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.)

Negative interest rates: some thoughts

I’ve been keeping an eye on the range of commentary and analysis appearing recently on negative policy interest rates –  options and limitations.  The issue has come back to prominence because of the BoJ’s recent modest move to introduce a negative policy rate, and amid the rising concerns about global growth and, perhaps, financial fragility that have been reflected in market prices –  equities, bonds, commodities, CDS spreads etc –  since the start of the year.

Doing something about removing, or markedly easing, the near-zero lower bound on nominal interest rates has been a cause of mine for some years.  While I was working for The Treasury in 2010 I wrote a discussion note, that got some circulation inside and outside the institution, concluding (somewhat to my own unease) that in some respects the world was less well placed than it had been in, say, 1930  – the early days of the Great Depression.   Back then, countries could get rid of the Gold Standard –  and eventually did so –  markedly easing monetary conditions in the process.  Having got nominal interest rates to around zero in much of the advanced world, there wasn’t a great deal else monetary policy could do if economies were to turn down again (or simply fail to recover).  Unsterilised fiscal policy (direct purchases of goods and services) might be an option on paper, but by then the tide had already turned against expansionary fiscal policy, and public debt levels in many countries were becoming worryingly (to the public, and conventional political wisdom) high.

The remaining option was to do something about the near-zero bound, which existed –  in a fiat money system –  only because of policy and legislative choices (typically, a state monopoly on currency issue, and a commitment to convert bank deposits into those state issued notes at a fixed one for one parity).   Why hold large proportions of one’s wealth at materially negative interest rates when –  once a few set up and holding costs were negotiated –  one could hold bank notes at a zero return?  (Some earlier thoughts on these issues are here and here)

No central bank had taken policy rates negative during the 2008/09 recession.  For some –  New Zealand was a good example –  there was simply no plausible need.  But in others –  the US and the UK appear to have been the prime examples –  it didn’t happen partly because the relevant authorities really weren’t sure about the implications would be.  Whole business models –  money market mutual funds, which had run into troubles in 2008 anyway –  had been built around the idea the interest rates don’t go negative.  And, at the time, it seemed to pretty much everyone that interest rates would be extremely low for only quite a short period, so why risk creating a mess, disrupting well-established business models, for a small short-period additional kick.

As we know, interest rates have now been very low for a very long time.  Some argue that wasn’t necessary, or wasn’t desirable, but whether one focused on an inflation target, on the level or growth of nominal GDP, or even economywide credit, it is difficult to conclude that interest rates in most countries should have been any higher in the last few years than they have been.  One could, in fact, mount a good argument that they (a) should have been lower, and (b) would have been lower if the technological/regulatory bound had not been there.   If, for example, inflation targets in the previous 20 years had been 4 per cent, not 2 per cent, I think there is little real doubt that real interest rates would have been lowered further.

In the last few months of Alan Bollard’s time as Governor of the Reserve Bank of New Zealand –  when yet another wave of the ongoing euro-area crisis was upon us –  I led an internal working group looking at some of our options if there were to be a new global crisis and a material downturn in New Zealand.  We concluded that in our relatively simple system there were few or no obstacles to taking the OCR negative should that be needed –  there was, for example, nothing like the money market mutual fund sector to trouble us.  We didn’t reach a firm view on how far the OCR could be cut before banks and other investors might turn to physical cash instead, but it seemed reasonable that we would have been able to cut to perhaps -50 or -75 basis points.  With a few suggestions to check that our technology could handle negative interest rates, we put the report aside as that wave of tensions eased.  Negative interest rates have not yet been needed in New Zealand.

What we didn’t do was to explore how to get around the floor that would inevitably be there at some point. I guess it wasn’t a high priority for the Reserve Bank of New Zealand –  with policy rates among the highest in the world, we were further from the floor (whatever it was) than most countries.  And –  always a comfort  – if our interest rates ever did get to zero (or negative) it seemed likely that the New Zealand exchange rate would be very weak.  We aren’t a surplus country, or any sort of serious “safe haven”, and if there are no yield advantages to holding NZD assets, in most circumstances there won’t be much foreign demand to hold them.

But as far one can tell, no one else in the senior levels of officialdom  anywhere else was doing very much about it either.  One can –  and should – bemoan the lack of contingency planning, but it probably just reflects the same mistake that has been made around the world since the crisis and downturn started to get underway in 2007.  There was a reluctance to recognise what was coming[1], a slowness to react even as the crisis was open us, and once the immediate worst of the crisis was over the constant relentless focus has been on “normalisation”.  And it wasn’t just central bankers…..market economists and participants were often just as focused on the tightenings that, it was confidently assumed, were to come.  It was the path that led various central banks into premature tightenings and then policy reversals  –  New Zealand leading the way, with two lots of reversals.  And it hasn’t just been about small central banks, or big ones –  pretty much everyone has shared in the delusion that it wouldn’t be long until we were well on the way back to “normal” –  real interest rates perhaps not much lower than they had been on average in, say, the decade prior to 2007.   The US Federal Reserve has often been as fallible as anyone, and it seems increasingly likely that its own “normalisation” programme might be brought to an end, and reversed, after just one tightening.

It all means that dealing with the zero lower bound doesn’t seem to have been treated very seriously by central banks and finance ministries.   We now have several advanced economies –  covering a large chunk of the advanced world’s economies –  with negative policy rates, but in each case it still comes with the question “how far can they go”, and in each case so far the move to negative rates has been less than whole-hearted. Central banks look and sound as though they are backed into it very reluctantly, rather than embracing enthusiastically what needs to be done.

Negative rates have been applied to only a portion of banks’ balances at the central banks –  structured, it seemed, to have as little impact as possible on banks and their customers.  There has been a logic to that –  the focus in many of these countries was on the exchange rate channel, and the announcement effects of moves to adopt negative rates appear typically to have been to weaken the respective exchange rates.  But it hasn’t exactly been a ringing endorsement of the efficacy of negative policy rates.  It all seems to have been accompanied by a fear of upsetting established business models, and a fear that before too long the limits of negative rates will be reached.

JP Morgan has an interesting note out last week looking at how far various central banks could take policy rates negative, without imposing more of a “tax” on banks than is being imposed in the most negative central bank now.  They suggested that some central banks could take a (tiered) negative rate as low as perhaps -4 per cent.

But monetary policy isn’t supposed to work by imposing taxes on banks, but by influencing private sector behaviour through a variety of channels.  Substitution effects matter.  And so do expectations channel.

But if central bankers don’t believe that they can do much more, or that their tools won’t really have much impact –  or perhaps, in their heart of hearts don’t really want to do much more ( after all, surely we need to keep “normalisation” in mind) –   it is hardly surprising that people more generally (not just market participants) become nervous when new risks come to the fore (China, Portugal, Italian banks, stresses on commodity producers or whatever)   When there is no ringing endorsement from central banks for banks to pass negative rates decisively through to firms and households (savers and borrowers) no wonder banks are tentative in doing so.  And that central bank tentativeness further undermines the potential effectiveness of the tools they might still have.  We see that with global inflation expectations falling, so much that central banks are struggling to avoid rising real interest rates.

I’m reading Scott Sumner’s The Midas Paradox at present, a stimulating take on the Great Depression.  As he notes, in that climate for a country to devalue, or go off gold, was stimulatory.  But when markets feared a country might go off gold, even if it had no desire to do so, that was severely contractionary (people –  and institutions – ran to gold, rather than paper money, with a cumulative contractionary effect). There wasn’t a belief that central banks could credibly do much to offset that sort of tightening in conditions.   There aren’t direct parallels to today’s situation, but if people think that the monetary options are almost exhausted it amplifies the adverse impact of any emerging bad economic news

It is all unnecessary.  If central banks five or more years ago had put their minds to dealing with the zero bound, we’d be far better positioned today.  Authorities could say with conviction that there was no limit to how far policy rates could be cut.  Banks –  and savers/borrowers –  would be that much more attuned to the possibility of materially negative rates (nominal, not just real).  As people like Miles Kimball have pointed out, it doesn’t take the abolition of all physical currency – which continues to have real convenience value for many people/transactions.   And that is why it still is not too late to act.  Central banks could cap the issuance of their currency, and work with ministries of finance to enable variable conversion rates.  These are unfamiliar concepts to the public –  and would take some socialisation.  But every day that is lost in beginning work on these sorts of initiatives exposes the world economy to really serious threats if the current set of risks crystallise (or another lot do a little further down the track).

In having delayed so long, when central governments and governments do finally move it risks looking like a panic measure.  It isn’t clear how to avoid that now –  but the best chances to avoid that sense is in those countries that still have some conventional monetary leeway (New Zealand and Australia among the few).

And, of course, the other option that could have been pursued was a higher inflation target.  I’ve written about this previously, as have others.  I still regard it as less desirable than the alternative  – doing something directly about the near-zero bound. That is particularly so in countries that have already pretty much reached the limits –  if the central bank has no effective instruments why would anyone give much weight to an increase in an announced inflation target.  Again, the options are different for New Zealand and Australia.

Central banks and governments have delayed far too long already, and they now risk reaping a very nasty harvest –  or, more accurately, seeing it imposed on their populations.  It was when central banks and governments finally moved off the Gold Standard –  usually just as reluctantly as today’s central bankers are too fully embrace negative rates and/or higher inflation targets –  that economies finally began to sustainably recover from the Great Depression.  Today’s threats are a little different in the details, but there is a pressing need for markets, the public and politicians to come to believe with some conviction that inflation will return, and that authorities have the instruments to raise inflation effectively and without question.  Persistent doubts on that score  –  including doubts of self-belief among the central bankers –  only increase the risks of a very nasty global deflationary period over the next few years.  Cutting policy rates barely as fast as inflation expectations are dropping away isn’t a recipe for boosting demand –  or creating any sort of robust confidence that inflation targets will be met.   Central bankers barely believe they will. Why would anyone else?

[1] I recall a serving G20 Governor telling me at a conference in early 2008 that he couldn’t understand what the Fed thought it was up to cutting interest rates.  A few months earlier, at another international meeting, a senior Fed staffer told us that while the market was beginning to look for cuts, the Fed still thought the next Fed funds move was upwards.

The zero lower bound and Miles Kimball’s visit

One of my persistent messages on this blog has been that central banks and finance ministries need to be much more pro-active in dealing with the technological and regulatory issues that make the near-zero lower bound a binding constraint on how low policy interest rates can go, and hence on how much support monetary policy can provide in periods of excess capacity (and insufficient demand).

I’ve found it surprising that the central banks and governments of other advanced economies have not done more in this area. In most of these countries, policy interest rates have been at or near what they had treated as lower bounds since 2008/09. A few have been plumbing new depths in the last year or so, but half-heartedly (the negative rates have not applied to all balances at the central bank), and no one is confident that policy interest rates could be taken much below -50bps (or perhaps -75bps) without policy starting to become much less effective. The ability to convert to physical currency without limit is the constraint. There are holding costs to doing so, but for all except day-to-day transactions, the holding costs would be less than the cost of continuing to hold deposits once interest rates get materially negative. For asset managers and pension funds, for example, that shift would look attractive.  I would certainly recommend that the Reserve Bank pension fund (of which I’m an elected trustee) transferred much of its short-term fixed income holdings into cash if the New Zealand OCR looked likely to be negative for any length of time.

I’ve been surprised by the lack of much urgency in grappling with this issue in other countries. I suspect there must have been a sentiment along the lines of “well, getting to zero was a surprise, and inconvenient, but we got through that recession, it is too late to do anything now, and before too long policy rates will be heading back up to more normal levels”.     But they haven’t, despite false starts from several central banks. And each of these countries is exposed to the risk of a new recession, with little or no macroeconomic policy ammunition left in the arsenal. Interest rates can’t be cut, and the political limits to further fiscal stimulus are severe in most advanced countries.

If the rather sluggish reaction of other advanced country central banks (and finance ministries) is a surprise, the lack of any initiative by the New Zealand and Australian authorities is harder to excuse. Neither country hit the zero bound in 2008/09, or in the more recent slowdown (Australian policy rates are now at their lows, and commentators increasingly expect that New Zealand’s soon will be).  The period since 2008/09 should have shown authorities that the zero lower bound is much more of a threat that most of us previously realised (not just, for example, a Japanese oddity). It should have suggested some serious contingency planning – as, for example, the Reserve Bank of New Zealand had done as part of whole of government preparedness for the possibility of a flu pandemic. Both countries have had years to get ready for the possibility of the zero lower bound. It is not as if the experience of the countries who have hit zero is exactly encouraging – slow and weak recoveries and lingering high unemployment.

But neither New Zealand nor Australia appears to have done anything about it. Indeed, in the most recent Reserve Bank of New Zealand Statement of Intent these issues don’t even rate a mention. I’m not suggesting it is the single most urgent or important issue the central banks face. Contingency planning never is, but that does not make doing it any less important. I’m also not suggesting that New Zealand is as badly placed as some – if we were to get to a zero OCR, our yield advantage would disappear and the exchange rate would probably be revisiting the lows last seen in 2000. And we have some more room for fiscal stimulus than some other countries. But no central bank or finance ministry should contemplate with equanimity the exhaustion of monetary policy ammunition.  Nasty shocks are often worse than we allow for.

My prompt for this post is the visit to New Zealand this week of Miles Kimball, Professor of Economics at the University of Michigan (and an interesting blogger across a range of topics). Kimball has probably been the most active figure in exploring and promoting practical ways to deal with the regulatory constraints and administrative practices that make the ZLB a problem. They are all government choices. I’ve linked to some of his work previously. I noticed Kimball’s visit through a flyer for a guest lecture he is giving at Treasury on Friday, on a quite unrelated topic. I presume he will also be spending time at the Reserve Bank, addressing some of the monetary issues. This would seem like a good opportunity for some serious and enterprising journalist to get in touch with Kimball – whether directly, or via the Reserve Bank or Treasury – for an interview on some of his work in this area, and the reaction he is getting as he promotes his ideas, and practical solutions, around the world.

I’ve suggested previously that if our authorities are not willing to start on serious preparations to overcome the ZLB then the Minister should think much more seriously about raising the inflation target. I’d prefer to avoid a higher inflation target – indeed, in the long-run a target centred nearer zero would be good – but current inflation targets (here and abroad) were set before people really appreciated just how much of a constraint the zero lower bound could be. Better to act now so that in any future severe recession there is no question as to ability of the Reserve Bank to cut the OCR just as much as macroeconomic conditions warrant.

Here are some other previous posts where I have touched on ZLB issues:

On the physical currency monopoly, and thus block to innovation, held by central banks.

On a sceptical speech on these issues by a senior Federal Reserve official

Some overnight reading

Last week I wrote up some thoughts on negative nominal interest rates, and how important it is that finance ministers and central banks start treating as a matter of urgency the elimination of the regulatory constraints and practises that make it impossible for policy interest rates to go materially negative.  If they won’t, they need to raise inflation targets, but that would be a distinctly inferior option.

In that light, it was encouraging to read the blog of Miles Kimball –  one of key academic proponents of action in this area – and learn that he was talking overnight on exactly that topic at the annual central bank chief economists’ workshop hosted by the Bank of England.  The annual BOE meeting is an important and interesting forum (I got to go once) and typically John McDermott, chief economist at the Reserve Bank, attends.  The link to Kimball’s slides (“18 misconceptions about eliminating the zero lower bound”) is here.

I don’t agree with everything in Kimball’s presentation.  In particular I still think he puts too much weight on government providing the answer, rather than just getting out of the way and providing greater scope for market innovation. But then there is (or should be) a much greater urgency to addressing the issue in most of the rest of the advanced world, where policy interest rates have now been stuck at or near zero for a depressing number of years now.

The obstacles to negative nominal interest rates have been around as long as banknotes, but haven’t mattered very much in the past  –  after all, despite the occasional peripheral discussions and local experiments during the Great Depression, there was then a mechanism to generate recovery –  breaking the link to gold.  That option isn’t available this time.  Kimball rightly compares creating the ability to take nominal interest rates materially negative to breaking off gold in the 1930s.

In countries where interest rates have not yet hit zero, such as New Zealand and Australia, the Minister of Finance (who controls the gateway to taking legislation to Parliament), the Treasury (as chief economic adviser to the governments), and the Reserve Bank (as, in essence, implementation agents –  and to some extent the institution that benefits from the current system) need to be planning now to ensure that these old restrictions don’t impede the ability of our countries to cope with the next severe downturn.  This isn’t just something of academic or obscurantist interest – it is about unshackling one limb of macroeconomic policy so that it is ready when it is needed.  And as I’ve noted before, at 3.5 per cent our OCR is less high now than most of policy rates were in 2007 in those countries now stuck with the near-zero lower bound constraint.

And two other brief items:

I drew attention some weeks ago to the work Ian Harrison had been doing on earthquake strengthening requirements, an area of policy which appeared to have the makings of another government “blunder”.   A group Ian is associated with called EBSS (Evidence Based Seismic Strengthening) now has a website, and it includes a brief critique of the government’s revised proposals in this area announced earlier this month.  Those changes seem to amount to a step forward, in reducing the extremely heavy cost burden that the government had planned to impose on building owners, to mitigate extremely low probability and low cost risks.

However, as the EBSS paper notes, the new proposals still seem a long way short of ideal.  Now that I’m based at home I’m often down in the Island Bay shopping centre.  Many of the older buildings there –  including one housing the excellent and popular butcher –  are yellow-stickered, but I neither notice among other people, nor feel any myself,  any unease in using them.  Sometimes I wonder if that is just a short-sighted perspective, oblivious to the risks, but that is where numbers help.  This quote from the EBSS paper caught my eye.

As a point of comparison, flying has similar characteristics to earthquakes. There is a very small chance that there will be a catastrophic event that results in death. The chance of being killed, per hour, when flying is 4000 times greater than being in a typical Auckland ‘earthquake prone’ building. For New Plymouth buildings it is about 600 times greater, and for Wellington 20 times.

We fly because we know that flying is very safe. But the Auckland, New Plymouth and Wellington buildings will be shunned because they will be falsely identified as ‘high risk’ when there is overwhelming evidence that they are not.

And finally China. I must have missed the reports of the recent Chinese government instruction to banks that they must keep lending on local authority projects even if those local authorities can meet neither interest nor principal commitments on existing debt.  Christopher Balding has an excellent summary of what an edict like that seems to mean.  As he puts it “the Chinese bailout is starting to bail fast”.