A couple of months ago I wrote a post about the work former Reserve Bank researcher Leo Krippner had been doing – over much of the last decade –  on trying to reduce all the influences on the government bond yield curve to a single number, to represent the effects not just of changes in the OCR (or similar rates in other countries) but also what are loosely called ‘unconventional policies’ undertake in the presence of the (actual or effective) lower bound on the OCR itself, whether central bank jawboning or, for example, asset purchase programmes.

As I noted then

This work wasn’t very relevant to New Zealand itself for a long time (there were internal sceptics as to whether it should even be done)….and yet now it is. (In his speech a couple of weeks ago the Governor even suggested the Bank might publish a semi-official series of such a measure.)   Leo’s work has been recognised in various places abroad –  cited in public by at least one Fed Reserve president, and honoured by the house journal of the central banking community, Central Banking magazine ..,  Leo left the Reserve Bank last year, but is continuing to update his work and earlier this week circulated a note with a Shadow Short Rate series for New Zealand, now that we operate with a formal OCR floor (and ceiling) and in the presence of the MPC’s commitment to buy $30 billion of government bonds over the coming year.

The size of the LSAP programme has been increased substantially since then.

Still more recently, Leo has updated his models for the other advanced economies he looks at, in a way that enables us to look at consistent estimates of the extent of monetary easing across eight advanced economies/areas.

Here is Leo’s estimate of the extent of the overall easing, as reflected in the Shadow Short Rate estimates for each country, since the end of last year (to the end of May).

Perhaps three things stand out from this chart:

• little or no effective easing in the countries/monetary areas where the official short-term rate was already negative.  Perhaps central bank interventions were relevant in other markets, perhaps for a time they stopped government bond rates rising much, but on this metric, no effective easing relative to the position just a few months back.
• the largest easing has been in the United States and Canada.  That is no surprise: official short-term rates late last year were quite a bit higher in the US and Canada than anywhere else in this group of advanced economies,
• Leo’s estimate of the New Zealand SSR suggests an easing equivalent to 117 basis points.    Recall that the OCR itself was cut by 75 basis points and so, if one accepts this as a good estimate for how much some mix of the LSAP programme and forward guidance is doing, all the rest is not thought to be worth more than about 40 basis points.    Not exactly consistent with the tone of the continued rhetoric from the Governor, who repeatedly insists –  he was at again on CNN yesterday (whoever runs their Twitter account seemed breathlessly excited that the Governor was on CNN) –  how much difference his MPC’s LSAP programme is making.

Leo has taken his estimates of the SSRs all the way back to the 1990s (the more yield curve information the better for trying to distill what is normal and what is not).  So out of interest I had a look at what happened in the previous severe recession.

When the recession of 2008/09 started all these countries except Japan had official policy rates clearly above zero.  In those circumstances, the SSR is much the same as the official rate.

In this chart, I’ve shown the median SSRs for (a) the big 4 central banks in the sample (US, euro-area, UK, Japan) and (b)  all eight central banks from mid-2007 to the end of 2014.

On these measures, monetary policy kept easing (on the whole) until well into 2013 –  in some cases by official rate cuts, in some by QE measures, in some cases by forward guidance (or perhaps just growing doubts in markets about when official rates might ever need to rise).

In this chart, I’ve shown the fall in the estimated SSRs for each country from mid-2007 (about the peak in rates, including in New Zealand) to (a) mid-2009, and (b) to the lowest point in the period in the chart.

One almost needs a different scale to compare these estimates with those for the  –  more savage –  economic downturn we are now in the midst of (see first chart).

And bear in the mind that in both episodes inflation expectations have fallen quite a lot in many most of these countries.  Adjust for that and the differences in the falls in the real (inflation-adjusted) SSRs would be even more stark.

Now it is certainly true that back in 2013 (say) longer-term government bond yields were still quite a bit higher than they are now (in the US, for example, 10 year rates in mid 2013 were about 2 per cent).  But then estimates of neutral rates have also fallen over that period.

I’m not entirely convinced by the SSR approach.  I set out some of the reasons in my earlier post, and in exchanging notes with Leo I don’t think he would disagree with any of those individual points.   Perhaps the simplest to explain point is one Leo himself included in his paper releasing the New Zealand results: the SSR is not a rate that can be transacted (unlike an OCR), and in New Zealand longer-term interest rates don’t tend to directly affect many borrowers other than the government itself (and monetary policy isn’t supposed to be about shaping the government’s behaviour –  it is a market mechanism, designed to change relative prices facing private sector firms and households).    I’m also a little uneasy about the fact that the Reserve Bank’s LSAP is explicitly targeting mainly long-term interest rates –  which, among other things, is impairing what information might be in those rates, which relate to periods well beyond the current crisis –  while, say, the Australian and US asset purchase programmes are (sensibly) targeted at the shorter end of the bond yield curve (horizons relevant to this recession, and in a sense trying to mimic what a lower policy rate itself will tend to bring about directly if those central banks were willing to cut their policy rates further).

There is also the point I noted in my earlier post that for New Zealand Leo treats the effective floor on the OCR as being 0.25 per cent.  But since that last post, the Governor has explicitly reiterated that it is a temporary floor only –  now only 9 months until the commitment expires –  as he did again yesterday in his CNN interview.  Leo advises that if the effective floor were set a bit lower, the SSR estimate itself would be closer to the OCR.  In other words, the extent of the fall in the New Zealand SSR may actually be skewed higher than is really warranted.

If I have my doubts about the indicator, it is still of some value in providing summary estimates across both time and country, it is the sort of methodology the Bank has in the past expressed enthusiasm for (without tying itself to specific numbers), his approach has received approbation from his peers in yield curve modelling etc, and Leo’s estimates are made available, including on his website.   And they leave us with the twin points that:

• the extent of monetary policy easing in New Zealand this time is little more than that of the cut in the OCR itself,
• the extent of the falls in the SSRs in all countries (even Japan) is much less than we saw in the period of the last serious recession.

It is fine for central bankers to talk –  as the Governor does –  of fiscal policy carrying the main load at present but

a)  there was significant fiscal support provided in all these economies (including New Zealand)  in the last episode as well,

b) fiscal policy operates coercively (relying wholly on the sovereign power to tax) and for many purposes –  other, say, than basic income support –  is inferior to monetary policy for stabilisation and recovery purposes,

c) in most if not all these countries recovery after 2008/09  –  best proxied probably by a return to normal of unemployment rates –  took (a) far longer than was expected then, and (b) far longer than most are still envisaging for a recovery now from this more severe downturn, and

d) fiscal policy has its limits (quite probably close to being reached, and more “political” than technical), in a way that monetary policy properly run –  ie not imposing an artificial floor on policy rates –  does not.  It is all the odder that central banks like ours (with the acquiescence of excessively conservative politicians) are acting so starkly to hold up interest rates at time when very  weak investment demand and a high precautionary savings demand would almost certainly deliver short-term market-clearing interest rates that are deeply negative (and while “market-clearing” might seem bloodless to you, what it means in practice is clearing the labour market and supporting a prompt return to full employment).

How long have I been banging on about the potential limitations of monetary policy in the next recession and issues around negative interest rates?  The first such post I could find on the blog was almost five years ago to the day, and as I’ve noted previously it had been a concern for some time before, going back to 2010 in the wake of the last serious recession and then the internal working group I chaired at the Bank when Alan Bollard rightly was concerned about downside risks at the height of the euro crisis.  (That was the report, adopted by senior management, which recommended that steps be taken to ensure that banks could operate effectively with negative interest rates.)

Ken Rogoff has been writing about such issues, and publishing in various prestigious fora, for at least as long.   And Rogoff is a Professor of Economics at Harvard and also served as Chief Economist at the IMF for a couple of years.    He and Carmen Reinhart wrote the book This Time is Different: Eight Centuries of Financial Folly  that attracted so much attention in the wake of the 2008/09 crisis.   As I noted in a post a couple of years ago he and another former IMF chief economist Olivier Blanchard proposed dealing with the lower bound issues by raising inflation targets (the suggestion at the time was to something like 4 per cent), which would –  if successful –  raise neutral nominal interest rates and provide more policy leeway in the next recession.

In the last few years his focus has shifted to addressing the lower-bound issues at source.  There was his 2016 book The Curse of Cash which I wrote about here in which –  among other issues physical cash raises –  he addressed the lower bound issues and proposed to address them in part by progressively removing higher denomination banknotes, leaving in time nothing higher than a $20 note.  More recently still there have been various papers, including last year’s paper (with a PhD student co-author) “The Case for Implementing Effective Negative Interest Rate Policy”.   And there have been a couple of short papers in recent weeks.    There was a piece on Voxeu by Rogoff and LIlley about three weeks ago.  This was the abstract

In the aftermath of the Global Crisis, conventional monetary policy has been constrained by low interest rates in many major economies. This has spurred debates on the possibility of introducing negative interest rates in the monetary policy toolkit. This column uses evidence from the US to show that not only do the markets expect the low interest rates to persist into the future, but they also expect the use of negative interest rates down the line.  Moreover, markets no longer believe that even quantitative easing can bring inflation to target, which leaves very few alternatives for monetary policy apart from negative interest rates.

As here, breakeven measures of implied inflation expectations in the US are now well below target.  There is a nice chart for the US suggesting that (at least then) markets there had already moved to put a non-trivial probability on materially negative short-term interest rates in the next couple of years.

Focusing on the medium-term implied inflation expectations they note that this

…suggests that the market’s change in beliefs has moved beyond the present crisis, and it now has re-evaluated the extent to which it expects the Fed to be constrained more generally. One problem with such a scenario is that it poses a perverse feedback loop. As the Fed becomes more constrained by the zero lower bound, the expected inflation rate falls, lowering the neutral nominal interest rate, which in turn makes the zero lower bound more binding.

Very much the same point I’ve been making here.

This week Rogoff has a very accessible piece on Project Syndicate (thanks to a reader for drawing it to my attention) under the simple and stark heading “The Case for Deeply Negative Interest Rates”.  His summary

Only monetary policy addresses credit throughout the economy. Until inflation and real interest rates rise from the grave, only a policy of effective deep negative interest rates, backed up by measures to prevent cash hoarding by financial firms, can do the job.

Some of the emphases are a bit different in a US context  (where much of government at all tiers is highly indebted)

For starters, just like cuts in the good old days of positive interest rates, negative rates would lift many firms, states, and cities from default. If done correctly – and recent empirical evidence increasingly supports this – negative rates would operate similarly to normal monetary policy, boosting aggregate demand and raising employment. So, before carrying out debt-restructuring surgery on everything, wouldn’t it better to try a dose of normal monetary stimulus?

More generally

It is not rocket science (or should I say virology?). With large-scale cash hoarding taken off the table, the issue of pass-through of negative rates to bank depositors – the most sensible concern – would be eliminated. Even without preventing wholesale hoarding (which is risky and expensive), European banks have increasingly been able to pass on negative rates to large depositors.

Some issues are relevant to the US and the euro-area but not in same form to us

A policy of deeply negative rates in the advanced economies would also be a huge boon to emerging and developing economies, which are being slammed by falling commodity prices, fleeing capital, high debt, and weak exchange rates, not to mention the early stages of the pandemic. Even with negative rates, many countries would still need a debt moratorium. But a weaker dollar, stronger global growth, and a reduction in capital flight would help, especially when it comes to the larger emerging markets.

In our case, a much lower exchange rate would make a material difference to the fortunes and prospects of the tradables sector.

Rogoff ends

Emergency implementation of deeply negative interest rates would not solve all of today’s problems. But adopting such a policy would be a start. If, as seems increasingly likely, equilibrium real interest rates are set to be lower than ever over the next few years, it is time for central banks and governments to give the idea a long, hard, and urgent look.

From which I’d depart only in replacing that “long” in the final line with a “short and intense” –  this isn’t the time for year-long reviews, but for early and decisive action (as has been managed on so many other fronts in recent months).

There has been a view in some quarters over the last few years that negative interest rates don’t work (in the sense of boosting demand, credit, inflation or whatever) and could actually be contractionary in their effect.  I’ve been sceptical of that, but also inclined to wonder whether results for slightly negative interest rates  –  where there might be threshold effects –  would generalise to deeply negative wholesale and policy rates.   Rogoff links to a recent paper, newly updated last month, by several researchers mostly at the ECB which uses very disaggregated data to suggest that actually negative interest rates in Europe have worked.   Their abstract is as follows

Exploiting confidential data from the euro area, we show that sound banks pass on negative rates to their corporate depositors without experiencing a contraction in funding and that the degree of pass-through becomes stronger as policy rates move deeper into negative territory. The negative interest rate policy provides stimulus to the economy through firms’ asset rebalancing. Firms with high cash-holdings linked to banks charging negative rates increase their investment and decrease their cash-holdings to avoid the costs associated with negative rates. Overall, our results challenge the common view that conventional monetary policy becomes ineffective at the zero lower bound.

The channels they examine look to work a little differently with negative than with positive rates, but not less effectively.

Another central bank with significant experience with mildly negative rates in Sweden’s Riksbank.  A year or so ago, a couple of Riksbank researchers published an accessible treatment of the Swedish experience, from a top-down perspective.    They summarise their results (with all sorts of caveats in the body of the paper) this way

It has been suggested that the response of bank lending rates to interest rate cuts may become weaker when the policy rate passes below a certain level. This column argues that in the case of Sweden, the pass-through of policy rate cuts below zero to the economy has been reasonably good and monetary policy has been effective even at negative policy rate levels.

As all researchers in this area recognise, a big problem is that limited data.  Only a few central banks have had negative policy rates, almost entirely in a single economic cycle, and none of them have taken the policy rate very deeply negative and dealt directly to the ability for big players to convert into physical cash.  So we cannot say with certainty what would happen if we took the – fairly straightforward –  steps that would enable the OCR to be cut to -3 or -5 per cent.  But the signs look fairly promising, whether on the limited experience we have, or  pretty basic economic theory (all else equal, holding New Zealand dollars will typically be much less attractive if NZD assets are earning a lot less than those in other countries).  And the idea of simply letting the Reserve Bank sit on its hands and do almost nothing that matters macroeconomically (hand-waving around big bond purchase programmes is mostly a distraction in macroeconomic terms, whatever value it might initially have added to market functioning).

You’ll recall that Westpac’s economists last week came out picking that the MPC will abandon its firm pledge not to cut the OCR further and go modestly negative later this year.  That would be welcome –  better than the status quo –  but inadequate, and not commensurate with the scale of the adverse economic shock.  In my post the other day I argued that in next week’s Monetary Policy Statement

The MPC on 13 May should:

• abandon the “no change for a year pledge”,
• cut the OCR to zero,
• announce that the OCR will most likely be cut further in June (which would get many of the benefits immediately, but give a little time if there are some real system issues re a negative OCR), and
• commit to have in place by June robust mechanisms that for the time being removed, or greatly eased, the current effective lower bound on short-term wholesale interest rates.

As it happens there have been a few other contributions on monetary policy locally this week.

Yesterday morning I heard the local chief executive of Westpac on RNZ talking about all the system and documentation changes that would be needed –  one has to assume he was talking about his bank, as he was quite specific in some cases –  to cope with negative (retail?) rates.  Unfortunately, the interviewer simply took Mr McLean at his word, and didn’t either challenge him on just how vital these things were or why – with 10 years global notice – a big bank like his appeared to have done nothing before now. (My initial reaction was a bit like that to the Governor –  if Mr McLean had spent less time championing all the right-on causes he and the Governor are so fond of –  especially climate change –  and actually managed his bank, his borrowers might be rather positioned now.)  Of course, from a public policy perspective, the bigger question is about years of failure from the Reserve Bank –  under Wheeler, his “acting” replacement, and more recently under Orr –  to ensure that the banking system could readily cope with the sort of cuts to the OCR that it was easily foreseeable some shock soon might make necessary.  In Orr’s case, it is particularly inexcusable given that big interview he gave eight months ago articulating why he favoured negative interest rates as a policy option.  “Saving the world” might seem more glamorous, but stabilising the local economy and keeping inflation target was actually his job.

Then there was a strange comment reported from the Leader of the Opposition.

Bridges said fiscal policy, rather than monetary interventions from the Reserve Bank, would need to do the heavy lifting in the Covid-19 response.

That clearly isn’t true –  it is simply a choice by the MPC to do nothing, and by the government which does not use clear legal statutory powers to compel them to act differently.  Sadly, it is still too much of the conventional wisdom.   I’d probably have forgotten about except that this morning Bridges is reported as worrying about risks of too much public debt being taken on.  Macro policy squares that circle –  delivers accelerated recovery without lots more debt –  by using monetary policy: yes, deeply negative rates in this context, to provide the support and stabilisation into the recovery towards full employment.  Such, it seems, is the power of conventional wisdom and the fear of successive Oppositions –  Robertson in Opposition was quite as bad, in less important circumstances –  to challenge anything that the (on their record) not-overly-capable RB/MPC does.

And finally, another reader this morning sent me this clip from a recent BNZ research report, previewing next week’s MPS.

We would strongly argue that lowering the cash rate further would provide almost no assistance to the economy. The cost of debt is the last thing on anyone’s mind now. The lack of availability of debt might be a concern and, for many, the lack of income to repay debt will be a pressing problem. Pushing interest rates sub-zero will do nothing to ameliorate those issues. Moreover, even if the cash rate was to go negative, it would not be fully passed on to borrowers as the banks will still be funding themselves with positive interest rates. Term deposit rates are excruciatingly low for many as it is. The last thing the household sector would want is zero rates across the board. And even at zero, it would mean bank funding costs well above the cash rate.

The research report is headed “RBNZ Can’t Save the World”, to which one can only agree.  What it can do –  what it is charged with doing –  is keep inflation and inflation expectations at around 2 per cent, and support as rapid as possible a return to full employment.  At present, those two goals are tightly aligned, given how high unemployment is forecast to be, and how far medium-term inflation expectations have fallen.

Perhaps it as well to remember here that the BNZ has been the most consistently “hawkish” –  pro tightenings, often uneasy about easings –  of any of the local banks for many years.  That has made them more wrong than most.

But that specific extract above simply makes little sense.  Sure, most businesses would probably prefer a quick and full rebound in demand/activity over a fall in their debt interest rate, but it isn’t as if the two concerns are in conflict –  in fact, lower interest rates and lower exchange rate will, in time, do their bit to support a stronger recovery.  And despite the bank economist’s claim that no one much cares about interest rates, the evidence is pretty clearly against that in the very low interest rates being offered on the government’s scheme (and the Opposition’s proposal yesterday).  In fact, the worst credits in the country –  those who can’t raise funds elsewhere –  get the cheapest rates, while deposit rates –  in the middle of a savage slump – remain positive in real terms, barely down this year, sending all the wrong signals.  And then there is the distraction: as BNZ knows only too well, if the OCR were taken to -0.5 per cent –  as Westpac suggests will happen and should happen –  retail rates, deposits and lending rates, would be still positive.  For now, negative retail rates are some way away.

And if, perchance, depositors were reacting negatively to, say, 1 per cent term deposit rates, what are they going to do instead?  Spend the money?  Well, that’s good – that is monetary policy working.  Shift it to another currency? Well, that’s good –  a lower exchange rate would be monetary policy working.  Seek to buy another asset?  Well, that’s pretty good too –  increasing both wealth effects and Tobin’s Q effects encouraging new investment, so that’s monetary policy working.  And, of course, in aggregate it is not as if deposits are going anywhere –  it is a closed system, with a floating exchange rate.  Your purchase is my sale etc etc.   Oh, if it makes people worry a bit about future inflation, that’s good too –  that’s monetary policy working to hold up, or lift, inflation expectations to something like target.

Like Ken Rogoff, I think the case for deeply negative interest rates now is pretty overwhelming.  It would ease the pressure on fiscal policy, it would support the tradables sector (on which our future prosperity rests), it would ease servicing costs on existing borrowers (and bring market rates closer to rates the government itself is happy to lend at).  There is nothing particularly odd about negative rates, at a time when savings preferences are high and investment intentions are very weak –  the interest rate simply serves to reconcile the two, while getting the economy towards full employment –  and in the particular circumstances of New Zealand, a materially negative OCR would be needed to even get retail interest rates close to zero.  As it is, recall that New Zealand now has materially higher retail rates than Australia, despite the deeper economic slump. That is a choice –  an anti-stabilisation choice –  made by the MPC, blessed by the Minister of Finance.

Late last year a (long ago) former Reserve Bank economist closed down his blog just like that. I didn’t have anything quite so dramatic in mind.  But after my elderly mother died last August, I got to thinking about the next stage in my life and how I could best use what skills and talents I have.  And before Christmas I’d decided that today would be my last day of high-frequency blogging.  Why today?  Well, for all practical purposes it is the fifth anniversary of the blog; five years today since I left the Reserve Bank.  It wasn’t that I’d run out of ideas or energy, but there is always the opportunity cost to consider, and I’d begun to map out a series of archival-research-based projects (mostly in New Zealand economic history) I wanted to pursue, as well as making more space for some other interests and priorities.   I’d planned to keep writing here perhaps once a week or so.

That is still what I want to move towards at some stage.  But in the middle of the most dramatic economic developments, and wrenching dislocations of economic policy, of our lifetimes it doesn’t quite seem the time to change course just yet.  We’ll see how things go, but for now, quite probably for at least the rest of this year, normal service continues (and in the meantime thanks to all of you who’ve become readers –  numbers that, for a fairly geeky New Zealand focused blog, I never imagined – and to (almost) all who’ve commented, either on the blog itself or directly to me).

And today I’m indulging the inner geek.

One of the most frustrating (to me) aspects of the response to the massive economic dislocation by the government and the Reserve Bank is their utter complacency, bounded by some deep-seated conventional wisdom, that interest rates can’t, shouldn’t, and won’t move down from here –  the OCR having been cut, in the biggest slump in modern history, by a mere 75 basis points.    The Minister of Finance was at it again in his testimony to the epidemic select committee yesterday highlighting the “certainty provided” by the MPC’s commitment not to change the OCR for some considerable time.  I presume he had in mind the idea that the MPC wouldn’t raise the OCR – as if anyone has supposed such increases were at all likely in the foreseeable future –  but he seems totally uninterested in the idea that considerable relief could be provided, and desirable income rebalancings achieved, with much lower interest rates.

Sadly most of our media also seems more interested in channelling conventional wisdoms rather than challenging them.  So I’ve heard MPs and journalists ask the Minister of Finance about commercial rents, but never once about interest rates, even though commercial rents are based on private contracts, whereas the OCR –  which influences a wide range of variable private interest rates – is directly under official control.   If the Reserve Bank refuses to act –  as it appears they do –  the Minister has existing statutory powers to simply override them.  They aren’t powers that should be used lightly, but they were put in the Act for a purpose, and these are pretty extreme times.  If the Minister refuses to use his powers, he makes himself directly party to the choice to hold New Zealand retail interest rates well above where they should be at present.   All while facilitating/encouraging firms and households to take on more debt at these interest rates.

Still, for the time being at least, the MPC’s floor is the floor, and markets have to take that into account in pricing other securities.  This has been an issue in a variety of other markets for some considerable time, particularly since the last recession when various central banks got a point where they were simply not willing to cut further, no matter the economic conditions, or to make the changes (around physical currency) that would have made further deep cuts –  of the sort Taylor rule estimates in the US, for example, suggested economic conditions warranted –  effective.   Central banks fell back on trying to do what they could –  often not much –  with other “unconventional” instruments.

And years ago, a Reserve Bank of New Zealand researcher Leo Krippner, got interested in the question of how one might represent the effectiveness of such policies in a single number.  Whereas in normal times, the OCR itself readily expresses the stance of policy, if there is a self-imposed floor on the OCR but other things are being tried, how best to express the overall stance of policy.

Leo is an expert in yield curve modelling, and got to try to estimate how different the interest rate yield curve was –  especially in the US –  in the presence of the floor on the Fed funds rate, as a result of unconventional policies (“QE”, loosely).     He has published various technical papers in journals, but I think his first paper in the area was published in 2012 in the Reserve Bank’s Analytical Notes series.  I was the editor of that series, and one of my priorities was to ensure that as much as possible was accessible to intelligent lay readers, and my impression is it still remains a good introduction to the work Leo is continuing to do and to update.

One can think of a yield curve of government bond interest rates (from overnight out to, say thirty years) as, broadly speaking,  a series of market implied expectations about the future setting of the official overnight interest rate (the OCR in New Zealand).  All else equal, if the central bank sets a floor on the OCR –  which is regarded as binding and credible – markets pricing say a 10 year bond will rule out any chance of an OCR below that floor, and the 10 year bond rate will be higher (all else equal) than it would be in the absence of such a floor.  On the other hand, if large scale bond purchases by the central bank –  even actively targeting a bond rate (as Japan and now Australia are doing) –  may succeed in lowering to some extent where the bond yields settle, relative to the floor-constrained normal market price.    Leo’s work, calculating what he calls a Shadow Short Rate, attempts to combine the OCR and this effect into a single number.

This work wasn’t very relevant to New Zealand itself for a long time (there were internal sceptics as to whether it should even be done)….and yet now it is. (In his speech a couple of weeks ago the Governor even suggested the Bank might publish a semi-official series of such a measure.)   Leo’s work has been recognised in various places abroad –  cited in public by at least one Fed Reserve president, and honoured by the house journal of the central banking community, Central Banking magazine (for whom I do some reviewing: my light lockdown reading is here).  Leo left the Reserve Bank last year, but is continuing to update his work and earlier this week circulated a note with a Shadow Short Rate series for New Zealand, now that we operate with a formal OCR floor and in the presence of the MPC’s commitment to buy $30 billion of government bonds over the coming year. (The quote that heads this post, from Galileo, appears upfront in Leo’s note.)

Leo’s modelling estimates that the overall stance of monetary policy is “approximately equal to an OCR of -0.48 per cent”, compared to an OCR itself of 0.25 per cent.    If so, that suggests a small but somewhat useful contribution from the “unconventional monetary policy” or UMP.  Small because even a total of 150 basis points of effective easing is tiny by comparison to the scale of the economic shock.

There are a number of caveats to this modelling.  Leo articulates some of them himself

1. The SSR is an estimated value rather than a setting like the OCR or an observed market short rate. Hence, any SSR series will (unavoidably) vary with the model specication and data used for its estimation. The choices I have made for the SSR series in this note have produced more favorable properties than alternatives for the United States,4 but the magnitudes of negative SSR estimations can easily vary by fractions of a percentage point on re-estimations, and sometimes more for UMP periods if the lower-bound setting in the model needs revisiting in light of central bank communications and/or actions. My model for New Zealand currently uses a lower-bound setting of 0.25%, consistent with the RBNZs 16 March 2020 forward guidance.
2. Related to estimation, in the present global UMP environment compared to previous years (e.g. for the United States easing/tightening cycle) yield curves may no longer capture sufficient information to quantify the stance of monetary policy. The reason is that yield curves in New Zealand and around the world are now very at(i.e. longermaturity rates are close to shorter-maturity rates). Only time (and updated analysis) will tell on this aspect, and model refinements may be needed.
3. The SSR is not a market rate at which borrowers and lenders can transact, particularly in UMP times when the OCR and short rates will remain close to zero while the SSR may become increasingly negative. Hence, SSR declines in UMP times will not result in the same cash flow effects from interest payments and receipts as OCR cuts in CMP times, so the SSR transmission to the economy may differ from at least that perspective.

I went back to Leo and asked about how safe it was to use a floor of 0.25 per cent for New Zealand (after all, we’ve seen more than a few policy lurches from the Reserve Bank over the last year, in fact over the last few weeks, and some other central banks have – eventually –  shown a willingness to take their policy rates lower, in the Swiss National Bank’s case as low as -0.75 per cent.  Leo noted that if one were to assume the New Zealand floor was anything like that low, the SSR for New Zealand would still be much the same as the OCR itself.

He went to say (with his permission to quote)

The longer answer is: should one use an assumption of the effective  lower bound in the model (perhaps something like your -0.7, but also  see further below), or should one use a value that central banks have  indicated they would go to? Across the different economies I’ve  modeled, I’ve noticed that the different yield curves seem to use the latter. For example, the US yield curve data has pretty much respected  the lower point of the 0-25 bp range, and the euro area data (OIS  rates) has pretty much respected the incremental settings of the ECB  policy rate. In particular, neither have had longer-maturity yields  rush to, say, the -75 bps of Switzerland.

So, based on what I’ve seen with the data, I set the lower-bound for  each economy according to the central bank’s indications. And then I  lower that if/when the policy rate gets set lower (which, again, seems  to be how the yield curves behave – perhaps not rational though, I agree).

To which my response in turn was to note that in at least some of those overseas central banks –  the Fed in particular –  the stated floor has been consistently applied for a decade, while the Reserve Bank of New Zealand has no track record in this area at all –  indeed in that same speech a few weeks ago the Governor was openly talking of negative rates as a possibility.  A rational investor in the current climate, with a Governor prone to lurches (and, actually, in the presence of override powers), might not price in a 100 per cent chance of the MPC sticking to its word.  Time will tell.

My bigger unease about this work, stretching all the way back to that 2012 paper (where I recognise a couple of sentences I insisted on being added) is the third in Leo’s own list of caveats above: the SSR is not a rate that can be transacted, and if much of borrowing and lending in an economy is either at (or swapped back to) or very close to a floating rate, the actual OCR (self-imposed constraint and all) will be a lot more important than the SSR estimate might suggest.  In the US, for example, a lot of mortgage lending takes places at very long-term fixed rates (and so what happens to very long-term bond and swap rates has a direct transmission mechanism).  That is much less so in New Zealand (or Australia or the UK).  That is consistent with some of the doubts I’ve expressed in earlier posts around quite what difference the Bank’s large scale asset purchase programme really makes where it matters (thus, on my telling, the main advantange of that programme is that it should reveal quite quickly how severe those limitations are and turn the focus back on the OCR and that self-imposed floor).

This stuff won’t be everyone’s cup of tea, but I’m really glad to see that Leo is continuing with this work –  he says he will provide updated estimates on his website http://www.ljkmfa.com each month for the time being –  and will be interested to see whether the Reserve Bank follows through on the suggestion of a quasi-official series (for what its worth, I would suggest they not do so, and use work such as Leo’s as a reference point for commentary/research when it is relevant).

It really is quite remarkable that the government is willing to shred our civil liberties, abandon Parliament, ban funerals –  to my mind, the most egregiously inhumane, almost evil, specific of the entire Ardern partial lockdown –  and accentuate, for now, the temporary implosion of the economy, and yet the same government is unwilling to act to bring about lower interest rates.

They have a recalcitrant public agency that simply refuses to (has formally promised not to) act, in face of a huge slump in activity and employment, a period when time has no economic value.  And yet they just sit politely by, as if this was some minor difference of emphasis over 25 basis points or so.  They have all the powers they need to act, but simply refuse to do so.  Having chosen not to act, interest rates are current levels are now the direct responsibility of the Prime Minister, the Minister of Finance, and the rest of the Cabinet collectively.

Consider a thought experiment.  Suppose that for the last 18 years instead of an inflation target of 1-3 per cent, centred on 2 per cent, we’d actually had a target of 9-11 per cent, centred on 10 per cent. (Note, I do not think this would have been an appropriate or necessary policy, but just humour me for a moment).  And pretty much everything else –  good and bad – about the economy to the end of 2019 unfolded as it did.  Assume that coming out of the Great Recession a decade ago, central banks would still have struggled to (or been as reluctant to) do what it takes to keep inflation at target, but they had more or less got there by 2019.  Perhaps core inflation was about 9.7 per cent, perhaps inflation expectations (a mix of survey and market measures) were somewhere between 9 and 10 per cent.    And, consistent with that, assume the OCR had been 9 per cent at the end of last year (a full percentage point below the target midpoint just as it was in real life.)

(And, yes, I know all about the interaction between the tax system and inflation which mean these things aren’t exact by any means, but for now this is just a very simple story.)

And then the coronavirus hits, and all that followed around fighting the virus  – policy measures here and abroad, personal choices to distance etc here and abroad – happened just as in real life.

Oh, and the economy?  Well, serious people would still be talking about the unemployment rate going to perhaps 25 per cent, a really major export industry had simply closed down, investment demand (national accounts sense) was heading for zero, and so on.

Does anyone imagine, for the slightest moment, that in such an alternative world –  but a path we and other countries’ could have chosen –  that the OCR would have been cut by only 75 basis points?

Of course not.    Not only do typical New Zealand (or US) recession see around 500 basis points of cuts, but even in crisis-type events in the past (precautionary responses to 9/11 and the 2011 earthquake) the Reserve Bank has cut by a bit more than that  –  and the Christchurch earthquakes, after the very brief initial hiatus, represented one of the largest positive, unforecast, demand shocks to the New Zealand economy ever experienced.

Who knows how low the OCR would have been cut in that alternative world where the OCR had started at 9 per cent.  But we know that in the 2009/09 recession – when GDP fell by about 3 per cent –  the Bank cut by 575 basis points. In the US, where the Fed cut by about 500 points in 2008/09, versions of the Taylor rule later suggested that the Fed funds rate could more appropriately have been cut by another 500 basis points on top of that.

So why (didn’t and) don’t adjustment of this magnitude happen?    Because central bankers abroad –  but specifically here, where the MPC has set an explicit floor at 0.25 per cent –  have becom almost terrified of the possibility of seriously negative nominal interest rates, and have spent a decade doing nothing much about making such outcomes work effectively.  Far too much of the focus of central bankers this last decade was on looking to the next tightening, and the idea of “normalisation”, not preparing for the next serious downturn –  now upon us in unusual and particularly savage form.

But they would have had few qualms in lowering a nominal OCR of 9 per cent –  in the presence of a 10 per cent inflation target –  to, say, 1 per cent.    It makes no sense.  It is bad money illusion in reverse, without any good justification.

Now, of course, everyone knows and accepts that monetary policy isn’t going to stop GDP collapsing over the next month (at least) –  perhaps on a scale just without precedent ever (if we ever had the data).  But it wasn’t really that much different in the fourth quarter of 2008.  Really substantial cuts in official interest rates happened, and rightly so, but in a climate an extreme loss of confidence, fear etc, that wasn’t going to stop GDP falling right then.  At the best of times, the lags are longer than that.

But markedly lower interest rates, when massive excess capacity is opening up and the neutral interest rate is falling, still do a number of useful things:

•  they signal to markets (and the wider public) that the central bank is thoroughly serious about doing its job, and keeping inflation expectations up very close to target  (the risks around this not happening are much greater in our real world than in the alternative, higher inflation target, world I mentioned above),
• they get relative prices positioned as soon as possible in way that puts the economy in as less-bad position as possible for the eventual recovery (not just the bounce back to a, say, 15 per cent loss of GDP if the lockdown itself is eased/lifted),
• and the greatly ease debt servicing burdens, reallocating income from (close to) variable rate depositors to (close to) variable rate borrowers, consistent with the new stylised facts in which time for now has no economic value.   As it is, short-term term depositors are still being taken at positive real interest rates – even as the economy is shutdown –  while variable rate borrowers, even with rock-solid collateral, are still paying substantially positive real interest rates.  All this at a time when the government appears keen to encourage firms to borrow more….

Given the significant margins between the OCR and retail interest rates (lending and borrowing) we really need, and should have, a substantially negative OCR –  deeply negative in real terms, and not that inflation expectations have been falling.

You might be wondering if (materially) negative official interest rates is just some hobbyhorse of mine.  Even if that we the case, it is still the arguments that should be examined, not the advocates.  But it isn’t the case.  Over the last decade or more, people like former Bank of England Monetary Policy Committee member Willem Buiter, or US academic Miles Kimball (who was the guest of the RB or Treasury just a few years ago) have been among those pushing the case for ensuring that official interest rates could be taken a lot lower in the next crisis.

As a refresher, the twin obstacles are that (a) central banks now have a monopoly on the issuance of physical currency, and (b) as monopolies do, did not innovate over time so still operate with much the same rules and technology as 100 years ago.  If the OCR were to be taken deeply negative, on those rules, it would at some point become attractive for wholesale investors, in particular, to switch from holding securities and bank deposits, to holding physical cash.   If so, you can cut the OCR all you like and it won’t make much useful difference to anything, except stocks of zero-interest cash.  It doesn’t happen easily: storage and insurance costs are real, AML restrictions are annoying, and it isn’t worth doing if you think the OCR will only be very low for a month or two  We don’t know quite where the limits are, but the current consensus has been that no one is really willing to try  –  on current rules – below about -0.7 per cent.

But those rules and practices can be changed.  Ideally, doing so would have been properly consulted on and socialised over a long period by governments and central banks. But in a crisis –  perhaps especially a crisis where surfaces, including bank notes, can carry the virus –  things can be done very quickly.  They should be in this case.    Suspend the issuance of net new bills in excess of $50, cap the total currency issuance (for now) at, say, 20 per cent above the current level, and if revealed demand for currency is higher than that, ration by price (run a weekly auction at which banks offer a premium over face value to buy physical currency, which they can pass through to all customers or just those taking a large amount of cash, at their discretion).

Of course, having led to believe for the last couple of years that a modestly negative OCR was an option they were open too, the Governor now tells us that the Reserve Bank simply never got round to ensuring that all banks’ systems would be able to cope with negative interest rates.  That’s a pretty stunning indictment, that he/they should be held to account for one day (perhaps the Simon Bridges-chaired select committee could summon him?)

As I’ve noted before, mostly even if what the Governor says is true, it is more likely an excuse for inaction (action they don’t want to take) rather than a real and valid justification.  As I’ve noted previously, many wholesale interest rates abroad have been modestly negative for years now.  An bank operating internationally has to have been able to cope (even in New Zealand some of our inflation indexed bond yields had gone negative).   And even setting all that aside, if the OCR were set to say -2 per cent, that would still only be consistent with term deposit rates near zero and lending rates still positive (business one quite a lot positive).    There is material relief that can be given, that really should be given urgently, without the main retail rates even getting to the point of going negative.   And, frankly, it is surely time for some naming and shaming.  If better banks have systems that can operate negative rates, it will provide a competitive advantage and put pressure on those who just didn’t get ready to fix things quickly (even if initially in an improvised way).  In the current climate, an OCR of -5 per cent might be something good to aim for.

A couple of my old colleagues have offered brief dissenting views in comments on earlier posts. I appreciate them taking the time to do so.    I dealt with the first comments, from Geof Mortlock, in a post late last week

A former colleague, from mostly a banking supervision background, left a comment yesterday disagreeing with my call for negative rates.

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….

What to make of Geof’s specific arguments?

First, I don’t accept that it would be destabilising to the financial system at all –  if anything, at the margin it would assist financial stability by shifting the burden from borowers (increasingly indebted in most cases) to depositors (time is offering no real return right now).

I also don’t belief that there would be anything like the sort of flight to Australia Geof suggests.  After all, exchange rates –  even NZD/AUD are volatile enough and transactions costs high enough – to swamp any possible small interest gains.   Perhaps more to the point, in a floating exchange rate system, unless there is a run to physical cash – and recall that under my model cash would be more expensive to purchase/withdraw –  the total deposits in the banking system do not shrink because someone seeks to withdraw money.    For every seller of NZD there has to be a buyer.  And, frankly, the more people wanted to sell NZD at present, the better –  a materially lower exchange rate is one more helpful part of the stabilisation package.

Finally, Geof also notes that lower interest rates won’t do much to boost spending right now.  That is, of course, true and a point I’ve been making throughout.   The point of policy right now is not to boost spending (the time for “stimulus” will be later) but, in this case, to ease servicing burdens materially, and to help stabilise and reverse the falls in medium-term inflation expectations that risk materially complicating the recovery phase, by starting us off with higher real interest rates than those we went into the crisis with.

Ian Harrison, now of Tailrisk Economics, also weighed in

I think the negative interest rate is a diversion, with several problems and does nothing that can not be done more effectively in most cases by direct interventions in our wartime economy.

Thinking about the flow through to interest rates people are paying – banks have reduced the floating rate to 4.5 percent – a huge margin still. It appears that the fixed rates where the business gets done haven’t moved much at all.

My off the top of the head suggestion is to pretend that time doesn’t exist for one two or three months. Time bound contractual -rents interest wouldnt exist for that period. lots of fishhooks and inequities of course. and it would put the banks under pressure. If that got too much then the OBR could be activated for the entire banking system and owners’ interest effectively confiscated.

But I think this is itself something of a distraction, and (after all) my scheme actually involves some quite direct interventions.  I quite like, at a conceptual level,  the idea of pretending that time doesn’t exist for contractural purposes in the midst of the crisis, but no one believes that problems are going away in two or three months.  When, for example, do we suppose the tourism sector might be back to “normal”.  Not next year would be my guess: we need relative prices to signal resource-switching and draw forward demand as recovery begins to beome possible.

As for OBR, it is of course a bank failure/resolution tool, but for now at least the presenting problem is not potential bank failure  (that could become a risk in time, as the toxic brew of falling asset prices and collapsing incomes lasts long enough) but the sustainability of borrowers themselves.  And using OBR in a bank failure –  unlikely to ever happen –  does nothing to relieve borrowers or support existing companies holding together.

Ian followed up on Friday with another comment

The problem with relying on a reduction in the OCR is that the transmission to borrowers who actually need the relief is highly uncertain. Some thing as direct as a maximum interest on bank lending would have some of the desired effect. – say 6percent, accompanied by no reduction in lending limits.

To which my response is that yes the transmission is a bit uncertain in the abstract.   In concrete terms though, what Ian suggests could be achieved by making it a condition of participation in the governments’s business loan guarantee scheme that any OCR cuts are fully, or almost fully passed through.  If necessary –  it is an emergency – legislation could be used directly.   And we don’t need 6 per cent interest rates for reasonable credit business borrowers at present, but something more like zero or negative (still a significant risk margin over, say, an OCR of – 5 per cent),

And finally, Geof put in another comment

Your continued advocacy for zero or negative interest rates ignores the commercial reality that, in periods of stress, such as this, the risk premium in interest rates will rise. This as true (maybe even more so) in a period of prospective deflation. Lenders will price in the risk of lending such that, even in periods where the zero default rate might be zero or negative, bank lending rates will be positive. Equally, bank funding rates are unlikely to go to zero or negative given that depositors, especially at the wholesale level, are factoring in the increased (but still low) risk of bank default. As credit markets globally tighten further, that risk premium is likely to rise. I therefore view your stance on negative interest rates as commercially unrealistic and inconsistent with how a well functioning market could be expected to operate.

As for Ian’s suggestion of regulatory caps on interest rates, I think that would be daft. Such regulatory responses rarely produce desired outcomes. They distort risk pricing in both funding and lending rates and impede efficient credit allocation.

The smartest way to address borrower stress is to provide targeted income support for a defined period, together with debt servicing holidays. If the lockdown is effective in markedly lowering infection rates to a low level, then we should be able to progressively normalise things after 4 to 8 weeks. Border controls will need to continue for months to come, but if the quick result (15 minute) tests, which are apparently under development, can be deployed as a prerequisite for boarding a plane or ship bound for NZ, or at leadt on arrival here, then maybe the economic damage can be reduced to a significant degree.

What is needed now are the indicators (eg infection rates etc) that will be applied for a progressive easing of restrictions after this 4 week period.

On his first point, as I’ve noted since the OCR in this climate should be deeply negative, retail interest rates that would be zero or slightly negative –  not that 6 per cent advertised rates ordinary SMEs face at present –  leaves plenty of margin for risk premia.

On his second point, if depositors are so confident about alternative investment options –  whether other countries or other assets – as to reluctant to accept negative deposit rates, that is (all else equal) a good thing, monetary policy at work.  Either they are spending (ie demand rising), trying to shift abroad (lowering the exchange rate, welcome), or supporting otherwise cheap asset prices (again one way monetary policy works.

On regulatory caps, of course in general they aren’t a good thing. They might not even be needed with a deeply negative OCR, but even if they are sometimes exceptional times call for exceptional measures.  We’ve seen a few in the last few weeks….

For the rest, I’m not debating what might or might not be possible on testing etc, but no one supposes that even if the current lockdown is lifted in a month or two, that we will quickly snap back to even a recession of the relative shallowness (by these standards) of 2008/09.  We still need, and should want, deeply supportive monetary policy, including because whatever fiscal policy might be able to do as time goes on, it is almost inevitable that there will be pushback before that long about the bills being run up for the future.  Monetary policy is designed to be the principal stabilisation and countercyclical tool.      If it is allowed to work and used decisively again, it can play that role again once the worst of the virus is behind us.

I’m happy to engage with, or respond to, any other sceptics with specific points.  But on the face of it –  and thinking much more deeply and practically – we are overdue some vigorous easing in monetary conditions.  The MPC could and should do it.  But if they refuse, the government should –  in these extreme circumstances –  simply override them and compel them to act.

(In the meantime, of course, the bigger issue is that of extreme uncertainty and downside risk around business and household incomes.  The government has done quite a bit to support households, although quite time limited.  On the business side, there isn’t much other than encouraging firms to take more debt, when for most it simply won’t be worth doing so.  And there are disconcerting hints of the government helping big firms, but not the vast mass of companies that make up most of the economy. My “ACC for the whole economy”,firms and households, remains the best option to provide some insurance, some certainty, to buy time, all without attempting to lock in firms that really may now have no readily conceivable future.)