A sadly diminished central bank

Under the Reserve Bank Act as it stands at present, before a Governor is formally appointed the Minister of Finance is required to reach agreement on a Policy Targets Agreement (on monetary policy) with that person.  It is a strange system –  again one no other country has chosen to follow in law.  A Governor-designate may, for example, not know a great deal about monetary policy before taking up the job.  And it also appears to give a great deal of policy-setting power to an unelected official, treating the Governor-designate as almost an equal with the elected Minister of Finance.   Since the Governor-designate will generally be ambitious for the role –  and as even potential Governors give some deference to, for example, electoral mandates – in fact the Minister of Finance has the greater say.

The system is shortly to be replaced.  Here is what the Minister of Finance had to say in his announcement on the Reserve Bank reforms in late March.

Currently, the PTA is an agreement between the Minister of Finance and the Governor. Looking forward, as the MPC will be collectively responsible for making monetary policy decisions, it would be inappropriate for the Governor to be the sole member of the MPC to agree the operational objectives for monetary policy. As a result, we are changing to a model where the Minister of Finance sets the operational objectives for monetary policy. These objectives will be set after nonbinding advice from the Reserve Bank and the Treasury (as the Minister’s advisor) is released publicly.

The approach the Government has agreed to for the setting of operational objectives going forward was recommended by the Independent Expert Advisory Panel. This approach imposes discipline on the decisions of the Minister, given the fact that the Minister’s decision will need to take account of publicly disclosed advice from the Reserve Bank and the Treasury. Further accountability measures, such as requiring the Minister to justify decisions before the House, will be considered in the detailed design of this policy proposal.

It is also intended that the setting of monetary policy objectives going forward will involve greater transparency and public input. Decisions on monetary policy objectives are important, and therefore public debate and understanding should be required.

There are still a few unanswered questions, details to be fleshed out, but that looks a largely sensible approach.  I especially welcome the emphasis on

a) the routine pro-active disclosure of official (Treasury and Reserve Bank) advice on the setting of the operational objectives for monetary policy, and

(b) greater ex ante transparency, public input, and public debate.   Setting the operational objectives for monetary policy is the key bit of policy around macroeconomic stabilisation, and is far too important to be done secretly by the Minister and a few internal advisers.  In almost other area of multi-year policy, proposed frameworks would be open for much more public consultation, scrutiny and debate.  I’ve written previously about the much more open approach adopted to the five-yearly refresh of monetary policy targets in Canada.

So, well done Minister.

But despite the admirable promises about the future, in the most recent PTA (that signed with Adrian Orr in late March, a day before he took office), the process seems to have borne no resemblance to what the Minister promises for the future.

There was no public consultation (indeed, the Treasury papers that have been released talk of some consultation with some market economists in 2016 –  under a different government with a different view on monetary policy and the Reserve Bank).

The Treasury advice to the Minister has been pro-actively released (I wrote about it here), but it was disturbingly thin in key areas (issues around the effective lower bound for nominal interest rates, and the next recession).

And what of the Reserve Bank?  One might expect that the Reserve Bank itself would have the greatest concentration of official expertise on monetary policy and related issues –  not just drafting issues, but the key economic issues, including some of those monetary management issues that are just over the horizon).  One certainly wouldn’t want only Reserve Bank perspectives taken into account –  after all, one key part of the PTA involves the Minister, acting in the public interest, disciplining and holding to account the Reserve Bank –  but it would be astonishing if they didn’t have useful perspectives to add.   Perspectives that really should be seen by both the Minister of Finance and by the Governor-designate.  The Minister’s statement about future arrangements would suggest that, at least in principle, he’d agree.

When the Policy Targets Agreement was released I noted that I had lodged an Official Information Act request for the Reserve Bank’s analysis and advice on PTA issues, but that I didn’t really expect much, because I expected to be obstructed and delayed.

There was a bit of delay, in that the Bank took almost the full 20 working days to respond when –  as will shortly be clear –  they could have (and by law should have) responded almost immediately.

This was what I asked for

Copies of any papers relating to the new Policy Targets Agreement signed earlier this week.  I am interested in any advice to the Minister or his office, and any advice provided to the then Governor-designate, as well as any substantive internal advice or analysis papers prepared or obtained in the period since the current government was formed.

and this was the response

The Reserve Bank didn’t provide advice about the Policy Targets Agreement (PTA) to Adrian Orr prior to his start as Governor, and advice to the Minister of Finance was provided by the Treasury rather than the Reserve Bank.

That is a categorical statement: no advice (written or oral) to the Minister of Finance, and no advice (written or oral) to the Governor-designate.

In a follow-up email exchange, I also clarified with them that there were no “substantive internal advice or analysis papers prepared or obtained in the period since the current government was formed” either.

And there was also nothing of this sort in the Briefing for the Incoming Minister released late last year either.

It is almost literally incredible –  ie impossible to believe.  Public servants of my acquaintance have suggested that the Bank might just be lying, but I don’t believe that.  Or perhaps I crafted my request too narrowly?  Perhaps they had done substantive analytical pieces before the election rather than after it, but given the differences in emphasis between the two main parties it doesn’t seem likely that one would really be a substitute for the other.  And they probably will have provided comments to Treasury on drafts of its advice to the Minister, but nothing in that advice is a distinctively Reserve Bank contribution.

It seems rather a sad commentary on what the organisation seems to have become over recent years.  There has been much talk about collective monetary policy decisionmaking –  and ministerial commitments to legislate –  and yet the new Governor apparently neither sought nor received any advice from his (new) senior colleagues on the drafting of the Policy Targets Agreement, the key macroeconomic stabilisation policy document.  The Reserve Bank has substantial experience with the conduct of monetary policy here,  substantial exposure to what is done in other countries, and a significant research capability funded by taxpayers (presumably, at least in part, to shed light on such issues).   The Minister of Finance says he wants future PTAs (or their equivalent) to benefit from (published) advice from both the Reserve Bank and the Treasury, and yet he sought –  or at least received –  none this time from the Reserve Bank.  And yet the Bank itself, if its OIA response is to be believed, had done no substantive analysis or internal advice on PTA issues in the months between the government  – with, for example, its new emphasis on employment – taking office and the signing of a new PTA.

It seems like some sad mix of abdication of responsibility, and the sidelining of the institution that is supposed to be centre of official professional expertise in the area.

It is a far cry from, for example, the approach taken fifteen years earlier.  In April 2002 Don Brash resigned as Governor, and Rod Carr was appointed to act, holding the fort until a new permanent appointment could be made.  That process in turn spanned a general election.  At the time, Reserve Bank senior management took the view that it would prudent and useful for us to invest quite heavily in preparing background papers which could assist the Minister of Finance, The Treasury, the Board, and whoever was being considered for appointment as Governor to (a) get to grips with the issue, and (b) see where our reading of the evidence and arguments had led us to.  The resulting 100 page document is here.    And that wasn’t the limit of our involvement.  We provided advice to Alan Bollard (before he took office) for his discussions with the Minister of Finance, and participated directly in at least one (I say “at least” because I attended one  myself) of his meetings with the Minister on detailed issues around the negotiation of the Policy Targets Agreement.   It wasn’t a climate in which Reserve Bank staff and management perspectives were necessarily overly welcome –  the Bank was to some extent seen as almost an ideological “enemy” (see, as one cause, Don Brash’s 2001 speech I wrote about recently) and there was a great deal of opposition in the Beehive to the idea of anyone internal getting the job as Governor.     But it didn’t stop the Bank preparing and supplying what was (to my mind) reasonably good quality analysis and advice.

As I’ve said previously, the Reserve Bank certainly shouldn’t have a monopoly on advice/analysis in this area –  and much of its analysis on various issues in recent years has been less good than it should –  but the apparent complete lack of any serious analysis or advice to the Minister or the Governor-designate reflects pretty poorly on all involved –  Minister, “acting Governor”, Governor-designate.   It tells of a sadly diminished central bank.

Inadequate Treasury advice

I wrote about the new –  and last ever –  Policy Targets Agreement when it was released by the incoming Governor and the Minister of Finance last week.  Mostly the changes were pretty small, and in some cases you had to wonder why they bothered (since the PTA system itself is to be scrapped when the planned amendments to the Reserve Bank Act are passsed later this year).

I lodged Official Information Act requests with the Reserve Bank and Treasury for background papers relevant to the new PTA.  I wasn’t very optimistic about what I might get from the Reserve Bank –  both because of a culture of secrecy, and because the incoming Governor probably wasn’t covered by the Official Information Act when he was negotiating this major instrument of public policy.   But The Treasury kindly pointed out that they had already pro-actively (if not very visibly) released several papers, including Treasury’s own advice to the Minister of Finance, and two Cabinet papers.

(I would link to those papers, but Treasury has been upgrading its website this week and the link they provided me with no longer works.  If I manage to trace one that does work I will update this.)  [UPDATE 9/4.   Here is the new link to those papers,]

Those papers help answer the question about why they bothered with the small changes.  The Treasury advice to the Minister of Finance was dated 7 February, well before Treasury had formulated its advice on Stage 1 of the Reserve Bank Act review, and before the Independent Expert Advisory Panel had reported. In other words, well before it was decided that PTAs would soon be done away with altogether.  Indeed, there are suggestions in the paper that most of the relevant work had been done 18 months ago –  they say they consulted “a number of economists and market participants over 2016” –  when they thought the Minister would be replacing Graeme Wheeler early last year (rather than falling back on the unlawful “acting Governor” route to deal with the election period).  Interestingly,  the advice suggests Treasury favoured, on balance, increasing the focus on the 2 per cent target midpoint and de-emphasising the 1 to 3 per cent target range, but the Minister appears to have rejected that option.

There are two Cabinet papers among the material that was released.  One was from 19 February, before the Minister had engaged with the Governor-designate on the possible wording of the PTA.  In that short document the Minister outlines for his colleagues the draft PTA he would be suggesting to Adrian Orr.  The other was from 19 March, advising his colleagues of the text he had agreed with Orr.

The differences in the two texts are small, but in my view the changes represent improvements relative to the Minister’s draft (for example, keeping the political waffle about climate change, inclusive economies etc, clear of the material dealing with the Reserve Bank’s own responsibilities).  Presumably Orr would have consulted senior Reserve Bank staff, but on the basis of what has been released so far, we don’t know.

The documents suggest that The Treasury has played the lead (official) role in reshaping the Policy Targets Agreement (the Treasury advice to the Minister refers to them having consulted the Bank, but there is no suggestion that the Bank staff had necessarily agreed with the recommendations, or any suggestion of a separate Reserve Bank paper).  In a way, the lead role for The Treasury makes sense –  macroeconomic policy parameters should be set primarily by the Minister, not the Governor-designate.  On the other hand, The Treasury will typically not have the degree of expertise, or depth, in issues around monetary policy that the Reserve Bank should have.   I welcome the Minister’s announcement that in future, when the Minister directly sets the operational goal for monetary policy, he will be required to do so after having regard to the advice (publicly disclosed) of both the Reserve Bank and The Treasury.

My main prompt for this post, however, was one element of The Treasury advice which seriously concerned me, and represented a grossly inadequate treatment of an important issue.

In Treasury’s advice to the Minister, they have an appendix dealing with a couple of aspects of the Policy Targets Agreement where they didn’t propose change.  The one I’m interested in was the question of the level of the inflation target itself.

Treasury note that “there have been a number of arguments advanced by commentators over recent years in favour of either a higher or lower inflation target”.

Treasury notes, correctly, that

The main argument in favour of increasing inflation targets is in order to ensure that central banks will have enough scope to lower interest rates in the face of a large contractionary economic shock that may result in monetary policy reaching the effective lower bound of [nominal] interest rates

Amazingly, this issue is dismissed in a mere two sentences.  As they note

a higher inflation target would lead to higher costs of inflation at all times, whereas the risks of a lower bound event occur infrequently

But instead of moving on to offer some numerical analysis, or even plausible scenarios, the government’s principal economic advisers simply observe that

Given this, the costs of a higher inflation target may outweigh the benefits

Or may not. But Treasury doesn’t seem to know, and doesn’t offer the Minister (or us) any substantive analysis.

Here is one scenario.  Recessions seem to come round about once a decade, and in typical recessions (admittedly a small sample) the Reserve Bank has needed to cut interest rates by around 500 basis points.  If it can only cut interest rates by, say, 250 basis points, and that difference meant even just 2 per cent additional lost output (eg the unemployment rate one percentage point higher than otherwise for two years, the annual costs of a higher –  but still low –  inflation rate would have to be quite large, for the costs of a higher target to outweigh the benefits.  Perhaps my scenario is wrong, but Treasury doesn’t offer one at all.

Treasury devotes more space to the possibility of lowering the inflation target.  They aren’t keen on that –  some of their arguments are fine, others flawed at best –  but even then they seem determined to play down the near-zero effective lower bound on nominal interest rates, noting that (emphasis added)

a lower inflation target marginally increases the risk that the ELB [effective lower bound] may be reached, thereby providing monetary policy marginally less space to respond to shocks

Those who have sometimes called for cutting the target probably have in mind cutting the target midpoint from 2 per cent to 1 per cent (where it was in the early days of inflation targeting).    When interest rates are 8 per cent, that might make only a marginal difference to the chances of the lower bound being reached –  indeed, that was standard Reserve Bank advice in years gone by, when the lower bound was treated as a curiosity of little or no relevance to New Zealand.   But when the OCR is at 1.75 per cent (and the central bank thinks the output gap and unemployment gaps are near zero) a 1 percentage point cut in the inflation target would hugely reduce the effective monetary policy space for dealing with serious adverse shocks.  The floor would be hit with relatively minor adverse shocks.

And they conclude this way

New Zealand’s inflation target has been changed a number of times in the past and frequent changes to the level of the target could undermine the credibility of the regime.

There were two changes in the level of the target inside six years, which was unfortunate.  But the most recent of those changes was 16 years ago.  At that time, the idea of running out of monetary policy room in New Zealand was little more than a theoretical possibility.  Now it seems quite likely whenever the next recession happens here, and has already happened to numerous other advanced countries.

As I hope readers recognise by now, I regard an increase in the inflation target as an undesirable outcome, a second-best option.  I would rather the authorities (Reserve Bank, Treasury, and the Minister of Finance) treated as a matter of urgency removing directly –  and with preannounced certainty and credibility –  the extent to which the near-zero lower bound on nominal interest rates bites, by reducing or removing the incentives in the face of negative interest rates for people (large holders of financial assets, rather than transactions balances) to shift to holding physical cash.   Even just ensuring that the Reserve Bank gets inflation up to around 2 per cent –  rather than the 1.4 per cent (core) inflation has averaged for the last five years –  would help.

But there is nothing about any of this in The Treasury’s advice on the main instrument of New Zealand macroeconomic policy.  It seems extraordinarily inadequate.  Perhaps they have provided some other, more in-depth, advice on these sorts of issues –  in which case it might be good to proactively release that –  but there is no hint of, or allusion to, any deeper thinking in the PTA advice.   “Wellbeing” is all the (content-lite) rage at The Treasury these days.  I’m not a fan, but perhaps they should reflect that one of the biggest things policymakers can do to avoid adverse hits to “wellbeing” is to avoid unnecessarily severe or protracted recessions (and spells of unemployment).     Indifference on this score is all the more inexcusable when the limitations arise wholly and solely from policymaker/legislator choices –  whether around the level of the inflation target or the system of physical currency issues (and the prohibitions on innovation in that sector).  Ordinary New Zealanders –  not Treasury officials –  risk having to live with the consequences of their malign apparent indifference.

As it happens, a reader last night sent me a link to a couple of new pieces on exactly these sorts of issues.  The first was the (brilliantly-titled) “Crisis, Rinse, Repeat” column by Berkeley economist and economic historian Brad Delong.  He concludes

It has now been 11 years since the start of the last crisis, and it is only a matter of time before we experience another one – as has been the rule for modern capitalist economies since at least 1825. When that happens, will we have the monetary- and fiscal-policy space to address it in such a way as to prevent long-term output shortfalls? The current political environment does not inspire much hope.

And his column took me on to recent work by his colleagues David and Christina Romer, and in particular to a recently-published lecture on macroeconomic policy and the aftermath of financial crises.

The authors focus on financial crises (and I have a few questions about which events are included and which are not), rather than recessions more generally, but it isn’t obvious to me why their results wouldn’t generalise.   Here is their abstract.

Analysis based on a new measure of financial distress for 24 advanced economies in the postwar period shows substantial variation in the aftermath of financial crises. This paper examines the role that macroeconomic policy plays in explaining this variation. We find that the degree of monetary and fiscal policy space prior to financial distress—that is, whether the policy interest rate is above the zero lower bound and whether the debt-to-GDP ratio is relatively low—greatly affects the aftermath of crises. The decline in output following a crisis is less than 1% when a country possesses both types of policy space, but almost 10% when it has neither. The difference is highly statistically significant and robust to the measures of policy space and the sample. We also consider the mechanisms by which policy space matters. We find that monetary and fiscal policy are used more aggressively when policy space is ample. Financial distress itself is also less persistent when there is policy space. The findings may have implications for policy during both normal times and periods of acute financial distress.

These are really huge differences.  And they reflect a combination (a) a substantive lack of capacity, and (b) a reluctance to use aggressively what capacity still exists when the bottom of the barrel is getting close.

Here is the chart they use for monetary policy space (and lack thereof).

romer chart

(the dotted lines are confidence bands)

The Romers offer some thoughts on the policy implications, including

Very low inflation means that nominal interest rates tend to be low, so monetary policy space is inherently limited. A somewhat higher target rate of inflation might actually be the more prudent course of action if policymakers want to be able to reduce interest rates when needed.

Our finding that policy space matters substantially through the degree to which policy is used during crises also implies difficult decisions. For example, it is not enough to have ample fiscal space at the start of a crisis. For the space to be useful in combating the crisis, policymakers have to actually enact aggressive fiscal expansion. However, countercyclical fiscal policy has become so politically controversial that policymakers might refuse to use it the next time a country faces a crisis.

What of New Zealand (included in their empirical sample)?      We have plenty of “fiscal space” –  both gross and net debt are pretty low (around the lower quartile of OECD countries).  In a technical sense that might substitute to some extent for a lack of monetary policy capacity (if a recession hit today, we start with an OCR at 1.75 per cent, while most countries were at 5 per cent or more going into the last recession).    But fiscal deficits blow out quite quickly in recessions anyway –  as the automatic stabilisers do their work –  and can anyone honestly assure New Zealanders that governments would be willing to engage in much larger than usual, more sustained than usual, active fiscal stimulus if a new and serious recession hits at some stage?  Of course they can’t.  Politicians can’t precommit (and even Treasury can’t precommit what its advice would be) and the political constraints on a willingness to actively choose to take on large deficits far into the future –  perhaps on projects of questionable merit –  would almost certainly be quite real (as they were in so many countries after 2008).  So we are better placed than some because of the fiscal capacity –  itself less than it was here in 2008 –  but we really should be taking steps to re-establish effective monetary policy capacity.  That might involve (my preference) dealing directly with the lower bound, it might involve changing the inflation target, it might involve putting more pressure on the Bank to get inflation up to 2 per cent, or it might even involve asking questions about whether inflation targeting (as distinct from levels targeting) offers more crisis resilience (senior US monetary policymakers have openly been discussing some of those latter issues).

There is no sign, for now, that The Treasury is taking the issue at all seriously, and there has been no sign –  in speeches, or Statements of Intent –  that the Reserve Bank has been doing so.  That needs to change.   Perhaps it is a good opportunity for the new Governor.  But the Minister –  rightly focused on employment issues –  should really be taking the lead, and insisting on getting better quality analysis and advice, engaging with the real risks and offering practical solutions, than what was on offer when the PTA was being reviewed.

Revisiting 1996

After the 1996 election, and as a small part of the deal whereby New Zealand First went into government with National, the Policy Targets Agreement governing monetary policy was amended.  The first section now read, adding the text I’ve underlined.

1. Price Stability Target

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

Going into that election, New Zealand First had campaigned for material changes to the way monetary policy was run.  What it got was an increase in the target range (from 0 to 2 per cent, to 1 to 3 per cent) and those new words.   Inside the Bank, we never paid any attention to the words ever again.   They never came up in policy deliberations.   They were seen as some mix of political rhetoric and a statement of the obvious –  from our perspective, pursuing price stability was the best and only contribution monetary policy could make to those other worthy things.  Note that in negotiating the drafting, Don Brash even got the crucial word “sustainable” in.

In the new Policy Targets Agreement signed yesterday, this is how the equivalent paragraph reads.

1. Monetary policy objective

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

b) The conduct of monetary policy will maintain a stable general level of prices, and contribute to supporting maximum sustainable employment within the economy.

All but equivalent I’d say.   Curiously enough, I didn’t see the parallel drawn in the material Treasury released (including the RIS) on the new formulation of the monetary policy objective.

To be sure, as I noted in yesterday’s post on the PTA, the new PTA does include a couple of other references to employment.  Employment is added to the list of things where the Reserve Bank Governor is supposed to seek to avoid “unnecessary instability”.  However, this is the clause the Reserve Bank has been relying on in the last few years to defend its belated and reluctant response to core inflation outcomes persistently well below the target midpoint.  And the Bank will be required to discuss, in each Monetary Policy Statement, how current OCR decisions are contributing to supporting maximum sustainable employment.   The Minister has attempted to suggest that this provision will give bite to the new employment focus.  If he really believes that, then –  despite all the time he spent on FEC  in Opposition –  he obviously hasn’t looked at all carefully at how the Reserve Bank complies with the current statutory provisions governing Monetary Policy Statements –  formulaic at best.  As I noted yesterday, it is easy to predict the formulaic language now –  brand new recruits could write the words, (and may well do so).

I’ve been a bit ambivalent about changing the statutory (or PTA) goal for monetary policy.   Active discretionary monetary policy exists for output and employment stabilisation reasons, and in principle it is worth recognising that.   Since day one of the current Reserve Bank Act, that focus has been implicit in the way Policy Targets have been constructed.  It is not a new thing.    On the other hand, there has been a suspicion that Grant Robertson was more interested in things looking a bit different –  like that wording Winston Peters had introduced in 1996 – than in things actually operating differently, and thus on occasion I’ve suggested this change was more about political positioning and “virtue-signalling” than anything else.

And that might be fine if the Reserve Bank had been doing a superlative job in the last decade, but somehow there was still debate in some quarters as to whether output/employment stabilisation was a legitimate objective at all.  But they haven’t.   Core inflation has been persistently below the target midpoint –  the focus of the PTA –  for years, and even on their own (diverse) estimates –  see their chart below – the unemployment rate was above the NAIRU for almost all the decade.

nairu x2

That combination just shouldn’t have been.    Monetary policy – again on the Bank’s own reckoning –  works much faster than that.  Instead, through some combination of forecasting mistakes and biases towards tighter policy –  recall Graeme Wheeler’s repeated hankering for “normalisation” and his actual ill-judged tightening cycle –  they allowed the economy to run below capacity for years, more people than necessary to stay unemployed for longer, and didn’t even come close to deliver inflation averaging around 2 per cent.

And yet when –  as he was on Radio New Zealand this morning – the Minister of Finance is asked what difference the new PTA (and proposed statutory amendment) will make he flounders, and won’t even refer to the experience of the last decade.    His officials seem to be as bad.  In the Regulatory Impact Statement section on the proposed new objective, here is what The Treasury had to say

The main non-monetised benefit is to ensure that monetary policy decision-makers continue to give due regard to the short term impacts of monetary policy on the real economy. This is intended to improve the wellbeing of New Zealanders by ensuring that monetary policy seeks to minimise, or does not exacerbate, periods of economic decline.

The new Governor’s comments yesterday were along similar lines –  just recognising how things are done already.

So the experience of the last decade is just fine is it?   If so, the proposed law change really must be just about political rhetoric and positioning.

To be clear, there are limits to how much any new words themselves could have changed the Reserve Bank’s approach to monetary policy.  And, as everyone recognises, in the longer-term, monetary policy can only affect nominal variables (inflation, price level, nominal GDP etc) not real ones (employment and output).   But the government –  supported by advice from The Treasury –  appears to have chosen the weakest formulation possible, with little or no effective buttressing elsewhere in the Policy Targets Agreement.   There is, for example, no requirement to publish estimates/forecasts of “maximum sustainable employment” or associated concepts such as the NAIRU, and no requirement to account, look backwards, for how monetary policy has done in effectively minimising cyclical deviations in employment/unemployment.

Individuals and organisational culture matter a lot.   Arguably they matter more, at the margins, than precise wording in documents like the PTA.    The Reserve Bank’s culture appears over the last decade to have backward-looking, constantly fighting the last war –  surprisingly strong inflation in the years running up to 2008 –  insular, and –  as has been the case for decades –  not really much interested in labour market outcomes at all.  In all that, they’ve been backed by the Reserve Bank’s Board.

Adrian Orr is a strong character, and has an incentive –  all those Stage 2 review battles to fight –  to at least sound different than his predecessor Graeme Wheeler.  Then again, he emerged through a selection process undertaken by the Board –  which was explicitly happy with what had happened in the previous decade –  and his Minister has given no indication that he is anything other than happy with the actual past conduct of monetary policy.  A pessimist would suggest that, to the extent we see change, it will be cosmetic more than substantive.  Cosmetics have their place, but substance –  avoiding repeats of situations where at the same time core inflation is well below target and unemployment is well above a NAIRU, including in the next recession – matters rather more.

It is interesting to ponder how the new Governor –  single decisionmaker for now –  will address the question of what “maximum sustainable employment” is.      I’m expecting something reasonably vacuous and circular –  “since we (again) forecast inflation getting back to target in a couple of years time, by definition – by construction of our model –  employment must be close to the sustainable maximum”.    Doing so will be easier because the employment rate has no public resonance in the way that the unemployment (or even underemployment) rates do.

But here is a chart of HLFS employment rates since the survey began in 1996.

employment rates by sex

Female employment rates have been trending upwards, as one might expect as part of social changes.   However, male employment rates (73.4 per cent) are still well below where they were in 1986 (77.2 per cent).   In plain English senses, there is little reason to suppose we are anywhere near maximum sustainable employment rates for the economy as a whole.  I’m sure the plain English sense isn’t intended, but still.

And those male employment rates aren’t just about more young people being in tertiary education –  who are, in any case, outweighed by more old people working.  Here are the three prime-age male employment rates

employment rate prime age males For all three groups, employment rates now are materially below those thirty years ago, in a more deregulated labour market.

It just reinforces my sense that in making changes they’d have been better off using unemployment rates as a reference point, and requiring the Bank to produce a richer array of labour market analysis.   The actual new wording will easily translate to nothing if that is what the Governor wants.

And, finally, almost in passing, there has been coverage of former Reserve Bank chief economist Arthur Grimes’s criticisms of the change in the monetary policy objective, in which he talked of a “disastrous route”, a “crazy target”, the potential for the changes to destabilise the economy and so on.  He went on to assert that most episodes of financial instability in the world have flowed from the the United States, and a lot of that has been caused by their dual objective system.

I’m not quite sure which episodes Arthur has in mind with that latter comment, although I assume that the 2008/09 crisis is the principal one he is thinking of.   It is perhaps worth remembering that our Reserve Bank itself has produced research suggesting that the way it was reacting to incoming data in the decade or two prior to 2008 was very similar to the way the Federal Reserve and the Reserve Bank of Australia were reacting.   That isn’t surprising. In practice, whatever the precise wording of the respective mandates, all three were functioning as flexible inflation targeters.  It hasn’t been easy to rerun the model for the last decade –  since for a prolonged period the Fed was at an effective interest rate floor.       The way the two Antipodean central banks have conducted policy have still been fairly similar and thus –  even though neither reached the effective interest rate floor –  both countries have had below-target inflation in the context of labour markets that haven’t exactly been overheating (the RBA still thinks unemployment there is above the NAIRU).

Of course, these comments are a bit of a double-edged sword.  I think Arthur Grimes is quite wrong in his suggestion that our changes are very damaging and dangerous.  On the other hand, they are also a reminder that individuals and institutional cultures (and blindspots) often matter more than precise specifications of statutory objectives.  Changing the statutory mandate here, in deliberately vague ways, won’t make any helpful difference –  other than perhaps in political marketing –  unless the new Governor is about to lead some material culture change, and bring a fresh focus on avoiding prolonged periods of unnecessarily high unemployment.

It is his first day, so only time will tell.  For now, the signs aren’t encouraging.  But perhaps there will pleasant surprises in store.

On the new PTA

The last ever Policy Targets Agreement was released this morning, signed by the incoming Governor and the Minister of Finance.  With it came the decisions the government has made on reforms to the legislative framework governing monetary policy (decision makers, governance, transparency etc).  We are now finally getting past the year in which first the outgoing Governor was a lame-duck, and then the period when there was no lawful “acting Governor” or lawful “Policy Targets Agreement” –  and even if you did regard both as lawful, they were no better than caretakers.   With the government’s planned reforms such an unfortunate hiatus should never happen again (as it doesn’t happen abroad).

The Policy Targets Agreement is the key document in short-term macroeconomic management in New Zealand: it is the mandate for the Governor in his role as single decisionmaker on monetary policy, and monetary policy is the active tool for short-term economic stabilisation.   This one isn’t expected to have a long life.  Once the new legislation is in place –  scheduled for next year –  the Policy Targets Agreement will be replaced by a mechanism in which the Minister of Finance unilaterally sets the operational objectives for monetary policy (the UK system), although only after receiving (published) advice from the Reserve Bank and the Treasury.   That is a welcome change –  not only does it put responsibility for goal-setting firmly where it belongs (with elected ministers) but it removes the awkward aspect of the current system, in which an incoming Governor has had to agree targets (sometimes dealing with quite technical points) before being appointed, and often with only limited staff advice.   It was also a necessary change once a committee, with evolving membership –  rather than a single individual –  was made responsible for monetary policy.

The new (shortlived) Policy Targets Agreement has a few changes, although mostly not of great substance.

  • there is an even longer statement of the government’s political aspirations (‘inclusive economy”, “low carbon economy”, an economy that “reduces inequality and poverty”) none of which has anything to do with monetary policy.  Closer to economic policy, there are worthy aspiration (“a strong diversified export base”) which monetary policy can’t do anything about, and government policy isn’t doing anything about.
  • the substance of the document has been shortened a bit, but mostly not in a good way.  For example,
    • if I welcome the deletion of the reference to asset prices added in 2012, I’m uneasy about removing the explicit expectation that in monitoring inflation the Bank shouldn’t just look at the headline CPI.
    • And perhaps it isn’t of much substance, but I’m interested that they chose to remove “average” from the requirement that policy “focus on keeping future inflation near the 2 per cent mid-point”.
    • And I am a little uneasy about the removal of the list of the sorts of event/shocks that might justifiably warrant inflation being away from target, and the removal of the requirement to explain, when inflation is outside the target range, what they are doing to ensure that future inflation remains consistent with the target.  At the margin, it slightly weakens formal accountability (weak enough in practice anyway) and –  in the current climate –  may weaken the impetus to get core inflation back to 2 per cent (after so many years),
  • there are several changes relating to the new employment aspect of the objective (which, contrary to Arthur Grimes, I consider neither ‘disastrous’ nor ‘crazy’, and which risk being more feeble and virtue-signalling in nature than anything else).
    • at a high level there is an expectation that “the conduct of monetary policy will….contribute to supporting maximum sustainable employment”,
    • adding “employment” to the list of in the provision requiring the Governor to seek to avoid “unncessary instability”, and
    • a requirement to explain in Monetary Policy Statements how “current” monetary policy decisions contribute to “maximum levels of sustainable employment”

Quite what, if any difference, these provisions make will really depend on the new Governor’s assessment.   His press release suggests no difference at all

Mr Orr said that the PTA also recognises the role of monetary policy in contributing to supporting maximum sustainable employment, as will be captured formally in an amendment Bill in coming months.

In other words, just formalising what is already there.  An approach that, not incidentally, delivered us an unemployment rate materially above the NAIRU –  on the Bank’s own numbers –  for most of the last decade.   At present, we can probably expect lots of rhetoric –  repeated references to the contribution the Bank is making –  and nothing of substance, although in fairness it may be hard to tell for some time (since the unemployment rate is now closer to a true NAIRU than it has been for some considerable time).  It will be interesting to see the Governor’s first MPS and the associated press conference.

Personally, I’d have preferred that the new requirements were specified in terms of unemployment –  explicitly an excess capacity measure. There probably isn’t a great deal in the issue, except that the current formulation tends to treat high rates of employment as a “good thing”, when there is little economic foundation to such a proposition. By contrast, minimising (sustainably) the rate of unemployment is more unambiguously a “good thing”.

Perhaps more disappointingly, it is fine to require the Bank to explain how current monetary policy decisions are contributing to maximum sustainable employment.  But that is the sort of obligation an undergraduate student of economics could meet without difficulty and without much substance.  It is unfortunate that the Bank is not being required to:

  • explain how past monetary policy decisions have actually contributed to maximum sustainable employment,
  • explain how its future monetary policy plans will do so (the Act requires the Bank to explain policy plans for the (rolling) next five years),
  • publish estimates of the maximum sustainable level of employment.

Finally, with the OCR at 1.75 per cent and the current economic expansion having run for eight or nine years, it is disappointing that the Minister and incoming Governor have not signalled anything about the importance of preparing for the next recession, and reducing the extent to which the near-zero lower bound (inability to take the OCR below about -0.75 per cent) could severely limit the capacity of the Reserve Bank to maintain price stability (or contribute to maximum sustainable employment) in the next recession.  That recession  –  timing unknown of course –  remains much the biggest threat of unnecessarily high unemployment.  And yet it still doesn’t seem to be being taken seriously.

I’ll do a separate post on the planned legislative reforms.   For now, suffice to say that if it is a small step in the right direction, it is a big win for the Reserve Bank establishment.

On aspects of Reserve Bank reform

On Tuesday Adrian Orr will take up the office of Governor of the Reserve Bank and thus become, for a time, the most powerful unelected person in New Zealand.  In some respects he will in fact be more powerful than the Prime Minister, albeit over a much narrower range of functions, because it is much easier to oust a Prime Minister (see Tony Abbott and Kevin Rudd) or to vote her down in Cabinet than it is to constrain, or oust, a Governor.

It is a statutory requirement that a Policy Targets Agreement, governing the conduct of monetary policy, be agreed between the Minister of Finance and any person he is considering appointing as Governor before that person is appointed.  It is less than ideal that, three days out from Orr taking office, 3.5 months on from the appointment being announced, there is still no Policy Targets Agreement.   Have Treasury and the Minister lost sight of the merits of predictability and certainty, and the fact that markets (and individuals and firms) operate on a forward-looking basis?     But, apparently, the PTA will finally be signed/released on Monday, just a day before Orr takes office.   One can only hope that there will also be a pro-active release of the background papers relating to this major component of New Zealand macroeconomic policy.  If not, I will immediately be lodging OIA requests.

We are also told that information on decisions the government has made about “the new decision-making structure at the Bank” and other material on Stage 1 of the review of the Act (focused on monetary policy) will be released on Monday. If the government has done the right thing, before too long Orr will be stripped of much of his personal power, to become primarily an agency chief executive, and perhaps primus inter pares on one or more committees.   That would be a long overdue reform.  Perhaps the Independent Expert Advisory Panel –  which, thus far, has operated totally in secret – might open themselves to questioning?   Perhaps too we might get some hints as to what Stage 2 of the review –  content as yet undefined –  will cover?  You can expect there will be several posts on these issues next week.

As for Orr himself, only time and experience will tell what sort of job he will make of being Governor.  Today’s Herald has what can only be described as a puff-piece profile –  they managed preferential access to the previous Governor (notoriously media-shy), and presumably are targeting ongoing good relations more than serious scrutiny.  After having had monetary policy a bit too tight for most of this decade, we can only hope that their cartoon –  the new Governor appearing to keep money securely locked away –  isn’t inadvertently prophetic.

New Reserve Bank Governor Adrian Orr. Picture / Rod Emmerson

There was another, rather more interesting, piece –  from BusinessDesk –  offering some  thoughts from various economists on Orr taking up his new role.

Hawkesby likened Orr to UK politician Boris Johnson. “The stereotype of a central bank governor is someone whose communication is cautious, reserved and dry. Adrian is more like Boris, with communication that appears more spontaneous and witty,” he said.

TD’s Beacher warned, however, “there is the risk that his ‘good clear communicator’ reputation means he could make a poor choice of words on occasion when explaining the bank’s stance on policy settings.”

I greatly enjoy a good Boris Johnson newspaper or magazine column, but a comparison to Boris Johnson seems a backhanded compliment at best.    My own thoughts on Orr, and some of the opportunities and risks were in these two posts –  here and here.).

But the main prompt for this post was an interest.co.nz column from a day or two ago by my former Reserve Bank colleague, and now consultant on things to do with financial regulation, Geof Mortlock.  That website often runs to long headings for their articles.  This one is headed

Ex-RBNZ and APRA official, Geof Mortlock, argues the RBNZ’s regulation of the financial sector is so inadequate this responsibility should be passed on to a new agency

The article is well-worth reading for anyone interested in New Zealand financial system regulation and supervision, or in the governance and conduct of the Reserve Bank.

A few weeks ago I outlined the case (and here) for splitting the Reserve Bank in two, and shifting the regulatory and supervisory functions into a new agency, perhaps called the Prudential Regulatory Agency.   Various other people have supported that sort of change, one senior business figure commenting that, if starting from scratch, structural separation would seem like a ‘no-brainer’.     My case for that reform was summarised this way

In favour of that position is that:

  • it is the more common model in advanced countries today (including Australia),
  • the synergies and overlaps between the various functions of the Reserve Bank are pretty slight (and probably no greater than, say, those between fiscal and monetary policy),
  • structural separation would allow for clearer lines of accountability, and
  • structural separation would allow for the creation of stronger, more effective, cultures  –  with appropriately skilled chief executives –  in each of the two successor institutions.

And so I welcome the fact that Geof Mortlock is also calling for structural separation

In my assessment, the best way to achieve the needed changes is to remove the financial regulation functions from the Reserve Bank and move them to a new, separate agency. I am sceptical of the willingness or ability of the Reserve Bank to change its cultural DNA.  Moving financial regulation out of the central bank was done in Australia with great success. Likewise, this has been done in many other countries, such as Canada, Germany, Japan, Sweden and Switzerland.

At present, we don’t even know whether the government is open to considering this option –  since nothing is yet identifiably included in the proposed Stage 2 of the review –  but they should.  It would be likely to make possible –  although there are no guarantees – a better monetary policy agency and a better regulatory one.

The bulk of Mortlock’s artice is actually about the Reserve Bank’s conduct of its regulatory responsibilities.  On some counts I strongly agree with him, and his observations and criticisms echo points I’ve made here on various occasions

The Reserve Bank’s approach to policy formulation and consultation on regulatory initiatives is deficient. Too often, the Bank has allowed far too short a period for affected parties to make submissions on regulatory proposals. All too often the Bank has often given the strong impression that it has little interest in the submissions it receives – i.e. that it is consulting for the sake of appearance and has no intention of modifying its approach in light of submissions. It generally provides inadequate responses to submissions and insufficient justifications for any decision to reject points raised in submissions. The argumentation for policy proposals is often poorly developed. Cost/benefit analysis is typically provided to justify the Reserve Bank’s preferred option, rather than being objectively and rigorously developed at an early stage in the policy formulation process. There is very little substantive independent assessment of the Reserve Bank’s cost/benefit analysis. In stark contrast, the Australian system provides for much more rigorous independent assessment of all regulatory proposals.

All of these deficiencies need to be rectified by imposing on the Reserve Bank much stricter requirements on consultation and cost/benefits analysis, and by bringing much stronger external scrutiny to the process. Similar arguments can be made for other regulatory agencies.

One could add that the Bank’s regulatory impact statements are typically a joke, with no independent internal or external review –  and thus simply serving to provide support for whatver a particular Governor has chosen to do.

One could also add that the Reserve Bank remains highly averse to public scrutiny of its regulatory role, regularly falling back on statutory provisions –  which themselves should be reviewed and refine –  designed to protect commercially-confidential information obtained in the midst of a crisis, but used much more broadly than that.  Thus, the Reserve Bank recently refused to release any of a consultant’s review of the director attestation regime –  a central element in the prudential system. The utter lack of transparency around the Westpac capital models issue, or the stuff-up around the Kiwibank capital instrument are other examples.    Perhaps more than some other government agencies, the Reserve Bank tends to treat the Official Information Act as a nuisance that really shouldn’t applied to them, rather than as an intrinsic part of our democratic system, and a normal part of being a government agency.   The “but we are different” mindset is a hard one to break.

Quite a bit of the rest of the article –  on the Reserve Bank’s regulation/supervision activities and rules –  I disagree with.   It is nearer territory Geof spent has most of his time on than it is for me.  Then again, Geof has been a regulator for a long time, and appears to make his living in part from providing advice on fitting in with international frameworks and standards.   Of itself, that doesn’t invalidate his views, but it is worth remembering the old maxim that

I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail.

And there isn’t much sign of any cost-benefit analysis in his proposals for spending quite a lot more money (or so it would appear) on these functions.  I’m certainly sceptical of governments and bureaucrats wanting to spend more of our money on ‘financial literacy’ (as Geof suggests).  ‘Physician heal thyself’ comes to mind –  as Geof notes, the Reserve Bank will not even produce decent cost-benefit analyses for most of what it imposes on us.

I don’t doubt that the Reserve Bank could do some things quite a bit better –  process and culture included. I have also argued for removing some of the regulatory powers back to the Minister of Finance, and for more standardisation of the regime applying to all deposit-takers.   But I’m more sceptical that even more supervision is likely to be the answer to anything much.  A fair chunk of the global enthusiasm for more regulation, more supervision, over the last decade has been about backside-covering by politicians and regulatory agency officials after the crisis of 2008/09, with little attention to the inevitable limitations of regulation/supervision, including the incentives and constraints that face officials in regulatory agencies.  Action was demanded, and action was delivered, but the analytical basis for much of that action was often thin, and not well-grounded in serious sceptical scrutiny of the causes of the crisis.

And it is perhaps worth bearing in mind that New Zealand’s track record of financial stability has been pretty good.  Geof argues that

The Reserve Bank is also not well placed to proactively identify and resolve emerging problems before they become obvious or the financial institution is about to fail. The recent failure of CBL Insurance is an example of this. In earlier years, the Reserve Bank was slow to detect and respond to problems in DFC (which failed in 1989) and BNZ (which came close to failing in 1990).

Im not sure this is very persuasive.  On the one hand it is worth bearing in mind that it appears the Reserve Bank was onto the CBL problems well before the market was –  including bankers lending CBL new money –  and the DFC/BNZ failures were almost 30 years ago, under different legislation in the earliest days of the Bank having any prudential responsibilities and in the immediate aftermath of far-reaching financial liberalisation (followed by booms and failures in various other countries including Australia and the Nordics).   And on the other hand, we could note the crises and failures/near-failures (of regulated institutions or indeed the system) of the last decade in countries as various as the United States, United Kingdom, Switzerland, Denmark, Belgium, Netherlands, France, Greece, Italy, Spain, Ireland and so on.  In many of those countries, the IMF had previously provided a tick in its FSAP reviews.  Several of those countries will have –  and did –  prided themselves on their regulatory agencies, on-site or in-depth detailed scrutiny and all.     Neither New Zealand nor Australia (nor Canada, nor Norway for that matter) ran into such problems.    APRA may like to flatter itself that Australias avoidance of crisis was down to their fine supervision –  I’ve heard senior people run that line – and that New Zealand, free-riding on fine Australian supervision, was in the same boat.   My response to that claim would be, at best, ‘case not proven’.

It is also worth bearing in mind that the Reserve Bank isn’t the principal in this business, but the agent.  It hasn’t been –  and isn’t –  funded for more intensive regulation and supervision, and that is a choice successive Ministers of Finance –  advised by Treasury over the years –  have made.  In a sense, the Reserve Bank has done what Parliament  –  and Ministers –  asked it to do, and in that sense that question isn’t just about the Reserve Bank’s competence and capability but about choices our political system makes regarding the intensity of regulation.

All that said, if we might differ in emphasis, and in our confidence as to what value regulators and supervisors can add, we seem to be at one in favouring structural separation.  A good part of the case for such a reform is the ability to build a culture dedicated to doing excellently, and only, the regulatory and supervisory functions Parliament delegates to the Bank.  It is telling that, for a function that now bulks so large in the Reserve Banks mandate, recent Reserve Bank Governors have had little background in banking or of financial system regulation (certainly true of Bollard and Wheeler, and to a lesser extent for Adrian Orr).  At best, financial regulation and supervision is a part-time focus for the Governor.  And the new Head of Financial Stability –  an appointment made by Graeme Wheeler as he was leaving, without advertising the position –  has no background in those areas at all.  We can and should do better.  That ball –  structural reform and separation –  is now clearly in the Minister of Finances court.

 

 

 

Preparing for the next serious recession

There have been three New Zealand recessions since inflation targeting was introduced.  That, in turn, wasn’t long after interest rates were liberalised and the exchange rate was floated in 1984/85.   Of those recessions, two were severe and one (the 1997/98 episode) was more moderate.    Here is how 90 day bank bill interest rates –  the benchmark indicator before the OCR was introduced –  fell (and were allowed to fall by monetary policy) in those episodes.

Mid-late 1990 to mid-late 1992                   780 basis points

Mid-1997 to end 1998                                   340 basis points

Late 2007 to mid 2009                                  590 basis points (OCR cut 575 basis points)

Over the first of those periods, medium-term inflation expectations fell by about 2 percentage points (from about 4.3 to 2.3 per cent) –  that was in the midst of the major drive to lower the inflation rate.  In the other two episodes there was no material change in surveyed inflation expectations.    So in the two severe recessions, short-term real interest rates fell (or were cut) by about 580 basis points, and in the less serious recession they fell by 340 basis ponts.

At present, the OCR is 1.75 per cent (and 90 day bank bill rates are about 1.9 per cent).    As things stand today (current laws, rules, and central bank practices), no one is confident that the OCR could be cut further than around -0.75 per cent.   Below that, it seems likely that it would become economic for large scale moves into physical cash (which earns zero less storage and insurance costs) to occur –  mostly not by households, but by market participants with large holdings of New Zealand dollars.  To the extent such shifts happen, market interest rates wouldn’t fall much even if the OCR was cut further.  That would dramatically undermine the effectiveness of conventional monetary policy (which works mostly either through direct interest rate effects, or through the influence of interest rates on the exchange rate).

There isn’t anything very controversial about that story.  At the Reserve Bank it was a conclusion we got to in a project I led back in about 2012 when the euro-crisis seemed to foreshadow risks of new externally-sourced crisis/recession.   It is consistent with the revealed practices of other central banks (no one has cut below -0.75 per cent), and is just pretty standard analysis.

So if the next recession hit today, the Reserve Bank could count on having around 250 basis points of policy adjustment capacity (the OCR could be cut that much).   But it has needed more than that in each of the (small sample of) recessions in recent decades.

And it isn’t that the New Zealand numbers are unusual.  In the US recessions going back to the 1960s, the median cut in the (nominal) Fed funds rate has been just over 500 basis points.

If the OCR can’t be cut as much as normal, monetary policy cannot do its job.  We have active discretionary monetary policy to minimise the output and employment losses in downturns (adverse economic shocks come along every so often, like it or not).    And if markets, and businesses, know that monetary policy is thus hamstrung, they will factor that into their expectations and the actual downturn will probably end up even worse (the monetary policy cavalry aren’t expected to ride to the rescue).

And so, every so often since I started writing this blog, I’ve been highlighting the potential problem the next time a serious recession comes along, and lamenting the apparent (certainly in public) indifference of our Reserve Bank, Treasury, and Ministers of Finance to the issue.  Other countries ran into the limits of conventional policy in the last recession.  They couldn’t do much about it then, and paid the price in a very sluggish recovery (slow closing of output and employment gaps). But no country needed to find itself in this position if it prepared the ground well before the next recession.

In raising these concerns, I’ve been in good company.    Since shortly after the last recession various prominent economists –  of pretty impeccable orthodoxy –  have been raising the possible need to think about an increase in inflation targets.  Two of the most prominent were former IMF chief economists, Ken Rogoff and Olivier Blanchard.  Their logic is simple.  Inflation targets were set on the assumption (implict or explicit –  in our case, we actually wrote it down at times) that the near-zero lower bound on nominal interest rates was only a theoretical curiosity, and of little or no practical relevance.  Experience in various countries proved that assumption wrong.   And in the medium to long term, the most reliable way to raise nominal interest rates –  and thus leave room for substantial cuts in future recessions – is to raise actual and expected trend inflation.  (One counter to this argument for some countries a few years ago was that since most central banks were having trouble meeting existing inflation targets, and had already exhausted conventional capacity, how could they hope to credibly target still higher inflation.)

Other economists –  Miles Kimball, Willem Buiter, and more recently Ken Rogoff –  have focused on the other side of the issue: can changes in currency laws or practices be put in place which would mean that nominal interest rates could be cut more deeply.  As various observers have noted, some estimates of a conventional Taylor rule suggest that ideally the Fed funds rate would have been cut –  for a short time perhaps –  as low as -3 or even -5 per cent at the height of the 2008/09 recession.

In practice, nothing much has changed yet.  No one has changed their inflation target –  or adopted, say, price level of nominal GDP level targeting which some (including the head of the San Francisco Fed) believe could provide more resilence –  or taken steps to deal directly with the practical lower bound.   We are drifting towards the next severe recession, with the toolkit severely depleted.

In New Zealand, it has been harder than in most places to get any serious debate going at all.   I suspect a variety of factors contributes to that, including:

  • the fact that we didn’t get particularly close to the near-zero lower bound ourselves in the last recession,
  • the persistent belief that before long interest rates will again be much higher,
  • the belief that New Zealand has lots of fiscal headroom such that even if monetary policy is constrained in some future recession it won’t matter,
  • given the perpetual discontent in some quarters in New Zealand around monetary policy (it has been an election issue for some or other party every election since 1990) a desire, among the orthodox, not to be seen as “giving aid and comfort to the enemy”.

There is also a bit of handwaving around the possibilities of QE (direct asset purchases), but this is mostly handwaving and attempting to play distraction as no one in other countries –  that have actually used QE –  believe it is an effective substitute, on feasible scales, for the conventional interest rate instruments.

I would not, myself, regard a higher inflation target as any sort of first-best option.  Indeed, in an ideal world, I’d be more comfortable with a regime that delivered average inflation near-zero over time (allowing for the modest measurement biases in the CPI).  Inflation has costs, although economists have struggled to find convincing estimates of large adverse effects at relatively low inflation rates.  And many of the costs that do exist arise from the fact that the tax system is designed for a zero inflation rate.  Inflation-indexing the tax system (mostly around the treatment of interest and depreciation) could tackle that issue quite directly (and there are official reports from decades ago, here and abroad) identifying how it could be done.   (It would treat savers, and borrowers, more fairly, even with a 2 per cent inflation target: perhaps I point I might make in my submission to the Tax Working Group.)

But if there are modest –  largely avoidable –  costs of a slightly higher inflation target, they quite quickly pale in comparison with the output and welfare losses if monetary policy isn’t able to operate as effectively in leaning against recessions.  Drifting towards imposing that cost on ordinary New Zealanders –  and it won’t be the Treasury or Reserve Bank officials who face those cyclical costs – should be pretty inexcusable.

And so I was encouraged when, the other day, Radio New Zealand’s Patrick O’Meara rang up.  He’d been reading my post which had noted, in passing, the IGM survey of US economists in which 86 per cent of those senior US academics agreed that

Raising the inflation target to 4% would make it possible for the Fed to lower rates by a greater amount in a future recession.

and was interested in how one might think about these issues, and do something about them (immediately and in the medium-term), in a New Zealand context.   We talked at some length, and then he talked to some other people, and the result was this story.

I was quoted this way

While uneasy about higher inflation, economic commentator and former Reserve Bank official Michael Reddell said increasing the Reserve Bank’s inflation target band of one to three percent was worth discussing.

“It’s really important to start planning, having the discussions about how we’re going to cope with the next downturn.”

“The next recession could be relatively minor,” he said.

“We could just get away with needing to cut the OCR by 50 or 100 basis points [0.5 to one percent].”

“But the typical severe recession, whether it’s in the US or New Zealand needs, typically, [400-600] basis points of interest rate cuts, and we’re just not positioned for that,” Mr Reddell said.

What surprised me was the comments from others that O’Meara talked to –  not so much the conclusion, but the argumentation.    In fairness to the individuals, I don’t know exactly what they were asked, or how much of their response was used, so what follows is a response to the Radio New Zealand reporting.

There was Kirk Hope, head of Business New Zealand, who (frankly) seemed an odd person to ask about details of macroeconomic policy and contigency planning for future recessions.

Business would also suffer, Business New Zealand chief executive Kirk Hope said.

“If the target is too high and there’s too much inflation and interest rates are too high, then it reduces investment in the economy … and that in the end costs jobs.”

As quoted, those proposition are simply wrong.  They don’t, for example, distinguish  –  quite importantly – between real and nominal interest rates.  All else equal, higher real interest rates might reduce investment.  Unchanged real interest rates –  actually perhaps a bit lower in a transition period – are unlikely to affect investment or jobs adversely.

And there is no sign that Hope had even engaged with the “how do we handle the next severe recession” –  when investment and jobs really will be adversely affected if monetary policy is hamstrung –  question.  Perhaps it wasn’t put to him?

The other person asked specifically was Arthur Grimes, these days a researcher on all manner of interesting things, but formerly a senior manager at the Reserve Bank (and, for a time, chair of the Reserve Bank Board).  Arthur has long been a vocal, and articulate, defender of the status quo.

Here was what RNZ reported of his views

Victoria University School of Government professor Arthur Grimes was adamant New Zealand’s existing inflation target band was more than adequate.

Professor Grimes said raising inflation to four percent, for example, would do nothing but hit households in the wallet.

“Why would we want the cost of living to be rising any faster than that? Don’t forget the cost of living makes it harder for people to live. It’s wonderful that inflation expectations are low and that inflation is pretty low.”

His response was more surprising, given his background.  Not that he didn’t favour raising the target (I don’t either) but the quoted thrust of his argumentation.  Higher (expected) inflation  –  and inflation expectations are at the heart of the story about nominal interest rates –  don’t “hit households in the wallet”; they see both wages and prices (and welfare benefits) rising a bit faster than otherwise.  If there are real adverse costs of higher inflation they come from things like the tax system effects (see above).  The confusion of reals and nominals in these quoted remarks seems pretty extraordinary.  If wages and price are both rising at 2 per cent per annum, and then subsequently – well foreshadowed –  they are both rising at 4 per cent, there simply isn’t a “cost of living” problem which “makes it harder for people to live”.

And again –  and perhaps he wasn’t asked –  there is simply no engagement with the case that people like Blanchard and Rogoff used in raising the option of a higher inflation target: how do we cope with the next severe recession when the OCR can’t be cut as much as we are used to?

My own position remains much as I outlined it the other day.  The first priority needs to be some serious engagement on the issue, and recognition, of the likely threat –  the constraint on the ability of monetary policy to do the job we’ve asked of it since the end of the Great Depression.   In my view, the second priority should be serious work on removing or greatly attenuating the near-zero lower bound, by taking steps (and being open about them) to limit the scope for large scale conversions to cash.  Far better to deal with the issues, and risks, now, than to attempt to grapple with them in the middle of the next serious recession (especially given recognition lags).

And for the immediate future, in the context of the PTA that has to be agreed in the next few days, and any associated letter of expectation to the new Governor, as I suggested the other day

  • In conducting monetary policy, and without derogating from its obligation to act to keep inflation within the target, the Reserve Bank should be required to have regard to the desirability of there being as much effective policy capacity (or at least rather more than at present) as possible to respond to the next serious recession, and

  • consistent with that, the Minister could indicate that he would be more comfortable if core inflation over the next few years fluctuated in, say, the 2.0 to 2.5 per cent part of the target range, than if core inflation continued to fluctuate around 1.4 per cent as it has now for a number of years.

Raising the inflation target itself should only be a fallback option.  I deliberately don’t use the words “last resort” –  that way nothing will happen until well into the next severe recession when it will be too late  – but if, after careful and open considerations, officials come to the conclusion that whatever can feasibly be done around easing or removing the near-zero lower bound won’t produce (with certainty) the desirable degree of policy flexibility, than we should be seriously considering a higher target. It might not be ideal, but we don’t live in a first-best world.  If one of the key assumptions that underpinned the current targets has been invalidated, and can’t be dealt with directly, the target would need to be revisited.

And finally, as much to anticipate commenters as anything, a couple of quick thoughts on the exchange rate and fiscal policy:

  • as I’ve pointed out here more than once, in such an adverse scenario –  with our OCR at the floor –  the exchange rate is likely to be very much lower.  Which is consoling, but unlikely of itself to be adequate.  After all, in typical New Zealand recessions we have both large OCR cuts and large falls in the exchange rate,
  • our net public debt is quite low, and clearly there is more room for fiscal expansion than in many countries.   Nonetheless, experience suggests that that room will prove smaller than it might appear (not so much technically but politically).  And since few other advanced countries will regard themselves as having much fiscal room, the advanced world as a whole will be short of offsetting stimulus.  Moreover, typically monetary policy can be deployed much more quickly than fiscal policy, suggesting that at best fiscal headroom is a poor substitute for fixing the monetary policy constraints.

And for anyone interested in another analysis of the option of raising the inflation target, this recent piece from the Bruegel thinktank in Europe, emphasising the importance of robustness, covers some of the ground quite nicely.

 

Towards a new Policy Targets Agreement

In 20 days time, 27 March, Adrian Orr is scheduled to take office as Governor of the Reserve Bank.  I say “scheduled” because he can’t be appointed until he and the Minister of Finance have signed a Policy Targets Agreement consistent with the statutory objective for monetary policy set out in section 8 of the Reserve Bank Act.

We can assume there will such a Policy Targets Agreement.  After all, the current (unlawful) acting appointment of Grant Spencer ends on 26 March, and all the powers of the Reserve Bank are vested in the Governor personally.

But given that (a) Orr’s appointment was announced three months ago, and (b) the changes in focus for monetary policy that the new government has foreshadowed, it isn’t very satisfactory that we still have no Policy Targets Agreement, and that whatever is being cooked up is being done in secret.   Perhaps I get repetitive in making the point, but as I’ve noted previously the Policy Targets Agreement is the main instrument of macroeconomic management, signed up for five years at a time, and then with all the powers delegated to a single individual (who hasn’t even been inside the Reserve Bank before signing up to his new mandate). against whose decisions there are no rights of appeal.

There is also a review of the Reserve Bank Act underway at present.  When the Terms of Reference were announced  –  four months ago today – we were told that as regards the first part of the review, dealing with monetary policy goals and governance,

A Bill to progress the policy elements of the review, including on the details necessary to introduce a potential committee for monetary policy decisions, will be introduced as soon as possible in 2018. This will give greater certainty on the direction of reform in advance of the appointment of the next Reserve Bank Governor, currently scheduled in March 2018.

The clear suggestion was not just that a report might have been provided to the Minister of Finance, but that a bill would have been introduced to Parliament before the new Governor took office.   The decisions in that legislation would, it was implied, inform PTA negotiations.   That phrasing was repeated when the Independent Expert Advisory Panel was appointed in December.

At the time we were also told that

The Panel will also be responsible for a report to the Minister that sets out their views on the Treasury’s policy conclusions and recommendations for phase 1. This will be delivered to the Minister at the same time as the Treasury’s recommendations for phase 1, which is planned for the second half of February.

Treasury’s dates seem to have been slipping.  The web page for the review now says

For Phase 1, please provide any submission to us by 19 February 2018 if you would like your input to be considered before initial advice is provided to the Minister.

If submissions were only due by 19 February, it didn’t give much time for (a) Treasury to reach its conclusions, and (b) for the independent panel to reach and write up their views on the conclusions, all by “the second half of February”.

When this review was initially announced the dates seemed tight but, if observed, ones that might allow some external discussion before the new Policy Targets Agreement was set, especially around the proposed wording of any change to the statutory objective of monetary policy.   As things stand now, we seem most likely to be shortly presented with some sort of fait accompli.

It isn’t a good way to make policy.  The details of the legislation will, in time, be subject to select committee review (and the publication of associated submissions) but the Policy Targets Agreement itself –  including the extent to which it aligns with the proposed new legislation – will have legal force almost right away.   There is no good reason why a more open process could not have been adopted.  At very least, I hope that the Minister of Finance will instruct the Reserve Bank and Treasury to pro-actively release all the papers relating to the forthcoming PTA (it took several years after the event to extract those relating to the 2012 PTA).

And when the Minister sits down to decide what he wants in the Policy Targets Agreement, I would urge him to take much more seriously –  than there is any sign his predecessors, or officials, did over the last few years –  the next serious recession.  As a reminder, in typical recessions short-term interest rates fall (or are cut)  by 500 basis points or more, and at present –  with inflation below target midpoint –  the OCR is at only 1.75 per cent.   I talked yesterday to a journalist who asked how this might be done.   I don’t think it is a matter of changing the inflation target itself at present – that might be appropriate at some point but should be a last resort –  but there are at least three items which could be included either in the Policy Targets Agreement (preferably, since it is an agreement) or in the Minister’s non-binding letter of expectation to the Governor.

  • The Reserve Bank should be required to prepare and provide to the Minister (preferably disclosing the bulk of such a report) a report on practical options that could be put in place early to alleviate or remove the near-zero lower bound on nominal interest rates.  The Reserve Bank’s forthcoming Bulletin article on digital money –  now apparently delayed –  (which they told me about when they refused to release any of their work in this area) may be one input to such work,
  • In conducting monetary policy, and without derogating from its obligation to act to keep inflation within the target, the Reserve Bank should be required to have regard to the desirability of there being as much effective policy capacity (or at least rather more than at present) as possible to respond to the next serious recession, and
  • consistent with that, the Minister could indicate that he would be more comfortable if core inflation over the next few years fluctuated in, say, the 2.0 to 2.5 per cent part of the target range, than if core inflation continued to fluctuate around 1.4 per cent as it has now for a number of years.

It might also be desirable to require the Governor to publish a substantive statement, perhaps within a month of taking office (or at the next MPS), outlining his interpretation of the new Policy Targets Agreement.  We should not have to rely on discovering the meaning of a major instrument of macro policy  solely by revealed preference.

Our Reserve Bank isn’t the only one facing a change in the way its objective is specified.  Just recently, a new objective was set down for the Norwegian central bank, the Norges Bank.   It was the culmination of a two-year process, of which the Ministry of Finance observed

The Ministry has placed emphasis on ensuring a transparent process

The new specification lowers the inflation target –  from 2.5 per cent to 2 per cent.  The initial 2.5 per cent target, adopted in 2001, had been justified on the basis of Balassa-Samuelson types of effects –  as the oil wealth flowed, Norway might have expected to see high non-tradables inflation rates.  Norway is now, on their own reckoning, past that phase.

Here is the bulk of the (notably short) new mandate

Section 1 Monetary policy shall maintain monetary stability by keeping inflation low and stable.

Section 2 Norges Bank is responsible for the implementation of monetary policy.

Section 3 The operational target of monetary policy shall be annual consumer price inflation of close to 2 percent over time. Inflation targeting shall be forward-looking and flexible so that it can contribute to high and stable output and employment and to counteracting the build-up of financial imbalances.

Section 4 Norges Bank shall regularly publish the assessments that form the basis of the implementation of monetary policy.

The second sentence of section 3 is new –  explicit references to “high and stable output and employment” and also to ‘counteracting the build-up of financial imbalances’.  The latter provision is completely new, while the output and employment reference replaces the current objective of “contributing to stable developments in output and employment”.

What I liked was two things:

  • firstly, the deliberate and transparent process used to make the change, and
  • secondly, the public exchange of letters betweeen the Ministry of Finance and the Norges Bank explaining the change and (from the central bank’s side) explaining how the Bank envisages implementing the mandate.  Thus, on the financial imbalances point they note:

The regulation and supervision of financial institutions are the primary means of addressing shocks to the financial system. To some extent, monetary policy can contribute to counteracting the build-up of financial imbalances and thereby reduce the risk of sharp economic downturns further ahead. How much weight this consideration will be given in the conduct of monetary policy will be situation-dependent and must be based on an overall assessment of the outlook for inflation, output and employment.

I don’t think the Norges Bank specification is the appropriate one for New Zealand.  If it were adopted it would be a sign that the government wasn’t really serious about a greater focus on employment outcomes and minimising deviations of unemployment from an (unobservable) NAIRU.   But the open and deliberate process looks like a good example to follow.

In the New Zealand context, one legislative change that should be made is that future Policy Targets Agreements (or mandates from the government, if that were the chosen model) shouldn’t be developed before a new Governor takes office.  (Among other reasons, because no new Governor appointed since the early 1980s has had any recent practical experience with monetary policy).  The target should instead be set, say, every five years (with potential for changes more frequently than that  – eg in the event of a change of government), with a requirement that prior to any new PTA there should be a period of public consultation.  The Reserve Bank has to do that when, eg, it wants to impose new LVR limits.  Governments typically have to do that when they want to legislate (select committees).  For such a major instrument of macroeconomic policy, it seems fitting that a similar sort of process should apply.