Brian Fallow of the New Zealand Herald wrote a very informative article on the inflationary target that the Reserve Bank of New Zealand keeps missing – the CPI has been below the bottom of the bank’s 1 to 3% target band. Some will say that the RBNZ has been too tight with its monetary policy stance – maintaining high interest rates for too long. Assistant Governor John McDermott has defended the bank’s position for the following reasons:
- Nearly half the CPI consists of tradables where the price of goods is impacted by competition from outside New Zealand. For the last four years the global economy has been in a disinflationary environment caused by excess supply and in particular low commodity prices especially oil. Year ending September 2016 Tradables = -2.1%. This offset almost all of the +2.1% rise in non-tradables prices. See graph below.
- The recovery form the GFC has been quite weak and with the NZ$ strengthening (imports cheaper) accompanied by lower world prices has meant that import prices have been very low.
- The growth of the supply-side of the economy has been particularly prevalent which again has led to less scarcity and lower prices.
- Recent years has seen immigration boost the demand side of the economy but because the age composition is between 15-29 rather than 30-40 in previous years, the former has a much less impact on demand as they don’t tend to have the accumulated cash for spending.
- The RBNZ reckon that the output gap is now in positive territory (actual growth being higher than potential growth) which will start to put pressure on prices as capacity constraints become more prominent.
- Statistically with a weak inflation rate in the December 2015 quarter the December 2016 quarter is most likely to be higher as the percentage change is taken on the CPI of the previous year.
The spectre of deflation hitting the New Zealand economy does not seem to be a concern at this stage especially with the longer-term inflationary expectations being in the mid range of the target bank i.e. 2%.
In the 1970’s and 1980’s the global economy was battling the menace of stagflation – high inflation and high unemployment. In order to counteract this, monetary policy was seen as responsible for controlling the inflation rate through the adoption of targeting. The New Zealand government was the first country to introduce this through the Reserve Bank Act 1989 which gave the responsibility of the central bank to keep inflation between 0-2% (later changed to 1-3%). Monetary policy should therefore play the lead role in stabilizing inflation and unemployment with fiscal policy playing a supporting role with automatic stabilisers – economic stimulus during economic downturns and economic contractions during high growth periods. Fiscal policy is therefore focused on long term objectives such as efficiency and equity.
In the post financial crisis world the usefulness of monetary policy is dubious. The natural rate of interest has now dropped to historical low levels. The natural rate of interest being a rate which is neither expansionary or contractionary. The issue for the central banks is how to bring about a stable inflation rate when the natural rate of interest is so low.
Historical Natural Rates of Interest
In the 1990’s the natural rate of interest globally was approximately between 2.5% and 3.5% but by 2007 these rates had decreased to between 2 – 2.5% – see graph. By 2015 the rate had dropped sharply and as can be seen from the graph near zero in the USA and below zero in the case of the euro zone. The reasons for this decline in the natural rate were related to the global supply and demand for funds:
- Shifting demographics and the ageing populations
- Slower trend productivity and economic growth
- Emerging markets seeking large reserves of safe assets
- Integration of savings-rich China into the global economy
- Global savings glut in general
Therefore the expected low natural rate of interest is set to prevail when the economy is at full capacity and the stance of monetary policy in neutral. However this lower rate means that conventional monetary has less ammunition to influence the economy and this will mean a greater reliance and other unconventional instruments – negative interest rates. In this new environment recessions will tend to be more severe and last longer and the risks of low inflation will be more likely.
Future strategies by to avoid deeper recessions.
Governments and central banks need to be a lot more creative in coping with the low natural rate environment. Fiscal policy could be used in conjunction with monetary policy with the aim of raising the natural rate. Therefore long-term investments in education, public and private capital, and research and development could be more beneficial. More predictable automatic stabilisers could be introduced that support the economy during boom and slump periods. Additionally unemployment benefit and income tax rates could be linked to the unemployment rate. The reality is that monetary policy by itself is not enough especially as the natural rate of interest and the inflation rate are so low. What can be done:
- The Central Bank would pursue a higher inflation target so therefore experiencing a high natural rate of interest which leaves more room to cut to stimulate demand. The logic of this approach argues that a 1% increase in the inflation target would offset the harmful effects of an equal-sized decline in the natural rate
- Inflationary targeting could be replaced by a flexible price-level of nominal GDP, rather than the inflation rate.
Monetary policy can only do so much but with global interest rates at approximately zero there needs to be the support of the politicians to enlist a much more stimulatory fiscal policy. Monetary policy has run out of ammunition and we cannot rely on central banks to fight recessions. However a less politicised fiscal policy, which is free to act immediately, has the ammunition to revive the economy.
Monetary Policy in a low R-star World – FRBSF Economic Letter
The Economist: September 24th 2016 – The low-rate world
From her Jackson Hole speech US Fed Chair Janet Yellen used the Taylor Rule to suggest that the Fed Funds rate today should already be around 1.33% – currently at 0.50%. She also used the Taylor rule to explain how US interest rates should have been negative after the Global Financial Crisis. This same rule suggests that the rate should already have been 1.25% in June – see Chart below.
Source: National Australia Bank: Australian Markets Weekly – 5th September
What is the The Taylor Rule?
This is a specific policy rule for fixing interest rates proposed by the Stanford University economist John Taylor. Taylor argued that when:
Real Gross Domestic Product (GDP) = Potential Gross Domestic Product and
Inflation = its target rate of 2%, then the Federal Funds Rate (FFR) should be 4% (that is a 2% real interest rate).
If the real GDP rises 1% above potential GDP, then the FFR should be raised by 0.5%.
If inflation rises 1% above its target rate of 2%, then the FFR should be raised by 0.5%.
This rule has been suggested as one that could be adopted by other central banks – ECB, Bank of England, etc for setting official cash rates. However, the rule does embody an arbitrary 2% inflation target rather than, say 3% or 4%, and it may need to be amended to embody alternative inflation targets at different times or by different central banks. The advantages of having such as explicit interest rate rule is that its very transparency can create better conditions for business decisions and can help shape business people’s and consumers’ expectations. Central banks prefer to maintain an air of intelligent discretion over the conduct of their policies than to follow rules, but to some extent they do unwittingly follow a Taylor rule. This makes the rule a useful benchmark against which actual policies can be judged.
Last Thursday it was no real surprise that the RBNZ cut the official cash rate to 2%. With this cut you would have expected some fall in the value of the $NZ but instead it appreciated. So why did the $NZ appreciate? Graeme Wheeler was interviewed by NZ Herald reporter Liam Dann and explained to him that we live in a phenomenal situation. Global interest rates have been incredible low especially in countries like Japan, the UK and Australia – see table below. Add to that the impact of quantitive easing since 2009 and negative interest rates in countries which account for 25% of world GDP and you have a very unusual situation.
Some key assumptions from the RBNZ are that:
The global economy will start to pick-up which will mean that there will be less pressure on the NZ$ as investors look to other currencies to invest in. Remember that the NZ$ is the 10th most traded currency in the world and at uncertain times in the global economy it is seen as safe place to ‘park’ your money. This therefore increases the demand for NZ$’s appreciating its value.
Also the growth of the domestic economy with GDP expanding by 2.4 percent over the year ended in the March 2016 quarter, could mean a rise in inflationary expectations which should bring the inflation rate closer to the 2% mid point method in the policy target agreement. However this is a drop from 3.2% from the previous year.
According to Stephen Toplis of the BNZ
Clearly, the NZD is already higher than anticipated and inflation expectations could well be constrained for longer as annual headline inflation falls, potentially, sub-zero. It was also interesting that the RBNZ did not repeat its upside scenario for interest rates due to higher house prices. This reaffirms the Bank’s easing bias.
All things considered then, and noting there is still significant uncertainty as to the exact way ahead, we can reasonably comfortably conclude that:
– There will be at least one more rate cut;
– The balance of risk is for even more;
– The cash rate is going to be at least as low as it is now for a long time;
– Inflation is likely to continue surprising to the downside in the near term;
– Only when the rest of the world plays ball will the NZD wilt.
With the RBNZ to announce the Official Cash Rate next Thursday there is common agreement that there will be a 0.25% cut to leave the OCR at 2.00%. However with 2.8% growth and a favourable PMI do the RBNZ need to cut rates? With inflation at 0.4% it is still not between the 1-3% target range (as outlined by the Policy Target Agreement in the Reserve Bank Act 1989), and there is pressure for the central bank to hit a target of 2% inflation. With the global economy in an era of very low inflation (even a threat of deflation) one wonders the logic of keeping the PTA at 1-3%. In fact it is being reviewed by the RBNZ in the next month. The logic behind the lower OCR will be to stimulate more spending but also trying to make the NZ$ less attractive for foreign investors.
With NZ rates being significantly higher than other developed countries the NZ$ is seen as a good investment and ultimately attracts a lot of ‘Hot Money’ into the economy. The NZ$ is the 10th most traded currency in the world and this is also due to the stable environment in the NZ economy as well as relatively high interest rates. But have the lower rates had the effect of reducing the value if the NZ$? A lower dollar makes exports prices more competitive and increases the price of imports.
If you contrast the OCR with the TWI over the last year you will see that a lower OCR doesn’t necessarily mean a lower NZ$. Furthermore the lower rates do nothing to halt the rise in the property market especially in Auckland.
The RBNZ faces potentially conflicting outcomes as it tries maintain financial stability and price stability. The Policy Targets Agreement demands lower interest rates in a bid to raise CPI inflation while financial stability concerns, especially with the housing market, probably demands higher rates.
Images from ANZ Bank
Below is a very good video from the Reserve Bank of New Zealand outlining how the Official Cash Rate (the key rate of the Central bank) works in maintaining price stability. This is part of the Internal Assessment for NCEA Level 2. Remember the following:
Reserve Bank Act 1989 – made price stability the sole aim of monetary policy.
- The RBNZ, who implements monetary policy, was made responsible for keeping prices “stable”.
- “Price Stability” is defined in the Policy Target Agreement (PTA) as keeping the inflation rate between 1 and 3%.
- “Inflation” is measured by the percentage change in the Consumer Price Index (CPI). Statistics NZ calculates the CPI.
A HT to Yr 13 student Albere Schroder for alerting me to this interview with the four most recent US Federal Reserve chiefs.
- Janet Yellen, the current Federal Reserve chairwoman was joined by:
- Ben Bernanke (2006-2014)
- Alan Greenspan (1987-2006)
- Paul Volcker (1979-1987)
Although the Fed Reserve chiefs served during widely divergent eras and are known to have different political views, the most notable take-away of the evening was the extent of their deep agreement.
There was a consensus that the Fed’s post-crisis rescue efforts have been successful and the economy is currently on a steady growth path, rather than rising thanks to a bubble that will soon burst. The remarks were a sharp rebuttal to the conventional wisdom of the contemporary Republican party and many grassroots conservatives that excessive stimulus from the Fed is either on the verge of sparking a drastic uptick in inflation, or already fostering a stock market or asset bubble.
“I’m not saying that the government should always be spending,” Bernanke said. “But at certain times, particularly in a recession, when the central bank is out of ammunition or ammunition is relatively low, then fiscal policy does have a role to play, yes.” Ben Bernanke
Greenspan had other ideas in that he disagreed with the idea that government spending should be increased during a downturn as this impacts on the country’s longer-term debt problem. Worth a look.