What if (2)

Michael Reddell inflation, Monetary policy

Last week I wrote a post suggesting that a rational Minister of Finance – one not unconcerned with macro stability but not particularly focused on price stability itself, one averse to severe recessions, one keen to be re-elected – might now seriously consider raising the inflation target. Such a Minister of Finance could find support among the economists abroad – quite serious and well-regarded figures among them – who have at times over the last decade or more championed a higher target to minimise the risks associated with the (current) effective lower bound on nominal interest rates.

To repeat myself, I would not favour such a move, and would quite deeply regret it were it to happen (here or in other advanced inflation-targeting countries – the UK for example). But interacting with a few commenters over the last week and reflecting further on the issue myself, I’m increasingly unsure why such politicians – and here I am talking about countries like New Zealand and the UK where the Minister of Finance has direct responsibility for setting the operational target of the central bank – would choose not to make a change. That is perhaps especially so in New Zealand, which has a history of politician-driven increases in the inflation target – changes that weren’t generally favoured by Reserve Bank staff or senior management, but which it has to be said have done little or no observable economic damage. Perhaps our Minister of Finance thinks he couldn’t fend off the tough forensic critiques that would come from the National Party? Perhaps he just thinks he can fob off any responsibility for the depth of the coming recession with handwaving about the rest of the world? Perhaps he would conclude it was already too late to get much benefit this term (not impossible)?

There isn’t yet much discussion (I’ve seen) of the possibility, whether here or abroad, although I did see last night a tweet from a former senior Bank of England researcher (and academic) championing just such a change. Of course, the most important two central banks are the ECB and the Fed, and in neither is there any provision for politicians to set operating targets, and the Bank of Japan is not yet grappling with high inflation. But it isn’t as if there is no discussion either: in this piece from late last year, by two former senior Fed officials, the case is made – or purely analytical/economics grounds – for exactly the sort of change I suggest a rational Minister of Finance might now consider. Among other things, the authors explicitly refer to the past New Zealand experience with raising inflation targets.

What disconcerts me is that, much as I would oppose an increase in the inflation target, I don’t think the case against will be particularly compelling to most people. I can highlight the distortions to the tax system, and thus to behaviour, that result from positive expected inflation, but that would be a more compelling argument were we starting from a target centred on true price stability rather than something centred already on 2 per cent inflation. I can, and do, make a strong argument for addressing the lower bound issues directly – easy enough to do as a technical matter, if only authorities would get on with doing so. There is a risk that materially raising inflation targets will lead to the public and markets being much less willing in future to take on trust the commitment of authorities to any (inflation) target they’ve announced (and one could note that the last New Zealand target change was 20 years ago – in the scheme of things still relatively early in the inflation targeting era).

So why would I oppose such a change? It isn’t impossible that some of it is just the reaction of someone who was present at the creation of (and actively engaged in forming) the current system and past inflation target. But I like to think it is more than that, and that many of the same arguments that persuaded me of the case for price stability 30-35 years ago still hold today. In the end I think it is largely almost a moral issue, and that – as we don’t tinker with our weights and measures, and look very askance on those who seek to fiddle them – there is something wrong about actively setting up a policy regime designed, as a matter of explicit policy, to debase the purchasing power of the currency each and every year.

Might it be different if – posing a hypothetical – nothing could be done about the current effective lower bound? Perhaps (although despite my advocacy for action on that front I’ve long been intrigued by the relative success of Japan in keeping cyclical unemployment low) but plenty can be done, as numerous economists have argued now for years. One can overstate the advantages of long-term price stability (there are very few long-term nominal contracts, and mostly that would be quite rationally so even if the inflation target was centred on “true” zero – ie allowing for the known modest biases in most CPIs) but it is like some gruesome triumph of the technocrats to be systematically destroying the value of people’s money by quite a bit each and every year on some proposition that doing so might produce slightly better cyclical economic outcomes, and even then only because politicians and technocrats wouldn’t address the problems at source. Sure, unexpected inflation is in many ways more troublesome than expected (targeted) inflation, but people shouldn’t have to take precautions against governments systematically eroding the value of their money.

Anyway, I would continue to be interested in alternative perspectives – either why the incentives on politicians aren’t as they appear to me to be, or why the economics-based case for pushing back strongly against increasing the target is stronger than it appears to me. Or, of course, why raising the target might just be good, on balance, economic advice.

Those comments got a bit longer than I intended. I’d really intended this post to be mainly some simple charts: given the (annual) inflation targets we’ve had, how have the cumulative increases in the price level over the decades compared with what might have been implied by the targets. I’ve seen a few charts around (for NZ and other countries) and did a quick one myself a few weeks ago on Twitter.

There are some caveats right from the start:

  • neither New Zealand nor any other country has been operating a price level target system.  In the New Zealand system, bygones are supposed to be treated as bygones –  eg a period in which inflation has overshot the target (for whatever reason) is not supposed to be followed by targeting a period of undershooting.  There are good reasons to prefer the “bygones be bygones” approach (even if some still contest it),
  • the charts below will focus on the midpoint of successive target ranges.  Since 2012 the Reserve Bank has been explicitly required to focus policy on the midpoint of the target range, but that was not so previously (and whereas Don Brash had quite an attachment to the idea of the midpoint, Alan Bollard did not particularly).  The targets have always been formally expressed as ranges.
  • while the targets have typically been expressed in terms of increases in the headline CPI, the Policy Targets Agreements (more recently the Remits) have explicitly recognised that there are circumstances in which CPI inflation not only will but should be outside the target range (a GST increase is only the most obvious, least controversial example).
  • the targets have been changed several times, but policy works with a lag.  In all these charts, I simply change the target when that change was formally made (even though if one were measuring annual performance –  not the issue here) one could not rationally hold a Governor to account for outcomes relative to a new target even six to twelve months after the target was changed).

With all that as background, here is a chart comparing the CPI itself with the successive targets, beginning in 1991Q4 (because the first formal inflation target was for the year to December 1992).  To December 1996 the midpoint of the inflation target was 1 per cent annum, rising to 1.5 per cent per annum to September 2002, and 2 per cent per annum since then.

CPI since 1991

Cumulative CPI increases have run a bit ahead of what a (very simple) reading of the successive inflation targets might have implied. It is a different picture than one would see for many other inflation targeting countries, but reflected the fact that until the 2008/09 recession (and despite lots of anti-Bank rhetoric about “inflation nutters”) we tended to produce inflation outcomes consistently quite a bit higher than successive target midpoints.

As I noted above, the Bank has only been formally been required to focus on the midpoint since September 2012 when Graeme Wheeler took office. Here is the same chart for the period since then.

CPI since 2012

Despite the newly-explicit focus on the midpoint, the annual undershoots during the Wheeler years cumulated to quite a large gap.

What about core inflation? The Bank’s (generally preferred) sectoral factor model has been taken back only as far as the year to September 1993. However, the Bank also publishes a factor model which goes back a couple more years (and which, although noisier year to year, has had exactly the same average inflation as the sectoral factor model in the decades since 1993).

This comparison surprised me a little. If you’d asked me I’d have guessed that over the decades the CPI might have increased perhaps 5 per cent more than a core measure (things like GST increases) but the actual difference is not much more than 1 per cent (the sort of difference best treated as zero given the end-point issues – chances of revisions – with such models).

CPI and fac model since 1991

Finally, although the Bank has never been charged with anything relating to the GDP deflator, I was curious. How would the cumulative path of the GDP deflator compare with that for the CPI? I didn’t have any priors, but was still surprised to find over 30 years the two series had increased in total by almost identical percentages.

CPI and GDP deflator since 1991

Inflation in the GDP deflator is a lot more volatile (mostly on account of fluctuations in export prices), so not at all suitable for targeting, but still interesting that over the long haul the total increases have been so similar.

To end, I should stress that I am not attempting to draw any fresh policy lessons, or offer either fresh bouquets or brickbats to the Reserve Bank (past or present). I was just curious.

What if?

Michael Reddell inflation, Monetary policy, zero lower bound

When inflation becomes established and pervasive – not just direct price effects of this or that supply shock or tax increase (or combination of them) – it generally doesn’t come down all by itself.

Expressed in terms of conventional monetary policy, it usually takes a period in which policy interest rates are raised to, and maintained at, a level above the (not directly observable) then-neutral rate. Of course, sometimes an adverse external demand shock – eg an external recession – comes along, which can do a big part of the job. But that isn’t usually much more pleasant. Either way, domestic demand growth typically needs to be held below growth in the economy’s productive capacity for long enough to lower inflation. And, among other things, that will typically mean a rise in the unemployment rate, to (for a time) levels beyond (not directly observable) then-neutral (sustainable, non-inflationary) rate.

In principle, it can all happen very smoothly and gradually (the vaunted “soft landings”, often talked of, rarely observed). Such “soft landings” are almost always forecast (not just by central bankers), at least until the alternative is unavoidably obvious. Of course, “soft landings” are generally preferable, but (except as a matter of luck) they assume a degree of understanding of what is going on, how economies are unfolding, that isn’t often present. If forecasters (central bank and otherwise) really had a good handle on how economies were behaving at present, we probably wouldn’t have landed in quite the current inflation mess in the first place.

Since the New Zealand economy and financial system were substantially liberalised after 1984, we’ve had two episodes in which pervasive (“core”) inflation has been lowered. Both fit the story. As it happens, in both cases, we had a period of quite-tight domestic monetary policy and an international economic downturn. Actually, in 1990/91 we had a fair amount of discretionary fiscal tightening as well.

Inflation had still been very badly entrenched in the late 80s. Core inflation was probably around 5-6 per cent, and hadn’t been lower for a long time. It took 90 day bill rates at 13-14 per cent for a couple of years. We didn’t have a concept of “neutral rates” then, but no one would have seriously doubted things were tighter than neutral: that was the point. The unemployment rate peaked at about 11 per cent (there were other structural changes going on at the same time) to get inflation down into the target 0-2 per cent range. It was a nasty recession, quite similar to one in Australia and no doubt with contributions from the US recession at much the same time.

Fifteen years later, core inflation had been rising for several years. On best estimates, it peaked at about 3.5 per cent, some way from the midpoint (2 per cent) of the revised target range. The OCR had been raised to 8.25 per cent to counter this inflation (at the time, from memory, the Bank thought of the neutral rate as being somewhere not much above 6 per cent). Core inflation, of course, came down, through some combination of the tight domestic monetary policy and a nasty global recession. The New Zealand unemployment rate, unsustainably low at the pre-recession trough (about 3.5 per cent), rose to about 6.5 per cent. Core inflation fell back to the target midpoint (and then overshot when monetary policy was kept too tight for years too long – but that is another story).

At present, of course, core inflation is probably a bit over 4 per cent (looking across the range of core measures). That is a long way below headline inflation (as was the case in 2007/08). The unemployment rate is 3.2 per cent, and even the Reserve Bank has been moved to observe that the labour market is unsustainably tight.

Core inflation can be brought down again, but it isn’t going to happen by magic. Most likely it will take a period of sustained weakness in demand growth, a period of a negative output gap, and – as part of that – a period when the unemployment is above the medium-term sustainable level. The Reserve Bank thought the neutral OCR was about 2 per cent pre-Covid: if so, then the subsequent lift in inflation expectations would suggest at least 3 per cent now. Getting above that is a long way from the current 1.5 per cent.

The situation isn’t much different in a bunch of other advanced economies, even if each have their own idiosyncrasies.

Most likely – here and abroad – getting core inflation back down again will take recessions.

Voters may not be altogether keen on recessions. That is understandable at the best of times, but right now it is only two years since the last dramatic dislocation and temporary loss of output and employment.

And so I’ve been wondering recently if, before too long, some government and/or central bank (probably the two together) might not just decide it is all too hard. Why put people through another recession? Perhaps especially if the government concerned is already not looking too good in the polls.

But, you say, wouldn’t that just be seen as feckless. “giving up” in the face of a “cost of living crisis”? How could serious people possibly defend such a stance?

Actually, quite easily.

Long-term readers of this blog will recall that for many years I banged on about the effective lower bound risks, and how difficult monetary policy would prove in the next recession. With hindsight, I (and the many others internationally who were raising such concerns) should have rephrased that “the next demand-led recession”. Covid proved to have been different, in ways little appreciated in March 2020. But the issue has not gone away. And not a single central bank has yet done anything much to ease the effective floor on nominal policy rates (at probably around -0.75 per cent, beyond which the incentives to convert to physical cash – neutering monetary policy – become increasingly strong). Nasty demand-driven recessions will come again.

Since the 08/09 global recession, several prominent macroeconomists abroad (including Ken Rogoff and Olivier Blanchard) had been suggesting raising inflation target, perhaps to something centred around 4 per cent) to grapple with exactly that lower-bound risk. I was not convinced then – including because these same central banks were failing to deliver even on their existing inflation targets (too low inflation was the story of the decade), and it was difficult to see how stated intentions of delivering even higher inflation were going to be given much credence.

To be clear, I still do not support such a policy change now. Economies function a bit less effectively at higher inflation rates (even stable ones), and the lower bound issues can be – and should be, as a matter of some priority – be addressed directly.

But the context has changed, a lot. Now, it wouldn’t be idle talk from ivory towers in the abstract about lifting inflation. Inflation is already high, and the question may soon be about willingness to pay the price to get it back down again. Few people are very fond of recessions. So why isn’t it quite possible – even likely – that some set of authorities somewhere, backed perhaps by some eminent economists focused on those lower-bound issues, as well as more-immediate political imperatives would suggest (initiate) a change. A 3-5 per cent inflation target range perhaps?

There would be pushback from some quarters of course. Do it once and won’t everyone believe you’ll do it again any time the pressure comes on? It is the sort of argument that sounded good 30 years ago, but actually New Zealand twice raised its inflation target – when the political pressure came on – and although I’m still not a big fan of those changes, it is hard for any honest observer to conclude that they were terribly damaging. Bond holders won’t necessarily like it, but many of the indebted would. Those on the margins of the labour market – the sorts of people most likely to lose their jobs, or find it harder to get one – might be responsive too. Realistically, in the face of such a change most forecasters would revise their numbers and project a little more output in the short-term (no long-term tradeoffs, but the costs of getting inflation back down are real).

There are quite a few places that aren’t likely to lead the way on any such change. The ECB, for example, sets its own specific inflation target, faces no election, and has a price stability focus embedded by treaty.

But there are other places where it could happen, and in particular any place where (as should happen) the elected government sets the inflation target.

New Zealand might be one of them. After all, the government is slipping in the polls, the likelihood of a recession between now and the election is steadily rising, and whatever merits the current Cabinet have, none of them seem like hard money people (to many of their voters that is probably a good thing). The current policy target Remit still has 21 months to run, but the Governor’s term expires in March, a new Board takes office in July, and so on. The Governor has already told us the Bank has analytical and research work underway – consistent with the provisions of the amended RB Act – for the next Remit review. Mightn’t it seem brave and pioneering, prioritising employment (immediate and in that next demand-led recession), to carve a new path and revise up the target (all perhaps flanked by distinguished experts).

To be clear, I do not (and would not) support such a change. Moreover, there is nothing in the public record to suggest that our government or central bank are looking at such a change. My point in writing the post is that, when one thinks about incentives, it isn’t obvious why some government or other mightn’t adopt exactly such an approach before too long. And it isn’t obvious why it wouldn’t be the New Zealand government. Just think of it, the ultimate product differentiation from Roger Douglas (the main consideration that seems to have driven Grant Robertson in the overhaul of the RB Act in recent years).

Of course, even if core inflation was to be stabilised at around 4 per cent, it seems almost certain that the unemployment rate will rise from here: that is the implication of the Reserve Bank’s observation that the labour market is unsustainably overheated. But there is quite a difference between settling at 4.0 to 4.5 per cent, and a couple of years at (say) 5.5 per cent. Shrewd political advisers will recognise this. They will also recognise that if most other advanced countries are heading for recessions we won’t fully escape the effects, but they might think that easing up on our target now might better position us for the (near-certainly) tough times on the horizon. Were I Ardern or Robertson – and I am very thankful I am neither – I might be tempted.

Perhaps the analysis here is all wrong. If so, I’d be really interested in reactions or alternative perspectives.

Not being entirely straightforward

Michael Reddell Fiscal policy, National Party

No posts last week between some mix of the war news (including related economics and financial markets news) being more interesting, and Covid – in our house that is. Not being too sick, but not being entirely well either I wasn’t concentrating very hard for very long. Fortunately, the isolation is now half over and no one’s health is particularly concerning. So back to some domestic economics and policy.

The leader of the National Party yesterday gave what he billed as a “State of the Nation” speech. You can read it all here. It was, however, largely a tax speech. And – and I say this as someone who would really really like to be able to vote for National – it was pretty disappointing.

It wasn’t that I disagreed with any of the tax ideas – none of them very radical anyway. So when he committed to repealing “each of these new taxes implemented by Labour”

I was quite pleased. On Radio NZ this morning he also committed to getting rid of the “ute tax” as well, and I was pleased to hear that as well. One might debate the merits of some of these measures at the margin (eg I’d be happy to limit interest deductibility – for all businesses – to real interest, not nominal), but none of them really represented good tax policy, and they make the economy work less efficiently.

I was also quite keen on the idea of adjusting income tax thresholds to take account of inflation since 2017 (although would be rather keener if that included a commitment to legislate indexation of the thresholds as a permanent feature of the income tax system). That is simply fairly good tax policy.

So far, so positive, although do note that all these proposals involve turning back the policy clock to 2017. National was the government then, so no doubt they look back fondly on that time. But our structural economic performance (productivity growth, business investment etc) wasn’t much chop then – as Labour then used to point out, before becoming indifferent to such trifles when in office, and implementing policies – and running into circumstances – that are likely to have made things worse.

My concern is the fiscal and macroeconomic aspects of what National is saying – in Luxon’s speech yesterday, and (on the other hand) in every second parliamentary question for weeks.

Of all those tax promises listed above, only the one-off indexation of the income tax thresholds is costed, presumably because they are actively calling for the government to adopt this proposal in this year’s Budget.

National has been trying to make a thing of the size of the operating allowance ever since it was announced in December. But doing so isn’t entirely straight. Here a couple of paragraphs from my post at the time

To illustrate the practical implications, here is a chart from that post.

The simplest explanation is simply that when there is a lot more inflation, things cost a lot more – the same bundle of goods and services (or real transfer) cost more – and the way the government’s systems are set up, most of that “cost more” has to be met through the operating allowance. I thought it was a daft system when I worked at The Treasury, and I still think it is a daft system – presentationally – but it is the system and both National and Labour-led governments have used it. When inflation is very low (eg undershooting the target), operating allowances can be low without any great austerity, and when inflation is very high (eg overshooting the target, operating allowances can look (and be) very high without any great fiscal extravagance. As the graph shows, if the government keeps to the plans announced in December, government spending will be falling (modestly) as a share of GDP over the next few years.

And what has happened (and is forecast to happen to) the price level?

When the current government Budget, and appropriations, were decided, Treasury thought that the price level (CPI) by June 2023 would be 6 per cent higher than it was in June 2020. By HYEFU time – when they decided on the operating allowance – they thought the increase would be 11.9 per cent. We don’t have new Treasury forecasts, but the Reserve Bank’s MPC published forecasts recently (and recall that the Secretary to the Treasury sits on the MPC) and they expected a 12.7 per cent increase. It isn’t impossible that events of the last 10 days – including last week the biggest weekly rise in commodity prices in 50 years – will have pushed those numbers higher again.

Things will cost more. That is true of things you and I buy (a point Luxon has, fairly, been keen to stress) but it is also true of things the governments buys or spends money on.

A very large proportion of that $6 billion operating allowance will be required simply to keep real spending at the levels the government had in mind in last year’s Budget. It is a really big price level shock, at a time when – almost every year – nominal GDP is at record highs, so it is hardly surprising that the operating allowance is itself a record high. It tells one nothing about fiscal profligacy. I suspect Labour is already finding putting together this year’s Budget quite a bit harder than they planned in December – harder that is if they are going to stick to the $6 billion.

I’m not suggesting that when the $6 billion was announced in December there was no room for new government discretionary initiatives. I’m quite sure there was (as pretty much every government ever has done). And it is quite likely that adjusting the income tax thresholds – for that big price level shock – is at least as good a use as whatever Labour has been cooking up. But……as the graph shows, Labour’s spending plans for the next few years were hardly looking reckless.

Here it is also worth repeating that National has not offered costs, or funding ideas, for their other tax promises. For some it doesn’t matter – the “Light Rail Tax” is vapourware at present anyway – but we know that the 39 per cent rate is pulling in a lot more people than initially envisaged, and probably a fair amount of money. Unless National proposes to run larger deficits/smaller surpluses in the out-years than Labour is planning/forecasting, the money needs to come from somewhere – presumably lower (than otherwise) government spending.

National has for months been running the line that high government spending is to blame for much of the surge in domestic inflation. I’ve been quite sceptical (and critical) of that view, including in a couple of recent posts, here and here).

If were a serious line of attack – as distinct from something that looks a lot like rank opportunism – one might have supposed Luxon and his party would be identifying significant areas where they would cut government spending. But this all they had to say

I’m not a fan of any of those policies, although it is hard to conclude that either the water system or the health system are just fine as they are, and (at least as far as I’m aware) daft as the “underground tram” might be, little is yet being spent on it, so it isn’t an explanation for the inflation we are now seeing. There was reference to welfare dependency – and again I agree it is a real issue – but no concrete ideas for materially cutting those outlays.

So we seem to be left with:

  • claims that high inflation –  even high domestic inflation –  are substantially the responsibility of high government spending, but (a) no serious analysis in support of the proposition, and (b) no substantial or material proposals for cutting government spending now, and
  • for the future, tax cuts promises that, while individually sensible and perhaps even laudable, aren’t supported either by burgeoning projected surpluses or by even a hint as to what expenditure will be cut (bearing in mind that demographic pressures on spending are likely to rise, not fall).

At best, even in the shorter-term we are left with an Opposition that wants to run no smaller deficits than Labour (operating to the same operating allowance for the coming year), and – on the things actually announced yesterday –  smaller surpluses or larger deficits than Labour in the years to come.  And all this while standard macroeconomic forecasters will put MUCH more weight on deficit/surpluses (and changes in them) as an influence on aggregate demand –  something the Reserve Bank needs to respond to in setting monetary policy – than on the level of government spending in isolation.

Ideally, National would now use this as an opposition to pivot and move on, abandoning the “government spending explains inflation story”, shifting their inflation focus back onto the Reserve Bank’s failings (and the government responsible for holding them to account), and if they are serious about future tax cuts, start telling us how they plan to pay for those cuts.  A serious move on the NZS age –  a fairly prompt lift to 68 and life-expectancy indexation from there –  would be a good place to start (as distinct from National’s policy hitherto of doing nothing at all for another 15 years or so).

Finally, as I noted earlier the speech seemed to involve turning back the policy clock to 2017.  But productivity growth –  the foundation of longer-term improvements in material living standards – was nothing to write home about back then either.  One hopes –  probably against hope – that before long Messrs Luxon and Bridges might let us on on their thinking on how we might do rather better over the medium-term than simply turning back the clock to five years ago, how we might at last begin to close those yawning economywide productivity gaps between us and the rest of the advanced world.


“Frankly simply daft”

Michael Reddell Reserve Bank

I wasn’t going to write anything here today, but I couldn’t let the final question and answer from this morning’s Finance and Expenditure Committee hearing on the Monetary Policy Statement go without record and comment.

Simon Bridges, National’s FInance spokesman, asked the Governor whether the current prohibition – agreed between the Governor, the Board and the Minister – on any (external) MPC member having any active, engaged (present or future) analytical/research interest in monetary policy was not “frankly simply daft”, and did it not “ruin the ability to have thought diversity”.

He might well have added, but time was short, “and without precedent anywhere else in the advanced world” (or quite probably in most of the less-advanced world). Ben Bernanke would be disqualified, Lars Svensson would be out, and one could run a very long list of the sort of people who’ve served with distinction on the MPCs of other countries, whom Orr, Quigley and Robertson bar as a matter of determined policy.

Labour chairman Duncan Webb attempted, somewhat half-heartedly, to stop the question being asked, suggesting that it wasn’t really relevant to this Monetary Policy Statement (as if that was not also the case with several other questions, notably those from government MPs).

But in the end, the Governor did answer. He claimed first it was a matter of “legislation and government”. What he might have meant was not clear, but here is what the legislation says. The Minister makes the appointments, but can only appoint people the Board recommends, and the Board has to consult the Governor on those recommendations. These types of people are (rightly) disqualified.

People with a strong ongoing, and possible future, analytical/research interest in macroeconomics or monetary policy are not. That ban – the blackball – is pure Orr/Quigley/Robertson in concert. And none of them has ever mounted a substantive defence of this extraordinary ban, a ban without precedent.

But then Orr went on to end with a claim that the Monetary Policy Committee has a “very high level of expertise in monetary policy”.

It is worth distinguishing here between the external (non-executive) members – to whom the formal ban applies – and the executive (and majority) members.

There are three non-executive members:

  • Professor Caroline Saunders, who knows quite a bit about international trade but even her RB bio does not suggest knows anything in particular about monetary policy,
  • Peter Harris, former adviser in Michael Cullen’s office and former chief economist at the CTU. His RB bio also lays no claim to any particular background or expertise in monetary policy, and
  • Professor Bob Buckle. Buckle is a retired academic, who also worked in The Treasury for several years. He has something of a background in macroeconomic matters, but his focus tended to be more on tax and fiscal issues. Buckle is not self-evidently unsuited for the role – although he has long tended to be a “don’t rock the boat” establishment figure – but has no particular track record on monetary policy, let alone “high level expertise”. And he has, presumably, signed on to the understanding that he will never again do any writing or research on matters associated with monetary policy or macroeconomics (that is part of the ban).

Hardly a “very high level of expertise”.

Then, of course, there are the executive members, to whom the formal ban does not apply:

I’m not going to dispute that either the Governor or the Deputy Governor has some relevant qualifications and experience (although the deputy governor’s day job is now financial regulation and supervision), but neither is what most people would call a high-level expert. That needn’t be a criticism – the central bank is more than monetary policy – but you might hope for high level expertise (even “a very high level of expertise”) somewhere on the MPC. As it happens, neither Orr nor Hawkesby has even given a serious and thoughtful speech on monetary policy in their time on the MPC.

There was, for yesterday’s decision, the outgoing chief economist Yuong Ha. But he is leaving, with no other job to go to, and in his three years on the MPC gave not a single speech, delivered not a single paper, on matters monetary or economic.

The new appointee is Karen Silk. She has been a general manager at Westpac for some years, and will have senior management responsibility for financial markets where, just possibly, her skills might be a match. But her qualifications are in marketing and accounting, and she has no work experience relevant to being a monetary policymaker, or the senior executive responsible for those functions. Hard to imagine that morale among the Bank’s remaining economists did not dip quite a bit further when her appointment was announced. It is as if they wanted to go above and beyond and apply the ban to executives too,

It is now more than three months since it was announced that Yuong Ha was leaving, and the Bank has still not been able to fill the role – a job that would once have been one of the best jobs in New Zealand for a macroeconomist with policy interests. Perhaps they will appoint the person who will be filling the vacancy on an acting basis, but we don’t know.

There are some competent people on the MPC, and as I’ve written previously I don’t believe all 7 need to be (or even should be) research economists, but there is really no one there now who – by any reasonable global standards – could be described as offering a “very high level of expertise in monetary policy”.

That isn’t good enough – and the problems are especially evident with recent macro and inflation developments – but it is a choice, by Orr, Quigley and (above all) Robertson. So I hope MPs and journalists keep asking about what possible justification there can be for this extraordinary ban on some of the potentially most talented people who might otherwise be appointed to the Committee.

The Monetary Policy Statement

Michael Reddell Monetary policy

If anything I came away from today’s Monetary Policy Statement and (the bulk of it that I saw) the Governor’s press conference more convinced that I was yesterday that the OCR should have been raised by 50 basis points today.

There were a couple of elements in the minutes that were a little more encouraging than one might have feared.

There was the fact that a 50 point increase was clearly seriously considered, and debated. There was the fact that that debate was actually disclosed in the minutes (I think that is a first). There was the explicit comment not ruling out 50 point increases in the future. And there was, at last, a slow start to the process of unwinding the huge punt on the future of bond rates taken on in the LSAP intervention of 2020 and 2021.

It could have been worse. There clearly is an element of unease around the Committee table around the rise in inflation expectations, even for the longer-term horizons the Bank has often previously used to reassure itself there was no particular problem.

But…..when 2 year ahead inflation expectations of relatively more-informed observers have increased (as they have) by 29 basis points since you last met, an increase of the OCR by 25 basis points – especially as those survey respondents will already have expected such an increase and factored it into their inflation expectations – isn’t getting on top of things, even slightly, rather it is just falling a bit further behind. Whether thinking about inflation or inflation expectations, the MPC has fallen short of the Taylor principle – that at very least one should raise (lower) the OCR to the extent inflation and/or expectations rise (fall). The real OCR is now lower than it was when they descended from the mountain top in November, even as all measures of inflation (including the core inflation ones) have moved considerably higher. In the Bank’s own words, all the core measures are now above the top of the target range.

And, of course, the real OCR is now materially lower than it was two years ago, even though (core) inflation has been high and rising and – again on the Bank’s own reckoning – the labour market is unsustainably tight, the unemployment rate is too low to be sustained.

And yet the Committee made no attempt anywhere in the document to justify why real monetary conditions now would prudently, on the balance of probabilities (and they even invoked the “least regrets” language again), be so much looser than they were two years ago.

Linked to that, and perhaps my major criticism of the document itself, is that there was no sustained effort to analyse and explain why the Bank’s core inflation forecasts had been so wrong, why core inflation was now above the top of the target range, or what the MPC had learned from that experience that now gave them greater confidence that they understood the inflation process sufficiently well to keep on with the “slowly does it” approach to adjusting the OCR. In the circumstances it is a pretty inexcusable oversight – and it was a bit disappointing that no journalists asked about the issue/omission.

If one goes back to those minutes, the MPC lists a few reasons not to raise the OCR by 50 points:

  • there were the LSAP sales, but that is a clearly just there to bulk out the paragraph, since the body of the document says any impact of the LSAP, including sales, is now very small, and the Governor reiterated that point even more strongly in the press conference. In any case, the bond sales don’t even start for several more months.
  • there was the fact that interest rates had increased quite a bit late last year.  Which is fine, but there isn’t any sign that (say) inflation expectations have dipped.
  • there was Omicron, which seems to have been a factor, even though monetary policy operates with lags that run well beyond the next 3-6 weeks of the peak Omicron wave, and
  • there was this strange line: “They also noted that conditional on the outlook, the OCR is expected to peak at a higher level than assumed at the November Statement.”.   They have certainly raised the peak of the tightening cycle quite a bit, but……that would normally be an argument for getting on it with now, not just carrying on in the slow and measured way, even though you think –  as the MPC appears to –  that another 240 basis points of increases will be required.

There are more than a few puzzles in the document. For example, the peak of the OCR cycle (3.4 per cent) seems to be well above the Bank’s estimate of neutral rates – chart suggests something around 2 per cent – and both core and headline inflation eventually come down a lot. But the economic forecasts suggest this all happens by “magic”, since the output gap only goes negative in the year to June 2025, and the unemployment rate looks as though it never gets above the NAIRU. It reinforces the point that the model – the understanding of the inflation process and what has gone on in the last couple of years – is at best weak, and possibly missing in action.

At this point I should make clear that I do not have a strong view on where the OCR cycle should peak. I tend to think it is a fool’s errand given how little we know, and so I concentrate on the next few quarters. But the Bank is clearly uneasy about inflation expectations, thinks there is a lot more to do, and yet seems to want to get there very slowly, running in the process risks of things getting even further away on them. 50 basis points would have prudent, especially at a time when no one supposes there is much risk that a few months down the track there would have been cause for regret, having raised the OCR to the fearsome level of (about) -2 per cent.

Is there reason to think economic activity may not do that well this year? Indeed there is, although the eventual opening of the borders will add to (not detract from) capacity (including labour market capacity) and inflation pressures), and core inflation having once got this high – and the Bank expects it to stay this high for at least the next year – doesn’t typically come down by magic. It typically requires some policy force – a little more than is implied by real monetary conditions a lot easier than they were before Covid and this inflation surge got underway. As it is, the Bank is probably painting a rose-tinted picture all round: core inflation falls surprisingly easily, and productivity growth actually picks up a bit. Perhaps it will happen, but there is no compelling case made (and the Bank’s answers to the productivity question were particularly half-hearted.

I could go on on other matters but will end just noting three points briefly:

  • since yesterday’s post, Bob Buckle and Peter Harris have been reappointed to MPC positions for further three year terms.  There was no question to the Governor about how he can possibly justify –  the more so in the current circumstances –  the blackball placed on anyone with a serious ongoing engaged analytical or research interest in monetary policy.    The final appointment is made by the Minister of Finance, but he can appoint only those nominated by the Bank’s Board and no doubts that Orr dominates the Board on such matters, 
  • there was no attempt by the Bank to justify or explain away the more-than $5 billion in losses run up on the LSAP and –  more disappointingly –  no questions from the assembled media,
  • there was not a single question about the appointment to the senior deputy position responsible for macroeconomics and monetary policy (and to the MPC) of someone so manifestly underqualified –  with no relevant qualifications or experience – as Karen Silk.

Perhaps the FEC members might do a little better when the Governor next appears there?

UPDATE: I had to go and pick up a child and so missed the last few minutes of the press conference. I gather the Governor explained that the strange cover was in honour of his departing chief economist, who told us last time he was going to coach his son’s cricket team. It is a nice touch…….for someone who appears to have been forced out in the great Orr restructuring.

What the MPC should do

Michael Reddell Monetary policy

The Reserve Bank and the MPC will tomorrow emerge from their long summer slumber to deliver a Monetary Policy Statement and OCR decision. It is quite extraordinary that in this period, of considerable volatility, uncertainty, and inflation surging above the target range (even on core measures) we’ve heard precisely nothing from any of them (individually or collectively), and had no policy actions, for three months.

But, at last, tomorrow we will hear. As I’ve said repeatedly here over the years, I’m not really in the business of trying to guess what the MPC will do. There are plenty of people with a strong interest in that, and banks have people who nurture every little contact or conversation they can secure with Reserve Bank officials, analysts, or policymakers. As the Bank says little in public, and isn’t that consistent through time in how it acts, all one can say is good luck to those people.

My interest is in what the Reserve Bank should do, given the target set for them by the government (and, of course, the wider but less immediate question of what that target should be). The target is really pretty specific, with a primary focus on keeping the persistent elements of inflation near 2 per cent.

Against the backdrop of the Remit, I think it is pretty clear what the MPC should be doing tomorrow:

  • they should be raising the OCR by 50 basis points, and giving a signal that, all else equal, they expect another 50 basis point increase at the next review on 13 April,
  • they should be terminating new loans under the Funding for Lending programme, the crisis programme introduced in 2020 which is still at the margin having the effect of holding interest rates lower than otherwise, and
  • they should commence a programme of bond sales, designed to liquidate the LSAP bond position within 2 years (or, equivalently, have agreed a programme with The Treasury under which it would sell new bonds on market, buying back on the same day an equivalent amount of the bonds held by the Bank).

I don’t suppose either of the last two items on that list are at all likely.  I don’t even think that LSAP sales would make much material difference to monetary conditions (exactly paralleling my argument when they were buying bonds) but (a) every little helps, and (b) we should get this massive taxpayer bet on the bond market closed out ASAP, on principle.   And there is no crisis now –  the OCR is fully able to be used as desired.  Much the same goes for the FLP programme.  Closing that now might have some modest useful impact in tightening overall monetary conditions, but it would also align messages –  this isn’t the 2020 Covid crisis any more, and the focus of monetary policy now is (or should be) getting core inflation back down fairly expeditiously.

But even if they took both of those steps, the case for a 50 basis point increase tomorrow is strong. 

There are a couple of ways I find useful to look at things.

It was in last August’s MPS that the Bank really set out towards some significant OCR increases.  They didn’t act that day because they had the misfortune of a (long-scheduled) release a few hours after the Level 4 lockdown was imposed.  Back then they envisaged the OCR being 0.9 per cent for the March quarter 2022 (roughly consistent with having been 0.75 per cent moving to 1 per cent now).  But back then:

  • they thought core inflation was about 2.2 per cent and would go little or no higher (headine inflation forecasts for the second half of this year and beyond were 2.2 per cent, dropping further away)
  • they expected the unemployment rate for this quarter to be 3.9 per cent, and to go no lower than that.  
  • their latest reads on inflation expectations weren’t particularly inconsistent with inflation near the midpoint of the inflation target range (the most recent 2 year ahead measure they had then was 2.3 per cent).

And where are we now? 

  • the unemployment rate – still probably the best indicator of spare capacity (or lack of it) – had fallen to 3.2 per cent in the December quarter, and there is talk it could go lower yet.  No one seems to suppose that the unemployment rate is near the NAIRU.
  • the latest headline inflation rate is 5.9 per cent, and may go higher this quarter.  Much more importantly, core measures have increased substantially –  the best of them, the sectoral core factor model measure, is now 3.2 per cent for the year to December, and
  • while there is a wide range of inflation expectations measures, none of them are as low as the Bank was seeing back in August, and the best of them are pretty consistent with people assuming (and acting as if?) inflation will stay outside the target range (and well away from the midpoint) for the next couple of year.  Even with the tightening in monetary conditions observed in recent months.

It was really captured quite well in a newspaper article yesterday that reported that all economists talked to thought that the Bank was now “behind the game”.   In that sort of environment, when you’ve been repeatedly surprised by the strength of inflation, and outcomes are no longer consistent with target –  suggesting that your model of what is going on is not working that well – the appropriate response is not to edge up the OCR ever so gradually and hope.   Least regrets –  of which we heard quite a lot from the Bank over the last 18 months – calls for something a bit bolder, to get ahead of the rise in (core) inflation and assure watchers (firms, households, markets) that you really are serious, rather than reluctant.

Is there a case in Omicron for holding back (25bps rather than 50bps)?   I don’t think so.  We can see how other countries have come through the short and intense Omicron waves –  which will temporarily disrupt both supply and demand –  and there is little sign of what is required from monetary policy being revised down in the wake.

(“Not surprising the market” isn’t a good excuse either.  When you say nothing for months, the market has little to go on re the MPC reaction function.  If you won’t talk, you have to live with surprises sometimes.  The market will cope, although might suggest that a bit more communication than once every few months would make sense.)

The second way of looking at things is to compare where are now to where we were two years ago.  Having cut the OCR during 2019 by early 2020 markets, not discouraged by the Bank, were beginning to think in terms of when a first OCR increase might be warranted (still then, it was thought) some time away.

The OCR is early 2020 was 1 per cent.  Core inflation was probably just under 2 per cent (having edged up over the previous couple of years towards the target midpoint), and the unemployment was about 4 per cent.   Where things are now we’ve already covered above –  much more inflation, more capacity pressure, and on any metric you like materially higher inflation expectations.

Any policy and/or monetary conditions?

Well, the OCR today is 0.75 per cent, still below where it was two years ago.  A 25 point increase tomorrow will only take it back, in nominal terms, to where things were in February 2020.  The nominal exchange rate is also now about where it was two years ago.

But what about the interest rates that firms and households face?   We’ve heard a lot about fixed rate mortgage rates have risen from their lows.  And that’s true: a two year mortgage rate is now about 170 basis points higher than the low (last April).

But what of comparisons to the start of 2020?

So nominal mortgage rates are perhaps 50 basis points higher than they were two years ago. But inflation is a lot higher than it was then, and so are all indications of inflation expectations. For these purposes, I’ll just use the Reserve Bank’s own survey of two-year ahead inflation expectations: 1.93 per cent in the survey done at the end of January 2020, and 3.27 per cent in the survey done a few weeks ago, an increase of 1.34 percentage points.

Here is the same chart, but expressed in real terms, adjusted for the increase in inflation expectations.

and the same chart for term deposit rates

(Real) monetary conditions have tightened a bit from the lows, but they really needed to. Compared to conditions prevailing two years ago, real mortgage rate, real deposit rates and of course the real OCR are substantially looser than they were. And whereas two years ago inflation looked to be fairly comfortably somewhere near the target midpoint, nothing remotely that optimistic describes the situation now.

Of course there are other influences – things like fiscal policy, the terms of trade, other regulatory restrictions (eg tax or the CCCFA) – but it would very very hard indeed to construct a story that suggested that real monetary conditions as we find them today (or might find them tomorrow) are likely to be consistent with the Bank delivering on its mandate, on the environment as we see it today. In fact, if core inflation becomes established at current rates (3% plus), standard economic analysis would tell us that reductions in core inflation – to the 2% the Bank is supposed to be focused on delivering – are likely to come about only by luck (ill-luck probably – adverse economic events) or by monetary conditions being tightened to above-normal levels of tightness for some time, a process that would (at very least) result in a period of sub-par economic growth, perhaps even a recession.

We’ll see tomorrow what the MPC has decided to do. But whatever the rate adjustment we should be able to expect a serious and rigorous accounting for just what has gone wrong in the last 12-18 months, what the Committee has learned, and a serious analysis of the options and risks in the monetary policy that might be required to get core inflation (and expectations of it) settling back around 2 per cent. Sadly, with this MPC it would probably be a bit of a surprise if we got even the appropriate degree of analysis, self-scrutiny, and accountability.

Misleading?

Michael Reddell Climate change, Reserve Bank

Back in mid-December, the Reserve Bank fronted up to Parliament’s Finance and Expenditure Committee for the Annual Review hearing on the Bank. I wrote about it here. You may recall that this was the appearance where (a) the Bank (unsuccessfully) tried to kept secret before the hearing the loss of another couple of senior managers, and (b) seemed to mislead the Committee on just how many of their senior managers had gone or were going. In the wake of it, the Governor forced the early departure of his deputy Geoff Bascand a couple of weeks before he was due to leave anyway, over unauthorised contact with the media [CORRECTION: “shared information to a third party”] (most likely over those two new senior management departures).

But towards the end of the hearing (about 50 minutes in here) there was a brief exchange on matters climate change, with an unusually clear and unconditional answer from the Governor. Here was my December account

The study by the Federal Reserve Bank of New York is here, and a Wall St Journal write-up is here. Here is the abstract

Which seems plausible and not very surprising. But it is just one working paper, on one aspect, and I’m not here to praise or critique the paper. My interest is in the Reserve Bank, and Orr’s response. “Yes”, he said, they certainly had done modelling of their own.

This is the Bank’s own climate change page. Even now, two months on, the only thing they are showing under Research Papers is this (their own words) preliminary analysis of some of the issues, dated July 2018 a few months after Orr had taken office. This was from the summary of that paper

So, I lodged an OIA request that day asking for copies of the modelling the Governor has been referring to, and of any write-ups of it. One might have supposed they would be keen to air it, but it still took them until 10 February to respond. They say they intend to put it on their website eventually, but it still isn’t on either the climate change or OIA responses page. So the full document is here

Climate change modelling OIA response from RBNZ Feb 2022

The first part of the response is a long (three page) letter, obviously attempting to provide some framing for what does (and particularly does not) follow.  Their Senior Adviser, Government and Industry Relations assures me that 

The RBNZ’s view is that there are significant climate-related risks for the New Zealand economy and financial system. This means that we consider that sectors of New Zealand’s economy will be at risk of being affected by physical risks, such as drought, flooding and sea level rise, and transition risks, such as international and national changes in policy/regulation, trade, investment and consumer preference. We consider that it is inevitable that policies and conditions will change in response to this global challenge, and that New Zealand’s economy will be affected and changed by these global and national changes. New Zealand banks and their international counterparts have set up teams to monitor and understand these risks and to respond as necessary.

While we are certain that there will be changes in the economy and financial system resulting from climate change and actions to mitigate climate change, the degree to which risks apply to financial stability will depend on a number of factors including how risks are understood and managed. New Zealand banks and their international counterparts have set up teams to monitor and understand these risks and to respond as necessary. 

At which point, I’m drumming my fingers and going “yes, so you say, but my question was about the modelling the Governor assured Parliament had been done”.

There then followed a 15 page memorandum, dated 13 October 2021, to one of the Bank’s internal committees on “Prioritisation of climate-related risks for financial stability analysis”. It is mildly interesting

So it seems that they intend to do some work, but haven’t done anything very serious yet. This is their own summary

and

The only thing the Bank itself seemed to have done was this

The rest of the OIA release consisted of 15 pages of a Powerpoint presentation (from July 2021) on that dairy scenario, reporting work undertaken jointly with MPI (the Ministry for Primary Industries). Much of the presentation is withheld, and we really learn nothing from it beyond what is in that extract just above. None of this appears to have been independently reviewed, none of it has been published, and the Bank’s own description (see quote above) is that there is “very little” New Zealand research on the (possible) threat to the financial system. All we have is a statement of the fairly blindingly obvious: a serious drought out of the blue (as 2013 was) combined with low dairy prices – an unusual combination given that earlier Bank research found that New Zealand droughts tended to boost global dairy prices, but not impossible – would result in some losses to banks’ dairy loan books. And? It sheds no light at all on risks to the New Zealand economy and financial system as a whole, and especially not from climate change – a multi-decade process.

To be clear, I don’t think the Reserve Bank should be spending lots of scarce taxpayers’ money (well, not scarce to them given how lavish their funding now is) on modelling climate change risks, at least not without a great deal more serious robust international analysis suggesting that there was a substantive issue/risk emerging. But it is the Reserve Bank that holds forth on the issue, asserting the existence of a threat….and, it appears, it has done almost no work itself, in a New Zealand context, to support its handwaving.

For anyone interested in reading further, I can recommend a couple of pieces by Ian Harrison – who would no doubt have been heavily involved in this sort of stuff were he still at the Bank. The first, from October 2021, is on Climate Change and Risks to Financial Stability more generally. The second, from January this year,

Did the Governor actively mislead Parliament with his answer in December?   At very best, it looks borderline.  As is clear, from the OIA release and the Bank’s own papers, what little semi-formal work has been done to date sheds very little light of anything of interest, despite repeated claims by the Bank and the Governor about alleged “significant” financial system risks. 

A deteriorating institution

Michael Reddell Adrian Orr, Reserve Bank

I write a lot here about issues around the Reserve Bank. Some of those issues are quite obscure or abstract, and I know some readers find some of those posts/arguments a bit of a challenge to grasp.

But yesterday we had as straightforward an example as (I hope) we are ever likely to find.

Inflation is very much in focus at present. Measure of inflation expectations get more attention than usual. There is a variety of measures, both surveys (in New Zealand mostly conducted for the Reserve Bank and by ANZ) and market prices. The Reserve Bank has been surveying households for 27 years, with a fairly consistent (although expanded on a couple of occasions) range of questions. At the Bank there was always a degree of scepticism about the survey – household respondents always seemed (eg) to expect inflation to be quite a lot higher than it actually was – but it was one more piece in the jigsaw, and if one couldn’t put much weight on the absolute responses, changes over time did seem to line with what households might be supposed to be feeling/fearing.

Of the questions, probably the one least hard for households to answer seemed to be the fairly simple one

No numbers needed, just something directional. We have 27 years of data.

The latest results of the survey came out yesterday. The Bank puts out a little write-up and posts the data in a spreadsheet on their website. Yesterday, the write-up didn’t mention this question at all, but the spreadsheet suggested that a net 95.7% of respondents expected inflation to increase over the next 12 months. That seemed like it should be a little troubling, given how high the inflation rate already is.

Except that……it turned out that the Reserve Bank had changed the question, without telling anyone, without marking a series break or anything. The new question is

And that is a totally different question. The old question is about whether inflation will increase or decrease, while the new one is about whether there will be inflation or deflation. At almost any time in the 88 year history of the Bank it would not be newsworthy if 95.7 per cent of people expected there to be inflation. There almost always is.

It isn’t necessarily a silly question in its own right (on rare occasions there are deflation “scares”) but (a) it is a much less useful question most of the time than the question that had been asked and answered for 27 years, and (b) you can’t just present the answers to one questions as much the same thing as the answer to the other. Especially when not telling users of the data.

It was real amateur-hour stuff. Now, in fairness to the Bank, there is a detailed account of the changed questions on the website, but when there was no hint that question had changed there was no motive to go on a detective hunt to find it.

The Bank tells us they have had a 38 per cent increase in the number of senior management positions in the last year, with no increase in the things they are responsible for, and they can’t even get fairly basic things like this right. They’ve destroyed the single most useful question in the survey, and right at the time when every shred of information on attitudes to inflation should be precious. And then seemed barely even to be aware of what they’d done – presenting the answers to two quite different questions as if they were in fact very much the same.

There were a few people yesterday suggesting it was some nefarious plot to reduce access to awkward data at an difficult time. I don’t believe that for a moment – although for wider peace of mind I have lodged an OIA request to confirm (and to find out whether, for example, MPC members even knew of the change). This was a stuff-up pure and simple, which management and senior management (for which the Governor is accountable) should never have allowed to happen. High functioning organisations don’t make stuff-ups like this.

Which is a convenient lead in to an article published this morning.

About five weeks ago Stuff’s business editor asked if I’d like to write a column for them on the Reserve Bank under Adrian Orr. I did so (a few days later) and the final version appeared this morning. I only had 800 words, and there was a lot of ground one could have covered, so much of the story has to be very compressed (and quite a few problem areas left out altogether). You can read the final Stuff version here, or the text I originally wrote is below. Were I writing it now rather than a month ago, I would put more weight on the inflation story – core inflation now having blasted through the top of the target range – but I wanted to distinguish between forecasting mistakes (which are somewhat inevitable, and the best central banks will make them) and things that are much more directly within the control of the Governor, the Board, and the Minister of Finance.

Alarming Decline

By Michael Reddell

Over the four years Adrian Orr has been Reserve Bank Governor, this powerful institution, once highly-regarded internationally but already on the slide under his predecessor, has been spiralling downwards.  The failings have been increasingly evident over the last couple of years.  Here I can touch briefly on only a few of the growing number of concerns.

One can’t criticise the Reserve Bank too much for running monetary policy based on an outlook for inflation and the economy that, even if wrong, was shared by most other forecasters. Until late 2020 the general view of the economic consequences of the Covid disruptions had been quite bleak. Notably, inflation was widely expected to be very low for several years.  The Bank got that wrong, and so inflation (even the core measures) has been a lot higher than expected.  If they were going to err – after 10 years of inflation undershooting the target – it may have been the less-bad mistake to have made.  But they have been slow to reverse themselves – the OCR today is still lower than it was two years ago – and slower to explain.

The Bank is much more culpable for the straightforward lack of preparedness and robust planning.  Orr had been quite open, pre-Covid, that he wasn’t keen on big bond-buying programmes, and if necessary preferred to use negative interest rates.  But when Covid hit it turned out that the Reserve Bank had done nothing to ensure that commercial bank systems could cope with a negative OCR.  They couldn’t.  So instead, as if keen to be seen to be doing something, the Bank lurched into buying more than $50 billion of government bonds.  Buying assets at the top of the market is hugely risky and rarely makes much sense, but the Bank kept on buying well into 2021.  As interest rates rise, bond prices fall. The accumulated losses to the taxpayer are now around $5 billion ($1000 per person, simply gone).  And yet the Bank has never published its background analysis or risk assessment, it offers up no robust evidence that anything of any sustained value was accomplished, and the Governor refuses to even engage on the huge losses.

What of the new Monetary Policy Committee itself?  From the start the Governor and the Minister agreed that anyone with current expertise in monetary policy issues would be excluded from the Committee.  For the minority of outside appointments, a willingness to go along quietly seems to have been more important than expertise or independence of thought.  Meanwhile, staff (Orr and three others who owe their jobs to him) make up a majority of the Committee.  Minutes of the Committee are published but deliberately disclose little of substance, there is no individual accountability, and four of the seven MPC members have not given even a single published speech in the almost three years the Committee has been operating.  Speeches given by the senior managers rarely if ever reach the standard expected in most other advanced countries.  Meanwhile, the in-house research capability which should help underpin policy and communications has been gutted.

And then there is the constant churn of senior managers.  In some cases, people who were first promoted by Orr have since been restructured out by him.  In just the last few months, the departures have been announced – not one of them to another job – of four of the five most senior people in the Reserve Bank’s core policy areas: the Deputy Governor, the chief economist, and the two department heads responsible for financial regulation and bank supervision.   It isn’t a sign of an institution in fine good health. 

And all this has unfolded even as total staff numbers have blown out, supported by the bloated budget the government has given the Governor.   Orr often seems more interested in things he has no legal responsibility for than in the handful of (sometimes dull but) important things Parliament has specifically charged the Bank with.  Perhaps worse, he has a reputation for being thin-skinned: not interested in genuine diversity of views or at all tolerant of dissent, internally or externally.  One might just tolerate that in a commanding figure of proven intellectual depth, judgement, and operational excellence, but Orr has exemplified none of those qualities.

How to sum things up?  Lack of preparedness, lack of rigour and intellectual depth, lack of viewpoint diversity, lack of accountability, lack of transparency, lack of management depth, lack of open engagement, and lack of institutional memory.  It is quite a list.  The Governor is primarily responsible for this dismal record of a degraded institution but it is the Minister of Finance who is responsible for the Governor.

This really is a matter of ministerial responsibility.

Finally, earlier in the week I wrote a post here about expertise and the Monetary Policy Committee in which, among other things, I lamented again the absurd policy adopted three years ago by Adrian Orr, the Bank’s Board, and the Minister of Finance, excluding from consideration for (external) MPC positions anyone with any ongoing systematic interest in macroeconomics or monetary policy. This morning Jenee Tibshraeny of interest.co.nz had a new article focused on that restriction. She has comments from various economists, the only one sort of defending it one who was adviser in Robertson’s office at the time the restriction – one without parallel in any other advanced country central bank – was put on, but had also asked Robertson and the Bank (Orr or Quigley or both?) whether the same restriction would be applied to filling the upcoming vacancies.

It should be incredible, literally unbelievable, if we had not seen so much from Robertson and Orr over recent years careless of the reputation, capability or outcomes of the Bank. As it is, it is just depressingly awful. One hopes – probably idly – that the Opposition political parties might think it an issue worth addressing. After all, not only are qualified people with an ongoing analytical etc interest in monetary policy excluded from the external MPC positions, but the latest appointment to an internal position (by Orr, Quigley and his board, and Robertson in concert) suggests the bias against actual expertise and knowledge might now be being extended to encompass executive roles.

Expertise and the MPC

Michael Reddell Reserve Bank

I’m yielding to no one in my low view of the Reserve Bank Monetary Policy Committee. I’ve been writing about the problems – structural and personal – since the new Potemkin-village model (designed to look shiny and new, but to change little) was set up three years ago, and it was (for example) one of my Official Information Act requests that got the written confirmation that the Minister, Governor and the Bank’s Board had formally agreed that no one with ongoing expertise in monetary policy or macroeconomics, or likely future interest in researching such matters, would be appointed (as an external member) to the new Monetary Policy Committee (three relevant posts here, here, and here). It was a simply extraordinary exclusion, which reflected very poorly on all involved, but which never seemed to get the scrutiny from media or MPs that it deserved. In no other modern central bank would such an approach be adopted.

But, for all that, I thought Eric Crampton’s op-ed in the Herald today overbalanced in the opposite direction. The column is behind a paywall, so I’m not going to quote extensively, but the gist seemed to be that you need a PhD in macroeconomics AND to be actively engaged in ongoing research to serve on the MPC. Crampton and an Otago university academic then report the results of a little survey they’d run of New Zealand academic macroeconomists to find out who those people thought should be appointed to the MPC, when the terms of two of the current externals expire shortly. It wasn’t noted that the most favoured candidate – one of the incumbents, Bob Buckle – does not have a PhD in macroeconomics, and has presumably taken a self-denying ordinance not to do any relevant research or analysis now or in the future (or otherwise he’d fall foul of the exclusionary rule, see above).

I don’t want to run commentary on all the individuals reported on. One or two might well be excellent additions, one or two would probably be dreadful, but none should be disqualified in advance simply because they might keep thinking about the issues, or writing about them in future. Even if the pickings are fairly slim, that far I agree (strongly) with Crampton. Of course, at present none of it probably matters much as management enjoys a permanent majority on the MPC, and the Orr/Robertson approach has been to prevent external members from speaking in public or even having their views recorded in the minutes. Three years sightseeing aside, it is difficult to know why really able people would seek, or accept, appointment at present. Management appointees matter much more, and the most recent appointment – the new executive deputy in charge of macro and monetary policy, with not a shred of relevant experience – suggests things are heading in the wrong direction there too.

But I think the “cult of the PhD” can be carried too far, at least when it comes to policy roles (as distinct from, say, staffing the Economics Departments of our universities). Don Brash had one, but had been primarily a banker and intellectually curious as he was (and is) had no demonstrated ongoing interest or expertise in macroeconomic research. Alan Bollard had one. Graeme Wheeler didn’t. But little or nothing about how well or badly those individuals did their jobs – and reasonable people may debate each – came down to how complex an NBER paper they could each critique (let alone produce). I’ve noted several times over the years that of the Reserve Bank’s chief economists over my working life, about half had PhDs and half did not. But there was no obvious correlation between those who did (or didn’t) and effectiveness or intellectual energy. Some (one?) of the best did, some (two?) of the best didn’t, but one who did was almost surely the worst of them. In English-influenced countries even 30-40 years ago it wasn’t particularly common for even the most able people to pursue PhDs unless they wanted an academic career. A couple of the more published researchers at the Reserve Bank in the last decade or so either didn’t have a PhD, or got one only rather belatedly (having already published quite a bit).

Or we could look around the world. Alan Greenspan was an economist but didn’t have a PhD (Update: thanks to the reader who pointed out that he acquired one well into his policy career). Jay Powell was a lawyer and private equity executive. Glenn Stevens, the previous RBA Governor, seemed to do a pretty reasonable job, and had neither a PhD nor a research track record. I’m not a great Lagarde fan, but she’s a lawyer and politician. Andrew Bailey has a PhD – in history – but spent his career in banking-oriented roles at the Bank of England. On the other hand, Phil Lowe, Mark Carney, Ben Bernanke, and Stefan Ingves have economics PhDs, even if not always with much sign of ongoing research interest.

Which is by way of saying that despite my many criticisms of Adrian Orr, the fact that he doesn’t have a PhD doesn’t bother me in the slightest. And the fact that Caroline Saunders – another of the independents – has one, if in quite unrelated areas of economics, allays not in the slightest my concern about the weakness (and tokenism) of her appointment.

A parallel I sometimes draw with the MPC is with the Cabinet. As Crampton notes, the MPC makes decisions that are final. So, in many areas, does the Cabinet (and often individual ministers). Very rarely do we expect the Prime Minister or Cabinet ministers to be professional technical experts in any of the areas they are minister for, let alone with the whole ambit of policies for which Cabinet is responsible. It often isn’t even helpful to have had a health expert as Minister of Health, and I’m pretty sure that in all New Zealand’s history we’ve never had an economist as Minister of Finance (nor is it common in parliamentary systems elsewhere). That isn’t a problem. We expect there to be a distinction between professional and technically-expert advisers on the one hand, and decisionmakers on the other. When either group tries to do the job of the other, or the advisory expertise is lacking, things run into difficulty.

[UPDATE: Bill Rowling, Minister of Finance 1972-74, did have an economics degree.]

The parallel with the MPC isn’t exact. We want the Cabinet to be making intrinsically “political” calls, about preferences, priorities, values etc. But we also want them to be judicious people – not unduly swayed by the latest whizz-bang research paper or think-tank idea, or the latest data point. We want/need them to be thinking about communications, public acceptability and so on.

So I’m not suggesting an MPC made up of the first 10 names in the Wellington phone book, or a bunch of pleasant (or otherwise) political hacks. But there is a place for a balanced committee, served by a highly expert staff (research, analytical, policy, markets, operational – all quite different components of what a capable monetary policy function needs). It seems quite likely that some of those roles would these days naturally be filled by people with PhDs – key figures in the research functions, most often perhaps the Chief Economist – but technical research virtuosity (of the sort a highly productive PhD may still offer – many do, many don’t) is just one, important, part of the relevant set of skills. Even in that sort of area, a passion to make sense of what is going on, to interpret evidence and data carefully, to be open to new ideas and fresh perspectives, seem to me to be what we should be looking for. Qualifications aren’t irrelevant, but qualities matter at least as much. And in an MPC that is dominated by management (which also controls all the staff resources), the willingness to think independently and ask hard but realistic questions, to engage effectively with experiences in other times and other countries, are what are likely to add most value. Some functioning academic researchers may be able to do that well, and their particular talents and experience should add value to the Committee. But so, far example, might someone who’d spent decades at the interface of economics and financial markets, or even – and one wouldn’t want this type dominating the Committee – the sort of classic old-school corporate director who is not afraid to ask questions when things don’t make sense, and who may act as a really effective test for how well the expert arguments, analysis, and lines of reasoning may be received in wider public audiences (I can think of a couple of these types who were on the RB Board in years past). Temperament is often at least as important as virtuosity. And effective public communications – not always an academic (or bureaucratic) strength – is vital.

Of course, the bottom line at present is that almost every dimension of the Reserve Bank (and particularly its macro/monetary functions) is weak: little research, little transparency, weak senior management appointments, a Governor with the wrong temperament for the job, an MPC structured to be ineffective, and weak appointees to the MPC. The ban on people with ongoing research interests – almost laughably bad as it is – is more like a symptom of a weak institution…..and a Minister of Finance who seems just fine with all that. And not even, it seems, bothered when core inflation bursts out the top of the target range.

UPDATE: I’d been aware that several of the top figures at the Bank of England in recent decades, including Eddie George and Paul Tucker, had not had PhDs (the latter having gone on to write a very serious book about central bank governance etc), but when I wrote the post I’d been labouring under the impression that the most prominent and eminent such figure – Mervyn King – had had a PhD. A reader got in touch to point out that he hadn’t. I’ve disagreed with many of King’s views, including in posts here, but no one can doubt that he was (and is) a figure of considerable intellectual eminence and thoughtfulness, whose speeches (for example) read well and make one think. He would seem ideally suited for an MPC.

Forecasting and policy mistakes

Michael Reddell inflation, Monetary policy, Reserve Bank

Yesterday’s post was a bit discursive. Sometimes writing things down helps me sort out what I think, and sometimes that takes space.

Today, a few more numbers to support the story.

I’m going to focus on what the experts in the macroeconomic agencies (Treasury and Reserve Bank) were thinking in late 2020, and contrast that with the most recent published forecasts. The implicit model of inflation that underpins this is that even if the full effects of monetary policy probably take 6-8 quarters to appear in (core) inflation, a year’s lead time is plenty enough to have begun to make inroads.

Forecasts – and fiscal numbers – in mid 2020 were, inevitably all over the place. But by November 2020 (the Bank published its MPS in November, and the Treasury will have finalised the HYEFU numbers in November) things had settled down again, and the projections and forecasts were able to be made – amid considerable uncertainty – with a little more confidence. And the government was able to take a clearer view on fiscal policy. The Treasury economic forecasts in the 2020 HYEFU incorporated the future government fiscal policy intentions conveyed to them by the Minister of Finance. The Reserve Bank’s forecasts did not directly incorporate those updated fiscal numbers, but…..the Reserve Bank and The Treasury were working closely together, the Secretary to the Treasury was a non-voting member of the Monetary Policy Committee, and so on. And, as we shall see, the Bank’s key macroeconomic forecasts weren’t dramatically different from Treasury’s.

The National Party has focused a lot of its critique on government spending. Here are the core Crown expenses numbers from three successive HYEFUs.

expenses $bn

From the last pre-Covid projections there was a big increase in planned spending. But by HYEFU 2020 – 15 months ago – Treasury already knew about the bulk of that and included it in their macro forecasts. By HYEFU 2021 the average annual spending for the last three years had increased further. But so had the price level – and quite a bit of government spending is formally (and some informally) indexed.

Here are the same numbers expressed as a share of GDP.

expenses % of GDP

By HYEFU 2021 the government’s spending plans for those last three years averaged a smaller share of GDP than Treasury had thought they would be a year earlier. (The numbers bounce around from year to year with, mainly, the uncertain timing of lockdowns etc).

There are two sides to any fiscal outcomes – spending and revenue. The government has been raising tax rates consciously and by allowing fiscal drag to work, such that tax revenue as a share of GDP, even later in the forecasts, is higher than The Treasury thought in November 2020. And here are the fiscal balance comparisons.

obegal

Average fiscal deficits – a mix of structural and automatic stabiliser factors – are now expected to be smaller (all else equal, less pressure on demand) than was expected in late 2020.

Fiscal policy just hasn’t changed very much since late 2020, and the fiscal intentions of the government then were already in the macro forecasts. Had those macro forecasts suggested something nastily inflationary, perhaps the government could have chosen to rethink.

But they didn’t. Here are the inflation and unemployment forecasts from successive HYEFUs.

macro forecasts tsy

In late 2020, The Treasury told us (and ministers) that they expected to hang around the bottom end of the target range for the following three years, with unemployment lingering at what should have been uncomfortably high levels. If anything, on those numbers, more macroeconomic stimulus might reasonably have been thought warranted.

There were huge forecasting mistakes, even given a fiscal policy stance that didn’t change much and was well-flagged.

That was The Treasury. But the Reserve Bank and its MPC are charged with keeping inflation near 2 per cent, and doing what they can to keep unemployment as low as possible. For them, fiscal policy is largely something taken as given, but incorporated into the forecasts.

Their (November 2020_ unemployment rate forecasts were a bit less pessimistic than The Treasury’s, but still proved to be miles off. This is what they were picking.

RB U forecasts

And here were the Bank’s November 2020 inflation forecasts, alongside their most recent forecasts.

rb inflation forcs

Not only were their forecasts for the first couple of years even lower than The Treasury’s, but even two years ahead their core inflation view was barely above 1 per cent. (The Bank forecasts headline inflation rather than a core measure, but over a horizon as long as two years ahead neither the Bank nor anyone else has any useful information on the things that may eventually put a temporary wedge between core and headline.) All these forecasts included something very much akin to government fiscal policy as it now stands. Seeing those numbers, the government might also reasonably have thought that more macroeconomic stimulus was warranted.

As a reminder the best measure of core inflation – the bit that domestic macro policy should shape/drive – is currently at 3.2 per cent.

core infl and target

There were really huge macroeconomic forecasting mistakes made by both the Reserve Bank and The Treasury, and – so it is now clear – policy mistakes made by the Bank/MPC. You might think some of those mistakes are pardonable – highly unsettled and uncertain times, not dissimilar surprises in other countries etc – and I’m not here going to take a particular view.

But of all the things Treasury and the Bank had to allow for in their forecasts, fiscal policy – wise or not, partly wasteful or not – just wasn’t one of the big unknowns, and hasn’t changed markedly in the period after those (quite erroneous) late 2020 macro forecasts were being done.

I guess one can always argue that if fiscal policy had subsequently been tightened, inflation would have been a bit lower. But Parliament decided that inflation – keeping it to target – is the Reserve Bank’s job. The government bears ultimate responsibility for how the Bank operates in carrying out that mandate – the Minister has veto rights on all the key appointees (and directly appoints some), dismissal powers, and the moral suasion weight of his office – but that is about monetary policy, not fiscal policy or government spending,