Getting prepared for the next serious recession

Not infrequently over the last few years, I’ve criticised the Reserve Bank (and The Treasury and the Minister of Finance, both at least equally responsible) for the lack of any real sign that they were taking seriously the potentially severe limitations on the use of stabilisation policy (monetary policy in particular) in the next serious recession.  The topic never featured in speeches from the Governor, there was no published research on related issues, and getting ready never featured as a priority in the Bank’s annual Statements of Intent.

The potential problem, of course, is that – as things stand – the OCR can probably be lowered another couple of hundred basis points (to around -0.75 per cent) but for anything beyond that conventional monetary policy will quickly become quite ineffective, as large depositors (I’m thinking financial institutions and investment funds mostly) would exercise their option to switch into large holdings of (zero interest) physical cash.   People will still use bank accounts (negative interest rates and all) for most day to day transactions, but most financial assets aren’t held for immediate transactions purposes.

In typical past downturns OCR cuts of 500 basis points or more have been judged necesssary (the Reserve Bank cut by 575 basis points in 2008/09).   Similar magnitudes of adjustment have been made in, for example, the United States.

It is now almost 10 years since the Reserve Bank first cut the OCR to 2.5 per cent.  In the early years after that, the assumption was that (a) the 2008/09 recession had been unusually large, and (b) interest rates would soon need to be raised quite considerably, and so that whenever –  perhaps a decade hence –  the next recession happened New Zealand wasn’t likely to face a problem.  That was then.  As late as 2014 the then Governor was loudly talking up his plans to raise interest rates a lot, to –  as he saw it –  ‘normalise’ monetary policy.

But now it is 2018, and nominal interest rates are even lower than they were in 2008/09, and no serious observer thinks the Reserve Bank will have 500 basis points of policy leeway if another recession were to strike in the next few years (many doubt that the OCR will be raised much, if it all, in the intervening period, and a few –  including me –  think cuts would be more appropriate).  Most likely, the New Zealand economy will go into the next recession –  whenever it comes –  with the OCR 50 basis points either side of the current 1.75 per cent.  That just isn’t enough.   And the problem will be (greatly) compounded by the fact that central banks in almost all other advanced countries will be in much the same situation of worse (several already have their policy interest rates at -0.75 per cent.

If your central bank can’t cut policy rates (very much), and markets and firms/households know it, any incipient recession is likely to be worse than otherwise, and worse than we are used to (when downturns happen, central banks cut policy rates, often quite aggressively (if also often a bit belatedly), and people know/expect it).  Expectations of inflation may also drop away more sharply than we are used to, compounding the problems (real interest rates could raise, with nominal rates already on the floor).  Monetary policy has been the key stabilisation tool for decades, and (at best) it will be hobbled in any recession in the next few years.   For those who argue that interest rates don’t affect anything much domestically (a) I think you are wrong, but (b) the connection to the exchange rate is vital.   In monetary policy easing cycles in New Zealand, we also typically see big exchange rate adjustments, and that is part of how the economy stabilises and the next recovery begins.

Which is all a fairly long introduction to welcoming a new issue of the Bulletin published a few weeks ago by the Reserve Bank under the heading Aspects of implementing unconventional monetary policy in New Zealand.   As the introduction puts it

This article provides an overview of the experience with unconventional monetary policies since the global financial crisis of 2007/8, and assesses the scope for unconventional monetary policy in New Zealand. While there is no need to introduce unconventional monetary policies in New Zealand at this time, it is prudent to learn from other countries’ experiences and examine how such polices might work in New Zealand if the need arises.

It is, unambiguously, good to see such an article being published by the Bank.  Unfortunately, there is a degree of complacency about the content –  echoing remarks the Governor made at a recent press conference suggesting there was nothing to worry about – that should be quite disconcerting.  Complacency on such matters might be expected from politicians, with a tendency to live from one news cycle to the next.  We should not expect it from our central bankers.

As a brief survey of what other countries have done, the article is not bad.  There is some discussion of the experience with negiative policy rates, which comes to the pretty standard conclusion that policy rates probably can not usefully be taken below about -0.75 per cent.  There is a fairly long discussion of large scale asset purchases (mostly the government bond purchasing programmes) and some discussion of targeted term lending programmes operated in a few countries in the wake of the 2008/09 crisis.

Of large scale asset programmes, the Reserve Bank authors cautiously conclude

A large body of evidence shows that LSAPs were successful in easing financial conditions, through lower bond yields, higher asset prices and weaker exchange rates.11 The forward looking nature of financial markets means that most of the impact occurred on announcement, rather than when purchases were executed. As highlighted by Gagnon (2016), LSAPs can be especially powerful during times of financial stress, although the signalling and portfolio balance channels should still have a significant effect in normal times. There may, however, be diminishing returns through these channels. In particular, given the lower bound on short-term interest rates, there will be a limit to how far interest rates can be reduced via the signalling channel. Similarly, there is likely to be a lower bound on long-term interest rates (as investors have the option of holding paper currency with a fixed yield of zero) meaning additional purchases might not drive yields much below zero.

What really matters for central banks is whether LSAPs helped central banks achieve their mandates, related to achieving inflation, output and employment goals. While most studies into the effect of LSAPs in the post 2007/8 global financial crisis period find positive effects, they must be treated with caution. In part this is because of measurement issues: LSAPs have been implemented over a relatively short period since the 2007/8 global financial crisis, and previous historical relationships can have been expected to have changed. Overall, early work suggests LSAPs can be a beneficial monetary policy tool in exceptional circumstances. However the nature and extent of the transmission of these polices to inflation and activity is still being established.

Cautious as that is, I suspect it is not cautious enough.  For example, if one takes a cross-country approach there is little sign that long-term interest rates have fallen further relative to short-term interest rates in countries that did large scale asset purchases than in those which did not (for example, New Zealand and Australia).   Whatever the headline or announcement effects –  and some probably real effects in the midst of the crisis itself – without those longer-term effect on real bond rates, it is difficult to believe that the asset purchase programmes really made much difference to stabilisation and recovery.

Relatedly, as the authors note, the real test is surely progress towards meeting inflation targets and getting unemployment rates back down again quickly.  Against that standard, with the best unconventional tools central banks could deploy, on top of large reductions in policy rates, the experience has been very troubling –  the weakest recovery in many decades.  With that set of tools, the outlook the next time a serious recession hits has to be, almost by construction, worse than over the last decade.

But in many respects, the most interesting part of the article is the second half, exploring options for New Zealand.   Unfortunately, they do not seem to have moved very far at all from past work.  Just based on things I personally was involved in, in the late stages of the last recession I spent quite a bit of time at Treasury looking at options that might be deployed in things worsened further, and when the euro crisis was at its height in 2012 I led a Reserve Bank working group looking at some of the issues around how far we could go with conventional monetary policy, and what other instruments were then at our disposal.     The sorts of options we looked at then were helpful (and even then we reckoned the OCR could be cut to perhaps -0.75 per cent) but pretty limited.  The Bank seems no further ahead now and –  disconcertingly –  seems unbothered by that situation.

What tools do they have in mind?

The first is a negative OCR.

Overall, it appears that the Reserve Bank could implement negative interest rates, with the potential leakage into cash relatively small in value terms at modestly negative rates.

That seems right to me.  It would not be expected to involve, say, negative mortgage interest rates, but there have been some examples even of those in Scandinavia.

But it is the limits to the negative OCR which are the issue.

The second possible instrument they cover in the option of large-scale asset purchases.

As they note, there are not many (liquid) bond issues in New Zealand other than government bonds, and even the stock of government bonds is (generally fortunately) smaller than in many other advanced countries (including the US, UK, Japan and the more troubled parts of the euro-area).    And many passive holders of government bonds –  having made long-term asset allocation choices –  will not be that interested in selling.

In a New Zealand specific severe recession, these constraints might not matter very much.   Many of our government bonds are held by foreign investment funds, who have no natural (benchmark) reason to be in New Zealand.  Shake them loose by offering a high enough price and not only might bond yields fall quite a bit – at least initially –  but the exchange rate could be expected to fall too.  That latter channel would probably be much the most important one (since few New Zealand borrowers issue long-term debt, and those that do will typically swap it back into a floating rate exposure).

But if the downturn is pretty synchronised across a range of countries (as it was in 2008/09), that is a less compelling story.  Everyone will be trying to cut policy rates, and pretty everyone will be coming up against practical lower bounds.   Everyone can try to depreciate their currency, but in aggregate that ends up with not much expected change.  I’ve argued previously that if our OCR is ever around that of other advanced countries, our exchange rate should fall quite a lot, but at present the margins between our OCR and those of other countries is already smaller than we often find going into past recessions.

The Reserve Bank authors also note that the Bank could engage in (unlimited) unsterilised exchange rate intervention, buying assets in other countries’ currencies, and selling (‘printing’) New Zealand dollars, which the Bank can do without technical limit.   All else equal, that should tend to lower the exchange rate.

This might be more of an option for a small and inobtrusive country like New Zealand –  among the majors ‘currency war’ rhetoric would soon be flying. But even then, it isn’t likely to be a terribly effective policy.  The Reserve Bank notes some of the reasons (other countries trying to do the same thing – eg Australia our largest trade/investment partner).  But the other reason involves thinking about transmissions mechanisms: printing lots more New Zealand dollars creates more interest-bearing assets in New Zealand.  In normal circumstances, unsterilised intervention will drive down domestic interests rates, setting in train a mechanism that will lower the exchange rate, raise inflation etc etc.  But in this scenario, by construction, short-term interest rates can’t fall any further.    And there is no compelling reason to suppose that the holders of those new New Zealand dollars will want to spend more on goods and services (a channel which really might raise inflation).

The Reserve Bank briefly discusses the option of transacting the derivatives market, via interest rate swaps (larger and more liquid than the bond market).  This idea has been around for years.  There is no doubt it would enable the Reserve Bank to, say, cap the long-term (synthetic) interest rate, but it isn’t clear what good that would do, and there is no sign in the article of any new thinking in that regard.  The Bank talks of signalling gains –  communicating a commitment to keep the OCR low for a long period –  but I doubt that does much good beyond the short-term announcement effect.  For one, central banks can’t pre-commit, and markets and other observers will make their own judgements based on their read of the emerging economic data.

The final option they discuss is targeted term lending.   What they have mind here isn’t replacing market credit when funding markets seize up (as happened in 2008/09) but direct intervention in which the government and the Reserve Bank try to target credit to particular sectors.

This type of facility would provide collateralised term lending to banks at a subsidised rate if banks met specified lending objectives. These criteria would ensure that the low policy rate was being passed on to households and businesses. Holding collateral against the loans would mitigate the risks to the Reserve Bank’s balance sheet. Since a targeted lending scheme could see banks taking on more credit risk than they might otherwise choose, it would need to be carefully managed.

That final sentence is an understatement to say the very least.  Policies of this sort are really fiscal policy and, if done at all (which they should not be) should be done by the government itself, not the autonomous central bank.   Government involvement in encouraging credit provision to particular sectors has a poor track record, here or abroad (see US crisis ca 2008/09).   And when the Reserve Bank takes collateral to try to encourage/coerce banks into providing credit they would not otherwise provide, it is directly preferencing itself relative to other creditors (including depositors) if things later go wrong.

In an article about monetary policy, it is not surprising that the Bank gives little space to discretionary fiscal policy. But it is disconcerting that when they do touch on it, they get their basic facts wrong.

And in New Zealand, fiscal policy played an important role in the response to the 2007/08 global financial crisis.

Discretionary fiscal policy played no role at all in responding to the recession of 2008/09 (if anything, it was marginally contractionary given the cancellation of promised tax cuts in 2009).  Yes, the overal fiscal position slid into deficit but that was wholly because of (a) policy choices made before the government or Treasury realised there was a recession, and (b) automatic stabilisers, which are weaker in New Zealand than in most advanced countries.

As I said earlier on, the degree of complacency –  and refusal to confront options that really could make a significant difference –  is disconcerting.    The Bank argues

The Reserve Bank would look to communicate well in advance of any of unconventional policies being implemented, so as to enable financial markets and the government to prepare.

A nice sentiment, but as they note a few sentences later

we are rarely given the luxury of time when financial crises [or other recessions] hit

including because central banks are usually slow to recognise what is happening.  When you only have 200 basis points of conventional policy leeway –  and everyone knows that (a point not touched on in the article at all) –  they will need to be willing to signal a credible strategy very early.  And, on the evidence of this article, they do not have one (that would be likely to make any very material difference).

I suspect the authors really know that too, but prefer not (or are institutionally prevented from) saying so.  After all, they each smart people, and they know how poorly the world economy coped with, and recovered from, the last downturn, even deploying all sorts of unconventional policies  (fiscal and monetary) on top of the considerable conventional monetary policy leeway that existed going into that recession.  Even here –  where we never reached the limits of conventional policy –  the output gap remained negative, and the unemployment rate above official estimates of the NAIRU for eight or nine years.   Eight or nine years……..  That is just a huge amount of lost capacity, and of lives that are permanently blighted (prolonged involuntary spells of unemployment do that to people).

Perhaps the implicit argument is that we, and other countries, will do even more next time round.   But that isn’t likely.   Perhaps fiscal policy is, or should be, an option, at least in modestly-indebted countries like New Zealand, but any sober observer will recognise the real world political constraints other countries faced in using active fiscal policy to any great extent, for long, in the last recession.  Why is New Zealand likely to be different?

For much of the last decade, one has had the feeling –  in gubernatorial speeches and other commentary –  that, when it comes to it, the Reserve Bank really isn’t that bothered by lingering unemployment, excess capacity, or undershooting inflation.  One would like to think –  given his new mandate –  that the new Governor is different.  But this article isn’t really evidence for the defence on that score.

It is striking that the article does not engage at all with either of the two more radical options debated in other places and other countries:

  • reconfiguring the target for monetary policy.   This could take the form of a higher inflation target or, for example, the use of a price level or nominal GDP level target.  Each approach has its weaknesses, but either –  done in advance of the next serious downturn, not in midst when much of the opportunity is lost –  could help raise, and hold up, expectations about the path of the nominal economy, including inflation.
  • taking steps to material reduce the extent of the effective lower bound on nominal interest rates.

The latter remains my preference, for a number of reasons (including that the existing problem arises largely because central banks have  –  by law – monopolised note issue, and then not proved responsive to changing circumstances and technologies. Problems are usually best fixed at source.

If there is still a useful role for physical currency (I discussed some of these issues here), the ability to convert huge amounts of financial assets into physical currency, on demand, without pushing the price against you, is now a material obstacle to monetary policy doing its job in the next recession.    There is a good case for looking seriously at a variety of reform options, such as:

  • phasing out large denomination Reserve Bank notes (while perhaps again allowing private banks to offer them, on their own terms, conditions and technologies),
  • capping the physical Reserve Bank note issue, scaled to growth in, say, nominal GDP (perhaps with provision for overrides in the case of financial crisis runs),
  • putting a spread (between buy and sell prices) on Reserve Bank dealing in bank notes, or
  • auctioning a fixed quota of bank notes, and thus allowing the price to adjust semi-automatically  (when currency demand rises, as when the OCR goes materially negative) the cost of conversion rises.

These sorts of ideas are not new.  They do not get rid of the entire issue –  at an OCR of, say, -10 per cent, even transaction demand for bank deposits might dry up –  but they would go an awfully long way to ensuring that the next recession can be dealt with more effectively than the last.

If, for example, you thought the OCR was going to be set at -3 per cent for two years, then once storage and insurance costs are taken into account (the things that allow the OCR to be cut to around -0.75 per cent now), even a lump sum conversion cost (deposits into physical cash) of 5 per cent would be enough to keep almost everyone in deposits and bonds (even at negative yields) rather than physical cash.  That is a great deal leeway than the Reserve Bank has now.   Having that leeway –  and being willing to use it – helps ensure nominal rates don’t need to stay extremely low for too long.

In principle, many of these sorts of initiatives probably could be done in short order in the midst of the next serious downturn.  But we shouldn’t have to count on unknown crisis responses, the tenor of which have not been consulted on, socialised, and tested in advance.  It may even be that some legislative amendments might be required.

In summary, I welcome the fact that the Reserve Bank has begun to talk more openly about the potential limitations in its response to the next recession, but it is disconcerting that they still seem to be trying to minimise the potential severity of the issue.   In that, they aren’t alone.  I’m not aware of any central bank that has yet laid out credible plans to minimise the damage (although senior officials of the Federal Reserve have been more willing to talk about the issues openly).  In that, they are doing the public a serious dis-service, and risking worse outcomes than we need to face –  repeating the sort of reluctance to address issues that saw the world drift into crisis in the early 1930s.  Fortunately for the central bankers perhaps, it won’t be central bankers personally who pay the price.  That won’t be much consolation for the many ordinary people who do.

Since politicians, and not central bankers, are accountable to the voters, the Minister of Finance should be taking the lead in requiring a more pro-active (and open) set of preparations to be undertaken by the Reserve Bank and The Treasury.

 

 

Inadequate Treasury advice

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

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

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

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

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

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

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

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

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

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

Treasury notes, correctly, that

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

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

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

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

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

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

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

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

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

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

And they conclude this way

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

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

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

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

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

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

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

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

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

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

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

romer chart

(the dotted lines are confidence bands)

The Romers offer some thoughts on the policy implications, including

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

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

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

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

An employment objective for monetary policy: some survey results

Some link or other took me recently to the website of the University of Chicago’s Booth School of Business and, in particular, the IGM (economic) Experts Panel that they run.

Every few months, this outfit runs surveys of US-based academics on interesting economic questions.  Their panel is described this way

our panel was chosen to include distinguished experts with a keen interest in public policy from the major areas of economics, to be geographically diverse, and to include Democrats, Republicans and Independents as well as older and younger scholars. The panel members are all senior faculty at the most elite research universities in the United States. The panel includes Nobel Laureates, John Bates Clark Medalists, fellows of the Econometric society, past Presidents of both the American Economics Association and American Finance Association, past Democratic and Republican members of the President’s Council of Economics, and past and current editors of the leading journals in the profession.

You might not go to this group for “truth”. Academic economists have biases and blindspots, like everyone else (and tilt leftward politically), and sometimes the answers can look quite self-serving.  But a panel like this is likely to provide a fair representation of what US-based economics academics are thinking about issues.  They even provide two sets of answers: the raw responses, and a set in which respondents self-identify how confident they are of their views on the particular topic.

Flicking through the surveys from the last year or so, there were a couple of some relevance to the current review of the Policy Targets Agreement –  a new PTA is required in the next few weeks –  and of the Reserve Bank Act.

The new government has indicated its intention to add some sort of employment dimension to the Reserve Bank’s statutory objective for monetary policy, and they have often cited the (to me rather vague) wording in the US and Australian legislation.   In the US, the Federal Reserve is required by law to manage the money supply to grow in line with production, with the aim of thus contributing to

the goals of maximum employment, stable prices, and moderate long-term interest rates.

The Fed itself has reinterpreted this mandate –  without statutory authority although probably not unreasonably – as

The Congress has directed the Fed to conduct the nation’s monetary policy to support three specific goals: maximum sustainable employment, stable prices, and moderate long-term interest rates. These goals are sometimes referred to as the Fed’s “mandate.”

Maximum sustainable employment is the highest level of employment that the economy can sustain while maintaining a stable inflation rate.

One of the concerns some commentators here have expressed is whether any employment dimension added to our central banking legislation will have any real meaning or substance.  My own view, articulated here previously, is that it could do, but whether or not it does depends on how the provision is written, and what sort of reporting and accountability obligations are imposed on the Reserve Bank in respect of the employment dimension of the goal.   The Minister of Finance has not yet proposed any specific wording.

Against this background, it was interesting that the IGM Forum asked their panel members about the US wording.

employment IGM Weighted by the respondents’ individual levels of confidence, 55 per cent thought “maximum sustainable employment” was well enough defined to be used beneficially in policymaking.  22 per cent disagreed, and the remainder were uncertain.

This survey was done only a couple of months ago.  In that light, it is also interesting –  although not directly relevant to New Zealand –  that more respondents thought the US was still operating below “maximum sustainable employment” than disagreed.

At very least, these sorts of survey responses suggest that the government can come up with a formulation that might pass muster, as useful, among academic economists.  As a practical matter – and most of these respondents haven’t spent much time around policy –  I’m sure they can.    As I’ve noted previously, Lars Svensson – the leading Swedish economist who did a review of New Zealand monetary policy for the previous Labour government –  certainly believes some such framing is desirable and practically useful.

It isn’t yet clear whether the government wants a formulation that is practically beneficial and makes some difference to the conduct of short-term monetary policy, or simply wants something that looks different.   With Treasury, and the Independent Expert Advisory Panel (of questionable independence if the report on the back page of Friday’s NBR is anything to go by), due to report very soon, we should have some stronger indications before too long.

There was another recent IGM survey question of some relevance to New Zealand and other countries.  Last July, panellists were asked their view of the following proposition

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

Weighted by the confidence of the individual respondents 86 per cent agreed.

The panel was also asked their view of this proposition

If the Fed changed its inflation target from 2% to 4%, the long-run costs of inflation for households would be essentially unchanged.

A majority (51 per cent vs 29 per cent) disagreed, presumably thinking the costs of inflation would rise.

I’d agree with the majorities in both cases, and would answer the same way if the questions were posed for New Zealand.    I’d prefer not to have the target raised to 4 per cent –  actually meeting (or perhaps slightly overshooting) the 2 per cent target would do for now –  because there are (modest) welfare costs from a higher inflation target in normal circumstances.   But limitations on macro policy in the next serious recession is a real challenge, and there is little sign that the Treasury or the Reserve Bank have really engaged with them (eg it never appeared in the work programmes in Reserve Bank statements of intent).      And if there isn’t a willingness to address the practical constraint on taking interest rates much below zero, the Minister needs to be taking much more seriously the option of a higher inflation target.   Better to address the problem at source, but there is no sign our government – or officials –  have been doing so.

For those of a technical bent, in a Brookings newsletter the other day I noted a description of an interesting looking new paper tackling this issue from another angle.

Decline in long-run interest rates increases optimal inflation, but not one-for-one
If the decline in long-run real interest rates in advanced economies persists, nominal interest rates may be constrained by the zero lower bound more frequently. To counteract this, some economists have supported increasing the inflation target. Using a new Keynesian DSGE model, Philippe Andrade of the Bank of France and co-authors find that a 1 percentage point decline in the long-run natural rate of interest should be accommodated by an increase in the optimal inflation rate of about 0.9 percentage point—an estimate that is robust to various specifications that allow for uncertainty about key parameters in the model.

Central bank e-cash

After my post last week, prompted by the Reserve Bank’s recent statement that

Work is currently under-way to assess the future demand for New Zealand fiat currency and to consider whether it would be feasible for the Reserve Bank to replace the physical currency that currently circulates with a digital alternative.

I exchanged notes with a few readers with some in-depth thoughts on the issue, and found my way to some other relevant material including the recent first report of the Swedish central bank’s e-krona project.    And I noticed that Phil Lowe, Governor of the Reserve Bank of Australia, was giving a speech on exactly that topic – “An eAUD?” –  yesterday.  I gather that among advanced country central banks this is now treated as quite a high priority issue.    But it is also interesting that –  contrary to the Reserve Bank of New Zealand comment about their work –  both the RBA and the Riksbank are only talking about the possibility of electronic retail cash as a a complement to physical currency, rather than a replacement for it (and Sweden already has one of the very lowest currency to GDP ratios of any country anywhere).

Lowe’s speech was interesting, but also unsatisfying and unconvincing in a number of important areas.    As a New Zealand reader –  from a country with many of the same banks (and presumably banking technology options) –  I was struck by the contrast in what has been happening to currency to GDP ratios in the two countries.   Lowe illustrates that the share of transactions being effected by cash is also dropping sharply in Australia.  But here is the New Zealand currency to GDP chart I ran last week

notes and coin

And here is comparable Australian chart from Lowe’s speech.

Aus currency to GDP
45 years ago, the levels of the two series were very similar.  Since then, the trends have been very different and now there are many more physical AUDs in circulation (relative to GDP) than NZDs.   But there is nothing in Lowe’s speech about just why so much physical currency continues to be held in Australia –  far more than any plausible transactions demands (supported by evidence from payments practices data) would support.    Ken Rogoff suggested, in a US context, that the bulk must be held to facilitate illegal activities, or tax evasion in respect of otherwise legal activities.   Perhaps Lowe felt it wasn’t his place to venture far into territory around lost tax revenue, crime etc, but it was still a surprise to see no mention at all, when the RBA seems largely content with currency physical currency arrangements.

I was also rather surprised to see no serious engagement with the issues around the near-zero lower bound on nominal interest rates, which arises because of the option to convert unlimited amounts of bank deposits etc into zero-interest physical currency, an option that would be likely to be exercised on a large scale if official interest rates were dropped much below, say, -0.75 per cent.  Like New Zealand, Australia hasn’t yet approached the near-zero bound.  Neither had the US, Japan, Switzerland, Sweden, or the euro-area, until they did.   But Australia’s official interest rate is now only 1.5 per cent.  Perhaps it will be raised a bit before the next serious recession hits, but no prudent central banker could be discounting the possibility that even the RBA will hit the effective floor –  and limits of conventional monetary policy –  when that next recession comes.    Dealing effectively with that floor  –  by significantly winding back access to physical cash –  should be one important consideration when central banks are considering e-cash options.  But Lowe doesn’t even mention the issue, and while the limits of monetary policy might not have been of much interest to his immediate listeners (the Australian Payment Summit), interest in his speech –  and the issue –  goes much wider than the immediate audience.   (Strangely, in the Riksbank’s work they also talk in terms of zero-interest e-cash options –  albeit with the flexibility to change that at a later date –  and thus don’t really grapple either with the near-zero bound problem.)

To me, the heart of Lowe’s speech was his discussion of the possibility of the Reserve Bank of Australia issuing one or other of two types of eAUDs.

  • An electronic form of banknotes could coexist with the electronic payment systems operated by the banks, although the case for this new form of money is not yet established. If an electronic form of Australian dollar banknotes was to become a commonly used payment method, it would probably best be issued by the RBA and distributed by financial institutions, just as physical banknotes are today.

  • Another possibility that is sometimes suggested for encouraging the shift to electronic payments would be for the RBA to offer every Australian an exchange settlement account with easy, low-cost payments functionality. To be clear, we see no case for doing this.

I’m not sure I have a particularly good sense of what the first option involves, but here is how Lowe describes the possibility

The technologies for doing this on an economy-wide scale are still developing. It is possible that it could be achieved through a distributed ledger, although there are other possibilities as well. The issuing authority could issue electronic currency in the form of files or ‘tokens’. These tokens could be stored in digital wallets, provided by financial institutions and others. These tokens could then be used for payments in a similar way that physical banknotes are used today.

But he doesn’t seem keen, and so I’m going to focus my discussion in the rest of this post on the second of his options.   The issues and risks are pretty similar for both options, and I favour (provisionally) something like the second option.

At present, central banks offer exchange settlement accounts to facilitate the interbank settlement of transactions (the RBNZ policy is here –  something they must be reviewing, as there was an RFP for work in this area a few months ago).   These accounts facilitate payments, but they also allow entities given access to such accounts to hold electronic claims on the Reserve Bank (that are free of credit risk).  Central bank physical banknotes are also credit risk-free claims on the central bank.   But one set of claims is newer technology, regularly updated, enabling banks to both easily make payments and store value, while the other is a declining technology.

Here is how Lowe describes the option in this area

Another possible change that some have suggested would encourage the shift to electronic payments would be for the central bank to issue every person a bank account – for each Australian to have their own exchange settlement account with the RBA. In addition to serving as deposit accounts, these accounts could be used for low-cost electronic payments, in a similar way that third-party payment providers currently use accounts at the RBA to make payments between themselves. Some advocates of this model also suggest that the central bank could pay interest on these accounts or even charge interest if the policy rate was negative.

I’m not sure anyone argues for this approach to “encourage the shift to electronic payments”, but rather to reflect the world we now find ourselves in, in which electronic payments media and (records of) stores of value overwhelmingly dominate.   If favoured banks and financial institutions are allowed access to risk-free overnigh electronic balances, why shouldn’t ordinary Australians (or New Zealanders) have such access?  After all, at the absurd extreme, central banks could still insist that to the extent banks wanted to deal with them, they did so in physical banknotes.  It would be wildly inefficient to do so, but it could be done.  But if it doesn’t make sense to restrict such “big end of town” transactions to physical currency, why does it make sense to restrict ordinary citizens’ access to central bank outside money?

But the RBA is firmly opposed to change of this sort.

On this issue, we have reached a conclusion, rather than just develop a hypothesis. The conclusion is that we do not see it as in the public interest to go down this route.

Why?   Lowe raises three concerns, of which two are substantive and one is mostly rhetorical.

If we did go down this route, the RBA would find itself in direct competition with the private banking sector, both in terms of deposits and payment services. In doing so, the nature of commercial banking as we know it today would be reshaped. The RBA could find itself not just as the nation’s central bank, but as a type of large commercial bank as well.

In times of stress, it is highly likely that people might want to run from what funds they still hold in commercial bank accounts to their account at the RBA. This would make the remaining private banking system prone to runs.

On both counts, I think he is largely wrong, and that any issues are quite readily manageable.

It isn’t at all clear why (many of) the public would want to use an RBA (or RBNZ) exchange settlement account for routine transactions services.  Revealed preference suggests that people are mostly very happy to run the modest credit risk associated with using private bank deposit and payment services.  Almost all of us now use bank deposits for most of our transactions –  even when physical cash is a perfectly feasible alternative (eg there is no additional cost in time or anything else to, say, taking out $400 from an ATM once a week rather than say $200).  And in the handful of places where private banknotes still circulate (eg Scotland) there doesn’t seem to be any unease about taking them, or transacting with them.

In addition, banks can offer bundled products –  cheaper fees for example where you have your mortgage, or term deposits, with the same bank as your transaction account.  No one proposes that central banks will be offering mortgages, term deposits or any of the rest of the gamut of products the typical commercial bank makes available.

I’m not aware that anyone is suggesting central banks should set out to out-compete banks.  The argument for making central bank e-cash readily available is about a fallback –  a residual option, much as cash is now for many purposes.   Central banks almost inevitably would lag behind commercial banks in their technology anyway, which wouldn’t make a central bank transactions account product particularly attractive.   And it could easily be kept that way –  don’t offer provision for regular direct debits etc, don’t allow overdrafts at all, keep the fees just a bit higher than those on commercial bank accounts, and –  of course –  be prepared to adjust the interest rates paid (or charged) on credit balances to limit potential demand.    What would be on offer would be a basic credit-risk free product –  something similar to the fairly basic products central banks provide to banks themselves.  Frankly, I’d be a bit surprised if there was much (normal times) demand at all (and I think back to the days –  decades ago –  when the Reserve Bank offered –  in direct competition with the private banks –  cheque accounts to its own staff; perhaps some people used theirs extensively,  but I used it hardly at all).

Lowe’s other concern –  and I’ve seen this concern in other places too –  is that provision of e-cash for ordinary citizens might destabilise the banking system.    As he noted earlier in his speech “it is likely that the process of switching from commercial bank deposits to digital banknotes would be easier than switching to physical banknotes. In other words, it might be easier to run on the banking system.”

Frankly, if the only thing that prevents runs on the banking system is that it is too hard to run to cash, central banks and regulators have bigger problems that they might need to address directly.  Runs are often quite rational –  there are real issues with the “victims” funding and/or asset quality.  If it really were easier to run with electronic central bank cash, banks – and their regulators –  might need to look to the size of the capital and liquidity buffers.   As it is, Lowe seems to be suggesting banks can free-ride on technical obstacles their (retail) depositors face.

But I’m not really persuaded that simply making available a basic retail e-central bank cash option would either increase the prevalence of runs or threaten the stability of the financial system.     When there is a concern about an individual bank (or non-bank) people “run” electronically anyway –  mostly they don’t withdraw their deposits into physical cash, but into liabilities of another private institution (and we seem to have been seeing such a quiet run on UDC in recent months).   Wholesale runs –  the sort that took down Bear Stearns and Lehmans –  all happen electronically.  Banks themselves can run straight to central bank cash, when they cut lines on each other.  Is the Governor really suggesting that it is just fine that wholesale investors should find it easy to run but not retail investors?  In practice, that is what he is saying.  In a systemic run –  or a period of heightened systemic unease – it is very easy for wholesale investors to find a safe asset (whether exchange settlement account balances for banks, or government bonds/ Treasury bills for others).  It isn’t for retail investors.  And recall that in New Zealand we have no deposit insurance.

If I’m uneasy at all about the idea of making available an eNZD (or AUD) for retail users –  a basic store of value/means of payment technology with no credit risk –  it is that demand would be very limited in normal times, and that if there ever was a systemic crisis it might prove very hard to scale the product quickly to adequately demand.   There are probably ways of resolving that concern, but it does need more work.

One other concern I’ve heard expressed if this if the central bank issued retail e-cash it would create a reinvestment problem –  what would the Reserve Bank buy and hold on the other side of its balance sheet (with associated credit and quasi-fiscal risks).  This is mostly a non-problem for several reasons:

  • normal times demand is likely to be low, and can be kept fairly low through pricing,
  • retail e-cash would probably go hand in hand with steps to reduce the stock of physical cash (and central banks already reinvest the proceeds of the sale of notes),
  • in a crisis, central banks have this issue anyway –  the substantial liquidity injections typically involve material credit risk anyway, and
  • in practice, many central banks typically reinvest the proceeds of note issue (or subscribed capital) in government bonds (predominant approach in New Zealand) or foreign reserves (typically mostly the government bonds of other countries).

With an integrated approach to gradually reduce the stock of physical currency, while making available a retail e-cash product, I would expect that if anything central bank balance sheets would shrink somewhat (especially in Australia, with a higher currency to GDP ratio) rather than grow.   Steps in that direction would:

  • help deal with the zero lower bound problem,
  • reduce the tax evasion etc issues apparently associated with large holdings of physical cash, and
  • provide ordinary citizens with the same sort of basic risk mitigant/payments product open to banks.

Finally, I said that one of Phil Lowe’s counter-arguments was mostly rhetorical. That was this one

The point here is that exchange settlement accounts are for settlement of interbank obligations between institutions that operate third-party payment businesses to address systemic risk – something that is central to our mandate. A decision to offer exchange settlement accounts for day-to-day use would be a step into a completely different policy area.

Well, yes, as conceived at present exchange settlement accounts are about interbank dealings.  That is a core part of the RBA’s (and RBNZ”s) responsibilities.  But the provision of basic “outside money” –  credit risk free –  has also long been a core part of both central bank’s responsibilitiies.  Retail e-cash helps fulfil that part of those mandates in a technological age.

 

 

Whither cash?

Last week the Reserve Bank released an interesting Analytical Note on “Crypto-currencies – An introduction to not-so-funny moneys” .    If, like me, you hadn’t paid a great deal of attention to Bitcoin and the like, it is a very useful introduction to the subject, from a monetary perspective (including some of the potential policy and regulatory issues).  At least for me, it struck just the right balance of detail and perspective.

Analytical Notes are published with the standard disclaimer that the material in them represents the views of the authors rather than, necessarily, of the Bank.  (That said, I’m pretty sure nothing has ever been published in one that the Bank was unhappy with.)  They are mostly written by researchers rather than policy people.  So it was interesting, and perhaps a little surprising, to get to the second to last page of this paper and find this

Work is currently under-way to assess the future demand for New Zealand fiat currency and to consider whether it would be feasible for the Reserve Bank to replace the physical currency that currently circulates with a digital alternative. Over time, analysis associated with this project will filter through into the public domain.

Interesting, because that is quite a radical and specific suggestion: to replace physical currency with a digital alternative.   And surprising because there was no hint of this work –  on a pretty major issue affecting all New Zealanders –  in the Reserve Bank’s Statement of Intent released only a few months ago.   Statements of Intent can seem like just another bureaucratic hoop to jump through, but the requirement to prepare and publish them was put in place for a reason: it is supposed to be the vehicle through which the Minister of Finance can inject his or her views on what the Bank’s work priorities should be, and is supposed to enable stakeholders and the public more generally to get a sense of what the Bank is up to.

I’m pleased the Reserve Bank is now doing this work on the future of currency.  Over the last couple of years I have been critical of the fact that, in published documents, there was no sign of any such preparatory work going on (including, more generally, around dealing with the problems of the near-zero lower bound, which will almost certainly become binding for New Zealand in our next recession).  In this year’s Statement of Intent, for example, published as recently as the end of June, there was 1.5 pages (pp 28-29) on the Bank’s currency functions, and not a hint of any work on the possibility of replacing physical currency with digital currency.   Perhaps doing the work is an initiative of temporary “acting Governor” –  but then he was required, by law, as Deputy Governor, to sign the Statement of Intent.  Or perhaps it was just the Bank deliberately keeping things secret?

As usual with the Bank, they talk loftily about how the analysis will eventually “filter through to the public domain”.  That isn’t good enough –  this is publicly funded work on a matter of considerable potential significance – , and I have lodged an Official Information Act request for the research and analysis they have already done.

I’ve come and gone for decades on what the best approach to physical currency is.  I’ve long been troubled by the monopoly Parliament gave to the Reserve Bank over the issuance of physical notes and coin.  There is no good economic reason for it (nothing about the efficacy of monetary policy for example) –  and for half of modern New Zealand history it wasn’t the situation in New Zealand.  For decades it may well have led to inefficiently low currency holdings: in a genuinely competitive market there is a reasonable chance that (eg) serial number lotteries would have provided a (expected) return to holders of bank notes.  In the high inflation years –  and especially as interest rates were deregulated –  holding as little currency as possible was the sensible thing to do.

notes and coin

As the chart shows, the ratio of notes and coins (in the hands of the public) to GDP troughed in the year to March 1988 –  when inflation and interest rates were both high (and, of course, returns to holding currency were zero).

At one level, the partial recovery in the amount of physical currency held isn’t too surprising.  Inflation has been low for decades, and interest rates are now very low too.  Holding physical currency isn’t very costly at all.

Then again, there have been huge advances in payments technologies.   Even when I started work, the Reserve Bank still offered to pay its staff (I think perhaps only the clerical and operational staff) in cash, and that wouldn’t have been too uncommon then.  ATMs didn’t exist then –  it was the queue at the local bank branch each Friday lunchtime –  let alone EFTPOS, internet banking and so on.   These days, by contrast, a huge proportion (by value) of transactions occur electronically.  Even school fairs –  often held out previously as the sort of place one really needed cash for –  have often gone electronic to some extent at least.

And although the ratio of cash to GDP is quite low in New Zealand (by international standards –  in many advanced economies something around 5 per cent isn’t uncommon –  there is still a lot of cash around.    The numbers in the chart are equivalent to a bit more than $1000 per man, woman, and child.    For a household like mine, more than $5000.    I’m a slow adapter, and almost always do have a reasonable amount of cash on me, but I’d be surprised if on an average day our household had more than $250 in cash in total (surveys from other countries suggest that isn’t unusual).   I’m not sure I’ve ever had a $100 bill, but Reserve Bank data suggest that on average each man, woman, and child has $400 in $100 bills.

As it happens, last week I was reading (Harvard economics professor) Ken Rogoff’s book The Curse of Cash.   As he notes, in the United States, there is around $3400 per man, woman, and child outstanding in US $100 bills –  while surveys of what ordinary consumers are actually carrying suggest that no more than 1 in 20 adults has a $100 bill on them at any one time.    Rogoff makes a pretty strong case that the bulk of physical currency holdings – even allowing, in say the US case, for the use of the USD in other countries – is held to facilitate illegality.   That could be outright illegal activities –  the drugs trade for example –  or tax evasion in respect of the proceeds of lawful activities.  The likely revenue losses, on his estimates, are very substantial.    The scale of the problem is probably smaller here, but there is no point pretending that the issue is specific to the United States (and, as Rogoff documents, a number of European countries have now put limits on the maximum size of cash payments –  although such rules seem more likely to catch those who comply with the law, rather than those who knowingly break it).

Somewhat reluctantly, Rogoff’s book has shifted my perspective on the physical cash issue.    As a macroeconomist, my main interest in this area in recent years has been to do something about the near-zero lower bound on nominal interest rates.  If the Reserve Bank cut interest rates to, say, -5 per cent, it would be attractive for people to pull money out of banks and hold it in physical currency in safe deposit boxes. If that happened to any large extent it would substantially undermine the effectiveness of monetary policy.  The fear that it might happen has already constrained central banks in various countries, and no one has been willing to cut official interest rates below 0.75 per cent (which was also about how far we thought the OCR could be cut when I led some work on the issue at the Reserve Bank some years ago).

Getting rid of physical currency altogether would solve the problem.  If there is no domestic cash, clearly you can’t hold any.  Of course, you could always seek out foreign cash, but the process of doing that would lower our exchange rate –  one of the ways monetary policy works, and thus not a problem.    But one doesn’t need to get rid of cash –  or even just large denomination notes –  to limit that risk.    There are various clever options that have been developed in the literature (effectively involving an exchange rate between physical and electronic cash), and as I’ve noted here previously, one could achieve the same result by simply putting a physical limit on the amount of currency the Reserve Bank issues, and then auctioning it to the banks (if demand surged this would, in effect, introduce an exchange rate or a fee).    It is disconcerting that, as far as we can tell, no country is properly prepared to use options like these in the next recession (which, in itself, risks exacerbating the recession because smart observers will recognise that governments have fewer options than usual) –  no one has (at least openly) done the preparatory legal work, or prepared the ground with the public.  Our Reserve Bank is, as as we can tell, no exception.

I’ve resisted the idea of getting rid of physical currency on both convenience and privacy grounds.  There is, as yet, no real substitute for cash if –  say –  one wants to send a child to the local dairy to buy the newspaper when one is on holiday.   And the ability to conduct entirely innocent transactions without the state being able to know what one is spending one’s money on (or one’s bank for that matter) remains a very attractive ideal.

And yet….and yet…..I wonder if it is a real freedom now to any great extent anyway.   We might not gone all the way –  yet –  to China’s “social credit” scoring system, but you have to be pretty determined to avoid the gaze of a government determined to find out what you’ve been up to.  Some of that is voluntary –  people choose to carry phones around, for example, which locate you –  and some of it isn’t (local councils put up CCTVs, and so do all too many retailers). AML provisions, and know-your-customer rules are ever more pervasive and intrusive.   Sure, using cash enables one to keep from a spouse what one spent on a birthday present, or where it was bought from, but it is a pretty small space left.

And so perhaps it is best for us to think now about serious steps towards phasing out physical currency.  Rogoff himself doesn’t recommend complete abolition at this stage, but rather ceasing to issue, and then over time withdrawing, high denomination notes.   Our largest note isn’t very large at all (NZD100 is only around USD70) but as I noted earlier a huge share of currency in circulation is in the form of $100 bills, even in New Zealand, which few people use for day-to-day transactions that are both lawful in themselves and where there is no intention to evade lawful tax obligations.   But if we were to amend the law to prohibit the Reserve Bank from issuing notes larger than (say) $20 –  and this is a decision that should be made by Parliament or at least an elected minister, not by a single bureaucrat –  we’d still make small cash transaction easy enough (school fair, or the kid sent to buy the newspaper, while greatly increasing the difficulty of a major flight to cash in the next serious recession, and increasing the difficulty of tax evasion and other criminal transactions.

If the government were to choose to go this way, it would still make sense for active precautions to be taken now to reduce the risk of the effectiveness of monetary policy being undermined even by a flight to $20 notes –   they take up roughly five times as much space as the equivalent amount in $100 notes, but you can still fit a lot of money in a secure vault.   Whatever the mix of measures, it is really important that the authorities –  Bank, Treasury, IRD, government, FMA –  adopt a greater degree of urgency.  No one knows when the next serious recession will be, but it isn’t prudent (ever) to assume it is far away.

And what of the Reserve Bank’s own scheme: the possibility of replacing physical currency with digital Reserve Bank currency?   We need to see more of what they have in mind.  My own long-held prediction is that they are two quite different products –  only the RB can issue physical notes, while anyone can issue electronic transactions media –  and that in normal times demand for a Reserve Bank retail-level digital currency would be almost non-existent.   That doesn’t mean they shouldn’t do it: there is something about the democratisation of finance, in enabling the public to hold the same sort of secure liability banks already can (in their case electronic settlement account balances), and  –  as we saw globally in 2008 –  banks runs can still happen.   Unless society decides to completely up-end the entire monetary system (and I have readers who favour that), we need an “outside money” that people can convert their bank liabilities into if/when they lose confidence in the issuing institution or system.    For most purposes, a digital Reserve Bank retail currency should be able to do that at least as well as physical banknotes.

Most….but not necessarily all (when serious people worry about EMP attacks on/by North Korea, there is no point pretending electronics is the answer to everything).   Those are the sorts of issues that need to be carefully examined, preferably in an open way, rather than with conclusions loftily filtered out to the public when it suits the officials.

Rogoff’s book is worth reading, especially (but not only) if you are new to the issue.  He covers a little of issues I didn’t have space for, including natural disasters (where cash might be more useful than cards, but most people don’t hold much cash anyway, so it actually isn’t that much of a help.)  Like the Reserve Bank paper, he also points out that things like Bitcoin offer a lot less effective anonymity than many people realise.

 

Monetary policy: towards the next recession

Tomorrow Graeme Wheeler will announce his second-to-last OCR decision.  Assuming, as everyone seems to expect, that the Governor largely restates the policy stance he adopted six weeks ago, I expect to agree with him.  Within the huge, and inevitable, bounds of uncertainty, the current OCR seems plausibly consistent with core inflation getting back to around 2 per cent, and there is no strong impetus that should be pushing the Reserve Bank to either raise or lower the OCR any time soon.

If anything, one could probably more readily argue for another cut, rather than any increase, just because core inflation has remained so low for so long and it has proved harder to get it back up than most had expected.  The unemployment rate – an indicator that the Labour Party is rightly calling for the Bank to give more weight to – points in the same direction.   In that respect, I disagree with the collective view of the NZIER’s Shadow Board, who have a clear upward bias.  As an aside, it is interesting  to note that the BNZ’s chief economist, Stephen Toplis, shares the upside bias, but is the only one of the panel to put a substantial weight on the possibility that further cuts might prove, as things stand, to be appropriate.   Here is the probability distribution (percentages) of his recommendations.

toplis shadow board

But in this post, I really wanted to focus on some longer-term issues where I think there is rather more serious reason to doubt that the Governor is adequately discharging the responsibilities of his office and reason to worry that, in fact, some of his duties have been neglected.     And these aren’t just issues about economic forecasting, something that no one is very good at, and where anyone who pretends otherwise is a fool.

My concern is the next recession.   No one knows when it will be, but it has been seven or eight years since the last one ended.    People will chip in to point out that there is nothing inevitable about another recession just because a few years have passed since the last one, and no doubt that is true.  Nonetheless, downturns and recessions do happen, and discretionary monetary policy exists mostly to help cope with them.  (And to anyone who wants to argue that Australia hasn’t had a recession for 26 years, the simple response is (a) check out the fluctuations in the unemployment rate, and (b) check out the fluctuations in the RBA’s policy cash rate.)

Perhaps others will want to point out that the Reserve Bank still seems to think that the neutral interest rate is perhaps 200 basis points higher than the current OCR.   Perhaps they are right, and perhaps not.    But even if, in some sense, they are right, it will be no comfort –  and provide no buffer – if the next recession were to occur in the next couple of years (and if you think that unlikely –  as probably I do too –  recall that the track record of forecasting recessions, globally or domestically, is even worse than the usual economists’ dismal record of macro forecasting).

If anything, of course, these issues are even more pressing in most other advanced countries.  The only upside to having, on average over very long periods of time, the highest interest rates in the advanced world is that the practical lower bound on nominal interest rates is a bit further away here.    But it is quite close enough.  In New Zealand recessions, cuts in short-term interest rates of 500 basis points or more haven’t been exceptional.  After the last recession, the OCR has been cut by a total of 650 basis points, and (core) inflation still hasn’t got back to target.   So when you are starting with an OCR of around 1.75 per cent, and the practical lower bound on nominal interest rates is probably around -0.75 per cent, the leeway that is left is much less than one would typically like.      People can put on brave faces and pretend otherwise, or simply try to ignore the issue (the latter seems mostly the New Zealand approach), but burying your head under the pillow doesn’t make the problem go away.

And it is not as if this is some flaky Reddellian issue that no one else in the world cares about.    In Canada, for example, there is formal process for reviewing their inflation target every five years.   At the last review, they left the target unchanged, but only after doing a huge amount of work looking at some of the alternatives.   That work was openly foreshadowed (eg in a speech here ), and a great deal of it was published, and is available here.

Over recent years, two former IMF chief economists –  Ken Rogoff and Olivier Blanchard –  have called for inflation targets to be raised to provide additional scope for discretionary monetary policy in the next downturn. [UPDATE: I had meant to include this link to a recent post from Simon Wren-Lewis, an Oxford professor of macroeconomics, which also touches on the fiscal options.]

In the US context, I linked a couple of weeks ago to a speech by John  Williams, head of the San Francisco Fed, openly exploring whether the Fed should move away from inflation targeting to price-level targeting, again with a view to increasing resilience in the next downturn.    As I observed then

I’m not persuaded by Williams’ case, but what struck me is how open the system is when such a senior figure can openly make such a case.  The markets didn’t melt down. The political system didn’t grind to a halt.  Rather an able senior official made his case, and people individually assessed the argument on its merits.

And then a couple of weeks ago there was an open letter to the Board of Governors of  the Federal Reserve from 22 economists calling for serious consideration to be given to an increase in the inflation target, and specifically that

the Fed should appoint a diverse and representative blue ribbon commission with expertise, integrity, and transparency to evaluate and expeditiously recommend a path forward on these questions.

As they noted, other senior Fed people had openly acknowledged the importance of the issues.

And was the letter  –  mostly from a group of fairly left-leaning economists, but including one former FOMC member, and one former member of the Bank of England’s Monetary Policy Committee –  just ignored?   Time will tell, but Janet Yellen was asked about it at her press conference.  Her response?

Ms Yellen stressed in her news conference last week that there were both costs and benefits to a higher inflation target, but she added that the Fed would be reconsidering the issue in the future. “We very much look forward to seeing research by economists that will help inform our future decisions on this.”

There are pros and cons to making changes, whether simply to raise the inflation target, or to look at options such as levels targets for the price level, nominal GDP, or wages.    Personally, I would prefer that central banks (and finance ministries) focused on options that eased or removed the effective lower bound on nominal interest rates  (issues on which, again, very able people internationally have written).   As I noted in an earlier post on these issues

At the extreme, central bank physical currency could be withdrawn and completely replaced with electronic central bank liabilities, on which (say) negative interest rates could be paid.  But that would take legislation and considerable organisation, and would be an unnecessary over-reaction, while there is still a considerable revealed demand to transact (in the mainstream economy) in cash.  Better options might be to, say, cap the total issuance of Reserve Bank physical currency and allow an auction mechanism to set a variable exchange rate between physical and electronic Reserve Bank liabilities.  Banks themselves could be allowed to issue currency again –  on whatever terms they chose.  Or the Reserve Bank could simply put in place an administered premium price on access to new physical currency (eg a 2 per cent lump sum fee would be likely to introduce considerable additional conventional monetary policy leeway).  Each of these possibilities has potential pitfalls and possible legal issues.

But now is the time to be doing the research and analysis.  Now is the time to be working through the technical obstacles and logistical constraints.  And now is the time to be (a) canvassing the issues in public, and drawing on the perspectives of outside experts as well as public servants, (b) to be making the informed decisions as to whether (reluctantly) inflation targets need to be raised, and (c) to be able to lay out in public a confident articulation of how the authorities envisage that they would handle the next significant recession, given the evident limitations at present.

Why does it matter now?     There are at least two reasons.  The first is that if a higher inflation target is part of the answer, now is the time to do it.  It can’t meaningfully or usefully be done in the middle of the next recession, because by then there will very serious doubts that the authorities can get inflation up to even the current target rate.  And the second reason is because when the next recession is upon us (whenever it is) commentators will very quickly realise the limitations of conventional monetary policy.  We’ve been used to a world in which central banks could act decisively to lean against recessions – not prevent them, but limit the damage that is done, and prompt a rebound.   If people realise that is no longer possible to anything like the usual extent, they will –  entirely rational –  adjust their expectations in light of that knowledge.   Expectations quickly become reality in that sort of climate, deepening (perhaps quite materially) the recession.     It would be almost inexcusable to simply let that happen –  with all the real adverse consequences on individuals and families from unemployment –  when there has been years to prepare against the possibility.

The third consideration is a bureaucratic one.  There will be a new Policy Targets Agreement negotiated before the new Governor takes office next March.  In the normal cycle of our law, that is the time to make any significant changes in the regime.    And now is time to be doing the work on these issues, and canvassing them in public.  There aren’t automatically obvious right answers to these questions, and answering them –  what are the best guidelines to govern macroeconomic management – isn’t just a matter where those inside the bureaucracy are blessed with a monopoly on wisdom.      (It is an  unusual and undesirable feature of our law that the Policy Targets Agreement is formulated before the Governor takes office –  when he or she may have little specific expertise, and little access to staff (or outside) advice –  but that is just one of the many aspects of the Reserve Bank Act that is overdue for reform.)

There are at least two countervailing arguments that I want to address briefly.     The first is one that I take some comfort from myself.    Foreign trade is more important to the New Zealand economy than it is, say, to the United States.    Should our OCR ever have to be cut to the effective lower limit (even if it was then no lower than those of most other advanced countries) it seems highly likely that our exchange rate would fall very substantially.    We’ve seen that in the past when the gap between our interest rates and those abroad has closed (most obviously in 2000).  That would make some material difference in buffering our economy.  Against that, however, it is important to recall that in each past New Zealand recession the exchange rate has also fallen a long way.  We seem to have needed both large interest rate cuts and large falls in the exchange rate.

The second countervailing argument is the potential role of fiscal policy.    But although New Zealand’s government debt position isn’t bad:

  • it is not as good as it was going into the last recession,
  • since then we’ve been reminded repeatedly of the potential fiscal pressures from natural disasters,
  • there is no coordination framework between fiscal and monetary policy and the Reserve Bank (rightly) has no control over the use of fiscal policy,
  • it isn’t clear that in any of the countries that actively used fiscal policy in the last severe recession it was done on a scale that was enough to make a decisive difference,
  • while politicians in other countries were often willing to actively use fiscal policy to boost demand for a year (or perhaps two), the imperatives –  political, economic or market –  for tightening up again seemed to take hold pretty quickly,
  • fiscal policy is simply less well-suited to the cyclical stabilisation role than monetary policy.

But if fiscal policy is to be a big part of New Zealand’s answer to the limitations on monetary policy in the next recession, again the issues need to be openly canvassed and debated now.

These are issues that should be worrying the Reserve Bank, the Treasury, and the Minister of Finance.  But there is not a hint of such concern in any of their publications or public statements.  This isn’t one of those issues –  is a bank on the brink of failure eg –  where secrecy is required.  If anything, it is one that would benefit (perhaps greatly) from open discussion, and a sharing of perspectives, research insights, and other analysis.

Each year the Reserve Bank (for example) is required to publish a Statement of Intent.  In many ways it is a bureaucratic hoop-jumping exercise, but it does require the Governor to set out the Bank’s priorites and areas of focus for the coming three years.  I’ve written here previously about how these issues –  really important medium-term considerations –  have had no mention in past Statements of Intent.   There will be a new SOI out in the next week or so –  they have to publish before 1 July.    Of course, at this stage with only three months left in office, what the Governor thinks of as the priorities for the next three years may not matter much in practice.  But it will be interesting to see if he has given these “next recession” issues any space in this year’s document.   I hope so, but fear not.

It is a shame that he hasn’t used the opportunity of his last year in office, when he could have acted as an honest broker and champion of opening up issues for his successors, to have openly put these issues on the agenda –  in public and for the Bank’s own research.  To do so would have been fully consistent with his responsibilities under the Act.  It would, almost certainly, have been a more appropriate use of his energies than corralling his senior managers into efforts to censor a market economist who disagrees with him in tones the Governor finds uncomfortable.  Leadership is about looking beyond the trivial, restraining your own irritations, and focusing attention on important issues that may be just beyond the horizon (and the immediate concerns of officials and market economists) right now, but are no less important for that.

One would hope that when the Board is interviewing candidates for the next Governor (recall that applications close in a couple of weeks) these are among the sorts of substantive issues they are conscious of.  But you have to wonder how they would do so.  The Board has no role in the formulation of the Policy Targets Agreement, and among its members there is very little expertise in the sorts of issues that need to be grappled with.  As a group that has collectively defended the status quo, it isn’t obvious that it would be in the personal interests of any applicants to seriously challenge in front of the Board whether things are quite right.  That would be a shame.  (And again, it is reason for reforming the Reserve Bank Act –  both to shift the setting of the policy target away from the appointment of a Governor, and to shift responsibility for appointing a Governor more squarely to the Minister of Finance.)

As a marker of just how untransparent the New Zealand system is, the Reserve Bank proved highly obstructive a couple of years ago when I sought papers relating to the 2012 Policy Targets Agreement.   To the credit of Treasury, while I’ve been typing this post I’ve just received a 90 page release of papers relating to the negotiation of the 2012 PTA.  People shouldn’t be having to dig this stuff out years after the event.    Setting the rules, and institutions, for New Zealand macroeconomic management should be one of those areas where government agencies are open and pro-active, before and after decisions are made.

 

 

Monetary policy leeway for the next recession

A chart of short-term nominal interest rates over the last thirty years looks something like this.

nom-interest-rates-since-1987

It looks dramatic for two reasons.  First, I’ve started the chart from almost the historic peak in New Zealand’s interest rates, and secondly because in the late 1980s inflation and inflation expextations were still quite high.  It wasn’t until around the end of 1991 that inflation got inside the then target range of 0 to 2 per cent annual inflation.

Here are the same two series adjusted for inflation expectations –  the Reserve Bank’s two year ahead measure, from a survey that began in the September quarter of 1987.

real-int-rates-since-1987

It is a less dramatic picture of course but –  as in most other countries –  the trend is pretty strong downwards.  In previous posts I’ve shown that over the last 25 years or so there has been no sign of New Zealand interest rates converging on those in other advanced countries.

For some purposes, thirty years just doesn’t provide that much data.  There might have been 10000 calendar days, but there have only been two or three big cycles in interest rates, and a few smaller ones.

What has troubled me for some time –  perhaps the more so as the years since the last recession have accumulated-   is what happens when the next recession comes.  We know that most advanced countries ran out of conventional monetary policy capacity in responding to the 2008/09 downturn.  That, almost certainly, slowed the recover in demand and activity in many of those countries (even recognising the underlying productivity growth slowdown that was already underway before that recession).

Back in 2009, this might not have looked like much of an issue for New Zealand.  After all, in 2009 the OCR troughed at 2.5 per cent and the time pretty much everyone –  market pricing included –  expected a fairly quick and substantial rebound.   Despite a couple of ill-fated policy attempts at a tightening cycle, it just never happened.  And years on now, inflation is still materially below the target midpoint, and the nominal OCR is even lower than it was then.

Views differ about the current position of the economy, but they are probably bounded quite tightly around an output gap estimate of zero.  I emphasise that the unemployment rate is still above the NAIRU, suggesting a modest (and unnecessary) negative output gap, and even the most optimistic forecasters/commentators don’t see much sign of a materially positive output gap.  There aren’t huge amounts of spare resources lying idle, but equally there isn’t massive overheating either.  For better or worse, we should probably be treating current interest rates as something like “normal”  – not perhaps in some very long-term sense, but certainly in terms of the sorts of macro conditions we’ve experienced in recent years.

And if interest rates are in some sense around normal/natural at current levels, we can’t prudently assume or plan on the basis that they are highly likely to rise from here (any time in the next few years).  They might, but it looks as though it would take some material new development for that to happen.  But it must be almost equally likely that the next material move is a fall.  This isn’t a debate about where the next 50 basis point move comes from –  reasonable people could probably differ over that range about where the OCR should be right now.  Instead, it is about the next multiple hundred basis point move will be.  They aren’t that uncommon –  we’ve had three in the last 30 years.

I think there is a tendency –  partly a recency error, partly the dramatic headlines of the times –  to think of the interest rate adjustments over 2008/09 as unusually large.  But they weren’t, especially not in New Zealand.  There were some very big individual OCR adjustments  –  twice in a row the OCR was cut by 150 basis points-  but in total they didn’t add up to much more than usual for a New Zealand downturn.  Retail interest rates fell by 400 to 500 basis points.    Over the short sample we have, that looks to be about the typical amplitude of New Zealand interest rate cycles.

Dramatic as the events of 2008/09 were internationally, when one looks at the New Zealand real economic data, 2008/09 simply doesn’t stand as an extraordinary downturn (although the subsequent weak recovery stands out more).  Here is a chart of annual average real GDP growth (using an average of the expenditure and production measures).

real gdp aapc.png

The recession wasn’t quite as deep as the 1991 episode (which came after several years of pretty sluggish growth and not much sign of a positive output gap), and the slowdown in the growth rate wasn’t much larger than the slowdown from around 1996 to 1998.

And here is a chart of the employment and unemployment rates.

e-and-u-rate

Again, neither the change in the unemployment rate nor the change in the employment rate over 2008/09 particularly stand out.

It is a small sample of events, but on the basis of that limited sample, it looks as though we should be planning on the basis that in the next material downturn we’ll need to lower retail interest rates by 400 to 500 basis points.  And, we should be planning for the possibility that such a downturn happens before economic conditions warrant raising interest rates much, if at all, from current levels.

But 90 day bank bill rates today are around 2 per cent, and term deposit rates are a bit above 3 per cent.  The OCR itself is 1.75 per cent. There is a pretty clear consensus that, on current technologies and institutional practices, a rate like the OCR probably can’t be reduced below about -0.75 per cent –  if it was attempted large holders of short-term assets would find it more economic to convert those holdings into physical cash.  The Reserve Bank of New Zealand might have policy leeway of perhaps 2.5 percentage points, but they can’t safely assume they have leeway beyond that.  And among the scenarios they have to plan on is that in the next downturn there could be a renewed widening of the spread between retail and wholesale interest rates –  and it is retail rates that influence consumption and investment behaviour.

It is easy to say “oh, but we can just bring fiscal policy into play”.  But, on the one hand, the Reserve Bank has no control over fiscal policy, and can’t just assume that the political imperatives driving/constraining fiscal policy will neatly fit with the Bank’s stabilisation (inflation targeting objectives).  And, on the other, while New Zealand’s overall fiscal policy isn’t bad by international standards, it isn’t stellar either. The Crown balance sheet is in nowhere near as good shape as it was in 2008.  It can take a lot of fiscal stimulus to compensate for the absence of monetary leeway –  and of the numerous countries that deployed discretionary fiscal stimulus in 2008/09, I can’t think of any where it made a decisive difference (we can debate Australia).  And, relative to the situation in 2008, we’ve since been starkly reminded over the last few years how (physically and financially) vulnerable to earthquakes New Zealand is, reinforcing the case for fiscal prudence (eg a positive net assets position as the norm).

In the next big downturn, there might be some scope for discretionary fiscal policy support (beyond the relatively weak –  in New Zealand –  automatic stabilisers) but no one –  and certainly not the Reserve Bank –  should be counting on it much.

The other reason to be uneasy is that the limited policy leeway is no secret.  In typical downturns inflation and inflation expectations fall to some extent, but everyone recognises that the central bank will cut interest rates as much as necessary, to help support a recovery in demand, and keep inflation near target.  Countries as diverse as the US and NZ could cut by 500 basis points in 2008/09 and did, and everyone knew in advance they had that potential.

But if the next material downturn were to occur in the next couple of years –  and typical expansion phases in New Zealand haven’t last much longer than that – everyone will know that (abroad as well as here) central banks just don’t have that sort of leeway.  The Fed might be able to cut by 1.5 percentage points, and the RBA and the RBNZ by as much as 2.5 percentage points.  But that will be about it.  Rational agents –  firms, households, markets, will assume that inflation, and inflation expectations will fall further.  That will make it even harder to stabilise activity and inflation.

(I’m not going to spend a lot of time on QE, but outside extreme crisis conditions, I think it is fairly common ground that it would take a great deal of QE to compensate for even 100 basis points of conventional monetary policy leeway.)

This isn’t a trivial, or abstruse technical, issue.  At the heart of the case for discretionary monetary policy –  the model advanced countries have run with since the 1930s –  is the ability to adjust monetary conditions as much as it takes, to assist in stabilising the economy when it faces significant shocks.  In the next downturn, there is increasingly unlikely to be enough leeway.

That should be concerning the Minister of Finance, the Secretary to the Treasury, and the Reserve Bank –  not just in some idle handwringing sense, but commissioning work to respond to this threat.  Perhaps there are secret projects underway in the bowels of the Reserve Bank and Treasury, but this isn’t work that should be kept secret; rather, it should be part of an open and ongoing conversation to help reassure the public and markets that the authorities have the capacity to respond decisively if and when the next serious downturn happens.  There are solutions.

At the extreme, central bank physical currency could be withdrawn and completely replaced with electronic central bank liabilities, on which (say) negative interest rates could be paid.  But that would take legislation and considerable organisation, and would be an unnecessary over-reaction, while there is still a considerable revealed demand to transact (in the mainstream economy) in cash.  Better options might be to, say, cap the total issuance of Reserve Bank physical currency and allow an auction mechaism to set a variable exchange rate between physical and electronic Reserve Bank liabilities.  Banks themselves could be allowed to issue currency again –  on whatever terms they chose.  Or the Reserve Bank could simply put in place an administered premium price on access to new physical currency (eg a 2 per cent lump sum fee would be likely to introduce considerable additional conventional monetary policy leeway).  Each of these possibilities has potential pitfalls and possible legal issues. It would therefore be highly deisrable if an open consultative process was got underway, enabling a range of perspectives to be considered and debated in the cool light of day, rather than in the urgency of an unexpected recession.  If, in the end, it all proved too hard –  which I’d be reluctant to believe –  the case for an increase in the inflation target would be strengthened.  As the PTA needs to be renegotiated next year, now is the time to have this work underway. (And as the Reserve Bank has just given itself, somewhat unwisely, a three month holiday from reviewing the OCR –  the next review is not til February –  now would seem a particularly appropriate time to assign some joint Treasury and Reserve Bank resources to this work.)

What is particularly disconcerting is that there has been no hint that this is even considered an issue, whether in comments from the Minister, in speeches from the Secretary to the Treasury (including those commenting directly on monetary policy), in the Reserve Bank’s Statement of Intent, or in the increasingly rare speeches from the outgoing Governor.  We should expect more.

(And in case anyone thinks otherwise, this issue is not an argument against the OCR cuts of the last year or so.  Without them, inflation and inflation expectations would be likely to have fallen further, only increasingly the severity of the “lack of leeway” problem if a new recession were to strike a year or two down the track.  The best way to maximise the limited remaining leeway is to keep interest rates low enough now that inflation is at, or even slightly above, the midpoint of the target range.)