A deteriorating institution

I write a lot here about issues around the Reserve Bank. Some of those issues are quite obscure or abstract, and I know some readers find some of those posts/arguments a bit of a challenge to grasp.

But yesterday we had as straightforward an example as (I hope) we are ever likely to find.

Inflation is very much in focus at present. Measure of inflation expectations get more attention than usual. There is a variety of measures, both surveys (in New Zealand mostly conducted for the Reserve Bank and by ANZ) and market prices. The Reserve Bank has been surveying households for 27 years, with a fairly consistent (although expanded on a couple of occasions) range of questions. At the Bank there was always a degree of scepticism about the survey – household respondents always seemed (eg) to expect inflation to be quite a lot higher than it actually was – but it was one more piece in the jigsaw, and if one couldn’t put much weight on the absolute responses, changes over time did seem to line with what households might be supposed to be feeling/fearing.

Of the questions, probably the one least hard for households to answer seemed to be the fairly simple one

No numbers needed, just something directional. We have 27 years of data.

The latest results of the survey came out yesterday. The Bank puts out a little write-up and posts the data in a spreadsheet on their website. Yesterday, the write-up didn’t mention this question at all, but the spreadsheet suggested that a net 95.7% of respondents expected inflation to increase over the next 12 months. That seemed like it should be a little troubling, given how high the inflation rate already is.

Except that……it turned out that the Reserve Bank had changed the question, without telling anyone, without marking a series break or anything. The new question is

And that is a totally different question. The old question is about whether inflation will increase or decrease, while the new one is about whether there will be inflation or deflation. At almost any time in the 88 year history of the Bank it would not be newsworthy if 95.7 per cent of people expected there to be inflation. There almost always is.

It isn’t necessarily a silly question in its own right (on rare occasions there are deflation “scares”) but (a) it is a much less useful question most of the time than the question that had been asked and answered for 27 years, and (b) you can’t just present the answers to one questions as much the same thing as the answer to the other. Especially when not telling users of the data.

It was real amateur-hour stuff. Now, in fairness to the Bank, there is a detailed account of the changed questions on the website, but when there was no hint that question had changed there was no motive to go on a detective hunt to find it.

The Bank tells us they have had a 38 per cent increase in the number of senior management positions in the last year, with no increase in the things they are responsible for, and they can’t even get fairly basic things like this right. They’ve destroyed the single most useful question in the survey, and right at the time when every shred of information on attitudes to inflation should be precious. And then seemed barely even to be aware of what they’d done – presenting the answers to two quite different questions as if they were in fact very much the same.

There were a few people yesterday suggesting it was some nefarious plot to reduce access to awkward data at an difficult time. I don’t believe that for a moment – although for wider peace of mind I have lodged an OIA request to confirm (and to find out whether, for example, MPC members even knew of the change). This was a stuff-up pure and simple, which management and senior management (for which the Governor is accountable) should never have allowed to happen. High functioning organisations don’t make stuff-ups like this.

Which is a convenient lead in to an article published this morning.

About five weeks ago Stuff’s business editor asked if I’d like to write a column for them on the Reserve Bank under Adrian Orr. I did so (a few days later) and the final version appeared this morning. I only had 800 words, and there was a lot of ground one could have covered, so much of the story has to be very compressed (and quite a few problem areas left out altogether). You can read the final Stuff version here, or the text I originally wrote is below. Were I writing it now rather than a month ago, I would put more weight on the inflation story – core inflation now having blasted through the top of the target range – but I wanted to distinguish between forecasting mistakes (which are somewhat inevitable, and the best central banks will make them) and things that are much more directly within the control of the Governor, the Board, and the Minister of Finance.

Alarming Decline

By Michael Reddell

Over the four years Adrian Orr has been Reserve Bank Governor, this powerful institution, once highly-regarded internationally but already on the slide under his predecessor, has been spiralling downwards.  The failings have been increasingly evident over the last couple of years.  Here I can touch briefly on only a few of the growing number of concerns.

One can’t criticise the Reserve Bank too much for running monetary policy based on an outlook for inflation and the economy that, even if wrong, was shared by most other forecasters. Until late 2020 the general view of the economic consequences of the Covid disruptions had been quite bleak. Notably, inflation was widely expected to be very low for several years.  The Bank got that wrong, and so inflation (even the core measures) has been a lot higher than expected.  If they were going to err – after 10 years of inflation undershooting the target – it may have been the less-bad mistake to have made.  But they have been slow to reverse themselves – the OCR today is still lower than it was two years ago – and slower to explain.

The Bank is much more culpable for the straightforward lack of preparedness and robust planning.  Orr had been quite open, pre-Covid, that he wasn’t keen on big bond-buying programmes, and if necessary preferred to use negative interest rates.  But when Covid hit it turned out that the Reserve Bank had done nothing to ensure that commercial bank systems could cope with a negative OCR.  They couldn’t.  So instead, as if keen to be seen to be doing something, the Bank lurched into buying more than $50 billion of government bonds.  Buying assets at the top of the market is hugely risky and rarely makes much sense, but the Bank kept on buying well into 2021.  As interest rates rise, bond prices fall. The accumulated losses to the taxpayer are now around $5 billion ($1000 per person, simply gone).  And yet the Bank has never published its background analysis or risk assessment, it offers up no robust evidence that anything of any sustained value was accomplished, and the Governor refuses to even engage on the huge losses.

What of the new Monetary Policy Committee itself?  From the start the Governor and the Minister agreed that anyone with current expertise in monetary policy issues would be excluded from the Committee.  For the minority of outside appointments, a willingness to go along quietly seems to have been more important than expertise or independence of thought.  Meanwhile, staff (Orr and three others who owe their jobs to him) make up a majority of the Committee.  Minutes of the Committee are published but deliberately disclose little of substance, there is no individual accountability, and four of the seven MPC members have not given even a single published speech in the almost three years the Committee has been operating.  Speeches given by the senior managers rarely if ever reach the standard expected in most other advanced countries.  Meanwhile, the in-house research capability which should help underpin policy and communications has been gutted.

And then there is the constant churn of senior managers.  In some cases, people who were first promoted by Orr have since been restructured out by him.  In just the last few months, the departures have been announced – not one of them to another job – of four of the five most senior people in the Reserve Bank’s core policy areas: the Deputy Governor, the chief economist, and the two department heads responsible for financial regulation and bank supervision.   It isn’t a sign of an institution in fine good health. 

And all this has unfolded even as total staff numbers have blown out, supported by the bloated budget the government has given the Governor.   Orr often seems more interested in things he has no legal responsibility for than in the handful of (sometimes dull but) important things Parliament has specifically charged the Bank with.  Perhaps worse, he has a reputation for being thin-skinned: not interested in genuine diversity of views or at all tolerant of dissent, internally or externally.  One might just tolerate that in a commanding figure of proven intellectual depth, judgement, and operational excellence, but Orr has exemplified none of those qualities.

How to sum things up?  Lack of preparedness, lack of rigour and intellectual depth, lack of viewpoint diversity, lack of accountability, lack of transparency, lack of management depth, lack of open engagement, and lack of institutional memory.  It is quite a list.  The Governor is primarily responsible for this dismal record of a degraded institution but it is the Minister of Finance who is responsible for the Governor.

This really is a matter of ministerial responsibility.

Finally, earlier in the week I wrote a post here about expertise and the Monetary Policy Committee in which, among other things, I lamented again the absurd policy adopted three years ago by Adrian Orr, the Bank’s Board, and the Minister of Finance, excluding from consideration for (external) MPC positions anyone with any ongoing systematic interest in macroeconomics or monetary policy. This morning Jenee Tibshraeny of interest.co.nz had a new article focused on that restriction. She has comments from various economists, the only one sort of defending it one who was adviser in Robertson’s office at the time the restriction – one without parallel in any other advanced country central bank – was put on, but had also asked Robertson and the Bank (Orr or Quigley or both?) whether the same restriction would be applied to filling the upcoming vacancies.

It should be incredible, literally unbelievable, if we had not seen so much from Robertson and Orr over recent years careless of the reputation, capability or outcomes of the Bank. As it is, it is just depressingly awful. One hopes – probably idly – that the Opposition political parties might think it an issue worth addressing. After all, not only are qualified people with an ongoing analytical etc interest in monetary policy excluded from the external MPC positions, but the latest appointment to an internal position (by Orr, Quigley and his board, and Robertson in concert) suggests the bias against actual expertise and knowledge might now be being extended to encompass executive roles.

Expertise and the MPC

I’m yielding to no one in my low view of the Reserve Bank Monetary Policy Committee. I’ve been writing about the problems – structural and personal – since the new Potemkin-village model (designed to look shiny and new, but to change little) was set up three years ago, and it was (for example) one of my Official Information Act requests that got the written confirmation that the Minister, Governor and the Bank’s Board had formally agreed that no one with ongoing expertise in monetary policy or macroeconomics, or likely future interest in researching such matters, would be appointed (as an external member) to the new Monetary Policy Committee (three relevant posts here, here, and here). It was a simply extraordinary exclusion, which reflected very poorly on all involved, but which never seemed to get the scrutiny from media or MPs that it deserved. In no other modern central bank would such an approach be adopted.

But, for all that, I thought Eric Crampton’s op-ed in the Herald today overbalanced in the opposite direction. The column is behind a paywall, so I’m not going to quote extensively, but the gist seemed to be that you need a PhD in macroeconomics AND to be actively engaged in ongoing research to serve on the MPC. Crampton and an Otago university academic then report the results of a little survey they’d run of New Zealand academic macroeconomists to find out who those people thought should be appointed to the MPC, when the terms of two of the current externals expire shortly. It wasn’t noted that the most favoured candidate – one of the incumbents, Bob Buckle – does not have a PhD in macroeconomics, and has presumably taken a self-denying ordinance not to do any relevant research or analysis now or in the future (or otherwise he’d fall foul of the exclusionary rule, see above).

I don’t want to run commentary on all the individuals reported on. One or two might well be excellent additions, one or two would probably be dreadful, but none should be disqualified in advance simply because they might keep thinking about the issues, or writing about them in future. Even if the pickings are fairly slim, that far I agree (strongly) with Crampton. Of course, at present none of it probably matters much as management enjoys a permanent majority on the MPC, and the Orr/Robertson approach has been to prevent external members from speaking in public or even having their views recorded in the minutes. Three years sightseeing aside, it is difficult to know why really able people would seek, or accept, appointment at present. Management appointees matter much more, and the most recent appointment – the new executive deputy in charge of macro and monetary policy, with not a shred of relevant experience – suggests things are heading in the wrong direction there too.

But I think the “cult of the PhD” can be carried too far, at least when it comes to policy roles (as distinct from, say, staffing the Economics Departments of our universities). Don Brash had one, but had been primarily a banker and intellectually curious as he was (and is) had no demonstrated ongoing interest or expertise in macroeconomic research. Alan Bollard had one. Graeme Wheeler didn’t. But little or nothing about how well or badly those individuals did their jobs – and reasonable people may debate each – came down to how complex an NBER paper they could each critique (let alone produce). I’ve noted several times over the years that of the Reserve Bank’s chief economists over my working life, about half had PhDs and half did not. But there was no obvious correlation between those who did (or didn’t) and effectiveness or intellectual energy. Some (one?) of the best did, some (two?) of the best didn’t, but one who did was almost surely the worst of them. In English-influenced countries even 30-40 years ago it wasn’t particularly common for even the most able people to pursue PhDs unless they wanted an academic career. A couple of the more published researchers at the Reserve Bank in the last decade or so either didn’t have a PhD, or got one only rather belatedly (having already published quite a bit).

Or we could look around the world. Alan Greenspan was an economist but didn’t have a PhD (Update: thanks to the reader who pointed out that he acquired one well into his policy career). Jay Powell was a lawyer and private equity executive. Glenn Stevens, the previous RBA Governor, seemed to do a pretty reasonable job, and had neither a PhD nor a research track record. I’m not a great Lagarde fan, but she’s a lawyer and politician. Andrew Bailey has a PhD – in history – but spent his career in banking-oriented roles at the Bank of England. On the other hand, Phil Lowe, Mark Carney, Ben Bernanke, and Stefan Ingves have economics PhDs, even if not always with much sign of ongoing research interest.

Which is by way of saying that despite my many criticisms of Adrian Orr, the fact that he doesn’t have a PhD doesn’t bother me in the slightest. And the fact that Caroline Saunders – another of the independents – has one, if in quite unrelated areas of economics, allays not in the slightest my concern about the weakness (and tokenism) of her appointment.

A parallel I sometimes draw with the MPC is with the Cabinet. As Crampton notes, the MPC makes decisions that are final. So, in many areas, does the Cabinet (and often individual ministers). Very rarely do we expect the Prime Minister or Cabinet ministers to be professional technical experts in any of the areas they are minister for, let alone with the whole ambit of policies for which Cabinet is responsible. It often isn’t even helpful to have had a health expert as Minister of Health, and I’m pretty sure that in all New Zealand’s history we’ve never had an economist as Minister of Finance (nor is it common in parliamentary systems elsewhere). That isn’t a problem. We expect there to be a distinction between professional and technically-expert advisers on the one hand, and decisionmakers on the other. When either group tries to do the job of the other, or the advisory expertise is lacking, things run into difficulty.

[UPDATE: Bill Rowling, Minister of Finance 1972-74, did have an economics degree.]

The parallel with the MPC isn’t exact. We want the Cabinet to be making intrinsically “political” calls, about preferences, priorities, values etc. But we also want them to be judicious people – not unduly swayed by the latest whizz-bang research paper or think-tank idea, or the latest data point. We want/need them to be thinking about communications, public acceptability and so on.

So I’m not suggesting an MPC made up of the first 10 names in the Wellington phone book, or a bunch of pleasant (or otherwise) political hacks. But there is a place for a balanced committee, served by a highly expert staff (research, analytical, policy, markets, operational – all quite different components of what a capable monetary policy function needs). It seems quite likely that some of those roles would these days naturally be filled by people with PhDs – key figures in the research functions, most often perhaps the Chief Economist – but technical research virtuosity (of the sort a highly productive PhD may still offer – many do, many don’t) is just one, important, part of the relevant set of skills. Even in that sort of area, a passion to make sense of what is going on, to interpret evidence and data carefully, to be open to new ideas and fresh perspectives, seem to me to be what we should be looking for. Qualifications aren’t irrelevant, but qualities matter at least as much. And in an MPC that is dominated by management (which also controls all the staff resources), the willingness to think independently and ask hard but realistic questions, to engage effectively with experiences in other times and other countries, are what are likely to add most value. Some functioning academic researchers may be able to do that well, and their particular talents and experience should add value to the Committee. But so, far example, might someone who’d spent decades at the interface of economics and financial markets, or even – and one wouldn’t want this type dominating the Committee – the sort of classic old-school corporate director who is not afraid to ask questions when things don’t make sense, and who may act as a really effective test for how well the expert arguments, analysis, and lines of reasoning may be received in wider public audiences (I can think of a couple of these types who were on the RB Board in years past). Temperament is often at least as important as virtuosity. And effective public communications – not always an academic (or bureaucratic) strength – is vital.

Of course, the bottom line at present is that almost every dimension of the Reserve Bank (and particularly its macro/monetary functions) is weak: little research, little transparency, weak senior management appointments, a Governor with the wrong temperament for the job, an MPC structured to be ineffective, and weak appointees to the MPC. The ban on people with ongoing research interests – almost laughably bad as it is – is more like a symptom of a weak institution…..and a Minister of Finance who seems just fine with all that. And not even, it seems, bothered when core inflation bursts out the top of the target range.

UPDATE: I’d been aware that several of the top figures at the Bank of England in recent decades, including Eddie George and Paul Tucker, had not had PhDs (the latter having gone on to write a very serious book about central bank governance etc), but when I wrote the post I’d been labouring under the impression that the most prominent and eminent such figure – Mervyn King – had had a PhD. A reader got in touch to point out that he hadn’t. I’ve disagreed with many of King’s views, including in posts here, but no one can doubt that he was (and is) a figure of considerable intellectual eminence and thoughtfulness, whose speeches (for example) read well and make one think. He would seem ideally suited for an MPC.

Forecasting and policy mistakes

Yesterday’s post was a bit discursive. Sometimes writing things down helps me sort out what I think, and sometimes that takes space.

Today, a few more numbers to support the story.

I’m going to focus on what the experts in the macroeconomic agencies (Treasury and Reserve Bank) were thinking in late 2020, and contrast that with the most recent published forecasts. The implicit model of inflation that underpins this is that even if the full effects of monetary policy probably take 6-8 quarters to appear in (core) inflation, a year’s lead time is plenty enough to have begun to make inroads.

Forecasts – and fiscal numbers – in mid 2020 were, inevitably all over the place. But by November 2020 (the Bank published its MPS in November, and the Treasury will have finalised the HYEFU numbers in November) things had settled down again, and the projections and forecasts were able to be made – amid considerable uncertainty – with a little more confidence. And the government was able to take a clearer view on fiscal policy. The Treasury economic forecasts in the 2020 HYEFU incorporated the future government fiscal policy intentions conveyed to them by the Minister of Finance. The Reserve Bank’s forecasts did not directly incorporate those updated fiscal numbers, but…..the Reserve Bank and The Treasury were working closely together, the Secretary to the Treasury was a non-voting member of the Monetary Policy Committee, and so on. And, as we shall see, the Bank’s key macroeconomic forecasts weren’t dramatically different from Treasury’s.

The National Party has focused a lot of its critique on government spending. Here are the core Crown expenses numbers from three successive HYEFUs.

expenses $bn

From the last pre-Covid projections there was a big increase in planned spending. But by HYEFU 2020 – 15 months ago – Treasury already knew about the bulk of that and included it in their macro forecasts. By HYEFU 2021 the average annual spending for the last three years had increased further. But so had the price level – and quite a bit of government spending is formally (and some informally) indexed.

Here are the same numbers expressed as a share of GDP.

expenses % of GDP

By HYEFU 2021 the government’s spending plans for those last three years averaged a smaller share of GDP than Treasury had thought they would be a year earlier. (The numbers bounce around from year to year with, mainly, the uncertain timing of lockdowns etc).

There are two sides to any fiscal outcomes – spending and revenue. The government has been raising tax rates consciously and by allowing fiscal drag to work, such that tax revenue as a share of GDP, even later in the forecasts, is higher than The Treasury thought in November 2020. And here are the fiscal balance comparisons.

obegal

Average fiscal deficits – a mix of structural and automatic stabiliser factors – are now expected to be smaller (all else equal, less pressure on demand) than was expected in late 2020.

Fiscal policy just hasn’t changed very much since late 2020, and the fiscal intentions of the government then were already in the macro forecasts. Had those macro forecasts suggested something nastily inflationary, perhaps the government could have chosen to rethink.

But they didn’t. Here are the inflation and unemployment forecasts from successive HYEFUs.

macro forecasts tsy

In late 2020, The Treasury told us (and ministers) that they expected to hang around the bottom end of the target range for the following three years, with unemployment lingering at what should have been uncomfortably high levels. If anything, on those numbers, more macroeconomic stimulus might reasonably have been thought warranted.

There were huge forecasting mistakes, even given a fiscal policy stance that didn’t change much and was well-flagged.

That was The Treasury. But the Reserve Bank and its MPC are charged with keeping inflation near 2 per cent, and doing what they can to keep unemployment as low as possible. For them, fiscal policy is largely something taken as given, but incorporated into the forecasts.

Their (November 2020_ unemployment rate forecasts were a bit less pessimistic than The Treasury’s, but still proved to be miles off. This is what they were picking.

RB U forecasts

And here were the Bank’s November 2020 inflation forecasts, alongside their most recent forecasts.

rb inflation forcs

Not only were their forecasts for the first couple of years even lower than The Treasury’s, but even two years ahead their core inflation view was barely above 1 per cent. (The Bank forecasts headline inflation rather than a core measure, but over a horizon as long as two years ahead neither the Bank nor anyone else has any useful information on the things that may eventually put a temporary wedge between core and headline.) All these forecasts included something very much akin to government fiscal policy as it now stands. Seeing those numbers, the government might also reasonably have thought that more macroeconomic stimulus was warranted.

As a reminder the best measure of core inflation – the bit that domestic macro policy should shape/drive – is currently at 3.2 per cent.

core infl and target

There were really huge macroeconomic forecasting mistakes made by both the Reserve Bank and The Treasury, and – so it is now clear – policy mistakes made by the Bank/MPC. You might think some of those mistakes are pardonable – highly unsettled and uncertain times, not dissimilar surprises in other countries etc – and I’m not here going to take a particular view.

But of all the things Treasury and the Bank had to allow for in their forecasts, fiscal policy – wise or not, partly wasteful or not – just wasn’t one of the big unknowns, and hasn’t changed markedly in the period after those (quite erroneous) late 2020 macro forecasts were being done.

I guess one can always argue that if fiscal policy had subsequently been tightened, inflation would have been a bit lower. But Parliament decided that inflation – keeping it to target – is the Reserve Bank’s job. The government bears ultimate responsibility for how the Bank operates in carrying out that mandate – the Minister has veto rights on all the key appointees (and directly appoints some), dismissal powers, and the moral suasion weight of his office – but that is about monetary policy, not fiscal policy or government spending,

Inflation

The National Party, in particular, has been seeking to make the rate of inflation a key line of attack on the government. Headline annual CPI inflation was 5.9 per cent in the most recent release, and National has been running a line that government spending is to blame. It is never clear how much they think it is to blame – or even in what sense – but it must be to a considerable extent, assuming (as I do) that they are addressing the issue honestly.

I’ve seen quite a bit of talk that government spending (core Crown expenses) is estimated to have risen by 68 per cent from the June 2017 year (last full year of the previous government) to the June 2022 year – numbers from the HYEFU published last December. That is quite a lot: in the previous five years, this measure of spending rose by only 11 per cent. Of course, what you won’t see mentioned is that government spending is forecast to drop by 6 per cent in the year to June 2023, consistent with the fact that there were large one-off outlays on account of lockdowns (2020 and 2021), not (forecast) to be repeated.

But there is no question but that government spending now accounts for a larger share of the economy than it did. Since inflation was just struggling to get up towards target pre-Covid, and I’m not really into partisan points-scoring, lets focus on the changes from the June 2019 year (last full pre-Covid period). Core Crown expenses were 28 per cent of GDP that year, and are projected to be 35.3 per cent this year, and 30.5 per cent in the year to June 2023 (nominal GDP is growing quite a bit). That isn’t a tiny change, but…..it is quite a lot smaller than the drop in government spending as a share of GDP from 2012 to 2017. I haven’t heard National MPs suggesting their government’s (lack of) spending was responsible for inflation undershooting over much of that decade – and nor should they because (a) fiscal plans are pretty transparent in New Zealand and (b) it is the responsibility of the Reserve Bank to respond to forecast spending (public and private) in a way that keeps inflation near target. The government is responsible for the Bank, of course, but the Bank is responsible for (the persistent bits of) inflation.

The genesis of this post was yesterday morning when my wife came upstairs and told me I was being quoted on Morning Report. The interviewer was pushing back on Luxon’s claim that government spending was to blame for high inflation, suggesting that I – who (words to the effect of) “wasn’t exactly a big fan of the government” – disagreed and believed that monetary policy was responsible. I presume the interviewer had in mind my post from a couple of weeks back, and I then tweeted out this extract

I haven’t taken a strong view on which factors contributed to the demand stimulus, but have been keen to stress the responsibility that falls on monetary policy to manage (core, systematic) inflation pressures, wherever they initially arise from. If there was a (macroeconomic policy) mistake, it rests – almost by definition, by statute – with the forecasting and policy setting of the Reserve Bank’s Monetary Policy Committee.

I haven’t seen any compelling piece of analysis from anyone (but most notably the Bank, whose job it is) unpicking the relative contributions of monetary and fiscal policy in getting us to the point where core inflation was so high and there was a consensus monetary policy adjustment was required. Nor, I think, has there been any really good analysis of why things that were widely expected in 2020 just never came to pass (eg personally I’m still surprised that amid the huge uncertainty around Covid, the border etc, business investment has held up as much as it has). Were the forecasts the government had available to it in 2020 from The Treasury and the Reserve Bank simply incompetently done or the best that could realistically have been done at the time?

Standard analytical indicators often don’t help much. This, for example, is the fiscal impulse measure from the HYEFU, which shows huge year to year fluctuations over the Covid and (assumed) aftermath period. Did fiscal policy go crazy in the year to June 2020? Well, not really, but we had huge wage subsidy outlays in the last few months of that year – despite which (and desirably as a matter of Covid policy at the time) GDP fell sharply. What was happening was income replacement for people unable to work because of the effects of the lockdowns. And no one much – certainly not the National Party – thinks that was a mistake. In the year to June 2021, a big negative fiscal impulse shows, simply because in contrast to the previous year there were no big lockdowns and associated huge outlays. And then we had late 2021’s lockdowns. And for 2022/23 no such events are forecast.

One can’t really say – in much of a meaningful way – that fiscal policy swung from being highly inflationary to highly disinflationary, wash and repeat. Instead, some mix of the virus, public reactions to it, and the policy restrictions periodically materially impeded the economy’s capacity to supply (to some unknowable extent even in the lightest restrictions period potential real GDP per capita is probably lower than otherwise too). The government provided partial income replacement, such that incomes fell by less than potential output. As the restrictions came off, the supply restrictions abated – and the government was no longer pumping out income support – but effective demand (itself constrained in the restrictions period) bounced back even more strongly.

Now, not all of the additional government spending has been of that fairly-uncontroversial type. Or even the things – running MIQ, vaccine rollouts – that were integral to the Covid response itself And we can all cite examples of wasteful spending, or things done under a Covid logo that really had nothing whatever to do with Covid responses. But most, in the scheme of things, were relatively small.

This chart shows The Treasury’s latest attempt at a structural balance estimate (the dotted line).

In the scheme of things (a) the deficits are pretty small, and (b) they don’t move around that much. If big and persistent structural deficits were your concern then – if this estimation is even roughly right – the first half of last decade was a much bigger issues. And recall that the persistent increase in government spending wasn’t that large by historical standards, wasn’t badly-telegraphed (to the Bank), and should have been something the Bank was readily able to have handled (keeping core inflation inside the target range).

The bottom line is that there was a forecasting mistake: not by ministers or the Labour Party, but by (a) The Treasury, and (b) the Reserve Bank and its monetary policy committee. Go back and check the macro forecasts in late 2020. The forecasters at the official agencies basically knew what fiscal policy was, even recognised the possibility of future lockdowns (and future income support), and they got the inflation and unemployment outlook quite wrong. They had lots of resources and so should have done better, but their forecasts weren’t extreme outliers (and they didn’t then seem wildly implausible to me). They knew about the supply constraints, they knew about the income support, they even knew that the world economy was going to be grappling with Covid for some time. Consistent with that, for much of 2020 inflation expectations – market prices or surveys – had been falling, even though people knew a fair amount about what monetary and fiscal policy were doing. In real terms, through much of that year, the OCR had barely fallen at all. It was all known, but the experts got things wrong.

Quite why they did still isn’t sufficiently clear. But, and it is only fair to recognise this, the (large) mistake made here seems to have been one repeated in a bunch of other countries, where resource pressures (and core inflation) have become evident much more strongly and quickly than most serious analysts had thought likely (or, looking at market prices, than markets themselves had expected). Some of that mistake was welcome – getting unemployment back down again was a great success, and inflation in too many countries had been below target for too long – so central banks had some buffer. But it has become most unwelcome, and central banks have been too slow to pivot and to reverse themselves.

Not only have the Opposition parties here been trying to blame government spending, but they have been trying to tie it to the 5.9 per cent headline inflation outcome. I suppose I understand the short-term politics of that, and if you are polling as badly as National was, perhaps you need some quick wins, any wins. But it doesn’t make much analytical sense, and actually enables the government to push back more than they really should be able to. Because no serious analyst thinks that either the government or the Reserve Bank is “to blame” for the full 5.9 per cent – the supply chain disruption effects etc are real, and to the extent they raise prices it is pretty basic economics for monetary policy to “look through” such exogenous factors. It seems unlikely those particular factors will be in play when we turn out to vote next year.

Core inflation not so much – indeed, the Bank’s sectoral core factor model measure is designed to look for the persistent components across the whole range of price increases, filtering out the high profile but idiosyncratic changes. Those measures have also risen strongly and now are above the top of the target range. That inflation is what NZ macro policy can, and should, do something about. But based on those measures – and their forecasts – the Reserve Bank has been too slow to act: the OCR today is still below where it was before Covid struck, even as core inflation and inflation expectations are way higher. Conventional measures of monetary policy stimulus suggest more fuel thrown on the fire now than was the case two years ago.

When I thought about writing this post, I thought about unpicking a series of parliamentary questions and answers from yesterday on inflation. I won’t, but suffice to say neither the Minister of Finance, the Prime Minister, the Leader of the Opposition, or Simon Bridges or David Seymour emerged with much credit – at least for the evident command of the analytical and policy issues. There was simply no mention of monetary policy, of the Reserve Bank, of the Monetary Policy Committee, or (notably) the government’s legal responsibility to ensure that the Bank has been doing its job. It clearly hasn’t (or core inflation would not have gotten away on them to the extent it has). I suppose it is awkward for the politicians – who wants to be seen championing higher interest rates? – and yet that is the route to getting inflation back down, and the sooner action is taken the less the total action required is likely to be. With (core) inflation bursting out the top of the range, perhaps with further to go, the Bank haemorrhaging senior staff, the recent recruitment of a deputy chief executive for macro and monetary policy with no experience, expertise, or credibility in that area, it would seem a pretty open line of attack. Geeky? For sure? But it is where the real responsibility rests – with the Bank, and with the man to whom they are accountable, who appoints the Board and MPC members? There is some real government responsibility here, but it isn’t mainly about fiscal policy (wasteful as some spending items are, inefficient as some tax grabs are), but about institutional decline, and (core) inflation outcomes that have become quite troubling.

Since I started writing this post, an interview by Bloomberg with Luxon has appeared. In that interview Luxon declares that a National government would amend the Act to reinstate a single focus on price stability. I don’t particularly support that proposal – it was a concern of National in 2018 – but it is of no substantive relevance. Even the Governor has gone on record saying that in the environment of the last couple of years – when they forecast both inflation and employment to be very weak – he didn’t think monetary policy was run any differently than it would have been under the old mandate. That too is pretty basic macroeconomics. It is good that the Leader of the Opposition has begun to talk a bit about monetary policy, but he needs to train his fire where it belongs – on the Governor – not, as he did before Christmas, forcing Simon Bridges to walk back a comment casting doubt on whether National would support Orr being reappointed next year. In normal times, you would hope politicians wouldn’t need to comment much on central bankers at all. But the macro outcomes (notably inflation), and Orr’s approach on a whole manner of issues (including the ever-mounting LSAP losses) suggest these are far from normal times. Core inflation could and should be in the target range. It is a failure of the Reserve Bank that it is not, and that – to date – nothing energetic has been done in response.

Inflation, monetary policy and all that

The CPI for the December quarter was finally released yesterday – even later in the month than that other CPI laggard the ABS. The picture wasn’t pretty, even if at this point not particularly surprising. My focus is on the sectoral factor model measure of core inflation – long the Reserve Bank’s favourite – and if, as my resident economics student says “but Dad, no one else seem to mention it”, well too bad. Of the range of indicators on offer it is the most useful if one is thinking about monetary policy, past and present.

Factor models like this provide imprecise reads (subject to revision) for the most recent periods – that’s what you’d expect, especially when things are moving a lot, as the model is looking to identify something like the underlying trend. The most recent observations were revised up yesterday, and the estimate for core inflation for the year to December 2021 was 3.2 per cent. That is outside the 1-3 per cent target range (itself specified in headline terms, although no one ever expected headline would stay in the range all the time).

It is less than ideal. It is a clear forecasting failure – which would be even more visible if we show on the same chart forecasts from 12-18 months ago.

But…it isn’t unprecedented. In 28 years of data, this is the third really sharp shift in the rate of core inflation – although both were in periods before this particular measure was developed. And, at least on this measure, at present core inflation is still a bit below the 3.6 per cent peak in 2007, or the 3.5 per cent the annual inflation rate averaged for a year or more in 2006 and 2007.

What perhaps does stand out is how little monetary policy has yet done, how slow to the party the Bank has been. Over 1999 to 2001, the OCR was raised 200 basis points. From 2004 to 2007, the OCR was raised 300 points. And as core inflation fell sharply from late 2008, the OCR was cuts by 575 basis points.

So far this time the OCR has been increased by 50 basis points, and is not even back to pre-Covid levels – even though, on this measure, core inflation never actually dipped in 2020. I refuse to criticise the Reserve Bank for misreading 2020 – apart from anything else they were in good company as forecasters – but their passivity in recent months is much harder to defend.

The sectoral factor model measure is itself made up of two components. Here they are

Because the model looks for trends, the big moves in this measure of core tradables inflation have often reflected the big swings in the exchange rate – which affects pretty much all import prices – but this time there has been no such swing. Just a lot more generalised inflation from abroad (as well as the one-offs that this model looks to winnow out). So a lot more (generalised) inflation from abroad – not something to discount – and a lot more arising from domestic developments (demand, capacity pressures, and perhaps some expectations effects too). It is a generalised issue – above target, and probably rising further (both from the momentum in the series, and continued tight labour markets and rising inflation norms).

The headline inflation number gets media and political attention it doesn’t really warrant. Headline inflation is volatile, and even if in principle it might be more controllable than what we see, it usually would not make economic sense to control it more tightly. For that reason, in 30+ years of inflation targeting it has never been the policy focus.

And to the extent that wage inflation fluctuates with price inflation, the relationship is much closer with core inflation (we’ll get new wages data next week, and most likely the annual wage inflation will have risen a bit further).

It is worth noting – for all the headlines – that in every single year of the last 25, wage inflation has run ahead of core (price) inflation. As it has continued to do even over the last year. That is what one would expect – productivity growth and all that – even if the economy were just growing steadily with the labour market near full employment.

It is true that the gap between wage and price (core) inflation is unusually narrow at present

Perhaps the gap will widen again over the coming year – overfull employment and all that – but bear in mind that true economywide productivity growth is probably atrociously (partly unavoidably) low at present, so the sustainable rate of real wage growth is also less than it was.

(None of this means wage earners aren’t now earning less per hour in real terms than they were a year ago, but that drop is, to a very considerable extent, unavoidable. The gap between headline and core inflation is typically about things that have made us poorer, for any given amount of labour supply.)

What does all this mean for policy? First, for all the criticism – often legitimate – of wasteful and undisciplined government spending over the last two years – core inflation is primarily a monetary policy issue, and sustained core inflation above target is a monetary policy failure. The government is ultimately accountable for monetary policy too, but if what we care about is keeping inflation in check, it is the Bank and the MPC that should primarily be in the frame, not fiscal policy. Monetary policymakers have to take fiscal policy – just like private behaviour/preferences – as given.

To me, the recent data confirms again that the Reserve Bank was far to slow to pivot, and far too sluggish when they eventually did. They are behind the game, as was clear even by November before they – like the government, but even longer – went for their long summer holiday in the midst of a fast-developing situation. It is pretty inexcusable that we will go for three months with not a word from the MPC, even as inflation has surged in an overheating economy.

What disconcerts me a bit is the apparent complacency even in parts of the private sector. (If I pick on the ANZ here it is only because they put out a particularly full and clear articulation of their story quite recently). As an example, ANZ had a piece out last week suggesting that the OCR would/should go to 3 per cent by about April next year, but that this would/should be accomplished with a steady series of 25 basis point adjustments. I’m also hesitant about making calls about where the OCR might be any considerable distance into the future (and in fairness they do highlight some of the uncertainties) but if you are going to make a central-view call like that most people might suppose it was consistent with a gradual escalation of capacity pressures, gradually leaned against with policy. But on their own description, the economic growth outlook over the next year doesn’t look spectacular at all – the word “insipid” even appeared – while the pressures (inflation and capacity) seem very real right now, in data that (at best) lags slightly. Core inflation has (unexpectedly) burst out of the target range, the economy is overheated, inflation expectations have risen (even in the last RB survey the two-year ahead measure was 2.96 per cent – up 90 points in six months, when the OCR has risen only 50 points. ANZ’s economists did address the possibility of a 50 basis point increase next month. They seemed to think it unlikely, because no ground has been prepared. They may well be right about that – and that may be what their clients care about – but, as advisers, they seemed unbothered about it. Why not urge the Bank to get out now and prepare the ground for next month’s review? Why not thrown caution to the wind and suggest the world wouldn’t end if the MPC actually took the market by surprise and took actions that increased the changes of keeping inflation in check? Based on what we know now, the economy would be better off if the Bank raised the OCR by 50 basis points next month (and sold some of that money-losing bond stockpile) and suggested it would be prepared to do the same again in April if the data warranted.

What difference does is make? The big risk right now is that people come to think that a normal inflation rate isn’t something near 2 per cent, but something near 3 per cent (or worse). If that happens – and no single survey will tell the story – it will take a lot more monetary policy adjustment (and lost output) at some point to bring things back to earth, all else equal. And whereas we have no real idea what monetary policy should be in the middle of next year, it is quite clear that considerably tighter conditions are warranted now, and that the Bank so far has not even kept up with the slippage in inflation and expectations.

What about Covid? By 23 February when the MPC descends from the mountain top, it seems likely that we might be nearing the peak of the unfolding Omicron wave. Experience abroad suggests that even when the government doesn’t simply mandate it, a lot of people will be staying at home, a lot of spending won’t be happening. Who knows – and we may hope not – MPC members themselves, or their advisers, may be sick and enfeebled. Tough as those weeks might be, they should not be an excuse for a reluctance to act decisively. MPC went slow last year, and to some extent now pays the price in lost optionality. Delay in August didn’t look costly then. Delay now looks really rather risky.

But who are we to look to for this action. As (core) inflation bursts out of the target band, and expectations of future inflation rise, we already have an enfeebled MPC, even pre Covid.

  • We have a Governor who has given few serious speeches in his almost four years in office,
  • A Deputy Governor who didn’t greatly impress when responsible for macro, and is now likely to be focused on learning his new job, and finding some subordinates after he and Orr restructured out his experienced senior managers before Christmas,
  • We have a Chief Economist who has been restructured out, and on his final meeting. No doubt he’ll give it his best shot but….that wasn’t much over the three years he was in the job, including not a single speech,
  • And we have the three externals, appointed more for their compliance than expertise, who’ve given not a single speech between them in three years, and two of them are weeks away from the expiry of their terms (and no news on whether they’ll be reappointed or replaced).

It was pretty uninspiring already, to meet a major policy, analytical and communications challenge. And then yesterday, the dumbing-down of the institution –  exemplified in speeches (lack thereof) and the near-complete absence now of published research –  continued, with the appointment of Karen Silk as the Assistant Governor (Orr’s deputy) responsible for matters macroeconomic and monetary policy.  And this new appointee –  who it seems may not be in place for February – seems to have precisely no background in, or experience of, macroeconomics and monetary policy at all (but apparently a degree in marketing)     But she seems to be an ideological buddy of the Governor’s, heavily engaged in climate change stuff.    Perhaps the superficial customer experience –  pretty pictures etc –  of the MPS will improve, but it is hard to imagine the substance of policy setting, policy analysis, and policy communications will.  It was simply an extraordinary appointment –  the sort of person one might expect to see if a bad minister were appointing his or her mates.  And if this appointment was Orr’s, Robertson has signed off on it, in agreeing to appoint her to the Monetary Policy Committee.  It would be laughably bad, except that it matters.  How, for example, is the new Assistant Governor likely to find any seriously credible economist to take up the Chief Economist position even if  –  and the evidence doesn’t favour the hypothesis at present – she and Orr cared?   Coming on top of all the previous senior management churn and low quality appointments it is almost as if Orr is now not vying for the title “Great team, best central bank”, but for worst advanced country bank.  (It is hard to think of serious advanced country central bank, not totally under the political thumb –  and rarely even then –  who would have such a person as the senior deputy responsible for macroeconomic and monetary policy matters: contrast if you will places like the RBA, the ECB, the Bank of Canada, the Bank of England, and numerous others.)

I sat down this morning and filled in the Bank’s latest inflation expectations survey.  For the first time –  in the 6/7 years I’ve been doing it –  I had to stop and think had about the questions about inflation five and ten years hence (I’ve typically just responded with a “2 per cent” answer –  long time away, midpoint of the target, 10 years at least beyond Orr’s term).  With core inflation high and rising, policy responses sluggish at best so far, and with the downward spiral in the quality of the MPC (and the lack of much serious research and analysis supporting them), how confident could I be about medium-term outcomes.  Perhaps it is still most likely that eventually inflation is hauled back, that over time core inflation gets towards 2 per cent, with shocks either side.  The rest of the world, after all, will still act as something of a check, no matter how poor our central bank becomes.  But the decline and fall of the institution is a recipe for more mistakes, more volatility, more communications failures, and less insight, less analysis, and fewer grounds for confidence that the targets the Minister sets will consistently be delivered at least cost and dislocation.  That should concern the Minister, but sadly there is no sign it –  or any of the other straws in the wind of institutional decline –  does. 

Central bank research

For some reason the other day I was prompted to have a look at how many research papers the Reserve Bank had published in recent years. This chart resulted.

RB DPs

Only one in the last two years, and that one paper – published last February – had five authors, four of whom worked for other institutions (overseas). It was really quite staggering. It wasn’t, after all, as if there had been no interesting issues, policy puzzles or the like over the last two years. It wasn’t as if universities had suddenly stepped up to the mark and were producing a superfluity of research on New Zealand macro and banking/financial regulation issues. It wasn’t even as if the Bank had suddenly been put on tight rations by a fiscally austere government – in fact, the latest Funding Agreement threw money and the Bank and staff numbers have blown out. Rather, or so it appears, management just stopped publishing research.

These research Discussion Papers are usually quite geeky pieces of work, formal research that is subjected to some external review before publication, and often written with the intention of being of a standard that might be submitted to an academic journal. The Reserve Bank had put quite an emphasis on this sort of research (mostly on macroeconomic matters) for probably 50 years, as one part of the sort of analytical work that underpins its policy, operations, and communications.

Of course, what ends up in published research papers like this isn’t all the thinking, analysis, or even research that the Bank has been doing – ever, not just now. Apart from anything else, they have a variety of other publications, including the Analytical Notes series that was started up a decade ago to fill a gap (for example, less-formal research, often with shorter turnaround times), and even the Reserve Bank Bulletin which had had a mix of types of articles, but itself appears to have been in steep decline. There are speeches from senior managers, but as I’ve pointed out previously these days these are few and rarely insightful (not much research, here or abroad, informs them). There will be other analysis and research that simply never sees the light of day – the Bank not being known for its transparency – but what appears in public is likely to be an indicator of what does (or doesn’t) lie beneath the surface. The Bank still has some staff who appear to have formal research skills – indeed a year ago they recruited one of New Zealand’s best economists apparently to work on preparations for the next review of the monetary policy Remit – but what we see is thin pickings indeed. Most of most able researchers of the last decade have left, and as far as I can see there is no one working in the research function with any long or deep experience of the New Zealand economy and financial system.

Recall that the previous Governor espoused a goal that the Bank should be not just adequate but the “best small central bank” in the world, while the current one often reminds people of his mantra “Great team, best central bank”, suggesting a vision not even constrained by the (small) size of New Zealand.

Does any of this matter? I could probably mount an argument that much of what the Bank is charged by Parliament with doing could, in principle, be done with little or no formal research (of the type that appears in Discussion Papers). In principle, a keen appetite for the products of overseas research, a climate that encouraged debate and diversity of ideas, active engagement with other central banks, and a steady flow of less-formal analysis wouldn’t necessarily lead to particularly bad outcomes. And having been around in the days when the Bank was doing some world-leading stuff (notably inflation targeting, but also some of the bank regulatory policies) it is fair to note that little or none of that drew on (or was reflected in) formal RBNZ Discussion Papers.

But it isn’t really the standard that we should expect these days, nor is there any sign that people in other countries do. It is not that a single research paper is likely to decisively change any particular policy setting (perhaps not even 5 or 10 would) and many of the papers might go nowhere much at all. But a flow of formal published research is one of the marks of an institution that thinks, that has an intellectually vibrant culture, that is open to new ideas etc etc. And on some policy calls, we really have a right to expect that the Bank – with huge amounts of policy discretion, and quite limited accountability – is doing world-standard research of its own, and/or commissioning it from others, and making that research available for challenge, scrutiny etc. One might think here of appproaches to bank capital policy, where the current Governor took a bold non-consensus decision, but where the institution has no published record of any substantive serious research. Sometimes these things might just be about trying to find frameworks that make some sense – never all of it – of what has been going on, or bringing formal evidence to bear on (for example) what the LSAP has accomplished.

But, these days, there is little sign of any of it from our central bank – and as a straw in the wind, it is at one with a record of few (and rarely good) speeches, inaccessible MPC members (themselves ruled out from doing research), and policy documents that rarely seem to reflect robust analysis.

Of course, one can expect formal research outputs to fluctuate a bit from year to year. Topics come and go, immediate management priorities come and go, particularly able and productive researchers come and go. But one paper (and that mostly co-authored) in two turbulent years isn’t a sign of an institution that any longer takes seriously generating research output, or the sort of climate that makes an institution attractive to really able people.

What about other countries? I went counting.

Much discussion in New Zealand compares us to other Anglo countries, and in central banking terms, Australia, Canada and the UK have had similar (inflation-targeting) macro policy frameworks.

anglo DPs

Of course, each of these are much bigger countries than New Zealand (and on that basis one might think the RBA rather light on its published research) but (a) there aren’t huge economies of scale in central banking (our economic puzzles can be just as intractable as those of much larger countries), and (b) both the RBA and the Bank of Canada have a narrower range of policy responsibilities than the Reserve Bank of New Zealand.

So how does the RBNZ compare with the central banks of other small advanced countries?

DPs adv countries

Central banks of very small countries (in this case, Iceland and Slovenia) have tended not to publish much formal research – although still more than the RBNZ in the last couple of years – and one might wonder at the budgetary priorities of the central bank of Lithuania (just under three million people and without a monetary policy of its own), but even before this decade the flow of formal research from our central bank looks to have been at low end of what one might expect given (a) our population, (b) the wider range of issues the RB is responsible for, and (c) the idiosyncratic nature of some aspects of our economy. There is no single right or wrong volume of formal research, but next-to-no published research simply looks like a dereliction of duty. (One might have hoped that a Board chaired by a university vice-chancellor – one with a reputation of getting research metrics looking good – might have raised questions, but…….this is the mostly-useless Reserve Bank Board.)

Again, does it matter? In my more cynical moments over the years I used to observe that perhaps the main difference inventing inflation targeting made was that we subsequently got invited to a better class of international conference. It might not sound much, but it is a straw in the wind for something that really does matter – the connectedness of the institution, the exposure to ideas, the ability to get leading people to take an interest and visit etc etc. We used to have that. Not all the conferences were useful, not all the visitors were useful, and so on, but becoming known as a central bank that (a) rules out from its MPC anyone with ongoing expertise in monetary policy, (b) publishes hardly any serious research, and (c) where senior management, if they speak at all (recall that the chief economist gave not a single published speech), make only the lightest-weight speeches isn’t a recipe for keeping engaged with the world, or the flow of ideas or research. When you are all already small, remote, idiosyncratic, and not as rich as Croesus (we can’t just throw money at potential visitors) it is a poor lookout.

These outcomes must have been the result of deliberate decisions. They need not be forever. Capability can be rebuilt, although doing so in an enduring way takes time and leadership. Who Orr appoints to the current key vacancies is likely to reveal quite a bit as to whether the Governor has any interest in creating a research-informed Reserve Bank, across the range of key policy areas he is responsible for. If not – and most likely not – it will be another sign of a deeply troubled institution, taking a similar path of decline to too many other New Zealand institutions in recent years. Responsibility for that rests not just with individual officials, but with a government (and Minister of Finance in particular) who seems not to care.

A sad ending

Yesterday morning’s news was an NBR headline – story accessible only to those with a subscription – in which the Reserve Bank appeared to have confirmed to this single media outlet that Deputy Governor, Geoff Bascand (a statutory appointee, and member of the Monetary Policy Committee) had left his job early, after speaking without authorisation to a third party about the Bank’s management restructuring. Later in the day, we got more accessible versions of this astonishing development (including this interest.co.nz account).

Bascand had been a public servant for a period spanning 40 years, starting in The Treasury in the 80s, and including stints as head of the Labour Market Policy Group (at the old Department of Labour), Government Statistician, and (since 2013) as Reserve Bank Deputy Governor. His public sector career had had its ups and downs, and he never quite reached the very top levels, but what a way to end it. In many ways, he was a classic public servant – most people seemed to like him, quite a few respected him, he wasn’t (it seemed) flamboyant or reckless. He went along. He wasn’t an intellectual leader, but he got things done. He didn’t seem to stand on titles etc – I was quite impressed that he was willing to take the step back from a CEO role at SNZ to (initially) the third-ranked position at the Reserve Bank (even as I assumed at the time that he saw it as a stepping stone back into the policy-institution mainstream, perhaps with aspirations to be Governor or Secretary to the Treasury). And in 2017 he was quite (unusually) open (to media) that he’d applied for the Governor’s role, knowing (presumably) that even as incumbent (but new) deputy chief executive he probably had no better than a 50/50 chance. In the first three years of the Monetary Policy Committee, he had been by far the least-unimpressive of the members, and gave speeches that were sometimes almost worthy of a member of a powerful independent policymaking committee in an advanced country.

I first met Geoff 35 years ago, but had only had off and on contact with him until he came to the Bank. We then sat on many of the same committees, but I left the Bank a couple of years later, and my main dealings with Geoff were actually over the last 8 years when we were both trustees of the troubled Reserve Bank staff pension scheme and spent too many hours locked in long meetings. We had our differences there – sometimes quite stark, sometimes on quite important issues – but in recent years in particular we seemed to have got on well, and even together crafted a resolution to one of the lesser issues the scheme was dealing with. I say this mostly as context. I don’t wish Geoff any ill at all.

When it was announced a few months ago that Bascand was leaving the Bank at the start of 2022, it wasn’t entirely clear what was going on. One plausible story was that at his age (60ish), unlikely now to ever become Governor, he’d simply opted for a slower pace of life – golf, grandkids, and some directorships/consultancies etc. Another was that he had become so frustrated with the Orr approach that he simply wanted out. The two weren’t incompatible necessarily, but if you are part of a project you are totally at one with, it isn’t usual to simply walk away – in good health, and not that old. But the new governance structure for the Bank was coming in mid-2022, and he might also have thought someone needed to be willing to commit several years to bedding in the new model. There was always the possibility Orr wanted him out, but as holder of a statutory office appointed by the Minister there was no direct way of effecting that, despite the reputation Orr had long had for churn among his senior staff. The speed with which Bascand’s replacement was announced – with no advertisement etc process – did tend to reinforce suspicions.

The concerns about top-level departures started to step up in November when it was announced that the Bank’s Chief Economist was leaving after less than three years in the job – having been appointed by Orr, it was quickly apparent he was being restructured out by Orr (Orr having restructured out the previous Chief Economist). Questions started to be raised, including at Parliament’s Finance and Expenditure Committee. With inflation rising sharply, and unease (justified and not) about the Bank’s handling of monetary policy through the Covid period, the Governor’s position was becoming somewhat exposed.

But there was more to come. The management restructuring was ongoing and now claimed the two senior managers responsible for banking regulation and supervision, who had been direct reports of Geoff Bascand’s (as deputy governor and head of financial stability). We still don’t know the details of the restructuring – the Bank is playing OIA obstruction – but both Andy Wood and Toby Fiennes decided to leave, their own previous jobs presumably having disappeared (Fiennes already having been effectively demoted in an earlier Orr restructuring). That might prove quite uncomfortable for the Governor, with annual select committee hearing coming up on 15 December (this time the annual Financial Review, focused on the year to 30 June, but allowing a very wide range of issues to be raised).

And so, it seems (Orr did not deny it when questioned on it at FEC), the Bank decided to keep this news secret (from staff and the public) until after the FEC hearing was over.

And yet the news got out, with a story from Business Desk’s Jenny Ruth late the previous afternoon (and a statement from the Bank confirming the departures). Orr faced repeated questions at FEC the following day (I wrote about it here), and some of the answers from him and his team proved to be quite misleading. There was a lot of bluster, and the Governor did not emerge well.

There were a couple of straws in the wind – no more – that week that suggested that the Bascand situation was less than happy. Watch the FEC hearing (accessible on the FEC Facebook page) and you will see that Bascand was there – Orr even mentions it at one point – but in the back seats with the large group the Bank brought along. That was odd. Bascand was at this point still the incumbent Deputy Governor, and the hearing was formally focused on the 2020/21 financial year. It wasn’t that there wasn’t room at the top table – Orr was joined there by the incoming Deputy Governor and one of the his many more-obscure Assistant Governors. Not having Bascand up front – and several MPs have made generous comments about Bascand – looked not quite right.

And then on the Friday of that week, Bascand simply did not turn up for a long and important meeting of the superannuation scheme trustees, a meeting that had been scheduled explicitly to draw on his expertise and experience before his scheduled departure in the first week of January. His replacement had already been appointed (from 5 Jan) and invited to attend the meeting as a silent observer. Initially not suspecting anything – other than idly wondering what financial stability drama there might be on 17 December – I asked the chair if Geoff had then nominated the replacement as his (legal) alternate, which would enable that person to participate fully. It would have been a natural thing to have done if something had come up and Geoff was simply too busy. But all we got was a rather flustered “no”.

But none of that took one anywhere, at least until yesterday’s story.

The story did not tell us what Bascand had told to whom, only that he had had unauthorised discussions with an outsider, had confessed and apologised, and had left the Bank on 17 December, several weeks before his scheduled (early Jan) departure date.

So it is hardly a stretch to suppose that he was the ultimate source of the 14 December story about the further senior management departures – since it (a) involved people who had directly worked for him for several years, and (b) came out late on 14 December, and while he was still there (FEC) on the early morning of the 15th he was gone by the 17th. Most probably Bascand didn’t directly communicate with the journalist who broke the story – although even had he done so, the journalist would have needed independent confirmation to help provide cover to her source – but may well have told someone with the explicit intention that the news get to a journalist with a reputation for taking RB issues seriously. (It is quite clear, on the other hand, that these unauthorised discussions weren’t, say, a passing mention to his wife – the consequences, confirmed by the Bank yesterday, tell us it was much more serious than that.)

There can’t have been many people at the Bank who knew (on say 13 Dec) that Wood and Fiennes were going. The Governor, the incoming deputy (who would soon be responsible for financial stability), perhaps the Assistant Governor responsible for HR, perhaps the respective PAs, Wood and Fiennes themselves, and Bascand. Bascand either because he was still incumbent Deputy Governor or because either or both of Wood and Fiennes would most likely have talked to Bascand – their boss for several years, but not now the person driving decisionmaking – before making their final decisions. Only disgruntled people had an incentive to leak, which would have quickly narrowed the field, and Bascand apparently confessed, apologised, and agreed to go early. It could reasonably have been seen as a sacking offence but (a) no doubt the Bank wanted to keep this quiet, and (b) getting rid of a statutory officeholder isn’t quite like dismissing an ordinary staff member.

Why would Bascand have done it? Presumably the motive was pure and simple to put Orr on the spot at FEC, perhaps driven by frustration at how his loyal and capable senior staff had been treated. But it was still a strange step for someone like Bascand – the mostly fairly buttoned-down bureaucrat – to have taken. After all, although the FEC hearing became more of a spectacle, and more uncomfortable for Orr, it wasn’t as if this was really whistleblowing – the FEC hearing itself was never going to be decisive (of anything), and the Bank would have announced the departures a day or two later anyway. If – as I think there are – there are serious questions to be asked about Orr’s stewardship, a couple of days wasn’t going to make much difference in the scheme of things. Perhaps Geoff was just at the end of his tether?

If this is the story – and while it seems likely we can’t be certain – did he suppose he’d not be found out? Perhaps, but why take the risk? Perhaps he thought there weren’t really any downsides for him? But if so, he was wrong. Leaving two weeks early a job you’d resigned from anyway isn’t the cost. But yesterday’s story is. I guess that story wasn’t guaranteed to leak out, but….Wellington is a small place, and who knows what story staff were told as to why Geoff wasn’t around for his scheduled last few days.

It is simply a really bad look. Even real whistleblowers – of information about (a) misbehaviour that (b) would never otherwise come out – rarely prosper (even though society needs such people). But this wasn’t whistleblowing – Orr was within his rights to restructure, and the news was going to come out anyway – and just looks rather petulant and undisciplined. And whatever you think of Orr’s stewardship of the Bank, a senior figure behaving this way – breaching his obligations (moral and otherwise) is unlikely to endear himself to people (government or private sector) considering Geoff for future directorships and consultancies. If he had real concerns about Orr’s stewardship – and he should have – a detailed letter to the Minister of Finance, after he had left the Bank, might have been in order. Perhaps even a serious interview with a major media outlet a few months down the track (Orr is up for reappointment early next year), although in cosy Wellington even that would have raised eyebrows. But not leaking to the media – with a high probability of being found out – simply for some short-term additional embarrassment for the boss. (And it is not as if Geoff in the past has not expressed firm views on anyone speaking out in a way that might embarrass him or those he supports.)

I was glad the news of those further senior management departures got out in time for FEC, was glad to see National and ACT MPs asking hard questions of Orr – and hope they now follow up further – but what Bascand (who had obligations to the Bank) appears to have done was quite inappropriate and unacceptable, and it is good that that news has belatedly come out. It is a sad way to end a long public service career.

But what a mess an important and powerful public agency is clearly in. So many key people going or gone, so little analytical, operational or policy excellence, so little banking or regulatory experience at the top of a major banking regulatory agency, and so on. Meanwhile, the Board chair who presided while all this went on has been given another term, and all indications are that none of this much bothers the person with the ultimate responsibility, the Minister of Finance. It should. We need to end, and reverse, the degradation of major New Zealand public institutions.

UPDATE: Continuing to mull over this business, I’m still a bit inclined to wonder if there is more to the story. Is there a possibility that Bascand took the fall, covering for someone else (for whom the consequences of discovery might have been greater)? I guess we’ll never know, and perhaps it is just that I don’t want to believe that someone like Geoff could have acted this way, even tired, even frustrated. There is something particularly treacherous about a deputy deliberately undercutting his boss in a way implied by the story told in this post. But probably only a couple of people know the truth of the matter, and they won’t be saying.

The Reserve Bank appears underwhelming

First thing this morning the Reserve Bank fronted up at Parliament’s Finance and Expenditure Committee for their Annual Review hearing.

The Governor kicked off with some introductory remarks that were celebratory (the focus of the hearing was notionally on the last financial year) but superficial. In some cases barely even honest. He was “very proud” of all the Bank had achieved, talked up monetary policy as having been “highly effective in preventing deflation”, claimed (wrongly) to have been one of the first central banks to have raised policy interest rates again, and ended with a paean to “diversity and inclusion” talking of having “many plans” and “much action” on that front. There was no mention, for example, of the $5 billion of taxpayers’ money they had lost, or of the continuing churn at the top of the organisation.

Last evening they had had to announce that two more senior managers were leaving, ousted in yet another of Orr’s restructurings. Orr didn’t deny the claim made by National’s Simon Bridges (and various journalists) that the Bank had hoped to keep these departures secret until after the hearing, and had only announced them late yesterday afternoon after the news had seeped out. It can be hard to keep track of all the departures – in several cases Orr can’t even blame his predecessors as at least two of the senior management departures have been of people who Orr had first promoted before changing tack and pushing them out. I’ll take the departure next year of the Bank’s long-serving CFO (who would be over 65) as a genuine retirement, but mostly the departures seem to have been Orr-initiated, such that of the large senior management group in place when he took office only 3.5 years ago, only two will soon be left.

And the departures aren’t simply in peripheral or support positions. Orr has now ousted two chief economists in succession, and we have no idea who will be filling that vacancy on the MPC, at a time when things are scarcely all quiet on the monetary policy front. On the financial stability side – largest part of the Bank and the growing bit – the gaps are even more obvious. The Deputy Governor (who ran that side of the Bank) is leaving, and now the two senior managers (heads of supervision and head of prudential policy/analysis) are leaving – the latter having already accepted a demotion a couple of years ago. Each of these guys has strengths and weaknesses (although I thought Andy Wood was good value), but all will be gone very shortly – and with them huge amounts of experience. In their place, we have a new Deputy Governor who has no background in banking, supervision or financial regulation, and two vacancies. So far at least, Orr has shown no ability to (or interest in doing so?) attract top-notch talent to the Bank at senior levels. And from 1 July next year, the Bank’s new Board is becoming the key decision-making body on prudential matters including policy. The Minister makes those appointments and so far no one whom one might think of as offering exceptional intellectual or practical leadership in these areas had been appointed. The Bank looks incredibly weak on that side of its business, and one wonders what their capable and experienced APRA counterparts make of it all.

But to return to this morning’s hearing, when Simon Bridges suggested that the volume of churn might almost be described as “reckless”, Orr’s only response was to suggest “or planned”. As Bridges noted the Bank was losing a lot of senior and experienced people, likely to be replaced with more junior less experienced people, perhaps “people who agree with you”. Bridges went on to comment on the number of people who had already got in touch with him to express concern at what was going on at the Bank. Orr offered no comment in response.

David Seymour also chipped in on this issue asking about turnover at senior levels. The Bank’s response seemed to be a mix of cute answers (people who had confirmed they were leaving shortly were nonetheless still there and so hadn’t left), obfuscation (emphasising how many more staff in total the Bank had – as if that too should not be a concern), and a bit of outright denial. Seymour asked Orr if he was “absolutely confident” that there was nothing about his (Orr’s) leadership that had led to conflicts resulting in departures”. Orr’s reply: “Absolutely”. I don’t suppose he was ever going to own up – the main who really hates being challenged or disagreed with – but it wasn’t a confidence-inspiring performance. And who is responsible for the Governor? Well, that would be the current ineffectual Board – whose chair has been carried over to the new and (legally) more powerful Board, and of course the Minister of Finance.

The Green Party’s Chloe Swarbrick also asked a couple of useful questions, and was simply fobbed off by Orr. Was there anything about the policy response over the last couple of years, she asked, that the Governor might have done differently with the benefit of hindsight? It was, she was told, a hypothetical that he wasn’t going to answer, but he then went on to say that he was “very confident” that “exactly the right decisions had been made”. With the benefit of hindsight, does any normal reflective human being make such bold claims? Well, Orr certainly does ($5bn of losses, as just one example, notwithstanding). Swarbrick went on to ask if there would be value in a review of Covid fiscal and monetary policy (a good idea, and a suggestion I’d also made to Treasury at a consultation session last week). Orr claimed that such reviews were ongoing and very transparent. If so, there is no evidence of it, and when someone reviews themself such reviews are often not received with total conviction.

David Seymour followed up, noting that the Governor had said earlier that house prices were above a “sustainable” level, employment was above the maximum sustainable level, and inflation was high and/or rising. Might it not be thought that the degree of monetary stimulus had been a bit overcooked?

Orr’s blustering response was that it was better than an alternative of extremely high unemployment and deflation, repeating his line that the Bank had been one of the first in the world to raise rates. Seymour pushed back and suggested some possibility of a middle ground – that, with hindsight, a bit less monetary stimulus might have been warranted, but Orr simply refused to engage.

There were no questions about the LSAP scheme ($5bn of losses notwithstanding) but National’s Andrew Bayly again asked about the Funding for Lending scheme. Crisis conditions have long passed, the OCR is working fine, and being raised, and yet the Bank keeps on for another year with the emergency facility that all else equal holds interest rates DOWN. The Assistant Governor burbled on about the need to provide certainty to banks – as if anything else about the economic (or virus) environment is certain. It is simply bizarre that emergency facilities are still providing stimulus, even as core inflation heads for top of the target range.

Not all the questions from non-Labour members was really to the point. As Orr noted, the MPC has to take the fiscal stance as given and adjust the OCR as required (having said that, National could point out that on occasion Orr has been an open cheerleader for bigger fiscal deficits), and National seems unable to decide whether it dislikes high inflation or a higher OCR more. Personally, I’m with the Governor on that one: high inflation needs to be brought back into check, and monetary policy is the most effective instrument. In fact, it was good to hear Assistant Governor Hawkesby explicitly note that inflation expectations had risen and that monetary policy was oriented towards getting inflation back to around the midpoint of the target range.

But two final questions are worth noting. A government member asked a patsy about the Bank’s climate change crusade, prompting National Andrew Bayly to note that the Federal Reserve of New York had recently published research suggested that climate change posed little threat to financial stability (he could have cited recent Bundesbank stress tests as well). Bayly asked if the Bank had done any modelling of its own. Orr’s response was an unequivocal “yes”. That was interesting because a quick check of the Bank’s climate change page showed that still the only “research” they listed was a single paper from 2018 which (“preliminary analysis”) also concluded that there wasn’t likely to be much to the climate change financial stability risk issue. You might have supposed that the Bank would be keen to get out in the public domain any research they’d done supporting the Governor’s ideological priors and political preferences. I have today lodged an OIA request for the modelling work the Governor was referring to this morning. On past form, we might see something six months from now.

And then Chloe Swarbrick got in one last question. You’ll recall that the Governor had told the Committee that in the Bank’s view house prices were currently higher than “sustainable”. All else equal, Swarbrick asked, how much would house prices need to drop to be considered “sustainable”. Orr’s response was “I don’t have that number” (he had what looked like a dozen staff present in support). It seemed an eminently reasonable question. The Bank has the biggest team of macroeconomists in the country, it has in-house research capability and has claimed – not once but many times – that prices are “unsustainable”. The way places like the Bank work is that there will be a range of model estimates informing the judgement that current prices are unsustainable. It wasn’t that Orr didn’t have a number (or, more likely, a range) it was that he simply refused to answer, and did not suggest he would follow up and get back to the member.

A year ago, one might have said (I would have) that it really wasn’t an issue for the Bank. But the Minister changed the Bank’s Remit, and Orr and the MPC have embraced the change. You may, like me, think that they way they approach “sustainable” is meaningless and often misleading (their concept has nothing at all to do with longer-term fundamental supply characteristics) but…….they are the ones openly opining that prices are “unsustainable”. How much then, even as a range? Orr’s refusal to reply really made a mockery of parliamentary scrutiny.

Overall, it was good to see the Bank and the Governor facing some serious questions. 55 minutes for the whole thing, including government patsys, really wasn’t enough in the circumstances, but what we saw was a weak and unpersuasive central bank. The Reserve Bank is a key economic agency in New Zealand, exercising a great deal of discretionary power, and we (and Parliament) should expect a solid team of really capable and experienced senior people, articulating credible and thoughtful nuanced responses to serious questions and challenges. It wasn’t at all what we saw today. But of course, there is little follow through, and no serious questioning on these issues of either the Bank’s Board or the Minister of Finance. Instead we just see the continued degradation of yet another of New Zealand key public sector institutions. I suppose unserious governments – there is little sign they care much about institutions or medium-term economic performance, let alone getting house prices down – invite increasingly unserious bureaucracies, of which today’s Reserve Bank is one. Perhaps Orr will surprise and he’ll soon announce the appointment of a phalanx really strong capable independent-minded senior managers, who last (perhaps outlast him) but nothing about his tenure to date (or the continued churn) should give us – or Parliament- much confidence.

LSAP losses

The Minister of Finance and The Treasury appeared before Parliament’s Finance and Expenditure Committee yesterday. It was encouraging to see National MPs asking questions about the Reserve Bank’s Large Scale Asset Purchase programme, which was undertaken with the agreement of both the Minister and The Treasury and which has now run up staggering losses for the taxpayer.

A standard way of estimating those losses is the mark-to-market valuation of the Bank’s very large LSAP bond portfolio. As of the latest published Reserve Bank balance sheet, for 31 October, those losses were about $5.7 billion. When the 30 November balance sheet is out, probably next week, the total losses will be lower (bond rates fell over November), but with a very large open bond position still on the books taxpayers are exposed to large fluctuations in the value of the position (up or down), with no good basis for supposing that the expected returns are likely to compensate for the risk involved. If there was a case for putting on a large open bond position early last year – I doubt it, but take that as a given for now – there is no case for one now, in a fully-employed economy with rising inflation, and with the conventional instruments of monetary policy – which expose taxpayers to no financial risk – working normally and effectively.

A post from a few weeks ago set out the issues.

I didn’t watch the whole 2 hours (link to the video above) but from exchanges with various people I think I have seen all the questions and answers relevant to the LSAP issues.

First, at about 43 minutes in, National’s Andrew Bayly asked the Minister of Finance (a) why, when Crown indemnity was approved the Minister did not then require a plan for unwinding the position (the Bank is currently talking about having a plan early next year, almost two years on), and (b) why there was no limit to the indemnity.

I’m not sure either question was that well-targeted, and the Minister had no real trouble responding. As he noted, the LSAP programme had been initiated in the middle of a crisis, time was short etc. And although there isn’t a limit on the indemnity itself there is a limit of how many bonds can be bought, and the government determines which bonds are on issue which amounts to much the same thing. That said, both responses take as more or less given that the idea of an LSAP had never occurred to anyone on any corner of the Terrace/Bowen St triangle until late March 2020. We know the Bank had been (rather idly) talking about the option for several years, including saying they’d prefer not to use it, but it seems they had not done the hard ground work, and neither had The Treasury nor the Minister insisted on it, well in advance. There is no sign any cost-benefit analysis for something like the LSAP was ever done, no analysis of likely Sharpe ratios, no analysis of potential peak taxpayer losses and so on. The Bank should be held accountable for that, but…the Minister is primarily responsible for holding them to account, and The Treasury is the Minister’s principal adviser (and the Secretary is a non-voting member of the MPC).

After the Minister left, Bayly returned to the LSAP (at about 68 minutes), supported by National’s new finance spokesman Simon Bridges. Bayly asked the Secretary to the Treasury whether an increase in the OCR would increase the liability for the Crown for the indemnity. The Secretary responded that the indemnity was net neutral from a whole of Crown perspective. What followed was a slightly confused discussion with Bridges ending up suggesting that the Secretary was “plainly wrong”. I don’t think the Secretary answered well, and she certainly didn’t answer in a way designed to help clarify the issues around the LSAP, but she is correct that the indemnity itself does not affect the overall consolidated Crown financial position (the claim the Bank currently has on its balance sheet is fully offset by an obligation the (narrowly defined) central government has on its balance sheet. It is quite likely that without the indemnity the MPC would have been very reluctant to have run a large-scale LSAP programme (the Bank’s own capital would not support the risk), but once the programme was established what determines the financial gains or losses is, in short, just the movement in market interest rates. The indemnity just reallocates any losses within the wider Crown accounts. In that particular exchange, The Treasury made none of this clear, and Secretary herself seemed a bit confused when the discussion got onto the different ways the bond position might eventually be unwound (there is little or no indemnity if the bonds are held to maturity, but that doesn’t mean there are no costs to the taxpayer). And thus (reverting to Bayly’s initial question) an increase in the OCR – particularly one now expected – doesn’t itself change the Reserve Bank’s claim under the indemnity

About 25 minutes further on, Bridges returned to the fray and a rather more enlightening conversation followed. Bridges asked whether the LSAP did not represent a significant increase in Crown financial risk. The Secretary agreed and both she and one of her colleagues explained – as I have here repeatedly – that what had gone on was that the Bank had bought back long-term fixed rate bonds, effectively swapping them for the issuance of settlement cash, on which the interest rate is the (variable) OCR. Unfortunately some of the discussion still got bogged down in matters of Crown accounting (the difference between the purchase price of the bonds and the face value, which is of no economic significance), and the Secretary was very reluctant to allow herself to be pushed into acknowledging that the position of the LSAP portfolio – implemented with her support – is deeply underwater. As a simple matter of analysis, she was never willing to distinguish between the mark-to-market loss to now, and the potential gains, losses, and risks on continuing to hold a large open position from here on. One is a given – now a sunk cost – and conflating the two (in the hope “something will turn up”) obscures any sense of accountability, including for the choices to keep running the position. She and her staff wouldn’t accept that sort of explanation from any other government agency running large financial risks.

Were the position to be liquidated today – as, at least in principle (crisis having passed, economy full-employed) it should be – a large loss for the taxpayer would be realised. At a narrow financial level it is as simple as that. If the position continues to be run – in the limit through to maturity, finally in 2041 – what will matter is where the OCR averages relative to what is currently priced into bond yields, but it won’t change the fact that the portfolio is starting behind – the OCR is already much higher than was expected at the time most of the bonds were bought. And if the portfolio is let continue to run, taxpayers are exposed to ongoing large risk for no expected return (there is no reason to suppose the Bank is better than the market at guessing where the OCR will need to go over the next 10-20 years).

(The current agreement between the Minister and the Bank requires that if the Bank looks to sell the LSAP bonds it do so only to the Treasury itself. Such a sale, of course, changes nothing of economic substance (purely intra-Crown transactions don’t) – the high level of settlement cash balances would still be there, earning whatever OCR the macro situation requires – but from a political perspective it would be convenient, as there would no longer be monthly updates on the Bank’s website as to the extent of the losses caused by the MPC’s rash choices (backed by The Treasury).

Treasury officials did chip in a couple of caveats. First, the Secretary noted that in assessing the overall LSAP programme one had to look also at the (any) macroeconomic benefits. In principle, of course that is correct, but (as I’ve argued previously) any such gains are unlikely to have been large:

  • the LSAP was designed to lower long-term bond rates, but these are a very small element in the New Zealand transmission mechanism,
  • it is hard to see much evidence here or abroad of sustained effects of LSAP-like programmes on long bond rates (eg movements beyond what changing expectations of future OCR adjustments themselves would simply),
  • the Bank always had the option of cutting the OCR further (on their own telling, to zero last year, and lower still since the end of last year), at no financial risk to the taxpayer, and
  • if there is a macro effect, perhaps it was modestly beneficial last year, but must be unhelpful now (recall that the literature suggests it is the stock of bonds that matters, not the flow of purchases, and we now have an overheated economy with above-target inflation.

And one of her deputies chipped in noting that there might have been some savings to The Treasury from having been able to issue so heavily at such low rates last year, the suggestion being that without the LSAP the Crown might not have been able to get away so many bonds so cheaply. There is probably something to that point, in an overall accounting, but (a) the effect is unlikely to have been large relative to the scale of the subsequent rise in bond yields, and (b) especially with hindsight a better model would have been for the Bank not to have been purchasing bonds and the Crown to have been issuing fewer.

The Select Committee discussion ended with the offer that National MPs could lodge a follow-up question for written response by the The Treasury. I hope they avail themselves of that offer.

The Treasury could be, and should be, much clearer and more upfront about the analytics of the LSAP issues, but it isn’t clear – given their involvement all along – that their incentives are in this case that well-aligned with the interests of the public in scrutiny, transparency, and accountability.

$5.7 billion

A few weeks ago I wrote a fairly discursive post on the losses the Reserve Bank had run up on its Large Scale Asset Purchase programme. I know some readers found the basic point a little hard to grasp (no doubt a reflection on my storytelling), so today I’m going to do a very stylised representation of what has gone on.

But first, as I noted in that post, as market interest rates rise losses mount. The Bank has now released its end-October balance sheet and this is the line item representing their claim on the Crown (the Minister of Finance indemnified the Bank for losses incurred).

lsap losses

So the losses have now reached $5.7 billion (roughly 1.6% of annual GDP). Market interest rates fluctuate each day, but as of yesterday’s rate current losses are likely to be very similar to those as at 31 October. Perhaps Covid has inured us to big numbers, but these are really large losses, which were quite avoidable.

Now I want to step you through a very stylised illustration of roughly what has gone on.

A severe shock hits (call it Covid, but it could be anything) and the government determines that it needs to run a large fiscal deficit. Say that (cash) deficit totals $70 billion. The government finances that deficit prudently by issuing (selling) long-term bonds, issuing $70 billion at par, and thus raising $70 billion in cash.

Once the government has borrowed and spent, its bank account balance (at the Reserve Bank) isn’t changed. And after recipients of the deficit spending and purchasers of the government bonds have all made their transactions, the aggregate balances held by banks in their settlement accounts at the Reserve Bank also haven’t changed.

But now assume the Reserve Bank enters the fray, deciding that it will launch a large scale bond purchase programme, in which it buys $50 billion of long-term government bonds (for simplicity, assume the same bonds the government just issued on market). The Bank pays for those bonds by issuing on-call liabilities (settlement cash balances), on which it pays the OCR interest rate.

What does the Crown’s overall debt exposure look like under those two stages?

Financing the fiscal deficit

Floating rate debt held by the private sector (settlement cash) $0

Long-term government bonds held by private sector $70bn

Add in the effect of the LSAP

Floating rate debt held by the private sector (settlement cash) $50bn

Long-term government bonds held by the private sector $20bn

The total amount owed by the Crown (government plus Reserve Bank) is $70 billion in both cases, but the risk to the Crown is substantially different.

The emergency having finished (by assumption in this stylised example), the Reserve Bank now has two choices. It can hold the bonds it purchased to maturity or it can sell them back to the market. One choices closes out the risky position they chose (rightly or wrongly) to run during the emergency, while the other leaves it running (for years).

Now assume that market interest rates rise sharply, across the curve (so long-term bond yields rise but so – perhaps gradually – does the OCR itself.

When market interest rates rise, the market value of a portfolio of long-term bonds falls. That is what has happened in New Zealand over the last year or so, reflected (in respect of the LSAP portfolio) in the chart at the start of this post.

If the bonds were sold back to the market, the Reserve Bank (and Crown as a whole) would realise less on the sale than they paid for the bonds. On present rates, a lot less. Selling the bonds back to the market would, however, restore the balance sheets as under the “Financing the fiscal deficit” scenario above. The private sector would hold no floating rate government debt (settlement cash) but lots of long-term bonds. All the risk would be with the private sector, although the Crown would have crystallised the large loss it let the Reserve Bank run up.

But what if, instead, the Reserve Bank just stuck the bonds in the bottom drawer and held them to maturity (last maturities not for 20 years)? The bonds would mature at par, and there might be little or no claim under the indemnity (depends on the initial purchase price relative to the face value). But, if things play out as current market prices envisage, the OCR would rise by quite a lot and (on average) stay much higher over the remaining life of the portfolio. Since the Bank is still holding the bonds, settlement cash would also stay high, and the Bank pays the full OCR on all settlement cash balances. Under that scenario, the Reserve Bank – having issued lots of floating rate debt, and having no matching floating rate asset – will be up for much higher interest costs.

Either way, the Crown (the taxpayer) has lost a great deal of money. If market rates play out as the yield curve currently predicts, either there will be a large payout under the indemnity, or the Reserve Bank’s future dividends to the Crown will be reduced. But the loss has already happened, it is just a matter of how it ends up being recorded/realised. $5.7 billion dollars of it. The Crown could probably have funded quite a few ICU beds for quite a few years with that sort of money…..but it has gone.

You’ll notice that I bolded some words in the previous paragraph. Even if the best estimate of future short-term rates is something like what the market currently prices, that is a very weak standard, and it is exceptionally unlike that actual short-term rates will follow exactly that path. They could be lower, but they could be higher (perhaps quite a bit higher or lower).

If the Reserve Bank sold the bonds it holds back to the market we (taxpayers) wouldn’t need to worry. The overall Crown would be back to having funded itself with long-term debt, and fluctuations in rates wouldn’t affect us (at least unless/until the bonds need rolling over years down the track).

But if the Reserve Bank keeps the bonds, we (taxpayers) keep the risk. Having had them drop $5.7 billion of our money so far, they keep the position open. From here, they could make us a bit of money, or they could lose a bit of money (well, actually “a lot” in either direction). But there is no obvious reason to have some bureaucrats speculating on bond markets – because that is what the LSAP portfolio now purely is – at our risk. It isn’t even as if these people – the MPC – have some demonstrated track record of generating attractive Sharpe ratios (returns relative to risk) for their punts. And if as individuals we do want to take punts, the market already has products for us.

Perhaps the key point here is that the $5.7 billion has already gone – that is what mark-to-market accounting measures – but the risk remains. From here we could lose another (say) $5.7 billion, or make a great deal of money, but there seems to be no effective accountability, for activities which – at this point, well beyond the crisis – is simply not a natural business of government. Monetary policy in a floating exchange rate system like ours normally involves next to no financial risk to the taxpayer.

Are there caveats to all this, or alternative approaches?

One possibility is that the government chooses to neutralise the risk the Reserve Bank continues to run. They could do that relatively easily, by issuing new bonds on market with the same maturity dates as those the Bank holds. All else equal that would eliminate the future floating rate exposure. They could probably do something similar (but hedging less effectively) with interest rate swaps. But it doesn’t seem terribly likely, or terribly sensible (including because it would simply further inflate balance sheets).

Since this is an entirely stylised exercise, I’ve been able to dwell in the simplified air of “sell” or hold”, as if “sell” was akin to selling a single excess car or house. But the Bank has more than $50 billion in bonds and it would not make sense to offload them all at once (doing so would be likely to push the price unnecessarily against the Bank/Crown). So when I say “sell” what I really have in mind is a steady pre-announced programme that would unwind the entire portfolio over 1-2 years. That means assuming quite a lot of risk in the menatime, but unfortunately that is the hole Orr and his colleagues dug for us.

Observant readers will have noticed that so far I’ve not mentioned at all any macroeconomic effects of the LSAP programme. The LSAP was launched with the intention of having stimulatory macroeconomic effects. I’ve always been sceptical there was much to the story, especially in the New Zealand context. The proceeds of the bond purchases were fully sterilised (that is what paying the OCR on all balances does), short-term rates were held low by (a) the OCR itself, and (b) some mix of RB statements and market expectations about the economic/inflation outlook, and long-term rates just don’t matter much to the transmission mechanism in New Zealand. But remember that the LSAP was explicitly sold as a substitute for the Bank last year not having been able (so it said) to take the OCR negative. It is now quite clear – even if it wasn’t at the time – that any such need had dissipated by this time last year. This year, inflation and unemployment have been overshooting and the OCR has begun to be raised. So even if you think – with the Bank – that the LSAP had a useful macroeconomic effect, any useful bits must have been concentrated in a few months last year. And it simply isn’t credible that any such gains were as large as the 1.6 per cent of GDP of our money that the Bank has….. lost. (Note that the literature on LSAPs suggests that any beneficial effects come from the stock of bonds hold not the flow of purchases, but the Reserve Bank continued its purchase programme well after it was clear the OCR itself could take any slack and now – when looking to tighten conditions – refuses to reduce risk to the taxpayer by making a start on reducing the Bank’s bond holdings.)

And all this from a weak and not very transparent, or accountable, institution. As per yesterday’s post, two of those responsible – MPC members – are moving on, and the Minister has to make various new appointments shortly. One of those most responsible – the MPC member responsible for monetary policy and financial markets – has just been given a big promotion. But none of them – internal, external, Governor or more specialist expert – has given any sort of adequate accounting for the public money they have lost.

(Where does the Minister himself fit into all this? I’m not particularly sympathetic to Robertson, who seems the epitome of a minister uninterested in holding anyone to account, but realistically on the dawn of a crisis, no Minister of Finance was likely to have turned down the Bank’s request for an indemnity, at least if The Treasury was onside with the Bank. No, the substantive blame here rests first and foremost with the Governor, the MPC, secondarily with the Bank’s Board and the Secretary to the Treasury, and only then with the Minister of Finance. But it is the Minister who is accountable to Parliament and the public, and who had failed to ensure that the Reserve Bank was fit for purpose (people, preparedness) going into a crisis like Covid.)

UPDATE: For those who have pointed out, or noticed, that I did not discuss here issues around actual settlement account balances over the last 20 months (or developments in the Crown account), they are discussed in the earlier post linked to above.