Meeting the inflation target in one OECD country

Michael Reddell inflation, Monetary policy

There is a small OECD country whose export commodity prices surged prior to the 2008/09 recession, and again in the years after that recession.  It has grappled with high and rapidly rising house prices –  some of highest ratios in the world – and high and rising levels of household debt.  It wasn’t New Zealand I had in mind, but Norway.

There has been a lot of talk from those opposing further OCR cuts of how countries everywhere are struggling to get inflation up, as if meeting New Zealand’s inflation target was either (a) a lost cause, or (b) not something we should be bothered about anyway.

So I found Norway’s experience interesting.

The Norwegian government has set an inflation target for the central bank:

The operational target of monetary policy shall be annual consumer price inflation of close to 2.5 per cent over time

They have all the usual ‘outs’

In general, direct effects on consumer prices resulting from changes in interest rates, taxes, excise duties and extraordinary temporary disturbances shall not be taken into account.

So far, so conventional.  The precise words are a bit different, but the gist is no different from New Zealand’s Policy Targets Agreement –  ours focused on 2 per cent inflation, and theirs on 2.5 per cent.

And, much as the Reserve Bank used to, the Norges Bank recognizes that there is no one foolproof indicator of underlying inflation

There is no one indicator that provides a precise picture of underlying inflationary pressures in all situations. Different measures of underlying inflation are discussed in Monetary Policy Report.

In fact, they include on their website a nice summary table of four different measures

And here is how they’ve been doing.

Inflation indicators

CPI CPI-ATE CPIXE Trimmed mean 1) Weighted median 1)
Jan.16 3.0 3.0 2.6 ND ND
Dec.15 2.3 3.0 2.6 2.3 2.2
Nov.15 2.8 3.1 2.8 2.5 2.4
Oct.15 2.5 3.0 2.8 2.4 2.3
Sep.15 2.1 3.1 2.9 2.4 2.3
Aug.15 2.0 2.9 2.7 2.3 2.4
Jul.15 1.8 2.6 2.5 2.1 2.4
Jun.15 2.6 3.2 3.1 2.3 2.4
May.15 2.1 2.4 2.4 2.1 2.3
Apr.15 2.0 2.1 2.1 2.1 2.5
Mar.15 2.0 2.3 2.3 1.9 2.4
Feb.15 1.9 2.4 2.3 2.0 2.3
Jan.15 2.0 2.4 2.4 2.0 2.1

1) Owing to Statistics Norway’s changes to the statistical structure at a detailed level, estimates for January 2016 are temporarily unavailable.

ATE excludes tax changes and energy products

XE excludes tax changes and (estimated?) temporary changes in energy prices.

The target is 2.5 per cent inflation, and the average of the last observations of the four underlying measures is 2.5 per cent.

Inflation in Norway had been below target, but they cut official interest rates further  –  currently, the Key Policy Rate is 0.75 per cent, down from 1.5 per cent a couple of years ago.  The central bank reports that inflation expectations have been fairly stable, so that the whole of the cut in the nominal policy rate has also been a fall in the real policy rate.

As you might expect, economic conditions in Norway haven’t been great in the last year or so, since oil prices plummeted –  even though most of the direct effects of fluctuating oil revenues are sterilised in the Petroleum Fund.  The unemployment rate –  while still one of the lowest in the OECD at around 4.6 per cent –  has increased by around a full percentage point, and is as high as it has been at any time in the last fifteen years.

But, nonetheless, the inflation rate has increased and core measures suggest it is around the target midpoint.    That hasn’t been the New Zealand picture. What is the difference?

A key proximate part of the story is the behaviour of the respective exchange rates.  Here are the BIS broad exchange rate indices for the two countries.  Norway’s exchange rate is the lowest it has been for decades, while ours –  off the 2014 peaks for sure  –  hangs around the average level of the last decade or so.

bis exch rate norway and nz

People could fairly respond that oil and gas are far more important to Norway than, say, dairy is to New Zealand, and oil prices have fallen even more steeply than dairy prices.  All of which is true.  Then again, all fluctuations in dairy prices flow straight through to private domestic incomes –  unlike Norwegian oil revenues.

My point isn’t to draw exact parallels, but just to highlight a case of an advanced economy, with a severe adverse terms of trade shock, which has managed to keep inflation near the target –  they’ve been willing to do what was needed, and in parallel the exchange rate response has been large.

The direct effects of higher import prices have helped to boost Norway’s inflation rate.  That shows up in that the exclusion measures (ATE and XE) have been a little above target, while the central tendency measures (trimmed mean and median) are still a touch below.

Here is a chart from the Norges Bank’s (excellent) recent Monetary Policy Report.

norway inflation

The inflation rate for imported consumer goods has increased quite substantially, while that for domestically produced goods and services is  estimated to be holding comfortably around the 2.5 per cent target rate.  Outcomes like these are mutually reinforcing with the inflation expectations measures  – expectations consistent with the target make it easier to keep meeting the target, and outcomes around target help validate the prior expectations.

There might still be questions about what happens when the exchange rate stabilises and imported inflation drops, especially if the unemployment rate is then still high (by Norwegian standards).  Alert to the risks, the Norges Bank has flagged the possibility of further cuts in the Key Policy Rate.  But again, my point is not that the Norwegians have solved their problems for all time, but that they are now meeting their inflation target once again. Our central bank isn’t.

As a reminder, in Norway (relative to the position a couple of years ago) real interest rates have fallen. In New Zealand they have risen.  Ponder a counterfactual in which our real interest rates were 100 or 150 basis point lower than they are now –  and that is about the magnitude of the change in the gap between the two countries’ real interest rates over the last couple of years.  I think it is hard to dispute that we would have (a) a materially lower exchange rate, and hence higher tradables inflation, and (b) somewhat more domestic and net external demand and hence more upward pressure on non-tradables inflation.  There would be few doubts in anyone’s mind of the Governor’s commitment to delivering on the 2 per cent target he signed up to a few years ago.  Oh, and we’d have the good fortune to have an unemployment rate that would probably have a 4 in front of it, and probably be near the NAIRU.

Perhaps New Zealand doesn’t yet need real interest rates quite that much lower –  I’ve been arguing for some time for an OCR of around 1.5 to 1.75 per cent. The point really is just to illustrate what has been done in Norway – a small commodity-dependent country, with serious house price issues –  and what could have been, and perhaps could still be, achieved here.

Thoughts prompted by the expectations survey

Michael Reddell inflation, Monetary policy

The Reserve Bank’s quarterly survey of expectations results were released the other day.  As a reminder, it is a survey  of business people, sector leaders, and quite a few economists.  The vision has always been that the survey should capture some mix of informed people and people who might influence actual behavior – whether through their own business transactions, or through their commentary or advice to others.    There is a sample pool of about 100 potential respondents, and they typically seem to get about 65 or 70 replies each quarter.  Some criticize the survey for its small sample, but for what it is trying to do, in a small country, it has never seemed too bad to me.  It is, after all, asking for numerical answers to quite a bunch of macroeconomic questions.  I know that when I fill it in, I sometimes have to go back to the data to check what the latest reported numbers were –  not carrying QES wage inflation data in my head.

For inflation expectations specifically there are other surveys with larger samples.  ANZ provide their long-running Business Outlook survey, and their newer survey of household expectations, and the Reserve Bank will release its  latest survey of household expectations next week.  At the other extreme is the (inaccessible to the general public) AON survey, designed primarily to provide inputs for actuaries evaluating pension funds.  They ask about, inter alia, longer-term inflation expectations, but they ask only a handful (perhaps 7) economists.

I’ve never been quite sure what to make of inflation expectations measures.  Inflation expectations play  a significant, and quite plausible, role in conventional macroeconomic models.  The difficulties come with mapping the data we have available with the concepts in the models.  For a start, what horizon matters?  In principle, 10 or 20 year ahead expectations sounds interesting, abstracting from all the short-term noise, whether around taxes and government charges, petrol prices, or even swings in the exchange rate.  Then again, how many people sign up to 10 year nominal contracts?   No one sets wages or selling prices that far ahead.  And while plenty of bonds are issued with long maturities, when corporates issue them they typically seem to swap back to floating rates.  So 10 year ahead expectations probably provide some useful information about how confident people are that, say, the framework will hold or be delivered on, over 10 years, but I doubt they make very much difference at all to this year’s inflation rate, or the challenges a central bank faces in meeting its inflation target over the next couple of years.  I don’t know much about the politics of the next 20 years, but if forced to write down a number for average inflation over the next 20 years I might still write down 2 per cent.  But with huge error bounds….and grateful that nothing rests on it and that my pension is inflation indexed.

Shorter-term expectations matter more. But not too short.  Quarter or year-ahead expectations are influenced by specific stuff people know about –  relative price changes and administered taxes and charges.  In trying to make sense of inflation expectations, analysts are typically trying to look through those effects, to get a sense of the “norms” people have in mind when they set selling prices, negotiate wages, and make decisions to borrow or save.  If firms have in mind a benchmark inflation rate of, say, 1 per cent, then when they come to review their pricing schedules –  perhaps every six or twelve months –  pricing adjustments are likely to be different (lower) than if firms had in mind a benchmark or normal inflation rate of 2.5 per cent.  Same goes for wage negotiations.  And for how potential borrowers react to any particular nominal interest rate.   When those norms are above the inflation target, it can be hard to get actual inflation down to target –  more interest rate pressure is needed, than otherwise, to deliver the desired inflation rate.  And vice versa.  Two year ahead expectations have often been seen as a reasonable horizon to focus on for these purposes –  far enough that it gets beyond most (but not all) of the immediate noise, but close enough that it is more or less within the planning horizons of many.  In the latest RB survey, for example, the actual question asked in early February 2016 was about the annual inflation rate for the year to December 2017.  Halfway through that year respondents are asked to focus on is only 16 months away.   (Similarly, it was pleasing that when the ANZ launched a household expectations survey they asked about two year ahead expectations).

If, in principle, measures of two year ahead inflation might usually give one a steer on the “pricing norms” that firms and households are operating on (at least implicitly), there is still the matter of whether the answers to survey questions actually give us the information we really need.  As I’ve noted before, for example, the ANZBO survey and the Reserve Bank household survey measures have consistently, over decades, been materially above actual average inflation.    In the 20 years the RB household survey has been running, mean expectations have been just over 1 per cent higher than the average inflation outcome.  Does it mean households really didn’t believe the Reserve Bank would do it job?  Does it mean those are the inflation rates people implicitly contract on?  We simply don’t know (at least without a lot more formal research).  There is no incentive for people to invest any time or effort in responding to one question in a substantial telephone survey –  whereas they might well be when they ponder taking out a mortgage, or negotiating a pay increase.

All of which is a roundabout way of getting to the point that historically the Reserve Bank has put most weight on the two year ahead inflation expectations measure from the Survey of Expectations.  And it has done so because (a) there is now a good long time series (back to 1987), (b) it fits the prior that, typically, it will be horizons just beyond the immediate noise that matter, given that most contracts reprice at least every year or two, and (c)  because historically  it had a mean which seemed to align quite well over time with actual inflation.  One way to see this is to compare the two year ahead expectation with the Bank’s preferred sectoral factor model indicator of core inflation (remember what I said yesterday –  whatever the potential problems, for historical periods it is probably as reasonable as any measure, effectively smoothing through the noise in headline inflation).

infl expecs and core inflation

So what actually happened in the most recent survey?  Two year ahead expectations fell by 0.22 percentage points to 1.63 per cent [1].  Relative to the midpoint of the inflation target, that is the lowest in the history of the survey.  That isn’t all a bad thing –  despite the rhetoric suggesting we were crazed mechanistic inflation zealots, actually under both Don Brash and Alan Bollard inflation had averaged higher than the successive target midpoints, and expectations (in this survey) seemed more or less consistent with that.  But we don’t have a price level target, and if expectations start undershooting the target that is pretty undesirable as well.

infl expecs and target

The size of the fall in inflation expectations wasn’t unprecedented, but it was pretty large for this (not overly noisy) series.  In the period since low inflation became the norm (say since 1992) the only materially larger quarterly falls were (a) in the depths of the 2008/09 recession, and (b) in March 2012, when (post GST) the headline inflation rate had just fallen, in a single quarter, from 4.6 per cent to 1.8 per cent.

So this fall will have got the attention of the Reserve Bank, its analysts and forecasters.  It can’t really have been expected  – only 2 weeks ago the Governor told us explicitly that “survey measures of inflation…are now consistent with inflation settling at 2 per cent in the medium term”.  That was arguable, at best, previously.  It doesn’t really wash at 1.63 per cent –  and the prospect of further falls from here.

In the internal debate in the Bank, some will try to dismiss the latest fall as “just about petrol prices”.  Inflation expectations measures do respond, to some extent, to headline inflation, some seem “excessively” responsive to petrol prices, and even this two year measure (of informed respondents) is a bit sensitive to headline movements.  But, as I have pointed out on several occasions, the latest annual CPI inflation rate excluding petrol was only 0.5 per cent.  The more internationally conventional ex food and energy measure of inflation was only 0.9 per cent.  So if headline inflation is influencing two year ahead expectations (a) that seems quite reasonable –  it looks as though there is some information in trends in the headline rate, and (b) nobody much seems to expect headline inflation (including or excluding petrol) to pick up soon.  It looks as though respondents are just gradually giving up on the Reserve Bank’s story that inflation is heading back to 2 per cent any time soon.    It should be doubly sobering for the Bank that this comes in a survey in which responses to the other questions are not uniformly bleak: large falls in inflation expectations have usually gone hand in hand with more pessimistic GDP growth expectations, but in this survey those expectations have actually risen a little.

If people more generally –  not just these respondents –  are giving up on the Reserve Bank story, that will make it materially harder to get inflation back to target.

In one sense, it often seems wrong and excessively “mechanistic” to put too much weight on a single survey, and of 65 people –  it often did to me, when I sat around contemplating the survey results and wondering what OCR advice to offer successive Governors.  And in isolation that would be fine.  But it isn’t the only information we have –  rather, if anything, it is somewhat belated confirmation that the persistent undershoots of the inflation target have changed how people are thinking about prospects for inflation in New Zealand.   I suspect the Reserve Bank, perhaps rather grudgingly, will come to the same conclusion.

Recall what Mario Draghi, head of the ECB, said in the speech I discussed the other day

… in a context of prolonged low inflation, monetary policy cannot be relaxed about a succession of supply shocks. Adopting a wait-and-see attitude and extending the policy horizon brings with it risks: namely a lasting de-anchoring of expectations leading to persistently weaker inflation. And if that were to happen, we would need a much more accommodative monetary policy to reverse it. Seen from that perspective, the risks of acting too late outweigh the risks of acting too early.

And it is not as if New Zealand monetary policy has somehow already got ahead of the problem.  If the two year ahead measure is a reasonable proxy for the inflation norms now abroad in New Zealand –  and it may yet prove too high – real interest rates have actually risen over the last couple of years.

The Reserve Bank lists three lending rates on its main retail rates page: a business lending rate, an SME rate, and new customer floating mortgage rate.  In nominal terms, all are almost exactly now where they were at the start of 2014 (just before the OCR tightening cycle began). Inflation expectations, by contrast, are 70 points lower than they were then.  With an unemployment rate above any measure of NAIRU, and inflation persistently below target, rising real interest rates  have not obviously been something this economy needed. Retail deposit rates are lower than they were two years ago – by even they are no lower in real terms.  And as funding spreads are rising –  as they appear to have been recently, reflecting market unease about banks internationally  –  all else equal, the pressure on retail rates over the period ahead will be upwards not downwards.

And all this is before we focus on the continuing high exchange rate, the continuing weak commodity prices, and the growing stress persistently weak dairy returns are going to be placing on demand and activity (even if they aren’t necessarily a threat to the soundness of our banks).  Let alone the worsening global situation.

And, of course, there are market measures of implicit inflation expectations (from the difference between indexed and conventional bond yields).  These are weakening everywhere, but a chart someone sent me yesterday highlighted that the fall has been particularly sharp in New Zealand.  As of yesterday, a 10 year conventional bond had a yield of 3.06 per cent, and a 2025 inflation indexed bond was yielding 2.12 per cent.  That gap is now less than 1 per cent (and look how far it has fallen this year so far).

infl expecs indexed bonds

These aren’t perfect proxies, and bond investors’ expectations don’t directly affect (CPI goods and services) pricing now, but I don’t think central banks –  ours in particular –  can afford to be indifferent to message from bond markets: people with money on the line are no longer acting as if they think inflation is going to be near target on average over the next decade.  They might be wrong, but why would central banks be so confident that those investors are wrong –  especially when central banks, ours foremost among them, have themselves been persistently surprised by how weak inflation has been.  In part, in turn, that  has been because central banks –  ours among them –  have been persistently focused not on doing “whatever it takes” to create confidence that inflation targets will be delivered, but on doing as little as they can away with, perennially focused on “normalization” and some long-term benchmarks of where, surely, interest rates have to get back to one day.

There is a story abroad  – I saw it in a commentary from one of the local banks yesterday –  that low inflation is good and inevitable.  It certainly isn’t inevitable here –  looser monetary policy would, for example, lower our exchange rate generating additional resource pressure over time.  And it isn’t good either.  The story seems to go that structural features are driving price levels down.  But remember that productivity growth rates globally have been falling, not rising.  And stories about global overcapacity tell you mostly about demand having failed to keep up with supply capacity:  discretionary monetary policy exists to influence demand.  The indifference to what is going on is hauntingly reminiscent of some of the discussion and debate during the Great Depression –  when there was excess supply capacity (reflecting, eg, past heavy investment in agriculture), even amid rapid ongoing productivity gains –  and a sense in too many circles, for too long, that nothing very much should be done about monetary policy and the monetary system.

[1]  For what it is worth, when I completed the survey I did not lower my two year ahead expectation from the one I recorded in the November survey. On both occasions, I wrote down 1.4 per cent.

 

 

How many OIA requests do government departments receive?

Michael Reddell OIA

The blogger No Right Turn, prompted by the Reserve Bank’s OIA charging policy, lodged requests with all government departments, and the Reserve Bank, about how many requests they had had in the last year, and how many they’d charged for.  His results are reported here –  unsurprisingly, charging is very unusual.

This chart takes his data on the total number of OIA requests each department received in the previous year (mostly the answers are for the financial year 2014/15). There don’t appear to have been responses yet from Environment and Corrections.

OIA requests

Every agency has different responsibilities, some are much larger than others (and one has to be a little wary of how things are classified, eg there is a note on the IRD response saying that their numbers include only requests handled at National Office (ones from media, MPs, and those of a sensitive nature)), but the Reserve Bank does not stand out among government departments as overburdened by requests.  The Ministry for Women, for example, or the Ministry for Pacific Peoples –  both with fewer requests – are tiny departments with little or no independent power or responsibilities.  The Treasury, it turns out, had five times as many requests as the Reserve Bank in this particular year.

By contrast to MfW or MfPP, the Reserve Bank independently sets monetary policy (with a huge short-term impact on the economy and the sectoral distribution of incomes), it regulates banks, non-bank deposit takers, and insurance companies (and now directly impinges on housing mortgage borrowers), it is a major payments system operator, it takes large financial risks in international markets, and it issues our notes and coins.  In some ways, against the backdrop of this data, it is a little surprising that such a powerful independent agency has not received more requests over the years.

 

 

 

Core inflation and the Reserve Bank

Michael Reddell inflation

Since the Governor’s speech a couple of weeks ago (building on the January OCR review announcement), I’ve been reflecting again on how best to think about what is going on with inflation in New Zealand.

The Governor cited a single measure of core inflation, the sectoral factor model measure of core inflation, to assert his comfort with the current headline inflation rate.  As I noted at the time, it is very rare for any specific measure of core inflation to be cited in official Bank announcements.  The typical story has been along these lines

There is no agreed upon ‘best’ approach to measuring core inflation, and each approach has various advantages and limitations. Some work best in some circumstances; some in others.

That line is taken from the abstract to a nice Reserve Bank Bulletin article reviewing core inflation issues and measure, published a little earlier in the current Governor’s term).

The same year they published a nice Analytical Note on the sectoral core measure itself. The non-technical summary at the start of that paper notes

There are many ways to measure core inflation. Statistics New Zealand publishes a range of measures that involve removing volatile price movements before inflation is calculated, or excluding certain groups of items from the calculation. As well, the Reserve Bank of New Zealand has a set of models that produce core inflation estimates. Every model is different, and the Reserve Bank uses the full suite of measures when forming an assessment of what is going on with inflation.

(For the record, I edited both these publications, but both were widely circulated in draft, and were approved by the Assistant Governor  –  Chief Economist – and the Bank’s Communications Committee, on which all four governors sit and actively participate. I don’t recall such lines ever being contentious.)

The Analytical Note went as far as to publish this chart, illustrating the variety of measures the Bank looked at.

core inflation measures

Incidentally, note the nice longer-term time series for the weighted median and trimmed mean series.  The Bank no longer publishes these (linked) series on its website, just reporting the very short official series published by Statistics New Zealand.  This is something that should be remedied –  as, for example, the Reserve Bank of Australia does.

But now, apparently, the Governor favours the sectoral factor model to the exclusion of all other core inflation indicators.  It is certainly convenient that it is, at present, the highest of any of the range of core inflation measures, and that the inflation rate, on this measure, has increased over the last year.

Here is a table I ran a couple of weeks ago:

Annual inflation, year to Dec 2015
Trimmed mean 0.4
Weighted median 1.5
Factor model 1.3
Sectoral factor model 1.6
CPI ex petrol 0.5
CPI ex food and vehicle fuel 0.9
CPI ex food, household energy and vehicle fuel 0.9
CPI ex cigarettes and tobacco -0.3
Non-tradables ex govt charges and alcohol and tobacco 1.8

But neither the Governor, nor his officials, have given us any reasoning as to why they think that on this occasion this indicator is the single best representation of what is going on –  so much so that the other measures aren’t even worth mentioning.  I suppose one could lodge a request but (a) I doubt there would be anything to support the Governor’s preference, and (b) no doubt, we’d be told it was none of our business and that information had to remain secret to, for example, “prevent damaging the economy of New Zealand“.    For an institution that likes to hold itself out as being transparent about its economic reasoning and analysis –  and which has more (taxpayer-funded) macro analysts and researchers than any other agency –  it really isn’t good enough.

Relatedly, if the sectoral core model is really providing much the best steer, what has changed since the start of 2014?  Recall that sectoral core inflation then had been almost dead-flat at around 1.4 per cent for a couple of years –  and yet the Governor began an aggressive tightening cycle.  Perhaps it was a misleading measure then, but the best measure now?  It is possible, but surely we are owed an explanation?

sec core and headline

Why might we be a little sceptical that some “true” notion of core inflation is (a) rising, and (b) as high as 1.6 per cent  (itself still materially below the midpoint)?

First, the sectoral factor measure is the product of a model, and that model has error bands around it. Even the historical period numbers are midpoint estimates of a range which the Bank tells us is around 0.6 percentage points wide.

sec factor uncertaintyAnd, as with all of these sorts of models, the problems are particularly acute for the most recent observations. The model is, in effect, trying to discern the common trends in the various component price series, but it can do that increasingly reliably with the benefit of more time and more data. That makes tools like this most valuable for identifying the underlying inflation processes in periods of history (eg looking back now on the pre 2008 boom) and relatively less useful for “spot” reads on what is happening right now. In that sense, it is a little like filter-based estimates of the output gap, and it is similarly unwise to put too much weight on real-time estimates of any one model of the output gap.

Second, there is no sign of any pick-up in wage inflation, or in measure of inflation expectations.

Third, the measures that are easier to disentangle mostly aren’t suggesting core inflation is rising, or that it is as high as 1.6 per cent. Take, for example, the internationally quite commonly used approach: CPI inflation rate excluding food, household energy and vehicle fuels is only 0.9 per cent.   It isn’t always reliable – in 2007 it ran below most other measures of core inflation because of some large changes in government charges (childcare subsidies). But we know (SNZ tells us) this time round that taxes and government charges are not, overall, affecting the inflation rate. It is a good example of why one needs to look at all the measures, and use them to develop an overall story. Focusing on a single indicator is often likely to be quite dangerous – especially when it is something of a black-box, prone to endpoint problems.

And here is a concrete illustration of something that bothers me about the sectoral factor model results at present.

We know that the repeated increases in tobacco excise has been having a big impact of overall non-tradables inflation in recent years (and the overall CPI). More recently, cuts to ACC motor vehicle registration charges have worked the other way. Statistics New Zealand do not give us a series of overall CPI inflation excluding tobacco and government charges, but they do provide one for non-tradables inflation (at least from 2007). And the Reserve Bank helpfully publishes separately the non-tradables component of the sectoral factor model.  The chart shows overall non-tradables inflation as well. (The 2010 surge is the increase in GST, administratively excluded from the sectoral factor measures.)

sec core NT

Over the period since 2007, the combined effects of tobacco tax increases and central and local government charges have substantially boosted non-tradables inflation (the red line has been well above the blue line). So it is troubling that the non-tradables sectoral factor model component looks so like the overall non-tradables series over the period since 2009, even though it is substantially boosted by factors that no one would regard as core inflation – they are administered (by governments) prices.   I’m less bothered by the idea that sectoral core inflation in the non-tradables sector might have been flat – a lot of the inflation in recent years looks to have been in the construction sector (think Christchurch) and the model will tend to look past that as not representative of the whole economy.

But if the Bank is going to drive policy – its assessment of the current inflation situation relative to target – off a measure that has looked more like a series that includes lots of administered taxes and prices, than it does the series that excludes those effects, they need to give us a lot more explanation than they have done to date. It is possible that there is a good and convincing story, and that the sectoral factor model is really capturing something important that has been going on in non-tradables inflation that simply isn’t visible to the naked eye (or in other price series), but we need to see that story. and the other supporting evidence for it. What is it, for example, that is leading to the sectoral measure holding up, and even rising, just as the overall non-tradables inflation rate converges (downwards) on the series excluding those government-determined prices?

Personally, I think it would be safer for the Bank to work on provisional basis that core inflation is around 1 per cent at present. That is around where the exclusion measures would suggest, and well above the trimmed mean – the approach to core inflation approach that, for example, tends to get most coverage among analysts in Australia.

[UPDATE: And don’t lose sight of the fact that the average of the blue line –  excluding the GST spike –  has been below 2 per cent since 2009.  No one I know of would expect non-tradables inflation to be at or below 2 per cent if core or underlying inflation in total were anywhere near the 2 per cent target midpoint.]

This whole episode is pretty unsatisfactory, and a poor reflection on the Bank. Reasonable people might differ on the appropriate stance of monetary policy. But the attempt to justify the stance on a single (complex) core measure, without substantive elaboration or explanation, when that same core measure would appear to have warranted policy easings when the Bank began aggressively tightening two years ago, looks disconcertingly like a Governor fixing for a time on the highest convenient measure of inflation. That isn’t good policy or good governance. And I suspect it makes many of the Bank’s own economists quite uncomfortable.

As a reminder of the Deputy Governor’s 2013 report of the Bank’s aspirations

The Reserve Bank is deeply committed to transparency – of policy objectives, policy proposals, economic reasoning, and of our understanding of the economy, and of course of our policy actions and intent. Clear communication and strong public understanding make our policy actions more effective.

We are working to enhance the openness and effectiveness of our communications

It just isn’t happening.

And note that all these quotes are from 2013, early in the Governor’s term, before things started going really wrong. And before they responded to those mistakes  –  which any humans will at times make –  by turning inward, pretending that nothing is wrong, and avoiding serious scrutiny and debate.  Digging deeper holes doesn’t usually solve such problems.

It was wryly amusing to note the other day that the Governor of the People’s Bank of China – central bank of a brutal repressive state not know for any sort of transparency – had given an extensive interview (not necessarily revealing a great deal) to a publication not historically known as a party mouthpiece. Our Governor has, I’m told, not given a single substantive interview in his three and half years in the job.

 

 

 

Negative interest rates: some thoughts

Michael Reddell zero lower bound

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Reserve Bank’s OIA charging policy release

Michael Reddell OIA, Reserve Bank

Thanks to Eric Crampton for alerting me to the Reserve Bank’s OIA release (to Alex Harris) around its new charging policy.

The documents are interesting in that they provide us with some data.  The Reserve Bank has complained about a large increase in the number of OIAs they have been receiving, and used that as one justification for the new charging policy.

 18 requests in calendar 2010

21 requests in calendar 2011 – up 17% from previous year

30 requests in calendar 2012 – up 42% from previous year

45 requests in calendar 2013 – up 50% from previous year

47 requests in calendar 2014 – up 4% from previous year

70 requests in calendar 2015 – up 49% from previous year

As they acknowledge, the Reserve Bank has been rather more active in a number of policy areas in the last few years –  LVR restrictions are the most obvious example –  which might have been expected to generate more requests, and more (attempted) scrutiny of the Bank.

But what is a reasonable baseline?

In their paper, the Bank staff note that the Treasury informed the Bank that they had a team for four full-time staff to handle OIA requests (and had charged only one person –  an academic with a large research grant – some years ago).  We don’t know how many OIA requests Treasury deals with each year (for requests to The Treasury itself, and those it handles for the Minister of Finance), but on the Treasury website there  are more than 100 OIA releases in the last 12 months –  and that list is described as “selected responses” and also excludes pro-actively released material (such as the post-Budget large pro-active release).

The Treasury is a larger organization than the Reserve Bank (around 420 staff to the Bank’s 260 or so), and covers a wider range of functions.  On the other hand, the Reserve Bank has a large amount of delegated power in a variety of very significant areas (monetary policy and banking regulation), and with a very large balance sheet.  It isn’t obvious that 70 OIA requests a year is an unreasonable number for an organization of the power, size, and importance of the Reserve Bank.  Perhaps –  as various people have suggested –  it is just that the Reserve Bank was getting off surprisingly easily in the previous few years?

In the note to the Bank’s Senior Management Group I am listed as one of the culprits –   having, at that time, apparently lodged 16 OIA requests in 2015 (the final total would have been 2 or 3 higher).  Curiously, the Bank proposes in the documents a benchmark for charging in which charges would apply to people making more than a rolling average of two requests per month.  Not even I managed that last year –  and I haven’t lodged a request with the Bank this year to date.   As the No Right Turn blog puts it:

The bank’s cutoff for when it will refuse a request for “substantial collation and research” is a mere three hours, while their definition of a “high volume requester” is someone who makes two requests a month for two months. Combined, these basically rule out any use of the OIA for serious research or investigation of the bank’s policies, whether by academics, investigative journalists, or the public. And while MPs won’t be charged, their requests will still be refused if they take more than that three hour limit. The net result: less scrutiny, and a specific incentive against regular scrutiny. Which means less accountability to the public.

I had a quick look through my email inbox to refresh my memory of last year’s requests:

  • four related to issues around the Bank’s superannuation fund. I am an elected trustee of that Fund, and we have been grappling with some difficult and serious issues raised by a pensioner about events in the late 1980s and early 1990s.  The Governor’s alternate (Geoff Bascand) had been actively seeking to close the issues down, without further investigation (even though they have already led to the discovery, disclosure, and apology for the fact that past trustees –  chaired by Don Brash, and including the current head of the New Zealand Transparency International –  had broken the law).  The only way to get some of the information needed was to request it from the Bank under the Official Information Act.    In no case was any substantial research or collation faced by the Bank (in one case I was simply told to photocopy the pages I wanted).
  • When I left the Bank I sought approval to use old discussion notes and memoranda that I had written.  This was an entirely friendly approach, designed to minimize future requests by, in effect, seeking general approval to quote old papers (I even excluded from the request one paper I knew the Governor was sensitive about).  Approval could have been granted, at least for older papers, with no Bank resources at all.
  • I sought the release of background papers to one of the 2005 MPSs.  These were 10 year old documents, nicely collated and stored. The point of the request was to establish the principle that such papers should be public, at least with a lag.  The request should have involved no material costs to the Bank, and when the papers were finally released –  well beyond 20 working days –  there were no deletions at all.
  • In two cases, I sought background papers after major changes of view by senior bank management –  changes where no reasoning was provided at the time.  One related to capital gains taxes, and the current one relates to immigration.  Since they were current issues, (of material public interest) there should have been limited resources required to respond promptly.
  • I requested background papers relating to 2012 Policy Targets Agreement. As this is the key document governing monetary policy, and no background papers had been released at the time the PTA was signed, it seemed desirable to better understand what the Minister and Governor had had in mind (especially in light of the current monetary policy stance debates).
  • I requested papers relating to the extensive work programme the Reserve Bank had been doing on reforming  the governance of the Reserve Bank.  The Bank has refused to release anything of substance, a quite extraordinary stance for a work programme that has now (apparently) ended (and quite in contrast to the Treasury’s approach to a request on that work).
  • I sought papers provided to the Bank’s Board relating to the September MPS.  The Bank will have spent next to no resources on this request, since was refused completely (as I expected, but I wanted to establish the point).
  • I sought minutes of the Bank’s Governing Committee for a defined period last year.  The Governor has been keen to stress the role the Governing Committee plays in decisionmaking, and as is well known it is common for minutes of key policy committees in other central banks to be released.  Totally refusing this request will also have taken almost no resources, since there was no sign in the response that they had considered the individual meeting minutes.
  • I requested one specific paper I had written about fiscal and monetary events in 1991 –  the first big test of the inflation targeting framework.  This request was, of course, necessary only because the Bank had (see above) refused my general request to be able to cite my old papers.
  • I requested copies of the submissions on the new investor finance restrictions.  After great difficulty, and only after another media request, were some of these documents released (in total). It remains common practice elsewhere in government to publish submissions pro-actively.
  • I requested copies of submissions on the regulatory stocktake.  Comments as for the previous item: costs and resource pressure arise entirely from the Bank’s choice to be non-transparent.
  • And I made two requests relating to the (TPP) Joint Macroeconomic Declaration, to which the Reserve Bank is a party.  The second request followed when the first request was denied in full.  The second request is still pending.

Reviewing that list with the benefit of hindsight they seem like exactly the sorts of requests that a central bank and financial regulator might expect in the course of a year like last year.  Most would have been avoided if the Bank adopted the sort of pro-active transparency, as regards process, that is now best practice, or (in some cases) had simply explained itself.  Even when material was released, it was almost always done on the last lawful day, or after an extension or two.

(Of course I would say this), but none of the requests appear vexatious or deliberately time-wasting.  I have been encouraged to make other requests of the Bank –  to seek information on the process they have used on each of the requests they have stalled, obstructed or refused, but have chosen not to.  I’m less interested in the details of any particular request than in the general pattern of obstruction and (despite their claims) non-transparency.

The Official Information Act is about improving access to official information –  an idea that the Bank appears to be rather uncomfortable with.  As I’ve noted before, it may be that their charging policy is lawful, but if so there is something amiss with the law itself. Whether or not it is lawful, it is not good practice, and not consistent with the sort of image –  an open and transparent institution –  that the Bank regularly tells us it wants for itself.

TPP: some more economists

Michael Reddell TPP

In a post a couple of weeks ago,  I highlighted the comments several New Zealand economists had made about the TPP agreement.  Reasonably enough –  since to evaluate the full detail involves a great deal of in-depth work –  none seemed overly confident in their views, but none seemed to see the agreement as any sort of landmark beneficial economic advance for New Zealand.

Since then, a couple of other economists have put views on record. Jim Rose, a consultant who has worked for various New Zealand and Australian government agencies (including the Australian Productivity Commission), starts by observing that the “correct” economists’ reaction to regional trade agreements, in principle, would be one of “lukewarm opposition”, reminding us that this is also the stance of Paul Krugman who – whatever his politics – built a stellar academic career thinking about trade issues.

Regional trade agreements risk making all parties to the deal worse off, not better off –  by increasing trade between country pairs that are party to the agreement, rather than those best able to produce goods and services most efficiently.  The Australian Productivity Commission has been quite forthright in highlighting this risk as regard Australia’s various regional trade agreements (including CER, but most notably including the US-Australia FTA).    A new, quite recent study, by Shiro Armstrong, a senior academic at the Australian National University, reviewed the US-Australia FTA.    He concluded

Australia’s historic trade liberalization efforts produced clear welfare gains, and the winners and losers from these reforms were determined by market forces and competition. Trade agreements that introduce distortions and discriminatory treatment mean that winners and losers are largely determined by preferences and privileges assigned through negotiated treaties.

The US agreement carries important lessons for Australia in its future trade and foreign policy strategy.  The conclusions of the Productivity Commission’s review apply to AUSFTA. Deals that are struck in haste for primarily political reasons carry risk of substantial economic damage. The question then is whether the economic costs of such policies are worth whatever the political gain, and indeed, how the balance of properly calculated political gains and costs might look.

Rose’s stance is informed by this sort of literature and experience, which barely seems to have factored in the New Zealand debate around regional trade agreements (and does not appear in the government’s National Interest Assessment).

Rose also highlights a number of other potential problems in the TPP

Trade agreements should not include labour or / and environmental standards as they, for example, limit our right to deregulate our labour market. Be careful what you wish for when you oppose international agreements on sovereignty grounds.
The intellectual property chapters of the TPP are truly suspicious. With each new day, the case for patents and copyrights is weakening in the economic literature. Some have made powerful arguments to abolish patents and copyrights altogether.
There are modest extensions of the term limits of drug patents and much more mischief on copyright terms. These should be watched carefully in future trade talks and one day will be a deal breaker.
Good arguments can be made against investor state dispute settlement provisions even after the carve-outs. These provisions have no place in trade agreements between democracies.

Notwithstanding all this, Rose’s bottom line is

For this lukewarm opponent of regional trade agreements, the TPP is a so-so deal with small net gains. There is no harm in it signing it.

I’m not entirely sure why he feels safe in concluding that there are net gains, but he appears to put some reliance on the modelling work suggesting that reductions in tariffs and non-tariff barriers will have some beneficial economic impact for New Zealanders.

Another independent consultant, Ian Harrison, has today released a fairly critical evaluation  (trenchantly headed “Garbage In, Garbage Out”) of the modelling work, on tariffs and non-tariff barriers, that was done for MFAT and the government.  That modelling is the basis for the government’s claims about the scale of the economic benefits the agreement offers.

Ian has gone back and looked at some of the papers that underpinned the assessment of the possible gains from the reduction/elimination of non-tariff barriers and improvements in trade facilitation (eg reducing customs clearances delays).  In fairness, the authors of the MFAT modelling do discuss how shaky much of this work inevitably is –  since there are not good, or agreed, metrics for non-tariff barriers (in a way that there are for tariffs),  but the rather shaky foundations seems to have been obscured in the politicized debate around the size of any benefits.  And the original authors seem to have done, or reported, little in the way of either sensitivity or plausibility analysis around the metrics they were using.

The Harrison paper suggests that the inputs are sufficiently flawed –  suggesting, for example, that New Zealand and Australia start with some of the highest non-tariff barriers around  –  that no serious evaluation of any gains from TPP can be done using them.  It is a difficult paper to excerpt, but I would suggest reading it.

Harrison also argues that there something distinctly odd about the estimated trade facilitation benefits, estimated at $357 million per annum.  He highlights the hugely, and implausibly, high estimates that appear to be assumed for the value of clearing products just a few hours earlier.  For some goods, those estimates might be very large –  but for most of sorts of products New Zealand trades in they won’t be.  If Harrison is correct, the model assumes, for example,

that an  oil importer values oil received in 30 days time at a third less than oil received today because of the time value effect.

The non-tariff gains dominate the estimated benefits in the National Interest Assessment.  But Harrison also comments more briefly on the estimated benefits from reduced tariffs and increased (export) quotas

harrison

Perhaps Harrison is missing something, but on the face of it this report seems to reinforce the case for an independent assessment of the economic costs and benefits of the deal, as finally agreed, perhaps by someone like the Productivity Commission.  It is hard to do such an exercise well –  a point Rose makes –  and reasonable people will still likely differ, but for such an extensive agreement it should be an almost automatic step in the process if we are serious about considered evaluation of policy.

The issue now isn’t really whether the deal should be ratified by the New Zealand government, but whether –  having been agreed – it represents a good deal for New Zealanders.  Regional trade deals often haven’t been.  Perhaps this one is different.  But without the detailed analysis and scrutiny it will be difficult to know.

 

 

Australia’s tradables sector….and Eaqub on the RB

Michael Reddell Exports, Financial stabilty, Reserve Bank

In a post on Thursday I showed this chart, a rough and ready decomposition (pioneered by the IMF) of real GDP per capita into that produced by tradables sectors (bits exposed to competition from the rest of the world) and non-tradables sectors.  My proposition was that successful high-performing economies will usually be led by strong tradables sector growth.
tradables and non-tradables gdp

I was curious about how the comparable chart would look for Australia.

aus t and nt

Total growth in non-tradables per capita has been almost identical in the two countries over these 25 years (around a 60 per cent increase).

But look at the differences in recent years in (this proxy for) tradables sector output, per capita.

aus and nz T sector

In New Zealand, (this proxy for) tradables sector output per capita hasn’t increased over 15 years (notwithstanding the strong last few quarters).  In Australia –  which certainly isn’t a stellar economy –  the picture is much less negative.

At a sub-sectoral level, manufacturing output in Australia (per capita) has been even weaker than in New Zealand over the full quarter century.  The big difference, of course,  is simply the rapid growth in mining output.

Changing tack, just briefly…

Some readers perhaps find this blog a fairly unremitting critique of the Reserve Bank of New Zealand.  But today I’m sticking up for them.

Independent economist Shamubeel Eaqub has a column in today’s Dominion-Post, which in the hard copy version runs under the heading “Gorging a warm-up act for debt horror show”.   And “gorging” is Eaqub’s word, not just some sub-editors hype.   According to Eaqub, all New Zealand’s debt chickens are about to come home to roost –  notwithstanding, apparently, the fact that debt/GDP ratios are little changed over the last eght or nine years, and that no one has any good sense of what a sustainable, optimal, or equilibrium level of such ratios might be.

But according to Eaqub

The Reserve Bank is complicit, as they regulate banks. They say that the banking sector is not at risk. Their modelling shows sufficient capital buffers – which influence banks’ risk appetite to lend and vulnerability in a recession.

Their modelling has also shown higher inflation and interest rates for the last seven years – mistakenly.

It’s time the Reserve Bank better regulated banks to stop the repeating cycle of debt gorging and economic vulnerability.

This is really just a “guilt by association” slur.  Yes, the Reserve Bank has got its inflation and interest rate forecasts badly and repeatedly wrong, but what possible connection does that have to the question of whether banks hold adequate capital (whether risk weights, or required capital ratios)?    Or whether the stress test results are plausible?  Eaqub produces precisely no evidence to support his insinuations.  It is a short column to be sure, but surely he could at least offer readers a hint.

Lets recall that the stress tests involved a 40 per cent fall in house prices across the country, and something like a 50 per cent fall in Auckland.  And they involved an increase in the unemployment rate larger than any seen in any advanced economy with a floating exchange rate since World War Two.  And the banks still looked pretty resilient.

And as the IMF has previously noted, when they looked at a variety of other countries, risk weights on housing lending in New Zealand were materially higher than those in other countries.

I suspect there are tough times ahead for the New Zealand and world economy.  One can always argue for more capital, but to do so from the current situation  –  where New Zealand banks are better-capitalized than most –  one really needs more than simply the claim that “they got monetary policy wrong, so we shouldn’t give them credence on any other score”.

 

John Kay on banks, regulators and politicians

Michael Reddell Financial stabilty, Prudential regulation

The Treasury has had Professor John Kay in town this week.  Kay has had a long and distinguished (microeconomics-focused) career in the United Kingdom as an academic, adviser, FT columnist, author etc and last year published a new book Other People’s Money: Masters of the Universe or Servants of the People, the introductory chapter of which is here.  Key’s Treasury guest lecture was built around the ideas in this book.  To be clear, I have not read the book –  although despite the skeptical comments that follow I may now do so.

It wasn’t a lecture, and apparently isn’t a book, about the 2008/09 financial crisis per se.  That said, the book probably wouldn’t have been written without the crisis, and he clearly sees the crisis as a manifestation of what, in his view, has gone wrong with the financial sector. In a line from his website :

The financial crisis of 2007-8 has dominated subsequent discussion of economic policy. In my view the responses are characterised by two widespread misunderstandings. The first mistake is to believe the crisis is an inexplicable, once in a lifetime, event, rather than another demonstration of an increasingly dysfunctional financial system.

Kay began with a line many have used –  the changing nature of the people who go into banking.  In the 1960s, when he grew up in Edinburgh, banking was for the people not quite smart enough to get into university (as in New Zealand, only a small proportion of school leavers then went to university).  By contrast, these days finance attracts many of the smartest graduates from top universities.  The range of products is, of course, much more complex.  But not, Kay would argue, so correspondingly socially useful, despite the staggering remuneration on offer to a fairly small number of people in these institutions (if I recall rightly, he notes that most people in the big UK bank Barclays actually earn less than the UK median wage).  And, of course, the incidence of financial crises is much greater today than it was in the post-war decades.

For a time, politicians across much of the advanced world fell at the feet of bankers.  Kay showed an amusing clip of Gordon Brown, then Chancellor of the Exchequer, opening a new headquarters in Europe for Lehmans only 10 years or so ago.  And in the United States in particular, there is the ongoing unease over the revolving door that seems to operate between senior government positions and highly-remunerated positions in the financial sector  (it isn’t just Goldmans’ alumni going into government and back into the financial sector (eg Robert Rubin), but the flow from government positions into the financial sector –  be it Bernanke, Summers, Geithner or whoever).  Bernie Sanders is currently tapping that anxiety.

Kay isn’t “anti-finance”.  As he notes

A country can be prosperous only if it has a well-functioning financial system, but that does not imply that the larger the financial system a country has, the more prosperous it is likely to be. It is possible to have too much of a good thing. Financial innovation was critical to the creation of an industrial society; it does not follow that every modern financial innovation contributes to economic growth. Many good ideas become bad ideas when pursued to excess.

And so it is with finance. The finance sector today plays a major role in politics: it is the most powerful industrial lobby and a major provider of campaign finance.

He seems to be arguing some combination of the following:

  • Banks are too large, and encompass too many different types of activities within them,
  • Banks should be broken up.
  • There is “too much finance”
  • Banks have huge political clout (especially in the US and the UK), and exercise that in their own interest, in particular in the (successful) pressure for bailouts.
  • Someone should pay for what went wrong in 2008/09.
  • Banking regulation has become too prescriptive and detailed.

I didn’t find the overall story that persuasive, partly because it doesn’t seem to generalize across countries, and partly because it doesn’t even seem to get to the heart of the 2008/09 issues.  There are bits of the story I agree with  –  concerns about the volume of increasingly detailed, lawyer-driven, focus of regulation, often in effect more concerned with process and form than with economic substance.  And I sympathise with his unease about the hubris implicit in the belief among central bankers that they can somehow determine what risk weights to use for each and every type of credit.

So what bothers me?

First, is there any evidence that banks were “bailed out” because of the political clout of the sector?  I’ve read huge number of the books written since the crisis, and tracked events through the crisis very closely, and that interpretation simply just doesn’t ring true –  in the US, the UK, Ireland, or anywhere else for that matter.  After all, by and large it was not bank shareholders (or senior management) who were bailed out –  and many of the senior management of banks had large proportions of their own wealth tied up in shares in their own banks.  The bailouts typically primarily benefited creditors  (not exclusively –  after all, even Bear Stearns shareholders walked away with a small amount of their money)  and – so the argument went –  the economy as a whole.  Creditors weren’t always voters, but most voters were creditors of banks in one form or another, and most were employees –  alarmed at the prospect of extreme economic disruption.

This isn’t the place to debate whether any or all of the bail-outs were good things or not, simply to note that –  as things were by 2008 –  they would have happened, largely as they did, if financial sector interests had had no clout and no superior access to politicians at all.

And what of the line that banks are simply too big and complex to be run effectively?  Well, for decades we saw that argument run about corporate conglomerates across the western world (including our own Fletcher Challenge).  But actually the market had ways of taking care of that problem –  companies were bought up, restructured, dismantled etc, by purchasers who could make more of the assets that the unwieldy conglomerates could.    The “asset strippers” weren’t always attractive personalities, and some probably went close to (or even beyond) the edge of the law, but the point simply was that the market has a way of ensuring that assets are owned by those who can place the highest value on them.   Bank takeovers aren’t always easy, but they happen.  It isn’t obvious what the (financial stability) policy problem is, unless a strong case can be mounted that some combination of size and complexity effectively buys a bailout insurance policy.  I don’t think the evidence for that point is particularly persuasive either.

At one point is his lecture drew the distinction between whether we thought as banks as a “den of thieves” or as a “monastery”.  I’m not sure either description is remotely warranted.  Avaricious, arrogant and unpleasant as many of these leading bankers seem to have been, I don’t see any sign that the crises of 2008/09 –  in any country –  occurred because anyone systematically set out to dupe anyone else.  Don’t get me wrong: I’m not suggesting there was none of that sort of activity, simply that much more of what went on is down to some combination of:

  • choices of politicians (choosing to adopt the euro, which involved holding interest rates well away from natural interest rates for year after year –  most obviously in Spain and Ireland –  and the high degree of political pressure brought to bear in the United States on the financial system to take on low quality housing loans)
  • collective over-optimism, among borrowers, lenders, citizens and politicians.

Were people let down?  Yes, no doubt.  Banks failed, but so did most of the world’s leading regulators and central bankers (as Kay put it, the effortless subsequent continued rise of several, who had been quite dismissive of risk before the crisis, illustrates the “unimportance of being right”), and most of the world’s leading finance ministers (and most of those who might have wanted to replace those central bankers and finance ministers).  So who should pay, and in what form?

And of course there is the “so what” question.  If one believes that the financial crises (or even the build up of debt prior to the crisis) was responsible for the world’s current economic travails (eg GDP per capita 15 per cent or more below pre-crisis trends) one might perhaps regard the financial sector as a dangerous bacillus, attacking the common wealth.  But as I’ve noted here several times, I don’t think the case is that strong.  Through its history, for example, the US was plagued by financial crises, and yet each time the economy bounced back  – usually quite quickly –  to much the same growth path it was previously on

What of New Zealand?  Is there too much finance here?    We don’t have complex banks (they lend, mostly in quite vanilla forms, and the borrow –  domestic households and institutions, and from abroad.)  We don’t have many complex instruments either –  actively traded or not.  It isn’t obvious banks have huge political clout either –  for better or worse, in the midst of the crisis we forced them to join the deposit guarantee scheme, we forced through the local incorporation policy, we compelled them to pre-position for OBR, and we’ve imposed higher effective minimum capital requirements than most of the countries.  We didn’t have a domestic loan losses financial crisis during 2008/09 (actually neither did the UK), and yet, as I’ve repeatedly highlighted, our economic performance over the last decade has been distinctly mediocre.  There is a lot going on globally, insufficiently understood, but it isn’t yet remotely clear that finance is the problem, rather than just another symptom.

finance and insurance

The New Zealand financial sector is larger than it once was. But much of that isn’t about  over-mighty financial institutions and their “master of the universe” bosses  – although we had our period of craziness in the mid-late 80s.  But if high house prices here  –  as in much of the West –  are about the interaction of supply restrictions and population pressures, the increase in the stock of credit is substantially an endogenous response to those structural distortions.  If governments make urban land really scarce and expensive, younger generations will need to borrow more real resources from older generations to be able to afford a house at all.  The stock of credit (on the one side) and deposits (on the other side) rises, and financial institutions facilitate that-  and value-added associates with that activity and accordingly appears in the national accounts.  Don’t blame banks for that, but governments that so badly mess up the markets in housing supply.

I’m left uneasy about what social value much of the activity in the financial sector generates.  As an analyst, even as a citizen, I’m curious about that.  But I’m not sure that Kay –  or others –  have made a convincing case that is deeply harmful either. In principle it could be –  as others might argue that sugar, alcohol, fast food, or fast cars could be harmful.    Kay avers that he wants less intrusive regulation, but in fact the thrust of his arguments tends to give aid and comfort to those who want more of it.  That appeals to regulators, responds to a public itch “something is wrong, and banks aren’t overly sympathetic causes”, but doesn’t rest sufficiently on a hard-headed analysis of the role of governments and regulators in past crises, and the importance of markets –  messy as they often are – as “a chaotic process of experimentation…the means through which a market economy adapts to change”.

That last quote comes from an excellent lecture, The Future of Markets, which I return to often, given by one John Kay in 2009.

In conclusion, I would just note that at one of his sessions this week, Kay was apparently asked about deposit insurance. He asserts that it is simply imperative: without it the pressure for bailouts of all creditors inevitably becomes almost impossible to resist.  It was a point I made here last week, and remains good advice for our political parties, our government, and for those among the official agencies who continue to believe that the OBR tool deals with these pressures.

Unborn firms utter no cries

Michael Reddell Exports, New Zealand economic performance

Late last year, in a series of posts on the quarterly national accounts I showed this chart of export volumes per capita (for New Zealand and Australia).

exports real pc

Exports (per capita) had carried on growing over the last decade or so, although at a materially slower rate than they had been growing previously.

Exports matter, but they are only one outcome of the international competitiveness of the New Zealand economy.  Another way of looking at things is to think of the economy as divided between tradable and non-tradable sectors.  It is a useful analytical device, but (like many useful economic concepts) doesn’t map 100 per cent easily onto the official data we have available.

My proposition (not, I think, overly controversial) is that a high-performing economy will be one in which the tradables sector –  the bits selling to, and directly exposed to competition from, the rest of the world –  is growing strongly, absolutely and certainly in per capita terms.   Such growth in the tradables sector in a mark of the success of companies operating here in being able to meet, and succeed in, the global market.  There is, of course, nothing wrong with non-tradables activity: we want phone services, cafes, theatre, and holidays at the beach.  But it is exceedingly rare that a strong sustainable economic performance, especially in a small economy, is led from production in the sectors that aren’t exposed to international competition.

In an IMF Article report from perhaps 10 years ago the Fund staff had the clever idea of representing the tradables and non-tradables sectors in a single chart.  It was rather rough and ready, and the Fund knew it, but it helped illustrate something of how the New Zealand economy had been unfolding.   They started with the production measure of real GDP, and allocated the primary and manufacturing sectors to tradables.    Our exports and imports are typically either primary or manufactured goods, or they are services.  To proxy the contribution of services to tradables production, they took the services exports component (from real expenditure GDP) and also assigned that to the tradables sector.  Everything left over was non-tradables.   The resulting chart was reproduced in various fora around Wellington over the years, even used by the Minister of Finance  –  much to the distaste of purists.

I hadn’t seen the resulting chart for a while, and was curious how things had been going.  In particular, given the rapid growth in the population over the last decade, I was curious about how tradables sector activity had been doing per capita.  After all, both National and Labour governments have constantly talked of strengthening New Zealand’s international competitiveness, international connections etc.

In this chart, I’ve shown primary and manufacturing real value-added per capita, and real services exports per capita, back to when the quarterly population series began in 1991.  Each component here is indexed to 100 in 1991.  At the end of the period, these three components of tradables production are of broadly similar size.

tradables components

If your eye is drawn to the services line, as it probably is, bear in mind that not one of these series is now at its historic peak.  One peak was in 2004, one in 2005, and one (primary) in 1997.     By contrast, real per capita GDP is at its historic peak –  growth hasn’t been strong over the last decade, but has been around 8 per cent over the last decade.  Per capita export volumes haven’t been doing that well (see first chart above) –  but they have clearly done a whole lot better than the domestic (import-competing) component of tradables production.

So here are the aggregate tradables and non-tradables components, as proxied by this particular approach.

tradables and non-tradables gdp

I found it a rather bleak picture, to say the very least.  Tradables sector production, per capita, is now nowhere near as high as it was as much as 12 or 13 years ago.  It is most unlikely that New Zealand will make any progress at all in sustainably closing income and productivity gaps to the rest of the advanced world if it can achieve no growth in per capita tradables sector production over a period that long.

Why has it happened?  What has so strongly skewed production towards non-tradables?  I’d argue that it has, primarily, been rapid population growth, which had to be accommodated through a much higher exchange rate (the big step in the exchange rate dates back to 2003). For many of our tradable product sectors, raising our own population does nothing to materially boost output –  land and sea and mineral resources are given, and the (real and significant) productivity possibilities in those sectors are independent of population.  And the higher exchange rate just made it that much harder for other firms in the tradables sector to survive or thrive.  The exchange rate has been so high for so long that we don’t hear many squeals any more –  those who can thrive at these exchange rates do, and dead firms and unborn (ie never launched) firms utter no cries.  Loosely speaking, it is a fully-employed economy (no 5.3% isn’t full employment, but 4.5% might be –  and that difference is swamped by the scale of the divergences evident in this chart), but it isn’t a path to sustained prosperity.   Non-tradables firms, especially in Auckland, do well –  as they do in every population-fuelled boom anywhere (in history or now) –  but it isn’t a path to sustained national prosperity.

Are there some caveats to the story?  Yes, sure. The Christchurch repair and rebuild process exacerbated the skew to non-tradables, and there wasn’t anything much we could do about that.  And high terms of trade, in principle, made it less necessary to produce tradables volumes (price substitutes for volume)….but, in the longer term, higher terms of trade tend to induce strong investment and volume growth in the sectors that are benefiting.  There was no sign of that in New Zealand.

As I noted, purists don’t like the tradables/non-tradables chart, for a variety of reasons (some good, others less so).  A couple of SNZ staff made an effort a couple of years ago to do a slightly more refined version. It was a worthwhile exercise, but I wasn’t persuaded that the more complex version materially altered the results, while making it a bit harder to explain just what had been done.  Bottom line: this has been quite an unbalanced, more inward-focused, economy for more than a decade now, and there is little real sign of that sustainably changing.