The government should insist the OCR be deeply negative for now

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.

uir

….

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.)

 

 

Preparing

In those distant days when world sharemarkets were still at or very near record highs –  actually, on Monday –  the Federal Reserve Bank of San Francisco released one of their short accessible Economic Letters summarising some research work done last year on the question “Is the Risk of the Lower Bound Reducing Inflation?“.   The views expressed are those of the authors, not the FRBSF let alone the wider Federal Reserve system, but the authors aren’t just fresh out of college either: one is the executive vice-president and head of research (one of the most senior policy positions) at the FRBSF, and the two authors are senior managers on the research side of the Bank of Canada.

Here is their summary

U.S. inflation has remained below the Fed’s 2% goal for over 10 years, averaging about 1.5%. One contributing factor may be the impact from a higher probability of future monetary policy being constrained by the effective lower bound [ELB] on interest rates. Model simulations suggest that this higher risk of hitting the lower bound may lead to lower expectations for future inflation, which in turn reduces inflation compensation for investors. The higher risk may also change household and business spending and pricing behavior. Taken together, these effects contribute to weaker inflation.

How does this work? Here is their description

If monetary policymakers are constrained by the ELB in the future, recessions could be deeper and last longer because central banks may be unable to provide sufficient stimulus. The greater decline in economic activity in this case would translate into lower inflation during such downturns relative to recessions when the policy rate is not close to the lower bound.

In addition, greater risk of returning to the ELB could also affect inflation during good times, when the economy is performing well and interest rates are above the lower bound. Investors and households often care about the future when making long-term investment decisions that are difficult to reverse, such as setting up a new production plant or buying a house. The possibility that recessions might be more severe in the future because of the ELB can affect their economic decisions today, prompting them to be more cautious to guard against this risk. For instance, households could start saving more in anticipation of possible harder times ahead. Similarly, businesses could engage in precautionary pricing by setting lower prices today if they anticipate a greater likelihood of deeper recessions in the future and do not review their pricing strategy frequently.

As something for the future –  perhaps the very near future –  it all seems a plausible tale, and is consistent with a line I’ve been running here for years, that when the next severe downturn comes markets (and other economic agents) will quickly focus on the limitations of conventional monetary policy and adjust their behaviour (for the worse, in cyclical terms) accordingly, deepening and lengthening the downturn.  But these authors go further and posit that people (real economy and financial markets) have already been factoring the ELB risks into their planning and decisionmaking, in turn directly contributing already to lower inflation and lower inflation expectations (than perhaps the current cyclical state of the economy might otherwise deliver).

I haven’t yet read their full working paper so can’t really evaluate the strength of their evidence on this point.  But if they are capturing something important about actual behaviour in the last decade or so, presumably those effects would be expected to have become larger the closer to the present we come.   Prior to 2007 the Fed (and other central banks other than Japan) had not reached the ELB at all. Immediately after the recession there was a pretty strong expectation that things would return to normal (including normal policy interest rates) before too long –  a view typically shared by markets and by central banks.    Only with the passage of time did those expectations gradually fade –  and perhaps more completely in Europe (where policy rates are still often negative, and pretty consistently lower than those in the US).

For New Zealand, of course, if there is anything to this story, it must be even more recent, having started with higher policy rates, and with markets and the Reserve Bank mostly looking towards higher policy rates until just the last couple of years.   The possibility of reaching the ELB in New Zealand has been a distinctly minority point (yours truly and perhaps a few others) for most of the last decade, in ways that leave me a little sceptical that the story will explain anything much of the inflation experience in New Zealand (or Australia) for the decade as a whole. In both countries, inflation has averaged materially below the respective target midpoints.

Whatever the case for the past, the FRBSF note ends with this point

These findings suggest that the puzzle of how to raise inflation to meet central bank goals may require new ways of addressing the risk of returning to the ELB and new ways of understanding how to set and meet inflation goals.

The problem is that there is a growing risk that it is now too late, and that central banks (and Ministries of Finance) have spent the last ten years not getting to grips with ensuring effective capacity for the next severe downturn, leaving things potentially almost paralysed when that severe downturn breaks upon us.  Which it could be doing right now.

Many advanced country central banks can now barely reduce the policy interest rate much at all –  the biggest problem with former Fed governor Kevin Warsh’s call yesterday for a coordinated international rate cut is that it would immediately highlight the limits, especially in Europe.  Even in a traditionally high interest rate country like New Zealand, there is perhaps 150 basis points of capacity, when the average recession in recent decades has involved 500+ basis points of cuts –  a point our Minister of Finance rather glossed over yesterday in his talk of the advantage of starting with relatively high interest rates.

As the FRBSF authors note

To compensate for this lack of conventional firepower, central banks can rely on unconventional policy tools, such as forward guidance or quantitative easing. While these tools proved effective during and following the crisis, it remains unclear whether they can fully compensate for the diminished conventional policy space and the more frequent encounters with the ELB

That is fairly diplomatic speak, as befits senior officials.  In reality, few really believe that unconventional tools under the control of central banks can adequately compensate for lack of conventional policy space.

In my view, those limits have not really been sufficiently focused on by markets, firms and households, or governments.  There has been quite a lot of wishful thinking around –  hankering for higher neutral rates, inability to spot an near-at-hand risk that might trigger an early severe downturn, or whatever.   But when people look at the looming coronavirus risks –  and markets will no doubt ebb and flow still, just as happened as the financial crisis unfolded a decade ago – and really begin to focus on what can, and will, be done, we are likely to see inflation expectations falling away much faster than in a normal downturn, in turn raising real interest rates and accentuating the problems, at a time when neutral interest rates are likely to be falling further (perhaps temporarily, but real enough for the time being).

To bring that back to the New Zealand situation, after ignoring the issue for a long time the Reserve Bank appears to have begun to take it more seriously in the last 18 months or so. But with little or no transparency and no apparent urgency.  We keep being told they are about to reveal their thinking –  I hope with a view to getting serious feedback etc –  but they’ve already mentioned enough that we can be sure that what they’ve had in mind simply will not make up for the limits of conventional interest rate capacity, even allowing for the likelihood that in such a severe downturn our exchange rate will fall a long way (as it did in most of those previous 500 basis point rate cut episodes).   There is also sadly little sign that the Minister of Finance has shown much leadership or urgency about seriously addressing this problem (again, nothing along those lines in yesterday’s speech –  good enough as far as it went, but it stopped short of the really serious issues/risks).

It would be easy for me to suggest that the Governor has been too much occupied with his tree gods, his climate change interests, his views on infrastructure or the distribution of income, rather than driving action urgently in this area of monetary policy capacity (core day job).  And that is no doubt true, but as a specific criticism it needs to be kept in perspective –  his predecessors had let the issue drift, and his peers at the top of many other central banks have also seemed to prefer to believe things would come right than to seriously prepare for the constrained alternative.  We risk paying the price now –  including with central banks paralysed by their own limitations and reluctant to act early and decisively to lean against (do what they can to buffer) the economic downturn (and downside risks to inflation and inflation expectations).

Quite possibly there is a place for fiscal policy in responding to a serious downturn, even one amid the chaos of a potential pandemic, but there needs to be a lot more realism about the likely constraints on how much, and how longlasting, any discretionary stimulus is likely to last.   There is no real excuse – even in a less fiscally constrained country like New Zealand –  for authorities not to have moved to greatly alleviate or remove the effective lower bound before now, and to have used relatively settled times to have socialised the case for doing so.

And even if the FRBSF authors are wrong about the influence of the ELB on inflation over the last decade, if it very quickly now becomes even more binding – starting from a lower initial level –  it will be front of brain for everyone through the next cycle.    It really needs to be dealt with now.  It isn’t technically hard –  there are various workable options –  but it needs leadership, will, and vision for something to happen, something which has the potential to limit the extremes (depth, duration) of that severe downturn whenever it finally strikes us.

 

Officials in pursuit of more powers

It is a big few weeks for the Reserve Bank and, in particular, the Governor.   This week the Monetary Policy Committee is gathering for its deliberations leading to next week’s  Monetary Policy Statement.  A couple of weeks later there is the Governor’s six-monthly Financial Stability Report,  and the week after that we are told that the Governor will descend from the mountain-top and reveal his decision on bank capital.   There are at least two press conferences scheduled (MPS and FSR) and given that he has deliberately chosen to release the momentous capital decision only after the FSR press conference one has to hope that he will make himself available to explain and defend his choices (and, although he has staff, all the decisions –  and responsibility for them –  are his alone).

Meanwhile stories rumble around about the possibility that the Bank’s Board has,for once, found its voice and suggested to the Governor that he needed to change his style.  I heard yesterday another version of a story that culminated in the Governor yelling at the chair of the Board after the latter (so it was reported) suggested that aspects of the Governor’s conduct were unacceptable.   I have no way of knowing whether these stories are true, or are just wishful thinking, but given the quiescent and deferential track record of the Board over many years, it would be perhaps a little surprising if there was nothing to the stories now.

One of the other projects the Reserve Bank has underway, which attracts less attention and controversy, is that around the future of cash.  It is both an apt issue to be focusing on and, at the same time, something of an odd one.  And, remarkably, in the discussion document the Bank put out a few months ago there was no mention –  at all, as far as I can see – of the most immediately pressing issue: the limits on the ability to cut the OCR that arise because of the (near) free option people have to shift from bank deposits etc to physical cash.

The future of (physical) cash is somewhat of an odd issue to be focusing on because cash outstanding has been rising relative to GDP.    This chart is from the Bank’s discussion document

cash 1.png

It tends to exaggerate the point, by starting from the trough.  Here is a longer-term chart from a post I wrote on these issues a while ago

notes and coin

All else equal, when interest rates are very low (and inflation is low too) people are more ready than otherwise to hold on to physical cash.  Of course, quite who is actually holding the cash, and for what purpose, is a bit of a mystery, one not really addressed in either the Bank discussion document or in the poll results they published last week, framed in terms of a high preference for using electronic payments media whenever possible.

The Bank included an interesting chart in its document illustrating that although the ratio of cash to GDP is quite low in New Zealand, the rise in that ratio wasn’t out of line with what has been seen in quite a few other advanced countries.  Sweden and Norway –  where the ratios have fallen –  are outliers.

cash 3.png

There is quite a strong suggestion that in the most recent period a big part of what is holding up currency in circulation was the surge in overseas tourism, especially from China.

cash 4

Overseas tourism remains one of the areas where physical cash is much more likely to be used than in normal domestic spending.

Notwithstanding these routine and entirely legitimate uses of physical cash, it is still hard not to conclude that a large chunk of the physical cash on issue –  in excess of $1000 per man, woman, and child –  is held to facilitate illegal transactions, including tax evasion.   That was Rogoff’s view, and as I wrote about here he –  against my priors – converted me to that way of thinking.

So there would seem to be no risk of cash disappearing from the New Zealand scene any time soon.   And yet the monetary policy constraint arguments, that the Bank simply doesn’t address in its discussion document, suggest that if anything the use of Reserve Bank cash (and especially the potential use of cash) should be constrained more tightly than at present.  The Governor may repeatedly assert that unconventional monetary policy options will do just fine, but few other people would look at the international experience of the last decade without thinking that monetary policy ran into limits.  Those limits arise mostly because of the non-interest bearing nature of the cash and the near-free option of converting into physical cash if returns on other short-term securities go, and are expected to stay, materially negative.

This limit need not exist, or at very least could be greatly eased.  Abolish the $100 note, for example, and at very least you double physical storage costs of secure large cash holdings.  Abolish the $50 note and you more than double the costs again (while the ability to give your kids pocket money in cash, or to use cash at the school fair isn’t materially affected).  That was, basically, Ken Rogoff’s argument in the US (restrict central bank notes to no more than $20 bills).  I’ve argued for one of a range of more-wholesale solutions that have been proposed: put a physical limit (perhaps indexed to nominal GDP) on the volume of currency in circulation (perhaps with overrides for bank runs), and auction the right to purchase new issuance (there is no reason why newly-issued cash has to trade at par).  Do that –  perhaps even set the limit fairly generously –  and the effective lower bound, as a convertibility risk issue, is abolished at a stroke.

This is coming close to being a fairly immediate issue.  No one supposes the Reserve Bank could, on current technologies, usefully cut the OCR by 200 basis points or more in a new recession, and yet in typical New Zealand recession something more like 500 basis points has been required.

It is pretty staggering that they haven’t addressed these considerations at all in their document.  Instead, having had submissions (lots of them) on the first consultation document, they issues another consultation document (deadline for submissions tomorrow) bidding for more Reserve Bank powers over the currency system.

The currency system seems to have rubbed along tolerably well for the 85 years since Parliament gave the Reserve Bank a statutory monopoly on the issuance of bank notes  (it seemed to function just fine in the earlier decades as well: whatever the case for setting up a Reserve Bank there was never a robust case for the statutory monopoly on bank notes).

But none of that deters the Reserve Bank.  It is a rare bureaucracy that looks to shrink itself, or is averse to an expansion of its powers, and the modern Reserve Bank seems to be no exception.  This is their bid

cash 5.png

As they note, there is no need for any such powers at present.  Which really should be determinative.  It isn’t like preparing for an extreme national disaster, where it makies sense to have some precautionary powers on the books.  This is about a payments media that is gradually being used less and less (for payments) and where change is exceptionally unlikely to happen overnight.     Were there ever to be severe problems, surely Parliament could address such issues when they arose, rather than inventing new laws now –  and delegating the use to unelected, not very accountable, officials –  just on the off chance?

There should be a strong pushback against this bid for power.  Their (short) document makes no compelling case for legislative action –  and more discretionary regulatory power – now.  Indeed, as they note

There is a host of international examples where cash system participants have found different solutions to fit their unique economies.

It is what the private sector does –  innovate in response to market incentives and opportunities.  They worry –  as busy bureaucrats will –  that “no single organisation has system-wide oversight of the cash system or a formal role to support it”.   There is no such organisation for, say, the corner dairy sector either.  Nor an obvious need for one –  let alone for the government to be taking charge.  They complain that they don’t have information gathering powers over participants who aren’t banks, but offer no analysis or convincing demonstration as to why they should have such powers.

They offer no analysis either as to why the market could adequately manage issues around ATMs or other processing machines, or even for the quality of the notes retained in circulation.    Much of it seems to be made up on the fly –  so it seems, to catch the decisionmaking process around other changes to the RB Act.  Thus they talk of powers to compel banks to distribute cash, but seem to have thought through very of this bid for power for hypothetical circumstances.  This, for example, is the last substantive paragraph of the document.

How accountability would be defined under such regulation, and therefore how sanctions could be applied, warrants further consideration. Banks could be held collectively accountable for the provision of cash services, meaning that banks would share the responsibility for providing access to cash, and all banks within scope would face sanctions for each case of noncompliance. This would be a novel regulatory structure in New Zealand, but might be practically workable and might encourage greater cooperation among banks. Alternatively, each bank could be individually accountable for the provision of certain services in certain areas. However, this presents challenges around how accountability is allocated. Both options present considerable practical challenges, which will need to be investigated in consultation with relevant parties if any policy is developed.

Doesn’t exactly instill much confidence.

Many of the problems the Reserve Bank worries about (perhaps arising one day) would, in any case, largely be a reflection of the statutory monopoly on banknotes. So perhaps a better legislative route would be to look at repealing that restriction –  simple one clause amendment to the Act would do it –  and allow banks to issue their own notes.   Perhaps it is now a little late for that, but we don’t know if we keep on ruling out the opportunity for innovation.  It might be considerably cheaper for banks to issue their own notes (as they issue their own deposits) –  since they wouldn’t have to worry about returning them to a central point for value –  and, conceivably, technological innovation might even allow interest-bearing bank notes  (it is the zero interest nature of  the existing notes that creates the lower bound issue for monetary policy).

Bids for new regulatory powers are often a response to issues, problems (or possible future risks) thrown up by existing regulatory or legislative interventions.  The Bank’s latest bid for more discretionary powers seems exactly in that class of bureaucratic initiatives.   The Minister of Finance should say firmly no to this latest bid, should insist on the Bank openly addressing the effective lower bound issue, and might consider asking the Bank what public policy end –  other than higher taxes –  is served by maintaining the 85 year old monopoly on note issuance.  We got rid of most statutory monopolies a long time ago.

 

Keep the focus on monetary policy

As we approach the OCR decision this afternoon and as some market economists are now talking about the possibility that the OCR could be below 1 per cent before too long, there has been more and more talk about whether fiscal policy should be brought to bear, to stimulate demand and (in some sense) assist monetary policy in its macroeconomic stabilisation role.  Just this morning there was an editorial in the Herald, a column on Stuff, and a comment from Bernard Hickey at Newsroom.   Some of the discussion is about what should be done now, and the rest is about contingency planning –  what happens when the next serious recession happens if the OCR is still constrained.

Much of the discussion seems to stem from people on the left who aren’t that happy with the government’s fiscal policy.  As someone not on the left, it has always seemed strange to me that Labour and the Greens pledged themselves to keep much the same size of government (and much the same debt) as National –  especially when, at the same time, you were running round the country talking about severe underspending on this, that, and the other thing.   I’m also of the view that structural budget surpluses are a bad thing, in principle, when net government debt is already acceptably low (on the OECD measure of net general government financial liabilities, New Zealand is now about 0 per cent of GDP, which seems like a nice round number – an anchor – to target).  There is an argument there –  whether from left or right – for some fiscal adjustment (taxes or spending), which might have the effect of a bit more of a boost to demand.

But those arguments really have almost nothing to do with the situation facing monetary policy.    They are fiscal and political arguments that should be made, and scrutinised, on their own merits: the arguments would be as good (or not) if the OCR was still 2.5 per cent as they are now, and you can be pretty sure that people on the left would have been making them then anyway?   The Governor of the Reserve Bank, for example, (a pretty staunch representative of the centre left) seemed keen on more infrastructure spending a year ago.  I guess he is a voter to so is entitled to his opinion, but it really doesn’t have much to do with monetary policy.

The general arguments that led countries around the world to adopt monetary policy more exclusively as the primary stabilisation policy tool have not changed.  Monetary policy can be adjusted quickly (to ease or tighten), operates pervasively (gets in all the cracks, without making specific distributional calls), is transparent, and so on.  If we had a fixed exchange rate –  as individual euro area countries largely do –  it would be a bit different (individual countries don’t have the monetary policy option any longer) but we have a floating exchange rate system which, mostly, works well for New Zealand.

To the extent that there is a monetary policy connection to the current calls for fiscal policy to be used (or the ground prepared to use it), it has to do with the looming floor on nominal interest rates.  International experience suggests that, on current laws and technologies, short-term nominal interest rates can’t be reduced below about -0.75 per cent without becoming ineffective (as more and more people shifted from other financial instruments into physical cash).  We don’t know quite where that floor is, as no central banks has been willing to take the risk of going further, but there is a fair degree of consensus (and it has long been my view too).

But that still means that in a New Zealand context there is 200 basis points of OCR cuts that could be used if required.    That isn’t enough for a typical New Zealand recession (rates have often been cut by 500bps), but is still quite a degree of leeway if what we are entering were to turn out to be a fairly mild slowdown in New Zealand.  It could (I’m not hedging here).   That capacity should be used energetically, not timorously.   So the issue –  monetary policy needing “mates” deployed now –  is not immediate.  It is about preparing the ground.

And there, the best macro stabilisation option remains the one the Reserve Bank –  and other central banks –  have done nothing active about, but really should.  Authorities (and it probably needs political support to do so) should be moving to make the effective floor on short-term nominal interest rates much less binding than it is.   It binds because the practice of central banks –  perhaps backed by law – has been to sell banknotes, in unlimited quantities, at par.   That practice can be changed.  It could be as simple as putting an (adjustable) cap on the volume of notes in circulation (quite a bit above the current level, but not at a level that would be transformative) and then, say, auctioning the right to buy additional tranches of bank notes from the Reserve Bank.  In normal times –  with the OCR at, say, current levels – the auction price would be at par.  If the OCR were cut to, say, -3 per cent (and be expected to stay there for some time) the auction price would move well above par, acting as a disincentive on people to attempt to make the switch from deposits to cash.  There is a variety of other ideas in the literature, as well (no doubt) as much less efficient regulatory interventions that could prevent really large-scale conversions happening.

Unusual as such options may sound, this is where the authorities –  here and abroad –  should really be concentrating their energies: giving monetary policy more leeway, in ways that will buttress market confidence that monetary policy will do the job when it is required.  At present, by contrast, when market participants contemplate a severe downturn they look into an abyss wondering what, if anything, will eventually be done, by whom, and for how long.  In a serious downturn that will just worsen the problem, driving down inflation expectations as economies slow (note that in the RB survey out yesterday, medium-term inflation expectations fell away quite noticeably –  and this while we still have conventional monetary policy to use).   And if there are objections that all this is somehow “unnatural”, bear in mind that had the inflation target been set at zero (rather than 2 per cent), as was the normal average inflation rate for centuries, we’d already have run into these practical limits, and been unable to get real interest rates even as low as they are now.

So there is plenty to be done with monetary policy, and the work programme to do it should be something open and active, drawing in the Bank, the Treasury, the Minister, and other interested parties.  The time to do preparation is now, not in the middle of a surprisingly severe downturn.

I have a few other reasons –  than “it shouldn’t be necessary” –  to be wary of calls for large scale fiscal stimulus now.  Just briefly:

  • there would be little agreement on what should be done –  these are inherently intensely political issues.  There is lots of talk of infrastructure gaps etc, but no agreement on what those are, let alone recognition of the twin facts that (a) the best projects, with the highest economic returns, have probably already been done, and (b) New Zealand government project evaluation is not such as to inspire confidence that new projects would add economic value.    And suppose there were attractive roading projects –  perhaps central Wellington and the second Mt Vic tunnel? – we know the attitude of the government’s support partner to new major roads.  Not a thing.  So what should we then spend on?  Uneconomic new railway lines?  Or what?  Perhaps some just favour more consumption or transfers spending – which might be fine if you are a lefty who believes in permanently bigger government, but if you aren’t the issue has to be addressed of how programmes once put in place are unwound later.
  • I don’t rule out the possible case for discretionary fiscal stimulus in the event of a new severe recession (especially if the authorities refuse to address the monetary policy issues above) but my prediction is that (in many ways fortunately) the political appetite for large deficits would not last very long, and that therefore we should preserve the option for when it might really be needed.  It isn’t now.   I take much of the rest of the world after 2008 as illustrations of my point: in late 2008 all the talk was of fiscal stimulus, but within two or three years all the political pressure was to pull deficits back again.  I don’t see why New Zealand would be any different (and that is to our credit, since low and stable debt has become established as a desirable baseline).
  • And thirdly, a point we don’t often hear from champions of more fiscal stimulus, relying more on fiscal policy and less on monetary policy to support economic activity and demand will, all else equal, put more upward pressure on the real exchange rate, further unbalancing an already severely-unbalanced economy (see yesterday’s long-term chart of the real exchange rate).  In a severe recession –  when the NZD tends to plummet –  that isn’t a particular problem, but it should be a worry now (when the TWI is still a bit higher than it was a year ago, let alone thinking about the longer-term imbalances.

Perhaps the Governor and the (experts-excluded) Monetary Policy Committee will proactively address some of these issues this afternoon. I do hope so. If not, I hope some journalists take the opportunity to push the Governor on why he (and the Minister and Treasury) aren’t actively pursuing work to make the lower bound on nominal interest rates much less binding, in turn instilling confidence in the capacity of New Zealand policy to cope conventionally with a severe downturn if/when it happens.

Oh, and I do hope some journalists might also ask the Governor this afternoon about the justification for ruling out from consideration for appointment to the Monetary Policy Committee

“any individuals who are engaged, or who are likely to engage in future, in active research on monetary policy or macroeconomics”

The Governor is, after all, a Board member and was one of the three person interview panel.    What was it that he –  or the Board generally –  were afraid of?    Expertise?  An independent cast of mind?  Of course, it isn’t only active researchers who have such qualities –  indeed, not all of them do either –  but it simply seems weird, and without precedent in serious central banks elsewhere in the advanced world, to simply disqualify from consideration for the (part-time) MPC anyone with the sort of background that many other central banks (Australia, the UK, the euro area, Sweden, the United States, and so on) have found useful, as one part of a diverse committee.

Can anything good come out of the ANZ?

ANZ’s New Zealand operation has had a bad run lately, what with the problems around the version of a model they were using for calculating operational risk capital, and then yesterday’s announcement of the loss of their CEO.    Perhaps it is a failure of imagination on my part, but I can’t claim that either episode greatly bothered me, whether as a customer or more generally.  Yes, both incidents suggest a degree of untidiness that isn’t ideal,  but it is a big organisation and they were pretty small issues.  Perhaps it suggests the local board doesn’t amount to much, but why would that surprise anyone?   Local incorporation is mostly about having (a) some assets that we can be reasonably sure will be available to meet local liabilities in the (very low probability) event of a major bank failure, and (b) having someone to prosecute if governance failures proved to have risen to a prosecutable standard (a reason for the otherwise questionable requirement for some of the directors to be locally resident).   Beyond that, it makes sense for the whole of the ANZ group to be able to be run, as far as possible, as a single entity.

But rather lost amid the headlines yesterday was a very useful new piece from the ANZ’s economics team, “Prospects for unconventional monetary policy in New Zealand”.   It is a very substantial piece of analysis, which gets into quite a lot of detail on how New Zealand might handle a situation in which the conventional limits of monetary policy had been exhausted (ie when the OCR has been cut to some modestly negative level).    I would encourage anyone with even a passing interest in the topic to read it.

Pretty much ever since this blog began in 2015 I have been lamenting the apparent failure of the Reserve Bank to take this issue very seriously.  It never popped up in Statements of Intent or gubernatorial speeches (in the days when we had a Governor who made them), even though many other countries had run into those limits in the last recession, and in most cases the pace of economic recovery had been disconcertingly slow.    Back in 2013 or 2014, perhaps the Bank had some small excuse –  the then management was so convinced the OCR was heading back up (and by a lot) that effective lower bounds just didn’t seem like an issue New Zealand needed to worry about.     But that was five years ago, and the OCR now is 1.5 per cent not the (say) 5 per cent the Bank might have hoped for.

In the last 18 months, there has been some movement by the Bank,  Last year, they published a Bulletin article surveying the experiences of other countries with unconventional monetary policy, and then offering some initial thoughts on options for New Zealand.   I wrote about that article here, welcoming the fact that it had been done, and the survey of other countries’ experiences, but regretting an apparent degree of complacency by the Bank about the New Zealand situation and the likely effectiveness of such policy tools.   That complacent tone characterised various comments the Governor has made at MPS press conferences: lots of handwaving, little hard analysis, and no engagement at all with just how slow the recovery was in most countries that were reduced in unconventional measures.    As I noted, central bank complacency risked coming at a cost –  a cost not to the comfortable central bankers themselves, but to those left unnecessarily unemployed for long periods of time.

The new ANZ piece is valuable for a number of reasons.  First, it will be more widely disseminated than the Reserve Bank article.  Second, it isn’t from the Reserve Bank (we need a wider range of discussion and debate around these isses and risks), and third, it goes into more operational detail (around important features of existing RB liquidity facilities etc) in several places than anything previously in the public domain.

I don’t agree with everything in the ANZ piece, and in particular I was surprised by the number of references to how distortionary or risky unconventional policies have been in other countries.  The rather bigger issue is that they mostly have not achieved much, at least once we got beyond the immediate crisis period (and this is a distinction the ANZ authors make).    As I’ve noted here repeatedly, there is little or no evidence that –  whatever the initial announcement effects –  long-term bond rates have fallen further relative to policy rates in countries that used unconventional policies than in countries that did not.

There was a useful reminder that some official RB interest rates will go negative well before the OCR itself gets to a negative number.    This is from their document

ANZ ZLB

The Bond Lending Facility is a facility whereby market participants can borrow bonds from the Reserve Bank (to support smooth market functioning) and, as the authors note, is little used.

The ANZ authors put more emphasis on the penalty on excess balances in settlement accounts.  I wrote about the Bank’s strange tiering policy in a recent post, but the gist is that the Bank determines for each bank what value of deposits at the Reserve Bank earn the OCR, and anything in excess of that earns 100 points less than the OCR.   Banks manage their settlement cash balances to minimise the extent to which anyone bears that lower return  But if the OCR were at -0.25 per cent, the rate on excess settlement account balances would be -1.25 per cent on current policies.   All else equal, that is a rate low enough that (a) no one else has imposed it, and (b) people might prefer to hold physical cash instead.

I’m a bit sceptical that this is a really important constraint on the ability of the Reserve Bank to use conventional monetary policy down to an OCR of around -0.75 per cent, since there is little reason to suppose the level of settlement cash balances would be rising as the OCR plumbed these new depths (if anything demand might be falling a bit), and banks would –  as the Bank would want –  be aggressively acting to limit the extent anyone bore the additional cost.   But it is an issue that is worth debating further, and which would become salient quite quickly if the Bank went beyond OCR cuts and started using unconcventional measures to boost settlement cash balances materially.  In earlier work, it was recognised that tiering policy would probably need to change if there was aggressive unsterilised asset purchases.

The authors rightly note many of the potential limitations of asset purchase options.  Sure, the Reserve Bank might be able to buy up a substantial portion of the government bonds on issue –  although some holders will be very reluctant sellers, having mandates that specify investment in government bonds –  but even if they could, what would be the channel whereby this would revive demand and economic activity (few borrowers took on long-term fixed rate debt).   And the Bank might be able to intervene heavily in the foreign exchange market –  perhaps on ministerial direction, to ensure the risks fall on the Crown –  but they’d likely be selling the New Zealand dollar when it was already undervalued, and if the OCR can’t go below -0.5 or -0.75 per cent, it isn’t likely that the exchange rate effect would be very large.  Intervening in the interest rate swaps market has been an idea around for a decade, and I’ve never been persuaded it would accomplish much.

But the options and issues really should be more widely debated, and the Reserve Bank and The Treasury should be taking the lead in encouraging open debate and serious scrutiny of the New Zealand specific issues.  As ANZ notes, perhaps interventions can be devised on the fly, but there is no excuse for finding ourselves in that position when we have had 10 years advance notice of the problem.  Adrian Orr’s tree god won’t offer the answers, no matter much Orr invokes Tane Mahuta.

My frustration is that thinking doesn’t seem to have advanced much at all in the ten years. I dug through some old files this morning, and among them I found a paper I’d written at Treasury in 2009 (benefiting from discussion with Reserve Bank staff)  on options if we reached the limits of conventional monetary policy.  I also found a discussion note I’d written in 2011 trying to engender some debate around the legislative provisions that support the near-zero lower bound on nominal interest rates, and was reminded of the report of a Bank working group I lead in 2012 on options if we faced near-zero interest rates (sparked by the intensity of the euro crisis then).  But nothing from either the Reserve Bank or The Treasury that has found its way into the public represents any advance on that thinking and work done up to a decade ago.  It really is pretty inexcusable.  It is almost as if our officials and minister think everything worked just fine in other countries after 2009 –  it clearly didn’t –  or they just don’t care.

Specifically –  and this is a criticism of the ANZ note as well (not even mentioning the issue) – there has been nothing done, no debate held, no analysis published, on dealing with fact that at present people can convert limitless amounts into hard currency, and will do so at some point once interest rates on other instruments (wholesale ones in particular) are substantially negative.   Here was what I wrote on that point in my post last year on the Reserve Bank’s article.

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.

There is no excuse for not having these issue all sorted out well in advance, and having communicated clearly to the public (and ministers and markets) how they will be handled, secure in the knowledge that rigorous planning and risk identification has occurred.

In part, that is because of one other issue that ANZ piece doesn’t touch on (neither did the Reserve Bank article).  Once a new severe recession is upon us, people will fairly quickly begin to appreciate how few effective and credible options central banks and governments have, and react –  eg adjusting inflation expectations –  accordingly.  In 2009, the typical reaction was to expect a quick rebound, partly because that was how economies were perceived to have usually behaved, and partly because so many interventions were being thrown into the mix. Next time, people (markets) will go into a severe downturn with the memory of post-2009, an awareness of the unpropitious starting point, and an awareness of the distinct limitations of unconventional policy. All that is likely to exacerbate the downturn and further complicate effects at countercyclical stabilisation.  People will suffer as a result.

We need some leadership on these issues. If the Reserve Bank won’t or can’t provide it, the Minister of Finance –  who will bear responsibility before the voters –  needs to lead himself, and insist that his agencies do more and better, more openly, than they have done so far.

In the meantime, well done ANZ for a substantial piece of work. Once again, I’d encourage people to read it and think about the issues and constraints it raises.

Has monetary policy run its course?

In one of the world’s most prominent economics platforms, the economics columnist for the Financial Times, Martin Wolf uses this week’s column for a piece headed “Monetary policy has run its course”, with a subheading “It has made secular stagnation worse.  Fiscal alternatives look a safer bet.”.    That headline was guaranteed to get my attention, disagreeing as I do with all three limbs of the apparent argument.

Wolf draws on various other papers, but doesn’t really make his case in a compelling way.  Take secular stagnation first.  There are various definitions: Wolf uses one of “chronically weak demand relative to potential output”, while the FT’s own lexicon uses a materially diferent version

Secular stagnation is a condition of negligible or no economic growth in a market-based economy.

On the former definition, most of the OECD is estimated to be back somewhere near a zero output gap, and the unemployment rate now in several major economies (but not New Zealand) is lower than it was going into the last recession (and there is a striking fact that the worst performers are all in the euro common currency, a system Wolf tends to be keen on).  That has happened without big new surges in overall ratios of private debt to GDP.

On the latter definition, even in countries with high starting levels of productivity, productivity growth has slowed but not stopped.  Per capita GDP across the OECD is now about 10 per cent higher in real terms than it was in 2007.  Not stellar, but it means that 10 per cent of all the output growth managed in the last several hundred years (since the Industrial Revolution) has been in the last decade alone.

I think there are credible stories under which monetary policy wasn’t used sufficiently aggressively in, and following, the last recession –  partly because both markets and central banks misjudged things and expected a strong rebound, so were always looking towards the first (or subsequent) tightenings.  But is very difficult to construct a story, in which monetary policy has made any material (adverse) difference to population growth, productivity growth, actual innovation opportunities or the like.    And even if, for argument’s sake, there was some effect in the frontier economies, most OECD economies (including large ones like the UK, Japan, Italy, Spain, Canada, South Korea) are nowhere near the frontier.

Having said that, there is little doubt that neutral real interest rates have fallen away very substantially over the last 15 years or more.  They are now at levels that are pretty much without historical precedent.  This is the first chart in the article.

ft chart

That means there are issues.  There is an effective lower bound, at present, on short-term nominal interest rates.  No one knows precisely where that bound is, but there is a degree of consensus that taking your policy interest rate much below -0.75 per cent will lead to fairly large scale conversion of deposit balances into physical cash (not, primarily, transactions balances –  where the inconvenience would dominate – but large wholesale balances).  The limit now exists wholly and solely because (a) governments monopolise physical currency issue, and (b) pay zero interest on physical currency.  Zero might not be much, but for a multi-million dollar fund, it is a lot more than -3 per cent (for the same credit risk).

Quite a few countries (including the euro area) are at or very near that floor already.  Other countries, including New Zealand, Australia, and the United States are not.   But even in those countries, a severe recession in the next few years would be likely to exhaust conventional monetary policy capacity (our Reserve Bank could cut by perhaps 2.5 percentage points, but it has often needed to cut by more than 5 percentage points in previous downturns).

Wolf isn’t apparently keen on doing anything about that, observing that a need for materially negative nominal official interest rates

would, to put in mildly, create a wasps’ nest of technical, financial and political problems.

Not nearly as many problems as doing nothing, and allowing persistently high unemployment for multiple years might create.

There are two broad options for creating more monetary policy space.   The first is to raise the inflation target (and reading a central banking magazine yesterday I noticed that a Swedish Deputy Governor is calling for exactly that), and the second –  and more reliable –  is to remove, or markedly ease, that near-zero effective lower bound.   No government or central bank has done so (and there are not overly complex ways of doing so), and that passivity –  apparently endorsed by Wolf – is increasing the risk of problems when the next serious downturn gets underway.  If interest rates can’t, for now, be cut far, people will quickly recognise that, not expect it, and adjust their behaviour, and asset holdings, accordingly.

Is there reason for unease about some of these options?  Perhaps.  If we were to allow short-term interest rates to go materially negative, no one knows how far they might eventually go.  There are good theoretical reasons to think not too far (human innovation hasn’t died, there are naturally productive (positive returns) assets (land or fruit trees) but no one knows with certainty.  Would it matter if interest rates went, and stayed, materially negative?  I’m not convinced it would, allow it would certainly be a symptom of something odd.   But such philosophising shouldn’t get in the way of actively preparing to handle the next serious downturn.  Neither central banks nor governments seem to be doing what they could on that score (and although the issue is a bit less immediately pressing in New Zealand, it is true here too).

Which brings me to the third limb of Wolf’s argument: “Fiscal alternatives look a safer bet”.   “We need more policy instruments he argues”.  In many respects, the rest of the article is a teaser for a conclusion around more aggressive use of fiscal policy.   (“More aggressive? perhaps Antipodean readers wonder, but as a chart in the article illustrates OECD net government debt as a share of GDP has trended quite strongly upwards in the last fifty years as, generally, has government spending.).  He asserts boldly:

If the private sector does not wish to invest, the government should decide to do so.

And yet who is “the government”, except a collective representation of the voters, themselves “the private sector” in one form or another.  There is no sense of trying to understand why the private sector might not choose to invest more heavily and then, if those things are in the gift of governments (tax, regulation, policy uncertainty or whatever), fix them.

And nothing at all on the near-certain “political problems” and constraints around the large scale and persistent (for it is something structural he is championing, not just a short-term cyclical response) aggressive use of fiscal policy, whether for consumption or investment.  Monetary policy has its problems, but if central bankers and politicians got on and fixed some of the regulatory (lower bound) obstacles, it would be a much more reliable tool to deploy.   At worse, even left-wingers (such as Wolf, and the Democratic economists he cites –  Laurence Summers, Olivier Blanchard, and Jason Furman) should want to have monetary instruments to hand, rather than some all-or-nothing wager on fiscal policy, when there is no political consensus at all (anywhere) on using fiscal policy in the ambitious way they suggest.

Wolf is right that central banks can’t deal with structural secular stagnation –  although they can do the important job of leaning against serious cyclical downturns, as they did in 2008/09. But even on the most optimistic of readings, it seems unlikely that aggregate fiscal policy is going to be able to either, whether for technical or political reasons.  And so-called secular stagnation should simply not be regarded as an acceptable excuse for poor productivity growth and weak investment in countries that are far from the productivity frontier, New Zealand pre-eminent (for how far it has drifted behind) among them.

Planning for the next recession

In a post earlier this week, I made passing reference to a new opinion piece on Newsroom headed “Why we need a recession plan”.  The article is written by another former Reserve Banker, Kirdan Lees, who these days divides his time between the University of Canterbury and economic consulting.  His article is organised around a list of five reasons, although it combines his arguments about the form any such plan should take.

I strongly agree that we need some serious, credible and open planning for the next recession (whenever it comes, but it is now eight or nine years since the last one and neither the foreign nor domestic outlooks are looking particularly rosy).  Indeed, in respect of monetary policy, it is a case I’ve been making for about as long as this blog has been running.    The case might have seemed a bit abstract four years ago –  especially to anyone who paid much attention to the Reserve Bank’s pronouncements (that interest rates were rising, and inflation would soon be getting back to target).  It should be much more pressing now, as the growth phase has got old and yet (New Zealand) interest rates are at record lows and inflation still isn’t back to target.  But, unfortunately, there has been nothing serious from the Bank –  under Wheeler, (unlawful) Spencer, or Orr.  They claim to believe there just isn’t a problem; that monetary policy can do as much as ever.

This is, more or less, Kirdan’s first reason.

Reason 1: The outlook now points to recession risk with little room for interest rates to do much

But interest rates have never been so low, leaving little headroom for monetary policy to kick in. Mortgage and lending rates can’t fall by much if the big banks are to retain margins. 

As a reminder, the real obstacle is around wholesale deposit interest rates. By common consensus, official interest rates could be lowered to perhaps -0.75 per cent, but any lower and the strong incentives are for people (including particularly wholesale investors) to convert their assets into physical cash and use safe-deposit boxes and strongrooms.  Conventional monetary policy no longer works then.     That means our Reserve Bank could cut the OCR by up to around 250 basis points –  more than many advanced country central banks could –  but in typical recessions they’ve needed to cut interest rates by 500 basis points (575 basis points last time, and the recovery then was very muted).

There are ways around this lower bound constraint, but the Reserve Bank and the government have shown no signs of any action (or even any serious analysis).  In principle, things could be done in a rush in the middle of the next recession, but that is almost always a bad way to make good policy, and by failing to clearly signal in advance that the authorities have credible responses in hand they are likely to worsen the problem (see below).

Kirdan doesn’t seem to see much scope for doing anything to increase the flexibility of monetary policy.  His focus is on fiscal alternatives.

Reason 2: By the time Treasury calls a recession it’s too late to trigger a fiscal stimulus plan

Not just Treasury of course.  Economic forecasters and analysts are hopeless at recognising recessions until they are well upon us (among the reasons why no one at all should take any comfort from the latest IMF update –  international agencies are among the worst in recognising things before they break).

It would always be better to have good forecasts, even so-called nowcasting (where is the economy right now –  given that our most recent national accounts data relates to the July to September period last year, and even that is subject to revision).      Kirdan is an optimist and believes we can do (materially) better than just waiting for the GDP data.

Today, a myriad of timely data exists: across transport movements, customs data, privately held data on small businesses (such as Xero) and consumption (such as Paymark). A small panel of experts could use that data to gauge recession risk and tell us when to pull the trigger.

In principle, of course, all these data are available to Statistics New Zealand (which could require them to be provided under the Statistics Act), and if the data could be available to “a small panel of experts” it could presumably be available to the Treasury and the Reserve Bank.

But even if these data can provide a few weeks advance notice of negative GDP quarters, there are bigger questions which more-timely data can’t answer.   The first is how long any downturn will last.  That matters quite a lot.   A couple of weak quarters might sensibly lead the Reserve Bank to consider a cut to the OCR, and probably the exchange rate would be weakening anyway.   But that is very different from a couple of weak quarters foreshadowing a deep and prolonged recession.   Telling the difference isn’t easy.  And who seriously supposes that –  in a democracy –  we are going to hand over to a panel of experts (self-appointed or otherwise) decisions about when to trigger big fiscal stimulus programmes which –  whatever their composition –  have huge distributional consequences.  These are inherently political choices, which will benefit from technical input, but the accountability needs to rest with those we elect (and can eject).

On which note

Reason 3: Economic theory can help: a fiscal plan needs to follow three principles
When it comes to fiscal stimulus principles, macroeconomists have their own triple-T: stimulus needs to be timely, targeted and temporary.

Which looks fine on paper, but is much less help in practice.  If you want “timely”. monetary policy can typically be adjusted faster than fiscal policy –  exchange rates, for example, adjust almost instantly to monetary policy surprises, and often in anticipation of monetary policy actions.   And monetary policy moves are designed to be temporary, but without tying anyone’s hands: you raise the OCR again when you are pretty sure inflation is going to back to target.

In the UK they tried what looked like a clever fiscal wheeze in the last recession: cutting the rate of VAT for a year, and only a year.  It looked like a fairly sensible move at the time it was announced –  encouraging people to bring forward consumption.  And it probably would have been if the downturn had been short and sharp, but it wasn’t.  More generally, people like the IMF championed fiscal stimulus in 2008/09, but again implicitly on the view that economies could rebound quickly.  When they didn’t, the mix of economic and political arguments about “austerity” took hold and only complicated the handling of the economy.

Of course, if you get can get your legislation through Parliament you can write cheques (electronic equivalent) quite quickly –  Kirdan is keen on focusing temporary additional spending on “poorer families” –  but you can’t do the same for the sort of infrastructure spending that those keen on fiscal stimulus often champion.

Kirdan’s reason 4 had me puzzled.

Reason 4: Trotting out the same tired approach will provide the same tired results 

One of the enduring traits of fiscal policy is tacking on extra spending in good times and taking away spending just when it is needed.

Hard to disagree too much with that second sentence –  pro-cyclical fiscal policy is a problem.

But even if you think there is a role for some active counter-cyclical fiscal policy, I wasn’t clear on the connection to what came next

Governments seeking a labour boost need a better targeted fiscal stimulus. That means targeting labour-intensive industries such as such as health and education, construction, horticulture, accommodation and retail industries. ….

But identifying labour-intensive industries is not enough. Maximum effectiveness comes from targeting the labour-intensity of the entire supply chain: labour-intensive industries that in turn use labour intensive inputs from other industries are the best bets for fiscal stimulus.

It seems to be an argument for, in effect, targeting reductions in average labour productivity –  by focusing on boosting industries that are (directly or indirectly) more labour-intensive.  Perhaps –  just possibly –  there is a case for something of the sort, as a pure short-term palliative, in a very deep economic depression, but in an economy where lack of productivity growth has been a decades-long problem (and particularly evident in the most recent growth phase) targeting low productivity industries doesn’t seem a particularly sensible medium-term approach.

Which brings us to the last point in Kirdan’s article

Reason 5: Articulating a trigger for the fiscal plan shapes the expectations of Kiwi businesses

I don’t think ministers can articulate a highly-specific trigger for action –  so much will depend on context (what is going on here and abroad) –  and attempting to do so is only likely to create a rod for the government’s back.  But where I do agree is that there needs to be a clear and credible commitment from both the government and the Reserve Bank that prompt and firm action will be taken if the economy turns down substantially, and particularly if that is in the context of a serious global event.

Kirdan’s focus is fiscal, and I have no problem with his points that (for example) debt to GDP should be expected to rise in a severe downturn, without threatening the medium-term commitment to moderate debt levels.  In fact, we would probably agree that there should be some public debate now about how the next downturn should be handled, as there is a risk that we get a serious downturn and the government is still fixated on its medium-term debt target (and avoiding leaving a target for National to attack them), even if that isn’t what is needed in the short-term.

But in my view, the argument generalises.  One of the problems we face going into the next severe downturn –  whenever it occurs –  is that (a) every serious observers knows that monetary policy has limited capacity, even in New Zealand and much more so in many other places (in the euro-area for example, the policy rate is still negative), and (b) that there are real political/social constraints on the flexibility of fiscal policy in many places (partly because debt levels are often high, partly because of distributional considerations, partly memories of post-stimulus austerity).  I’m not necessarily defending these constraints, just attempting to identify and describe them.

Faced with these limitations, the quite-rational response to a downturn will be to assume that there isn’t that much authorities will be able to do about it.  That, in turn, will deepen any downturn, and be likely (for example) to lower inflation expectations, making the recovery job even harder (it is going to be even harder to generate inflation in the next recession than it was in the last one).   Perhaps the general public don’t yet recognise these constraints, but many more-expert observers already do, and the news will rapidly spreads if and when a serious downturn gets underway.  What, people in Europe would reasonably ask, can the ECB do?  How much, Americans will reasonably ask, will the Fed be able to do?  And what appetite will there be for much large scale on the fiscal front.   These things matter to us, even if our government has more fiscal leeway than most, precisely because recoveries from serious recessions often result from the combined efforts of many authorities at home and abroad.  Many engines are likely to be missing in (in)action next time round.

I’m critical of our own government and Reserve Bank on these issues.  It isn’t clear that other countries’ authorities are doing anything much more –  there seems too much of simply hoping the situation will never arise and interest rates will get back to “normal” first.   But we can’t do anything about other countries, and we can get ready –  and have the open conversations – ourselves, taking account of the probable constraints other countries will face.     There may well be a place for some fiscal action in the next serious domestic recession, but monetary policy is better-designed for stabilisation purposes and we could be taking action now that would give people and markets much greater confidence that the lower bound won’t bind.      To the extent there is a role for fiscal policy, it is more likely to be used well if there is open debate and contingency planning now –  although my expectation is that, however much advance discussion there is, political constraints (community tolerance) will bite quite quickly.  We shouldn’t need discretionary fiscal policy in a short sharp recession, and it is unlikely to be there long enough in a deep and prolonged recession.

Finally, to anticipate comments about quantitative easing programmes.  Reasonable people can interpret the evidence about those programmes differently (I tend towards the sceptical, once we got out of the midst of the immediate crisis) but I’m not aware of anyone who regards even large scale QE programmes as more than pallid supplements to what conventional monetary policy could usually be able to do.

A serious Reserve Bank would be engaging –  indeed leading, given its role in stabilisation policy –  this sort of discussion and debate.  At our Reserve Bank the Governor has now been in office for 10 months and we’ve had not a single speech on monetary policy issues.  Quite extraordinary really.

(UPDATE: In my post last Friday about stress tests and the Reserve Bank’s plans to increase bank capital requirements, I referred to a letter the Governor had sent to a journalist who had written a critical article.  I noted then that I had lodged an OIA request for the letter, and that the Bank is legally required to respond as soon as reasonably possible.  Given that the letter was already in the public domain (the recipient being a private citizen) there were no obvious grounds for any deletions, except perhaps the name of the recipient.  The letter had been written only a couple of weeks ago, so there were no search problems, and no good “holiday period” grounds for delay.  That request was lodged nine days ago and I’ve still not had a response (and we also still haven’t seen the background papers the Governor promised in the letter that he was just about to release).     As it happens, the recipient of the letter –  Business Desk’s Jenny Ruth –  has now sent me a copy, which I appreciate, but that doesn’t justify this small scale Reserve Bank obstructionism around a major public initiative –  capital requirements –  in which the Governor will act as a one-man prosecutor, judge and jury in his own case –  at potentially large cost to the rest of us.)