Taylor rule and New Zealand interest rates (OCR) at 8%

The Taylor Rule is a specific policy rule for fixing interest rates proposed by the Stanford University economist John Taylor. The rule is a formula for setting interest rates depending on changes in the inflation rate and economic growth.

A simplified formula is: r = p + 0.5y + 0.5 (p – 2) + 2
r = the short term interest rate in percentage terms per annum.
p = the rate of inflation over the previous four quarters.
y = the difference between real GDP from potential output.
This assumes that target inflation is 2% and equilibrium real interest rate is 2%

Taylor argued that when:

• Real Gross Domestic Product (GDP) = Potential Gross Domestic Product
• Inflation = its target rate of 2%,
• 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 1.5%.
He stated that the real interest rates should be 1.5 times the inflation rate.

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.

New Zealand and the Taylor rule
When the Taylor Rule is applied to the New Zealand economy it suggests an optimal, OCR of more than 8% – see graphic from live gross domestic product (GDP) tracker. A rate as high as this would do significant damage to the economy even if inflation did get down to the 2% target for inflation. Households and businesses would find it particularly hard with incomes being squeezed. An OCR of this level would have an unwieldly impact on households and businesses, squeezing incomes.

Criticisms of Taylor rule
The theory assumes that only the central bank can affect the equilibrium real rate of interest and there is a closed economy with households that have identical consumption patterns and the same declining marginal utility. However, an economy is a much more intricate machine which aims to allocate scarce resources to satisfy the utility of economic agents such as individuals, firms and government. The dominant model for many years has been “Dynamic Stochastic General Equilibrium” (DSGE) and it takes all the characteristics of an individual (this person is typically called the representative agent) which is then cloned and taken to represent the typical person in an economy. These agents make supposedly perfect decisions by optimising, working out the kinds of mathematical problems in an instant. This almost rules out any fluctuations in the natural rate that might arise from alterations in how individuals discount the future, from how consumption preferences may differ among individuals or alter over time for one individual, or from differences in the distribution of wealth.

Source: Live GDP tracker

OCR – LSAP – FLP = New Zealand’s Monetary Policy Toolkit

Below is a useful flow diagram from the ANZ bank which adds Large Scale Asset Purchases (LSAP) and Funding for Lending Programme (FLP) to the Official Cash Rate (OCR – Base Rate)

LSAP – this is the buying of up \$100 billion of government bonds – quantitative easing
FLP – this gives banks cheap lending based on the Official Cash Rate – could be about \$28 billion based on take up
OCR – wholesale interest rate currently at 0.75%. Commercial banks borrow at 0.5% above OCR and can save at the Reserve Bank of New Zealand (RBNZ) at 1% below OCR.

With FLP and more LSAP this will mean lower lending rates and deposit rates. This should provide more stimulus in the economy and allay fears of future funding constraints making banks more confident about lending. Add to this a third stimulus – an OCR of 0.75%. Although there is currently a tightening policy the rate is probably still stimulatory. The flow chart shows the impact that these three stimulus policies have on a variety of variables including – exchange rates – inflation -unemployment – consumer spending – investment – GDP. Very useful for a class discussion on the monetary policy mechanism.

For more on Monetary Policy view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.

Monetary Policy in New Zealand – what the OCR means.

The Monetary Policy Committee of the Reserve Bank of New Zealand (RBNZ) operates monetary policy in New Zealand through adjusting the official cash rate (OCR). The OCR was introduced in March 1999, and is reviewed 7 – 8 times a year. The recent amendment to the Reserve Bank’s legislation sets up a Monetary Policy Committee that is responsible for a new dual mandate of keeping consumer price inflation low and stable, and supporting maximum sustainable employment. The agreement continues the requirement for the Reserve Bank to keep future annual CPI inflation between 1 and 3% over the medium-term, with a focus on keeping future inflation near the 2% mid-point.

Through adjusting the OCR, the Reserve Bank is able to substantially influence short-term interest rates in New Zealand, such as the 90-day bank bill rate. It also has an influence upon long-term interest rates and the exchange rate. In theory this is what the impact should be:

Higher interest rates = contractionary effect which leads to lower inflation and less employment growth

Lower interest rates = expansionary effect which can lead to higher inflation but more employment growth.

However the Reserve Bank of New Zealand acknowledge that it is a very complex mechanism as interest rates impact the aggregate demand through various channels – C+I+G+(X-M) – and over varying time periods.

On a normal day consumers, producers, government etc undertake financial transactions involving the commercial banking system. At the end of each day they need to ensure that their accounts balance but some registered banks may find that they are short of funds following the net aggregate result of these transactions, while others may find that they have substantial deposits.

Commercial banks that are have positive balances can leave this money with the Reserve Bank overnight. They receive the OCR on deposits up to a threshold level, and then receive the OCR less 1% for the remainder. Commercial banks that have a negative balance can borrow overnight from the Reserve Bank at an overnight rate of the OCR plus 0.5%. Therefore if you use the current OCR rate of 1% you get this situation. Remember that 50 basis point = 0.50% and 100 basis points = 1.00%.

Banks have the option (and incentive) of borrowing from each other, and using the Reserve Bank as a last resort. In doing so, both parties gain as the lending and borrowing rate tends to mirror the OCR (given the level of competition in the banking market). Those banks with excess deposits can then receive an overnight rate close to one percent (rather than a zero interest rate on any funds over the threshold level). Those banks who need to borrow funds can do so at around the OCR rate, rather than at 1.50 percent. The interest rate at which these transactions take place is called the overnight interbank cash rate see graph below.

Source: Grant Cleland – Parliamentary Monthly Economic Review – Special Topic – October 2019

RNBZ can’t seriously be thinking about reducing the OCR

Today’s labour market data showed a drop in unemployment from 4.4% to 3.9% and an employment rate of 68.3% the highest since the HLFS survey was first reported in 1986. The
unemployment rate of 3.9% is the lowest since June 2008 and towards the lowest bound of the RBNZs estimated 4% to 5.5% range for the Non-Accelerating Inflation Rate of Unemployment (NAIRU). See graph below:

Tomorrow the RBNZ present their November Monetary Policy Statement (MPS) and these figures give them limited time to change any policy direction. Remember that the RBNZ is now tasked “supporting maximum sustainable employment within the economy” alongside its price stability mandate of 1-3% CPI with a target of 2%. However these figures seem to suggest that further easing is not required to meet employment objectives.

What is the Natural Rate of Unemployment?

The natural rate of unemployment is the difference between those who would like a job at the current wage rate – and those who are willing and able to take a job. In the above diagram, it is the level (Q2-Q1).

Source: economicshelp.org

The natural rate of unemployment will therefore include:
Frictional unemployment – those people in-between jobs
Structural unemployment – those people that don’t have the skills that fit the jobs that are available.

It is also referred to as the Non-Accelerating Inflation Rate of Unemployment (NAIRU) – the job market neither pushes up inflation nor holds it back.

Source: BNZ – Economy Watch – 7th November 2018

How does RBNZ use OCR (interest rates) to influence short-term rates.

From the Reserve Bank of New Zealand – useful for Monetary Policy.

The Reserve Bank uses the Official Cash Rate (OCR) in two ways to influence the short-term interest rates your bank offers you.

Monetary Policy – the OCR and how it works

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.

King’s College win Reserve Bank of New Zealand Monetary Policy Competition

Congratulations to Martin Luk (Governor), Amanda Ngo, Jake McConnell, Shaan Keesha and Amay Aggarwal who won the Reserve Bank of New Zealand Monetary Policy Competition. The team made a 10 minute presentation on their OCR decision to three RBNZ economists Jed Armstrong and Hayden Skilling, and Assistant Governor John McDermott. They then had a 20 minute question and answer session in which they showed great teamwork in answering some very searching questions. There were 5 other schools in the national final.

Bank Funding Costs

From the BNZ Economy Watch.

In the Post-GFC environment, heightened bank funding costs have driven a wedge between the OCR and borrowing costs. The key contributor has been RBNZ regulation requiring banks to source more secure forms of funding. Some relief in costs was experienced last year as some expensive funding from the GFC rolled off, and some reduced competition in the domestic deposit market was experienced. At the margin there is potential for a little further decline in funding costs. However, greater stability is now expected. Therefore more of the rise the underlying OCR will ultimately be felt by borrowers.

“Beware the Ides of March” – RBNZ

Although the Ides of March refer to the 15th March, the next Monetary Policy Statement from the Reserve Bank Governor is on the 13th March and most commentators believe that this will be the first of many hikes that will see the OCR hit 4.5% by late 2015. There was a belief that RBNZ Governor Graeme Wheeler would start hiking last week but central banks don’t like giving exact dates. But the Christchurch rebuild and the increase in Auckland house prices will warrant higher costs of borrowing

Central Banks have often used the term ‘the neutral rate’ which refers to a rate of interest that neither stimulates the economy nor restrains economic growth. This rate is often defined as the rate which is consistent with full employment, trend growth, and stable prices – an economy where neither expansionary nor contractionary measures need to be implemented. In most economies post GFC the neutral rate of interest fell as they have required lower rates to try and encourage growth. The graph from the BNZ below shows that the neutral rate in NZ has dropped form 6% to 4.5%.

To cut, increase or status quo – that is the question.

The BNZ Markets Outlook looked at reasons why Graeme Wheeler, the RBNZ Governor, might keep a ‘steady as she goes’ attitude to Thursday’s OCR review. Below are some thoughts as to why he could be swayed to increase or decrease the OCR rate.

With all that said it is expected that Graeme Wheeler will leave the OCR unchanged at 2.5%.

Unemployment worries for New Zealand economy

Figures out today show that the unemployment rate increased by 0.5% from the previous quarter to 7.3% – see ASB Bank graph.. This was a concern considering the market expectation was a reduction of 0.1% to 6.7%. The main fall was in Auckland where employment fell by 2% and this should mean that new Reserve Bank Governor Graeme Wheeler will hold off on any increase until late next year. A reduction in the OCR is unlikely unless there is further deterioration on overseas markets.

Remember the types of unemployment

Frictional – The unemployment that inevitably results from the process of job-seeking. It will exist under conditions of generally so-called full-employment conditions (see employment, full), but it is not precisely clear what proportion of total unemployment can be called frictional.

Structural – Unemployment arising from changes in demand or technology which lead to an oversupply of labour with particular skills or in particular locations. Structural unemployment does not result from an overall deficiency of demand and therefore cannot be cured by reflation, but only by retraining or relocation of the affected work-force, some of which may find work at low wages in unskilled occupations.

Cyclical – Demand-deficient unemployment occurs when there is not enough demand to employ all those who want to work. It is a type that Keynesian economists focus on particularly, as they believe it happens when there is a disequilibrium in the economy.

Seasonal – Some workers, such as construction workers or workers in the tourist industry, tend to work on a seasonal basis. Seasonal unemployment tends to rise in winter when some these workers will be laid off, whilst unemploymnet falls is summer when they are taken on again.

RBNZ keeps OCR at 2.5%

Today Alan Bollard, Governor of the Reserve Bank of New Zealand, unsurprisingly kept the Official Cash Rate at 2.5%. One area of concern in today’s statement was the NZ dollar – the RBNZ would prefer to see it a lower levels (see notes below on advantages and disadvantages of a strong dollar). Therefore the future direction of NZ dollar will be critical to interest rate decisions. The bank did suggest that they would hold off on rises with the sustained strength of the NZ dollar.

The Output Gap
The output gap refers to the difference between potential GDP and actual GDP or actual output. According to the BNZ the Treasury produced three estimates of the output gap using various filtering techniques. They were all close to zero, with one slightly abovevand two slightly below. If this is where the true output gap currently sits, it means there is little spare capacity in the economy. So, any reasonable growth is likely to lead to inflationary pressure before too long. It could yet turn out that the RBNZ does not have that much time up its sleeve, before medium term inflation pressures emerge. That though, is likely to be a story for later in the year.

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• A high NZ\$ leads to lower import prices – this boosts the real living standards of consumers at least in the short run – for example an increase in the real purchasing power of NZ residents when traveling overseas
• When the NZ\$ is strong, it is cheaper to import raw materials, components and capital inputs – good news for businesses that rely on imported components or who are wishing to increase their investment of new technology from overseas countries. A fall in import prices has the effect of causing an outward shift in the short run aggregate supply curve
• A strong exchange rate helps to control inflation because domestic producers face stiffer international competition from cheaper imports and will look to cut their costs accordingly. Cheaper prices of imported foodstuffs and beverages will also have a negative effect on the rate of consumer price inflation.

• Cheaper imports leads to rising import penetration and a larger trade deficit e.g. the increasing deficit in goods in the NZ balance of payments in 2001
• Exporters lose price competitiveness and market share – this can damage profits and employment in some sectors. Manufacturing industry suffered a steep recession in 2001 partly because of the continued strength of the NZ\$, leading to many job losses and a sharp contraction in real capital investment spending and the lowest profit margins in manufacturing industry for over a decade
• If exports fall, this has a negative impact on economic growth. Some regions of the economy are affected by this more than others. The rural areas are affected by a strong dollar in that our produce becomes more expensive to overseas buyers.