In two successive days last week, two heads of central banks gave speeches on monetary policy.   Graeme Wheeler’s speech was characterized by a rather desperate defensiveness –  attacking nameless critics for views that no one seems to hold, in an attempt to defend his (and the Bank’s) rather poor track record: a CPI inflation rate that hasn’t been at the midpoint of the target range for four years.

A commenter pointed me to ECB head Mario Draghi’s speech, given the following day, “How central banks meet the challenge of low inflation” .   It isn’t a perfect speech by any means –  the claim that “monetary integration in the euro area is both complete and secure” must just be one of those lines he has to use, regardless of the continuing severe stresses on the system.  It is a speech of two halves –  the second half is about the particular challenges of the euro area, but the first half is an excellent and authoritative discussion of how central banks generally should respond to low inflation.

Core inflation in each jurisdiction is quite similar: in 2015 CPI inflation ex food and energy was 1 per cent in the euro-area, and was 0.9 per cent in New Zealand.  If anything, New Zealand’s inflation target is a little higher than that for the euro-area: our Reserve Bank is required to focus on 2 per cent, while the ECB articulates its goal as keeping CPI inflation close to, but below, 2 per cent over the medium-term.

Draghi’s speech is well worth reading.  It is the speech of someone who has a deep belief in the power of monetary policy – that inflation is, over time, a monetary phenomenon, and that if inflation is persistently below whatever goal is set for the central bank it is the central bank’s responsibility to do something about it.    It is a refreshing speech, especially as the ECB is no doubt closer than it would like to the limits of conventional monetary policy (with the policy rate already below zero).    Draghi could have offered excuses, but instead it is robust call for monetary policy to simply do its job.

Draghi draws on the lessons of the 1970s, when central bankers often wanted to shift the responsibility for high inflation onto other structural forces.  He fully recognizes the wide range of shocks than can hit an economy (demography, technology etc), and the way some of them can persist, but  argues that monetary policy authorities are responsible for offsetting the effects of those shocks on inflation –  whether they are pushing upwards (as in the 1970s) or downwards (as at present).

… in a context of prolonged low inflation, monetary policy cannot be relaxed about a succession of supply shocks. Adopting a wait-and-see attitude and extending the policy horizon brings with it risks: namely a lasting de-anchoring of expectations leading to persistently weaker inflation. And if that were to happen, we would need a much more accommodative monetary policy to reverse it. Seen from that perspective, the risks of acting too late outweigh the risks of acting too early.

In sum, even when faced with protracted global shocks, it is still monetary policy that determines medium-term price stability. If we do not “surrender” to low inflation – and we certainly do not – in the steady state it will return to levels consistent with our objective. If on the other hand we capitulate to “inexorable disinflationary forces”, or invoke long periods of transition for inflation to come down, we will in fact only perpetuate disinflation.

This is the clear lesson of monetary history, especially the experience of the 1970s.

Nor does he offer up excuses of the sort that “inflation is low everywhere, so there isn’t much we can –  or perhaps should –  do about it”.

We now have plenty of evidence that, if we have the will to meet our objective, we have the instruments.

and

So there is no reason for central banks to resign their mandates simply because we are all being affected by global disinflation. In fact, if all central banks submit to that logic then it becomes self-fulfilling. If, on the other hand, we all act to deliver our mandates, then global disinflationary forces can eventually be tamed.

He even deals with the line of argument that easing monetary policy to get inflation back to target may do more harm than good.

Still, there are some that argue that even if central banks can lean against global disinflationary forces, in doing so they do more harm than good. In particular, expansionary monetary policies at home lead to the accumulation of excessive foreign currency debt or asset price bubbles abroad, especially in emerging markets. And when these financial imbalances eventually unwind, it weakens global growth and only adds to global disinflation.

To which his response is:

In fact, when central banks have pursued the alternative course – i.e. an unduly tight monetary policy in a nascent recovery – the track record has not been encouraging. Famously, the Fed began raising reserve requirements in 1936-37, partially due to fear of a renewed stock bubble, but had to reverse course the next year as the economy fell back into recession. That has also been the experience of some central banks in recent years: raising rates to offset financial stability risks has undermined the primary mandate, and ultimately required rates to stay lower for longer.

This suggests that the so-called “assignment problem” between monetary policy and financial stability at the domestic level should also apply at the global level. Monetary policy should not try to balance opposing objectives: it is optimal for all parties if it delivers its mandate. And if that creates financial stability concerns, they need to be addressed by other policies more suited to the task. And in fact there are several policy levers available.

Countries can improve their financial regulation and supervision to make their financial systems more resilient to external shocks. They can adjust their fiscal policies. They can adopt macro-prudential measures.

That is the sort of speech that Graeme Wheeler should have been giving last week – indeed, given how badly inflation has been undershooting the Reserve Bank’s target, he should have been giving it a year or two ago.  Instead, he drove up interest rates –  when his preferred measure of core inflation was even lower than it is now.  And even now that the OCR increases have reluctantly been fully reversed, we are left with real interest rates that are higher than they were two years ago, even as confidence in inflation getting back to target erodes further (and the terms of trade have fallen, the peak impulse from Christchurch has passed, and the global situation has materially worsened).

Chris Green, at First New Zealand Capital, had a commentary out late last week on the Governor’s speech.  I agreed with almost all of it.  But two lines particularly caught my eye:

“My sense is that the Governor is far more focused in defending his current position than objectively attempting to assess the optimal risk-adjusted monetary policy response”

and

“The perception that they give of a reasonably high hurdle before cutting rates would be more consistent with CPI out-turns around the top of the band, not having been below the midpoint for more than 5 years [I presume he means on the Bank’s preferred core measure] and not projected to get back there until the December quarter of 2017 –  at the earliest”.

Quite.   And one could add that the problem is compounded by the Governor’s reluctance to substantively engage with the issues –  rather than responding to straw men of his own imagining –  or indeed to open himself to sustained scrutiny from the media.

The Governor and his chief economist have been putting a lot of weight on inflation expectations measures recently, and suggesting that there is really nothing to worry about.  We’ll have a new round of inflation expectations data shortly, and I’ll come back to the topic then, but for now consider this chart, drawn from the Bank’s survey of household expectations.

People are asked whether they expect inflation to rise, fall or stay the same over the coming year.  The survey has been running for over 20 years, and in every single survey a net balance have reported expecting inflation to increase (suggesting that not much weight should be put on the absolute numerical value of the answer).  But what I wanted to highlight is that at present fewer people expect inflation to rise than at any time in the history of the series, with the exception of the depths of the recession in 2008/09.    But in March 2009, when only 20 per cent people expected inflation to rise over the coming year, the last annual inflation rate they’d seen was 3.4 per cent.  Of course –  in the middle of a recession, with plummeting oil prices –  they didn’t expect inflation to rise.  And they were right.  Annual inflation fell sharply.    The most recent observation in the survey was November 2015.  When those respondents completed the survey, the most recent annual inflation rate they’d seen was 0.4 per cent.  And still, not many (by historical standards) expected annual inflation to rise.   There is nothing to be complacent about in the inflation expectations data –  and even among more expert observers, medium-term inflation expectations are lower, relative to the target midpoint, than they have been since inflation targeting began.

It must almost be time for the Minister of Finance’s annual letter of expectations to the Governor.  As I noted last year, the persistent undershoot of the target has had little or no attention in  past year’s letters.  We must hope that this year’s is different.  The primary responsibility for the persistent undershoot of the target rests with the Governor, his chief economist, and his other senior advisers.  But the apparent passivity to date of those charged with holding the Governor to account –  the Minister of Finance, who set the target, and the Bank’s Board, paid to monitor the Governor’s pursuit of the target –  risks making them complicit in the failure.  After all, together they were responsible for the appointment of an individual as Governor who increasingly seems to lack the stature and qualities that the position demands.

Perhaps not surprisingly there has been a lot of coverage of yesterday’s CPI outcome –  an inflation rate of only 0.1 per cent for the year; materially lower than either the Reserve Bank (in its December MPS) and all other published forecasters had expected.

Quite what the numbers mean isn’t so clear-cut, and I’ll come back to that, but it is very low inflation.

Of course, this is an era of low inflation.  According to the OECD database, nine OECD countries had even lower inflation (or deflation) than we did last year –  eight of those countries have policy interest rates at zero (or even a bit below).

The media made much of our inflation rate being the lowest since 1999, but they probably missed the story.  After all, 1999 isn’t that long ago (and the target was lower then).  And in those days, the CPI included retail interest rates, and interest rates dropped by around 400 basis points in 1998.  All the experts thought that in a deregulated economy including interest rates in the CPI was daft –  apart from anything else, it meant that when the Reserve Bank tightened monetary policy, inflation temporarily went up.  So daft in fact that the Policy Targets Agreement in place at the time, signed by Winston Peters and Don Brash, set the target in terms of CPIX (ie the CPI excluding credit services).  In fact, the way the official CPI was calculated was changed shortly afterwards to essentially the approach used today.

We don’t have a consistently compiled historical CPI in New Zealand (the way all sorts of things have been measured, but especially around housing, has changed materially over time, but then so –  for example –  has the extent of price controls, regulation etc).   But here is a chart using the official historical CPI all the way back to the 1920s, with an overlay (in red) of the CPIX inflation rate over 1997 to 1999.  At the trough, annual CPIX inflation was around 0.9 per cent –  not that much below the midpoint (1.5 per cent) of the then target range.

Taking a longer horizon, annual CPI inflation got as low as 0.3 per cent in 1960 (I recall tracking this number down in the early days of inflation targeting and holding it out as something to aspire to, the last time New Zealand had managed ‘price stability’).  And since the Reserve Bank opened in 1934, the only time annual inflation has really been lower than it was in 2015 was in 1946, when the annual inflation rate briefly dipped to -0.2 per cent.  The lowest inflation rate for almost 70 years might have been more of a story.  “Lowest inflation since the Great Depression” would no doubt be a headline the Reserve Bank will be keen to avoid, but that too must be a non-trivial risk now.

Quite what to make of the inflation numbers is another matter.  Although the Reserve Bank has been playing up headline inflation in its recent statements, headline inflation shouldn’t be (and rarely is) the focus of monetary policy.  What matters more is the medium-term trend in inflation: as the PTA puts it

“the policy target shall be to keep future CPI inflation outcomes between 1 per cent and 3 per cent on average over the medium term, with a focus on keeping future average inflation near the 2 per cent target midpoint”

But it has been four years now since headline inflation was 2 per cent.  The Reserve Bank keeps telling us it is heading back there relatively soon, and has continued to be wrong.  Even before this latest surprise, they had been forecasting it would be another two years until inflation got back to 2 per cent.

If the weak inflation was all about petrol prices perhaps we could be relaxed –  whatever mix of supply and demand factors is lowering oil prices, taken in isolation it is a windfall real income gain to New Zealand consumers.   But CPI inflation excluding vehicle fuels was 0.5 per cent last year, down from 1.1 per cent in 2014.  Indeed, tradables inflation excluding vehicle fuels was -1.2 per cent in 2015, also a bit lower than the 0.9 per cent in 2014.

Over the last few years, a common explanation for New Zealand’s low inflation rate had been the rising exchange rate, which tends to lower tradables prices.  But the exchange rate peaked in July 2014, and in the December quarter 2015  (having already rebounded a little) it was 7 per cent lower than it had been in the December quarter of 2014.  Of course, some Reserve Bank research not long ago suggests that when the exchange rate has fallen previously the inflation rate itself has tended to fall –  presumably because the exchange rate falls don’t occur in a vacuum and are often associated with a weakening terms of trade and a weakening economy.

Government taxes and charges throw around the headline CPI –  for the last few years, large tobacco tax increases held headline inflation up, and more recently the cut in vehicle registration fees lowered the headline rate.  But in the last year, non-tradables inflation excluding government charges and tobacco and alcohol taxes was 1.8 per cent, exactly the same as overall non-tradables inflation.   Non-tradables prices tend to rise faster than tradables prices (think of labour intensive services) so with an inflation target on 2 per cent, one might normally be looking for a non-tradables inflation rate of perhaps 2.5 to 3 per cent.

What of the “core” measures of inflation?   Probably for good reason, the “ex food and energy” measures don’t get much focus in New Zealand.  But SNZ do report such a measure, and it recorded 0.9 per cent inflation last year, right at the bottom of the target range although barely changed from the 1.0 per cent in 2014.

The Reserve Bank reports four core inflation measures on its website.  None of them is close to 2 per cent, but the message from them in terms of recent trends isn’t that clear.  Two measures (the weighted median and the factor model) suggest little change in the core inflation rate over the last year.  One of them –  the trimmed mean –  suggests a material slowing in core inflation (indeed, in quarterly terms the trimmed mean –  which excludes the largest price changes in both directions – had its weakest quarter in 15 years of data).  But the fourth measure –  the sectoral core factor model –  actually suggests that core inflation has picked up quite noticeably over the last few quarters.  It is a pretty smooth series, and so an increase in inflation from 1.3 per cent to 1.6 per cent, especially when headline inflation is so weak, is worth paying attention to.

The sectoral core measure has been the Reserve Bank’s preferred measure of core inflation, and mine.  Frankly, I’m not sure what to make of it, although I take some comfort from the fact that the increase seems concentrated in tradables prices (the sectoral factor model separately identifies common factors among tradables and non-tradables prices and only then combines the two factors).  The tradables factor seems quite sensitive to exchange rate movements –  as one might expect –  but is not obviously something monetary policy should be responding to.    It is always important to think hard about data that go against one’s story, so I remain a bit uneasy about what the sectoral core measure is telling us (even recognizing that it has end-point problems, that mean recent estimates are sometimes subject to quite material revisions).

For the last nine months I’ve been arguing here (and had earlier been arguing the case internally) that monetary policy needs to be looser if future inflation is once again to fluctuate around 2 per cent –  the target the Governor and the Minister have agreed.  Somewhat belatedly, and grudgingly the Reserve Bank has cut the OCR, and it will take some time for the full lagged effects of those cuts to be seen.   Current core inflation –  whatever it is –  partly reflects the lagged effects of previous overly-tight policy.

In terms of future monetary policy, yesterday’s CPI results in isolation aren’t (or shouldn’t be) decisive.    They rarely are.  But equally there isn’t much reason in those data for anyone to be confident that inflation will relatively soon be fluctuating around 2 per cent.  That confidence matters –  as I noted earlier in the week, both financial markets and firms and households have been gradually lowering their expectations of future inflation .  If that becomes entrenched, it is harder to get inflation back up –  but the risks of trying more aggressively to do so are also diminished (people today simply aren’t looking for inflation under every stone, worried that some nasty inflation dynamic is just about to destroy everything they’ve worked for).

And context matters too.  As I explained in December, I thought the Reserve Bank’s case  that the economy and inflation would rebound over the next couple of years –  and hence no more OCR cuts were needed –  was unconvincing.  The intervening six weeks have done nothing to allay those concerns.  Over recent years there were some huge forces pushing up domestic demand –  strong terms of trade, the upswing in the Christchurch repair process, and the huge increase in net migration.  None of those factors seemed likely to be repeated.  Dairy prices seem to be lingering low, global economic uncertainty is rising, global growth projections are being revised downwards (even by that lagging indicator, the IMF) and just today US Treasury bond yields dropped back below 2 per cent.   Unease seems to be turning to fear, in a global climate where deflationary risks seem more real than those of any very substantial positive inflation.

In sum, the case for further OCR cuts in New Zealand now is pretty clear, and the risks (of materially or for long overshooting the inflation target) seem low.  Would doing so boost the property market?  Relative to some counterfactual, no doubt.  That is a feature not a bug.  Monetary policy works in part by increasing the value of long-lived assets, and encouraging people to produce more of them.  But what it would also do is lower the exchange rate, providing a buffer to more-embattled tradables sector producers (think dairy farmers) and increasing the expected returns to new investment in other areas of the tradables sector.

Who knows what the Governor and his advisers will make of the recent data flow.  In a more transparent central bank we could look forward to seeing the minutes of next week’s meetings, the alternative perspectives and arguments.  As it is, the Governor will tell us what he wants us to know in his OCR release next week, and perhaps in his speech the following week.