Inflation and the tax system

When I went looking for the interim report of the Tax Working Group, I found that various other papers had been released.   These include background papers prepared by the Treasury and IRD secretariat looking at various possible options for reducing other taxes if, for example, new capital taxes were to provide more government revenue.

Among them was a short and rather unconvincing paper on productivity.   It was notable for highlighting how difficult it was to give any concrete meaning to the aspiration repeatedly expressed by the Minister of Finance, and included in the terms of reference, of “promoting the right balance between the productive and speculative economies”.  And it was also notable for the aversion of officials to lowering the company tax rate (or the effective tax rate shareholders pay on company income), even though they accept that our business income tax rates are now high by international standards, and that business investment (including FDI) is low by international standards. This chart is from the paper.  In general, what is taxed heavily you get less of.

corp income tax

But this time I was more interested in another of the background papers, this one on the possibility of inflation indexing the tax system.   Even with 2 per cent inflation, failing to take explicit account of inflation in the tax system introduces some material distortions and inefficiencies.  Many of the costs of inflation arise from the interaction with the tax system, and these distortions may be greater in New Zealand than in many other countries because of the way we tax retirement income savings (the TTE system introduced, as a great revenue grab at the time, in the late 1980s).

In the days of high inflation there was some momentum towards doing something about indexation. It had, for example, been a cause championed by former Reserve Bank Governor Ray White.  And in the late 1980s, the then government got as far as publishing a detailed consultative document.  But then inflation fell sharply (and maximum marginal tax rates were cut) and the issue died.  We don’t even have the income tax thresholds indexed for inflation, allowing Ministers of Finance ever few years to present as a tax cut an increase in revenue that should never have occurred in the first place.

In the early days of inflation targeting there might even have been a case for letting the issue die.  The inflation target was centred on 1 per cent annual CPI increases, and that target was premised on a view that the CPI had an annual upward bias of perhaps as much as 0.75 per cent per annum).  But since then, the extent of any biases in the CPI have been reduced, and the inflation target has twice been increased.   The inflation target now involves aiming for “true” inflation” of at least 1.5 per cent per annum.

The distortions are most obvious as regard interest receipts and payments.  Take a short-term term deposit rate of around 3 per cent at present.  Someone on the maximum marginal tax rate (33%) will be taxed so that the after-tax return is only 2 per cent. But if, as the Reserve Bank tells us, inflation expectations are 2 per cent, that means no real after-tax return.  Compensation for inflation isn’t income and it shouldn’t be taxed as such.  Only the real component of the interest rate (1 per cent) should be taxed.   The same distortion arises on the other side, for those able to deduct interest expenses in calculating taxable income: in the presence of inflation, this tax treatment subsidises business borrowing.  The amounts involved are not small.   As economist Andrew Coleman notes in his (as ever) stimulating TWG submission

Even at low inflation rates, these distortions are substantial. In 2017, for instance, residential landlords borrowed $70 billion. Even if the inflation rate is as low as 1 percent, this means residential landlords can deduct $700 million of real principal repayments from their taxable income, a subsidy worth over $200 million per year. New Zealand households lend in excess of $150 billion. When the inflation rate is 1 percent, lenders are expected to pay tax on $1.5 billion more than they ought. Many people who invest in interest-earning securities are elderly, risk averse, or unsophisticated investors. For some reason the New Zealand Government believes these investors should pay more tax than any other class of investors in New Zealand. It is a strange country that taxes the simplest, most easily understood, and the most easily purchased financial security at the highest rates. It suggests the Government has little interest in equity, its protestations notwithstanding.

There are other distortions too, notably around trading stock valuations and asset valuations on which true economic depreciation would be calculated.

As reflected in the paper released this week, officials are very wary about doing anything about fixing these distortions (and they fairly note that “no OECD country currently comprehensively inflation indexes their tax system”), and they devote many pages to outlining the practical challenges they believe would be involved, and the new distortions they believe would arise from partial approaches to indexation.

I have some sympathy with the stance taken by officials on the specific challenges to doing comprehensive indexation, especially in a way that does not bias transactions through favoured institutional vehicles.  But it is a particularly bloodless document that seems to reflect no sense of the injustice involved in taxing so heavily relatively unsophisticated savers (while subsidising business borrowers, especially those financing very long-lived assets).

This seems like a case where some joined-up whole-of-government policy advice would be desirable.  There would be no systematic distortions arising from the interaction between inflation and the tax system if there was no systematic or expected inflation.   Systematic inflation isn’t a natural or inevitable feature of an economic system –  in some ways it is about as odd as changing the length of a metre by 2 per cent a year, or the weight of a gram by 2 per cent a year.  In the UK, for example, (and with lots of annual variation) the price level in 1914 was about the same as it had been in 1860).  And the most compelling reason these days for targeting a positive inflation rate is the effective lower bound on nominal interest rates, itself created by policymakers and legislators.   Take some serious steps to remove that lower bound and (a) we’d be much better positioned whenever the next serious economic downturn happens, and (b) we could, almost at a stroke, eliminate the distortions –  and rank injustices –  that arise from the interaction between continuing, actively targeted, positive inflation, and a tax system that takes no account of this systematic targeted depreciation in the value of money.

It wouldn’t be hard, but our ministers, officials (Treasury and IRD), and central bankers currently seem utterly indifferent to the issue.

The Fed looks to options in the next serious recession

I’ve written quite a bit recently about the apparent complacency of the Reserve Bank (and The Treasury and the Minister of Finance) around the ability of monetary policy to adequately cope with the next serious recession (here, here, and here).

Against that backdrop, it was interesting to see a substantive report of a recent discussion of exactly these sorts of issues in the minutes of a meeting a few weeks ago of the Federal Open Market Committee, the arm of the Federal Reserve that makes monetary policy decisions.   One might reasonably suggest that the discussion is happening several years later than it should have –  the problems and the limitations of conventional monetary policy have been apparent for some years now (especially in countries like the US that reached the effective lower bound in the last recession) – but better late than never.   And in the US context, some individual members of the FOMC have felt free to speak openly (eg here) on the issues and some possible policy responses.  It is the way open monetary policy committee systems can work.

Here are some extracts from the FOMC minutes

Monetary Policy Options at the Effective Lower Bound

The staff provided a briefing that summarized its analysis of the extent to which some of the Committee’s monetary policy tools could provide adequate policy accommodation if, in future economic downturns, the policy rate were again to become constrained by the effective lower bound (ELB). The staff examined simulations from the staff’s FRB/US model and various other economic models to assess the likelihood of the policy rate returning to the ELB and to evaluate how much additional policy accommodation could be delivered by the current toolkit.

Somewhat surprisingly, a footnote indicates that the staff modelling was still based on an effective lower bound of 12.5 basis points (the actual low the Fed went to for years after 2008), even though other countries have gone modestly negative (and our Reserve Bank has taken the view that the OCR could go to, say, 0.75 per cent.  There is no hint in the minutes of the FOMC discussing a lower effective floor, or what steps might be considered to lower it.

The staff’s analysis indicated that under various policy rules, including those prescribing aggressive reductions in the federal funds rate in response to adverse economic shocks, there was a meaningful risk that the ELB could bind sometime during the next decade.

Hardly surprising, given that the current Fed funds target is 1.75-2.0 per cent, and recessions seem to come round every decade or so.

In the discussion that followed the staff’s briefing, participants generally agreed that their current toolkit could provide significant accommodation but expressed concern about the potential limits on policy effectiveness stemming from the ELB. They viewed it as a matter of prudent planning to evaluate potential policy options in advance of such ELB events. Many participants commented on the monetary policy implications of the apparent secular decline in neutral real interest rates. That decline was viewed as likely driven by various factors, including slower trend growth of the labor force and productivity as well as increased demand for safe assets. In such circumstances, those participants saw monetary policy as having less scope than in the past to reduce the federal funds rate in response to negative shocks. Accordingly, in their view, spells at the ELB could become more frequent and protracted than in the past, consistent with the staff’s analysis. Moreover, the secular decline in interest rates was a global phenomenon, and a couple of participants emphasized that this decline increased the likelihood that the ELB could bind simultaneously in a number of countries. A few other participants raised the concern that frequent or extended ELB episodes could result in expectations for inflation that were below the Committee’s symmetric 2 percent objective, further limiting the scope for reductions in the federal funds rate to serve as a buffer for the economy and increasing the likelihood of ELB episodes.

There was clearly a range of views round the table, but it was encouraging to see some members highlight a variant of a point I’ve made here: because firms, households and market participants know that central banks will have relatively more limited firepower in the next recession, it may be harder to keep inflation expectations near the target, which may compound the challenges.

In the US, high government debt and large deficits are likely to be a constraint on the scope for active fiscal policy to complement monetary policy.

Fiscal policy was viewed as a potentially important tool in addressing a future economic downturn in which monetary policy was constrained by the ELB; however, countercyclical fiscal policy actions in the United States may be constrained by the high and rising level of federal government debt.

That might be on “technical” grounds –  genuine risks of bond market sell-offs –  or the wider political constraints that I highlighted in my post the other day, and which are likely to apply even in less-indebted countries like New Zealand.

Participants generally agreed that both forward guidance and balance sheet actions would be effective tools to use if the federal funds rate were to become constrained by the ELB. In the Addendum to the Policy Normalization Principles and Plans statement issued in June 2017, the Committee indicated that it would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing  the federal funds rate.  However, participants acknowledged that there may be limits to the effectiveness of these tools in addressing an ELB episode. They also emphasized that there was considerable uncertainty about the economic effects of these tools. Consistent with that view, a few participants noted that economic researchers had not yet reached a consensus about the effectiveness of unconventional policies. A number of participants indicated that there might be significant costs associated with the use of unconventional policies, and that these costs might limit, in particular, the extent to which the Committee should engage in large-scale asset purchases.

The uncertainties seem considerable.

The FOMC discussion concluded this way

While the Committee’s current toolkit was judged to be effective, participants agreed, as a matter of prudent planning, to discuss their policy options further and to broaden the discussion to include the evaluation of potential alternative policy strategies for addressing the ELB. Building on their discussions at previous meetings, participants suggested that a number of possible alternatives might be worth consideration and agreed to return to this topic at future meetings. Several participants indicated that it would be desirable to hold periodic and systematic reviews in which the Committee assessed the strengths and weaknesses of its current monetary policy framework.

As one reader noted in sending me the link to these minutes “refreshing (at least directionally)”,   which sounds about right to me.   The FOMC still seems quite a long way from really grappling with the severity of the next serious recession, when they (and all their major peer central banks) will have (it appears) little conventional monetary policy leeway, there is a great deal of uncertainty about the potential of unconventional instruments, and everyone –  especially in the financial markets –  will know it.

But it is to their credit that they are willing to have a discussion of this sort, publish fairly substantive minutes highlighting some important differences of emphasis and uncertainties, and are open to independent (named) perspectives from members in speeches.    That said, it should disconcert people that the FOMC is not already rather better prepared for the next serious recession –  like all central banks, their ability to anticipate the timing of the next such event is non-existent.

The Governor of the Reserve Bank has apparently been at the Jackson Hole retreat for central bankers this weekend.  Perhaps he could compare notes with his US counterparts and come back ready for some more open and substantive engagement on these issues in a New Zealand context (after all, in a day or two, he’ll have been in office for five months and we’ve still not had a substantive speech from him on any topic the Bank is responsible for).  Encouragingly, the Governor is reported as telling an interviewer in the margins of Jackson Hole that

The “biggest challenge” is to “get inflation to rise”

But it will be much more of a challenge in the next serious recession if people can’t be confident that central banks, here or abroad, can do all that needs to be done.  At present, no one can reasonably be that confident.  New Zealand can’t fix the world’s problems, but our policymakers can ensure our economy is well-positioned.  Not doing more just because others are still not doing enough should be no more excusable than when all too many countries drifted to the limits of conventional monetary policy at the end of the 1920s.  It wasn’t as if no one then was highlighting the risks.

I have a few other substantial commitments over the next two or three weeks, which means that blogging here may well be quite light for a while.

 

 

Options for the next serious recession: fiscal policy

I’ve run various posts over the last few years urging the authorities (Reserve Bank, Treasury, and the Minister of Finance) to get better prepared for the next serious recession (and lamenting the relative inaction on this front in other countries too, many of whom are worse-positioned than New Zealand is).

As a reminder, we went into the last recession with the OCR at 8.25 per cent, while the OCR now –  years into a growth phase, with resources (on official assessments) fairly full-employed –  is 1.75 per cent.  In that last recession, the Reserve Bank cut interest rates a long way, the exchange rate fell a long way, there was really large fiscal stimulus cutting in as the recession deepened, and there were lots of other interventions (guarantee scheme, special liquidity provisions) and it was still as severe as any New Zealand recession for decades, and took years to fully recover from (on official output and unemployment gap estimates perhaps seven or eight years).   Lives were blighted, in some cases permanently, in an event where there were no material constraints on the freedom of action of the New Zealand authorities.  In fact, our Reserve Bank cut the OCR (over 2008/09) by more than any other advanced country central bank.

Next time, whenever it is, it seems very unlikely that the Reserve Bank will have that degree of freedom, particularly around monetary policy.  On current policies and practices around bank notes, it seems unlikely that the OCR could be usefully cut below about -0.75 per cent.  Beyond that point, most of the action would be in the form of people shifting from bank deposits etc to physical currency, rather than buffering the economic downturn.

Our Reserve Bank has long appeared disconcertingly complacent about this issue/risk.  The latest example was comments by the new Governor and his longserving chief economist following the latest Monetary Policy Statement.    They talk blithely about the unconventional policy options other countries have used, but never confront the fact that almost no advanced country could have been comfortable with the speed of the bounceback from the last recession.   Output and unemployment gaps of eight or nine years (the OECD’s estimate for advanced countries as a whole) aren’t normal and shouldn’t be acceptable.

Quite why the Reserve Bank is so complacent is something one can debate.   My hypothesis is that it is some mix of assuming we will never face the problem (recall that they have spent years hankering to get the OCR back up again) and of noting that other people/countries will most likely face the problem before New Zealand does.   They also like to remind us that New Zealand has a floating exchange rate as if this somehow differentiates us (as a reminder so do Australia, Canada, Norway, Sweden, the US, the UK, Japan, Korea, Israel, and even the euro-area as a whole).  Whatever the explanation,  robust contingency planning, and building resilience into the system, is what we should be expecting from the Reserve Bank (and Treasury).  There is no sign of it happening.  Meanwhile, the Governor plays politics in areas (eg here and here) that really aren’t his responsibility.

In my post on Saturday, I touched again on the desirability of doing something –  specific and early, consulted on and well-signalled –  about removing the effective lower bound on nominal interest rates.   That would tackle the issue at source.    Monetary policy has been the primary stabilisation tool for decades for good reasons.  Among other things, it is well-understood and there is a fair degree of (political and economic) consensus around the use of the tool.  And confidence that the tool is at hand in turn proves (somewhat) self-stabilising, because people expect –  and typically get – a strong monetary policy response.

Perhaps the other reason why authorities –  perhaps especially in New Zealand – have been so complacent is the view that “never mind, if monetary policy is hamstrung there is always fiscal policy”.  After all, by international standards, public debt here is low (on an internationally comparable measure from the OECD, general government net financial liabilities, about 1 per cent of GDP, which puts us in the lower quartile –  less indebted – among OECD countries.)

The implicit view appears to be that, with such modest levels of debt, if and when there is another serious recession, New Zealand governments can simply spend (or cut taxes) “whatever it takes” to get economic activity back on course again.   After all, the upper quartile of OECD countries have net general government liabilities in excess of 80 per cent of GDP.

I’m sceptical for a variety of reasons.

One of them is the experience of the last recession.  For this, I had a look at the OECD data on the underlying general government primary balance as a per cent of potential GDP:

  • general government = all levels of government
  • underlying = cyclically-adjusted (ie removing the impact of the fluctuating business cycle on revenue (mostly), and adjusted for identified one-offs (eg recapitalisations of banking systems)
  • primary balance =  excluding financing costs, so that comparisons aren’t affected by changes in interest rates themselves
  • as a per cent of potential GDP =  so that a temporary collapse in actual GDP doesn’t muddy the comparison

The numbers aren’t perfect, and there are inevitable approximations, but they are the best cross-country data we have.  Changes in this balance measure are a reasonable measure of discretionary fiscal policy.

Here is how those underlying primary balances changed from 2007 (just prior to the recession) over the following two or three years.  I’ve taken the largest change I could find, and in every case that was over either two years to 2009, or over three years to 2010.

fisc stimulus

Some countries (Hungary, Estonia) were engaged in severe fiscal consolidation from the start.  Several others experienced almost no change in their structural fiscal balances.

Quite a few countries saw 5 percentage point shifts in their underlying fiscal balances.   Spain –  a country with no control over its domestic interest rates –  is recorded as having gone well beyond that.  I don’t know much about the specifics of Spain, but for those who are upbeat about the potential scope of discretionary fiscal policy I’d take it with at least a pinch of salt – on the OECD numbers, the Spanish primary deficit dropped again quite sharply the next year (and Spanish unemployment didn’t peak until several years later).

Note that both Australia and New Zealand are towards the right-hand end of that chart.  In Australia’s case, most of the movement resulted from deliberate counter-cyclical use of fiscal policy (the Kevin Rudd stimulus plans).  In New Zealand, by contrast, the change in the underlying fiscal position was almost entirely the result of discretionary fiscal commitments made by Labour government at a time when Treasury official forecasts did not envisage a recession at all.  From a narrow counter-cyclical perspective, those measure might have been fortuitous, but they were not deliberate discretionary counter-cyclical fiscal policy measures.  In fact, at the time they were seen in some quarters as exacerbating pressure on the exchange rate, and limiting the scope of any interest rate reductions.

Perhaps it is worth stressing again that in not one of the OECD countries did the reduction in structural fiscal surpluses (expansion in deficits) last more than two years.  In every single country, by 2011 structural fiscal policy (on this measure) had moved –  sometimes modestly, sometimes quite sharply –  into consolidation phase.  In most countries, either conventional monetary policy limits had been reached or (as in individual euro area countries) there was no scope for conventional monetary policy.  And it was to be years before output and unemployment gaps closed in most of these countries.

What is my point?   Simply, that it looks as though the political limits of discretionary fiscal stimulus were reached quite quickly, even in countries where there was no market pressure (any of the established floating exchange rate countries other than Iceland), and even though the economic rebound in most was anaemic at best.   That is why so many countries needed more conventional monetary capacity than in fact they had (and QE in various forms was not much of a substitute).

The OECD table on underlying primary balances only has data going back a few decades.  No doubt experiences in wartime were rather different –  in those circumstances huge shares of the nation’s resources can be marshalled and deployed in ways which (incidentially) stimuluate demand and activity.  But looking across the OECD countries over several decades, I couldn’t any examples of discretionary fiscal policy being used as a counter-cyclical tool materially more aggressively than happened over 2008 to 2010.  In Japan, for example, the structural fiscal balance worsened by about 6 percentage points over seven years after 1989.

So from revealed behaviour patterns, I’m sceptical as to just how much practical capacity there is for fiscal policy to do much, and for long, in the next serious recession, even in modestly-indebted New Zealand.    The limits aren’t technical –  they mostly weren’t last time –  but political.   Perhaps people will push back and run some argument along the lines of “oh, but we’ve learnt the lessons of unnecessary premature austerity last time round”.     To which my response would be along the lines of “show me some evidence, or reason to believe that things would, or even should, be much different next time”.   When – outside wartime –  has it ever happened?  And what about our political systems makes you comfortable that it is likely to happen next time?     We could probably run large structural deficits for a year or two, but pretty quickly the pressure is likely to mount to begin reining things back in again (especially if, for example, the next recession is accompanied by heavy mark-to-market losses on government investments –  eg NZSF).

And recall that here in New Zealand we had almost as much fiscal stimulus last time as any country, and even supported by huge cuts in interest rates (and without a home-grown financial crisis), we had a nasty recession (even a double-dip in 2010) from which it took ages to recover.

And all of this is without even examining how effective realistic fiscal policy is likely to be.    The easiest fiscal stimulus is a tax cut (or even a lump sum cash handout).   You can do clever ones, like the UK temporary cut in GST, which not only put more money in people’s pockets, but actively encouraged them to shift consumption forward –  only to then create problems as the deadline for raising the value-added tax rate loomed.   But putting money in people’s pocket –  in a recession, and often explicitly temporarily –  doesn’t guarantee they spend much of it.  The most effective demand-stimulating fiscal policy (supply side measures are another issue –  but lets just agree that deep cuts in company tax and related rates will not happen in the depths of a recession) is direct government purchases of goods and services.  Most talked of is government capital expenditure, infrastructure and all that.

But, approve or otherwise, no government has a reserve list of projects, designed and consented, just waiting to get starting the moment it is apparent the next deep recession in upon us (that moment usually being several months after the recession has begun).  It is almost certainly politically untenable for them to do so –  if the project is so good, so the argument will run, why not do it when times are good?  And so realistic government fiscal stimulus through the capital expenditure side will take months and years (more probably the latter) to even begin to get underway.   Faced with the actual physical destruction in Christchurch, look how long it took for major reconstruction to get underway.

What of income tax cuts?   Either the cuts are focused on those who pay the most taxes (in which case there is quickly one form of political pushback) or perhaps they take the form of a tax credit paid as a lump sum to everyone (in which case there is likely to be pushback of another political type –  ideas around “everyone becoming a welfare beneficiary).  I’m not attempting to defend either type of response, just to anticipate the risks.

By contrast, monetary policy –  the OCR –  can be adjusted almost immediately, and often begins to have an effect before the central bank even announces its formal decision (market expectations and all that).  And if monetary policy changes don’t affect everyone equally, they affect the entire country –  a borrower/saver/exporter in Invercargill just as their counterparts in Auckland.  In the line from a US Fed governor, monetary policy gets in “all the cracks” (although he was contrasting it with regulatory interventions).  Government capital expenditure is, by its nature, very specific in location.  There probably isn’t a natural backlog of major (useful) capital projects in Invercargill or Dunedin.

I’m not saying fiscal policy has no useful place in the stabilisation toolkit –  although my prior is that it is better-oriented towards the medium-term, with the automatic stabilisers allowed to work fully –  but that we should be very cautious about expecting that it is any sort of adequate substitute for monetary policy in the real world of politics, distrust of governments and so on, in which we actually dwell.    It is well past time for the Reserve Bank and the Treasury, led by the Minister of Finance, to be taking open steps towards ensuring that New Zealand has the conventional monetary policy capacity it would need in any new serious recession.

 

Towards a (physical) currency auction

A week or so back, at the Monetary Policy Statement press conference, veteran Herald economics journalist/columnist Brian Fallow asked the Governor about how well-situated New Zealand was to cope with the next recession, given how low the OCR is now (1.75 per cent, as compared with 8.25 per cent going into the previous recession).

As I recorded in a post the same day, the Governor and his offsiders responded with a degree of confidence that wasn’t backed by much substance.  It all smacked of a worrying degree of complacency.

Fallow also apparently wasn’t persuaded, and returned to the issue in his weekly Herald column yesterday.  I wanted to pick up today on just one of the topics he touched on in that column.

The key issue is the effective lower bound on nominal interest rates.  The Reserve Bank has indicated that it believes the OCR probably couldn’t usefully be taken lower than -0.75 per cent (I agree with them, and that assessment of the effective lower bound is consistent with the lowest any other country has set its policy interest rate).  Beyond that point, it seems likely that an increasing proportion of holders of short-term financial assets would transfer into holdings of physical cash.  There is no direct cost of conversion, although there are storage and insurance costs for physical cash (which is why large scale conversion doesn’t occur at, say, -5 basis points).

When official interest rates were dropped below -0.75 per cent it still probably wouldn’t affect very much much (or how) little cash you hold in your wallet/purse.  If you hold much cash at all, it is probably for convenience (or privacy), balanced against (say) risk of loss/theft.  And a secure physical storage facility for even $10000 of cash would be much more inconvenient –  and probably expensive – than holding a short-term bank deposit.  You might well, grudgingly, live with an interest rate of -2.0 per cent per annum (as it is, since the last recession, marginal term deposit rates have been well above the OCR anyway).   Or you might seek to shift your money to riskier (potentially higher-yielding assets) –  in which case the lower policy interest rate would still be somewhat effective.

But the big issue here isn’t so much what the ordinary householder does.  Most don’t have that many financial assets that could be converted directly to cash anyway.  The bigger issue is institutional investors (resident and foreign, including –  for example –  Kiwisaver funds).   The funds management market is pretty intensely competitive, and (risk-adjusted) yield-driven (as an example, I was in a meeting yesterday where we looked at a restructuring option to save perhaps 3 basis points).     So if the Reserve Bank tried to cut the OCR to, say, -2.0 per cent (and it was expected to remain at least that low for a couple of years), there would be big incentives to find alternative assets yielding a less-negative (or positive) return.  The most obvious example is physical cash.   And if there are incentives for fund managers to find such alternative options, there are incentives for trusted operators to provide them (secure physical storage for large quantities of physical currency).   Willing buyers and willing sellers usually find a way to get together, at least if regulators don’t come between them (in this case the regulator –  the Reserve Bank –  actually creates the problem.  People sometimes talk about a lack of secure storage facilities, but $1 billion in $100 bills doesn’t take much space (nor, really, does $100 billion).  (On US note dimensions, the calculations are here.)  If conversions of this sort happened on a large scale, a lower OCR won’t have any material effect –  other than encouraging remaining asser holders to convert to cash.  It wouldn’t lower retail interest rates (much) and wouldn’t lower the exchange rate (much).

These sorts of conversions wouldn’t happen overnight.  Probably most funds managers and the like won’t have physical cash in their list of approved assets.  Some will be able to change that faster than others. Those that can will be able to offer better returns than those that don’t.   And such conversions would be much more likely in the next recession precisely because the starting point –  initial low interest rates –  is so bad.  It is quite likely that official rates could be negative for years.  Or perhaps the conversions will just never happen because central banks (here the Reserve Bank) just don’t lower their official rates far enough to make conversion economic.  But, if so. they will have made the point: conventional monetary policy will have very quickly exhausted its capacity.

And so various people, including me in the New Zealand context, have been arguing for some years now that something needs to be done –  and needs to be done early, to condition expectations about the next recession –  about the effective lower bound.  Brian Fallow refers to this in his article

Overseas experience suggests that at most, a negative policy rate might move the effective lower bound for interest rates 75 basis points into the red. Moving it lower still would require, economist Michael Reddell suggests, imposing a fee on banks switching from virtual to physical cash.

It wouldn’t be difficult.  There are more complex models on offer –  see Miles Kimball or Citibank’s Willem Buiter – but the desired results looks to me to be able to achieved quite simply by setting a cap on the regular holdings of physical currency (say 10 per cent above current levels).  It might need to be a seasonally adjusted cap (currency demand rises around Christmas and the summer holidays, and then falls back again).  The cap would need to rise through time (currency demand rises with the size of the nominal economy).  But the key point is that any net issuance beyond that level would be auctioned (perhaps fortnightly or monthly).   Any creditworthy entity –  the sort of institutions the Reserve Bank deals with routinely –  could participate in the auctions, and the marginal exchange price between settlement cash and wholesale volumes of physical cash would then be established quite readily, and could alter through time.  If the state of the economy and inflation meant the Reserve Bank needed to cut the OCR to -5 per cent (and in the US context, there are estimates that such a – temporary –  rate would have been desirable in 2009), there would be a lot of demand for physical currency, and no more supply.  The market-clearing price would rise, perhaps sharply.

Of course, banks supply currency to retail customers on demand, mostly through ATMs.   Banks would be free to respond to the rise in the marginal cost of obtaining new notes by passing those costs onto customers (retail or wholesale).   A (say) 5 per cent conversion cost of obtaining cash would encourage retail customers to economise on cash holdings (using EFTPOS etc instead), while allowing those who put most value on having physical currency to pay the price.  These days very few domestic transactions strictly require much cash.

Perhaps there are pitfalls in such a scheme.  If so, now is the time to be identifying them, not in the middle of the next serious recession.  Now is the time to be socialising –  including with the public – possible solutions, not in the middle of the next serious recession (when putting a premium price on physical currency suddenly announced might actually be seen as a negative signal about the soundness of banks –  ie discouraging people from holding cash).   Perhaps there even legislative obstacles – I’m not aware of any, but all sorts of obscure issues can arise when one looks into anything in depth. But, again, now is the time to identify those issues and fix them, not in the middle of the next serious recession.  There would probably need to be an override mechanism to cope with a genuine financial crisis driven run to cash.

And if there are better, workable, models, now is the time to identify them, and to test the alternative models in open dialogue, to ensure things are easily pre-positioned to cope with the next serious downturn.

Unfortunately, there is no sign of any of this sort of preparation occurring.  Certainly, nothing has been signalled by the Reserve Bank or by the Treasury or by the Minister of Finance.  If they aren’t doing the work, it is (complacent) negligence.  And if they are, but simply aren’t telling us, it would be quite unwise.

After all, as I noted in the earlier post, a key consideration the authorities need to be addressing is expectations (about inflation and policy).  In a typical serious downturn, inflation expectations fall but not too much, as all market participants expect that the downturn will be relatively shortlived, partly because of aggressive cuts to official interest rates.  But going into the next recession –  whenever it happens –  it seems increasingly likely that few central banks will have the interest rate adjustment capacity they would like.  And all economists and market participants will recognise the constraint, and are likely to factor it into their expectations are seen as a downturn in underway.  A rational response would be to cut inflation expectations (actual or implicit) much more sharply than usual  –  in turn, driving up real interest rates (for any given nominal rate), worsening the downturn, and worsening the reduction in inflation.  This issue doesn’t seem to get the attention it deserves even in the international discussions of these lower bound issues, but it looks to me like a pretty straightforward implication of the current situation.

Since none of us knows when the next severe recession will hit –  it could be years hence, but it could be next year –  this isn’t the time to let the issue drift.  Too many people paid the (unemployment) price of central bankers reaching their limits last time around to contemplate with equanimity going into the next recession starting from a situation where current low official interest rates are still only consistent with inflation at or below target in most countries, including New Zealand.  Dealing with the lower bound issue should be treated a matter of urgency.

(For those who are quite relaxed because of fiscal policy options, I might do a post next week on why it shouldn’t be very much consolation at all.)

Getting prepared for the next serious recession

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What tools do they have in mind?

The first is a negative OCR.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

UPDATE (6 July):   I have only just discovered that one of the authors of this article, whom I had known –  although not been close to  – for 35 years, had died shortly before publication.    Rereading this post, I don’t particularly resile from any of the content, but had I known I’d have written differently.

 

 

Inadequate Treasury advice

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

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

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

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

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

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

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

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

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

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

Treasury notes, correctly, that

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

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

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

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

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

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

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

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

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

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

And they conclude this way

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

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

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

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

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

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

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

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

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

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

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

romer chart

(the dotted lines are confidence bands)

The Romers offer some thoughts on the policy implications, including

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

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

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

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

An employment objective for monetary policy: some survey results

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The panel was also asked their view of this proposition

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

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

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

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

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