things that reasonable people can reach quite different views about.  That means at times we will make mistakes.  When we do, we’ll be very open about them, and correct them as quickly as we can.  What I can’t promise you –  and no one can –  is that there will be no mistakes in the future.

I’m disappointed that we got it wrong this time –  and as the chief executive and single (statutory) decision-maker I have to take responsibility for that error.  Our mistakes matter for people’s lives and businesses.   But you have my commitment that we are going to learn from this episode –  not just about the economy, and also about our processes for making sense of, and responding to, the data.

I’d have applauded an answer like that. I suspect the wider community probably would have too.