Why not?

The Governor’s press release this morning, leaving the OCR unchanged, was no surprise.

But it continues to seem out of step with the data, and with his responsibilities under the Policy Targets Agreement. The statement has the feel of being written by someone who really really does not want to cut the OCR, but who won’t explain why.  It is if the current level of the OCR were being treated as an end in itself, or being held up in pursuit of some other goal, rather than being a tool for influencing the (rather too low) medium-term rate of inflation.

Fortunately, the statement corrects what must have been a mis-step in John McDermott’s speech last week.  Today the Governor states that:

It would be appropriate to lower the OCR if demand weakens, and wage and price-setting outcomes settle at levels lower than is consistent with the inflation target.

Last week, that criterion was expressed in terms of lower than the “target range”.

But there is no reference anywhere in the statement to the 2 per cent midpoint, even though the Governor and the Minister explicitly agreed that the midpoint should be the Bank’s focus.  And wage and price-setting outcomes are already inconsistent with the target midpoint and have been now for some years.  This statement offers no tangible basis for expecting that to change, just the limp observation that underlying inflation “is expected to pick-up gradually”.  Why?  When?  What is about to change that will now reverse a slide in core inflation that has been underway, more or less continuously, since 2007?  It has to be something more than just a belief that monetary policy is “stimulatory”.

Once again, the Governor anguishes about the exchange rate.  I agree totally with the substance of his references to New Zealand’s long-term economic fundamentals and how out of step the exchange rate is with them (it was the heart of this paper I wrote for the Treasury-Reserve Bank forum on exchange rate issues in 2013).  But……this is a press release about the nominal OCR, not about the real factors that shape New Zealand’s longer-term competitiveness.  And while the Governor observes that “the appreciation in the exchange rate, while our key export prices have been falling, has been unwelcome”, he seems unwilling to take the obvious step in response.  Exchange rates are largely influenced by expected relative risk-adjusted returns, broadly defined.  When New Zealand interest rates have been rising while those in most of the rest of the world have been falling, and we have a Governor who appears very reluctant to cut those interest rates, it is hardly surprising that we end up with a cyclically strong exchange rate.  Cutting the OCR won’t solve the long-term economic challenges:  they are about real factors, not monetary policy. But a strong sense from the Bank that the OCR was heading back towards 2.5 per cent over the coming year, or perhaps even lower, would be likely to make a useful difference.

And why not do so?  Core inflation is very low, the number of people unemployed (and underemployed) lingers uncomfortably high, inflation expectations are falling, farm incomes are falling, credit growth is pretty modest, and so on.  So why not cut?    Of course, no one can be totally certain that, with hindsight, cuts will prove to have been the right policy, but on the New Zealand and global data as they stand today –  and without a compelling case to suggest the inflation picture is about to change materially –  not doing so increasingly looks negligent.  In time, it is the sort of stance that also risks further undermining public and political support for the broad monetary policy framework, and the Governor of the Bank’s powerful position within it.

The Bank’s take on the rest of the world, as reflected in the press release, is both puzzling and disconcerting.  The Governor reiterates what appears to be one of his favourite lines, that trading partner growth is around its long-term average.  This is true, but largely irrelevant.  First, it simply reflects the fact that China is a more important trading partner than it was, and its growth rates are higher than those in our other trading partners.  But even China is slowing, probably quite sharply.  And commodity prices –  a key way the rest of the world’s economy affects New Zealand –  have fallen a lot.

In addition, in almost all of our trading partners – and in most countries that are not our trading partners –  GDP remains well below pre-crisis trend levels. Not all of that is excess capacity, but a significant proportion is likely to be.  Again, the Governor makes much of the low interest rates abroad, but seems not to put much weight on why those rates are so low.  There are all sorts of idiosyncratic factors in individual countries, but across the world interest rates are low and falling not because central banks have arbitrarily put them there (it isn’t some “monetary policy shock” in the jargon), but because markets and central banks both judge that underlying demand and inflation pressures require interest rates be at least as low as they are.  That is a very worrying perspective on the world, not a comforting one.

Finally, the Reserve Bank likes to claim that it is highly transparent, citing for example its scores in papers like this one.  But in many of the more transparent central bank we could look forward to the minutes of the meetings that led to the decision being published. In some central banks, even the range of views is extensively outlined.  The Governor has noted he now makes his OCR decision in the so-called Governing Committee, with his three senior colleagues.  But we do not have access to the minutes of these meetings, even with a lag, or to a summary of the advice provided to the Governor by his wider group of advisers, including the external advisers.  Transparency and open government are not just about announcing and explaining final decisions, but about the process whereby those decisions were reached.  Some other New Zealand government agencies are quite good at pro-active release of background material (for example, papers leading up to the Budget).  It is a model the Reserve Bank could look at emulating.  In the next few days, I am expecting a response from the Reserve Bank to my OIA request for background papers to an OCR decision from 10 years ago.  It will be interesting to see how they interpret the Act is deciding how to respond.

Tomorrow’s OCR announcement

Tomorrow morning Graeme Wheeler, the single unelected official responsible for the conduct of New Zealand’s monetary policy, will announce his latest OCR decision.  That decision will, no doubt, already have been made – lags between decision and announcement are longer in New Zealand than in most other countries, even more so at Monetary Policy Statements  – and the only discussion now will be around wording the one page press release.   Do we really need to say anything this time about future policy?  Will that slight change of words spook the markets?  Is that claim really defensible?  How appropriate is it to comment on another country’s monetary policy?  How does talk about the exchange rate and the medium-term challenges it poses fit in a statement about today’s OCR.  How will local economists read it?  How will offshore markets read it?  Where are the political fishhooks?  Don’t we need a comma there rather than a semi-colon?  And so on. But the heart of the matter is the OCR decision itself – where will the interest rate the Bank pays on (some) settlement cash balances be set for the next six weeks or so.  The key influence on that should be the inflation target: a range of 1 to 3 per cent annual CPI inflation, with a focus on keeping future inflation “near the 2 per cent target midpoint”. The Reserve Bank would no doubt argue that that is exactly what they have been doing.  The target is not about inflation today, it is about “future inflation outcomes over the medium term”.   The Reserve Bank’s published inflation forecasts always show inflation coming back towards the target midpoint a year or two ahead.  They do that by construction, but policy over the last few years has been set consistent with that view.  The judgement was that interest rates needed to be first at 2.5 per cent, and then move progressively higher, to ensure that future inflation did turn out consistent with the inflation target.   Reading through the Monetary Policy Statement from last March, when the OCR increases began, it is quite clear that the Bank expected to see more non-tradables inflation, higher inflation expectations and higher wage inflation, even with the programme of OCR increases they had in mind. But the Reserve Bank was wrong.  There is no particular shame in being wrong, so long as one learns from one’s mistakes.  It isn’t clear that the Reserve Bank has been very good at that.  Of course, what matters is not that so-called headline inflation was 0.1 per cent in the last year.  All sorts of things will throw headline inflation around in the short-term and generally it won’t make sense for monetary policy to try to offset them.  That is why people develop measures of core inflation –  simple ones like CPI ex food and energy (volatile items), trimmed means, weighted medians, and the sectoral core factor model. Core inflation has been falling core cpi So have household inflation expectations household So have business wage and inflation expectations business And dairy prices – a major influence on incomes, and incentives to invest – have been coming in much lower than the Reserve Bank expected, consistent with the pretty relentless decline in global commodity prices. Had the Reserve Bank had known last March how the New Zealand economic data would turn out, I don’t think Mr Wheeler would have seriously considered raising the OCR then.  Had they done so anyway, they would, I hope, have faced very serious questions from their Board and from the Finance and Expenditure Committee: raising the OCR while showing forecasts suggested that core inflation would keep falling even further below the target midpoint looks like something other than inflation targeting. Everyone makes mistakes, and economic forecasting is something of a mug’s game,  But it is the Reserve Bank that chooses what weight to put on its own forecasts, and how far ahead to look.  When they have been so persistently one-sided in their errors, it is surely time to down-weight the forecasts quite considerably.  The “model” –  the way of thinking about what is going on –  just isn’t helping much, if at all. Such one-sided errors aren’t new.  During the boom years, the Reserve Bank was consistently surprised by how strong inflation was.  We didn’t fully understand what was going on, but didn’t correct for that and, as a result, by the end of the boom core inflation measures were above the top of the target range.  The underlying belief that surprisingly strong inflation pressures were just about to end is quite strongly parallel to what seems to be going on now – an apparent wish to believe that whatever has kept inflation down is just about to end. With perfect foresight the OCR would not have been raised to 3.5 per cent. No one has perfect foresight, but knowing what we now know  there is a strong case for starting to lower the OCR now.     As it is, it is not just that nominal interest rates were raised by 100 basis points last year (and not just the OCR, but floating mortgage rates) but that as inflation expectations are still falling, real borrowing rates are still rising further. Perhaps it would be different if there were strong, well-substantiated, reasons to think that underlying inflation pressures were just about to recover strongly –  and I stress “strongly”; it has taken five years or more for core inflation to drift this far below the target midpoint. But there aren’t.  The construction cycle looks to be pretty close to peaking .  Recall that the gearing-up of activity in Christchurch represented the biggest single project pressure on resources in New Zealand at least since Think Big, and yet core inflation just went on falling.  There is no sign of business or consumer confidence pushing up to new heights.  Export commodity prices are weak, especially for dairy –  and the exchange rate is at a level which, if sustained, can only act as a drag on other tradables sector activity.  And while I wouldn’t suggest setting policy on a non-consensus forecast for the rest of the world, no one really sees global activity or inflation posing a material new inflationary risk in New Zealand in the next year or two.  If anything, the deflationary clouds continue to gather. John McDermott’s speech last week was slightly encouraging –  a very belated recognition of just how weak inflation has been, and how little the Reserve Bank (or anyone) really understands about what is going on.  But I noted then this disconcerting line from the speech:

We remain vigilant in watching wage bargaining and price-setting outcomes. Should these settle at levels lower than our target range for inflation, it would be appropriate to ease policy.

In 2012, the Governor and Minister explicitly, and consciously, decided to include a focus on the target midpoint in the PTA.    It is the midpoint, not the bottom of the target range which the Bank should be focusing on. I can really only see one argument against an OCR cut, a line which I’ve seen reported in various media: the housing market, and what lower interest rates might do to house prices.  There are several points worth making briefly here:

  • In its monetary policy, the Reserve Bank is explicitly not charged with managing house prices.  The only target for monetary policy –  agreed with the Minister – is for the CPI.  Neither existing house prices nor land prices are in the CPI, and the CPI’s treatment of housing is one the Reserve Bank has endorsed.
  • To the extent that rising house and land prices in some parts of the country reflect the interaction of regulatory obstacles and population pressures, they are real relative prices changes –  not something that, even in principle, monetary policy should be paying much attention to.
  • House prices in much of the country have been flat or even falling.  There is no evidence of some generalised speculative dynamic, let alone a credit boom.
  • Any possible threats to future financial stability –  the case for which the Reserve Bank has not yet convincingly made – should be dealt with through prudential regulatory tools.  Higher required capital ratios, or higher risk weights on housing loans, would be an orthodox response if a cost-benefit analysis suggested that larger buffers were required.

Finally, the Reserve Bank does not have an explicit “dual mandate”.  But any time a central bank engages in discretionary monetary policy – as opposed to, say, a long-term fixed exchange rate – it is assumes such a responsibility de facto.  Changes in the OCR affect output and employment in the short to medium term.  Perhaps I’ve completely lost perspective, but it disconcerts me how little public attention the Reserve Bank gives to the number of people unemployed (and underemployed).  At 5.7 per cent, the unemployment rate is still well above normal, and underemployment measures in the HLFS have not come down much at all.  The decision to hold the OCR is not just a decision between higher and low inflation.  If it were, there would still be a case for a cut.  But the cut/hold choice is also one between a faster reduction in the number of people unemployed and a slower reduction.  Involuntary unemployment is a blight, that scars families and individuals, and often has permanent adverse economic effects on the unemployed.    When there is so much  inflation leeway –  inflation so far below target, with few looming inflation pressures – the plight of the unemployed should get more attention from the Reserve Bank, and from those who hold it to account.