The RBNZ's dilemma

I've been thinking about the Reserve Bank's current predicament, and found the following framework helpful to sort out the issues in my own mind. It's a kind of IS-LM approach.

As graphed above, for any given inflation target there is a range of possible combinations of the cash rate and  the value of the Kiwi dollar that would be consistent with the target. Three illustrative combinations are shown above, for inflation targets of 1%, 2% and 3%. These combinations slope downwards to the right, reflecting the fact that a lower cash rate would require a higher NZ$ to maintain the same degree of overall monetary policy pressure on inflation, and are flattish, in that interest rates are probably the more powerful instrument, so that a relatively small change in cash rate would require a relatively large change in the NZ$.

Let's assume that there's some sort of at least short-term relationship between the cash rate and the exchange rate - it's not settled in macroeconomics (as far as I know) that there is a stable longer-term relationship, with a coefficient of known sign, between local interest rates and the exchange rate. It's plausible that there is an inverse relationship (overseas investors require higher interest rates to accept the risk of a weakening currency); one can also imagine a positive relationship (in current conditions, any currency offering even modestly higher interest rates is likely to get swamped by inflows from zero-interest-rate economies). For the sake of argument, let's assume, realistically, that at least for now higher local interest rates would lead to a higher Kiwi dollar, giving us the R$0 line in the graph below. At the RBNZ's chosen cash rate C0, the financial markets will set an exchange rate of $0.

Now let's suppose that overseas monetary policy becomes easier (as has just happened in Japan). The R$0 line shifts outwards to the right, to R$1: for any given cash rate, the Kiwi dollar is now more attractive than before, as its relative interest differentials have widened. It will appreciate, as shown in the graph below.

So here's the RBNZ's dilemma. If it keeps the cash rate at C0, monetary policy will be too tight: at the exchange rate $1 that corresponds to C0, inflation will be lower than 2%. To stay on track for 2% inflation, the RBNZ ought to cut the cash rate to C* (to get back on the P = 2% line), which will reduce the exchange rate to $*. But the new C*$* combo is a move rightwards along the P = 2% line, away from C0$0, with lower interest rates and a higher currency than before, making both of its problems (frothy housing and uncompetitive exporters) worse.

Fortunately, the Bank's got a bit of leeway: it doesn't have to keep inflation strictly at 2%. It's got a band of 1% to 3% to work with (on average aiming at a longer term average of 2%). Where the logic of things leads you to, though, is this: in current markets, the Bank will need to use this leeway, and let inflation undershoot 2% for some time.

Recession - what recession?

This morning, Radio New Zealand's 7.00am News had an item about a Christchurch food bank facing budget cuts, although the operator of the place said the need for it was still high. She said as many people as ever were still coming through the doors, and blamed it in part on "the recession".

She's not alone: you'll find any number of people convinced that we are in some sort of recession.

So, to be clear: we're not. We haven't been, for some considerable time. And we're not going into one any time soon.

By way of background, the authorities on what is or is not a recession, and how would you know one, are the Business Cycle Dating Committee at the National Bureau of Economic Research in the US: it produces the authoritative judgement on when the US is in recession or out of it. The Committee says that "During a recession, a significant decline in economic activity spreads across the economy and can last from a few months to more than a year". They don't go by the journalistic "two successive quarters of GDP contraction is a recession", and in their FAQ on the issue, they note that two small declines in GDP wouldn't meet their idea of a recession - they say "we consider the depth of the decline in economic activity", and they repeat that their definition includes the phrase "a significant decline in activity". Emphasis on significant, in other words.

And by "economic activity", they mean the broad behaviour of the economy as a whole, not just GDP. They say they do not have "a fixed definition of economic activity. It [the Committee] examines and compares the behavior of various measures of broad activity: real GDP measured on the product and income sides, economy-wide employment, and real income. The Committee also may consider indicators that do not cover the entire economy, such as real sales and the Federal Reserve's index of industrial production (IP)".

By no conceivable stretch of the imagination would eight successive quarterly increases in GDP meet the NBER's definition of a recession - yet that's what we've actually experienced. The last time New Zealand's GDP declined was in the December quarter of 2010: since then it's all been positive (very strongly so in the latest, December '12, quarter). The quarters in mid 2012 weren't flash, but they still showed the economy growing, though slowly.

Nor have things deteriorated in recent months: quite the reverse. Going by their latest (March) surveys of business and consumer confidence, the ANZ's economists reckon the economy will be growing at an annual rate of 2.8% by the middle of this year, and say "That’s solid stuff amidst extremely dry conditions". And there isn't a single forecaster amongst the 11 surveyed in the NZIER's Consensus Forecasts expecting a recession in the next three years. At worst, the outlook is for slow growth (1.5-1.9%), while the middle of the road consensus view is for two years of 2.7% growth, followed by 2%.

That's not recession, folks. Let's keep the term for when it's warranted. Spain's unemployment rate has just hit 27.2% - that's a recession.

Pricing for profit

I've just read an excellent article in the Sydney Morning Herald about how the promoters of the latest, low attendance, City-Country NRL game could have made more money from the event and got more spectators along, if they'd paid more heed to some standard economics principles.

But I'm also reminded that you can push your luck on price discrimination: I appreciate it's been around for a while and maybe you've seen it already, but if not, give this a go.

A propos of nothing (2)

One of the fishing books I've read recently is Tony Taylor's Fishing The River Of Time (Text Publishing, 2012). It came with good reviews, and its central proposition - a Sydney-based geologist, teaching a grandson to fish in Canada, while gently encouraging the wider perspectives that fishing brings - was a good one. It didn't hit home especially well with me, but give it a go for yourselves and see if you feel differently.

Along the way (p195) I was amused to read that "Recently, we have become preoccupied with wealth" - I'll give him that one, maybe we have - "and have become enamoured with a pseudo-science called economics that seems to be only concerned with the 'growth' of a convenient but impractical thing called money".

Even from someone with a low opinion of economics, that's an  inadequate description. And it reminded me that the giants of the profession have typically had rather more realistic and down to earth ideas of what economics is about. As Keynes said (Essays In Persuasion, 1931), " If economists could manage to get themselves thought of as humble, competent people, on a level with dentists, that would be splendid!"

Housing problems - lessons from Ireland (3)

What caused the Irish housing boom and bust crisis, and could it happen here?

The biggest element in the Irish event was a grossly inappropriate monetary policy. After Ireland joined  the Eurozone, it got the monetary policy of the European Central Bank - it got low interest rates, reflecting the slow growth conditions in the major Eurozone economies. Ireland, on the other hand, was 'the Celtic tiger', with strong growth in output, incomes, and prices. The 'one size fits all' Eurozone interest rates were way, way too low for an economy growing at a gangbusters rate.

The other important element was the 'me too' behaviour of both borrowers and lenders. On the borrowers' side, people saw their neighbours making pots of money by taking out mortgages at the low Eurozone interest rates, and buying houses that trebled in value in a decade. The house buying took on a self-fulfilling frenzy. On the lending side, banks, even if they saw a problem lurking down the track, and they may not have, did not want to lose out to their competitors when it came to getting their fair share of this booming mortgage market, so they accommodated the boom as well.

It didn't help that neither borrowers nor lenders were able to sort out, in real time, the speculative excesses from the increases that would have happened perfectly naturally anyway. There was strong net inward migration to Ireland (70,000 people a year at its peak), and strong growth in employment and incomes. House prices would have risen by some amount - perhaps by a substantial amount - in any event. Who, in the midst of very robust economic conditions, is able to figure out that the first 10% of price appreciation is in line with the strong economic fundamentals, but that the next 5% or 10% or 20% isn't?

Could it happen here? To some extent, we've got the Irish problem of importing too-easy monetary policy: we've had to match, or at least get within spitting distance of, the zero or near zero short term interest rates of the major OECD economies, to prevent our currency being driven up to even more insane levels. We've certainly got the same household and bank behaviour. And we've got some modest level of genuinely higher demand for housing, from immigration and from net increase of the domestic population, coupled with some degree of constraint on supply responding quickly to the increased demand. Increased demand and constrained supply make for higher prices, and can seed a subsequent expectations-driven bubble.

You can see why the Reserve Bank is worried. And you can also see why it won't be a surprise if the Bank tries to stop the arms dealers supplying the ammunition for this campaign - or in other words, looking to do something about the banks providing easy finance for a housing debacle.

A propos of nothing (1)

I've recently been reading a bunch of fishing books, and it took me back a few years to when my Dad and I used to go to the RDS Library in Dublin. On one occasion we came out and discovered that we had independently chosen the same book, A A Luce's Fishing and Thinking (1959).

Luce - Arthur Aston Luce MC - was a fixture in Trinity College Dublin. As his Wikipedia entry , https://en.wikipedia.org/wiki/A._A._Luce,  notes he holds the record for the longest serving Fellow (1912-77) of the College. The MC is for his Military Cross in the Great War.

When I was an undergraduate in Trinity (1969-73), I was what Trinity calls a 'waiter' - not, as you might think, someone who serves and clears the tables at the communal College meals ('Commons'), but rather someone who is paid to recite the Latin Grace before meals and the Latin Grace afterwards (20 quid a term, from memory, worth having back then). These days, nobody bothers much with Grace, either before or after, though occasionally as a party trick I will do the Grace before ('Oculi omnium in te sperant Domine. Tu das eis escam eorum in tempore opportune. Aperis tu manum tuam et imples omne animal benedictione tua. Miserere nostri, te quaesumus Domine, tuisque donis quae de tuae benignate sumus percepturi, benedicito, per Christum dominum nostrum').

One lunchtime - there are mid-day and evening 'Commons' - Luce was having lunch, and it happened to be his 90th birthday. When I got into the pulpit to recite the Grace after the meal, I decided to change the correct 'Tibi laus, tibi honor, tibi gloria, o beata et gloriosa Trinitas', to 'Tibi, Luce, tibi honor. Tibi gloria', and so on.

I regret to say, virtually nobody noticed, though Declan Kiberd, now a professor at Notre Dame, was one of them, giving me a "very droll, Curtin", as we came out onto the steps of the Dining Hall.
Luce, a distinguished academic, philosopher, historian, author, and war hero, who had survived the Western Front with conspicuous gallantry, was mugged by a lowlife in Dublin in 1977, and died of the injuries.

Housing problems - lessons from Ireland (2)

Some people like graphs, others don't relate to them, so here are some anecdotes to back up the previous post's graph of the Irish house price collapse.

My parents owned a house in a pleasant, middle class suburb of Dublin; my mother lived there until quite recently, when she had to move into care, and some cousins now live there. Four bedrooms, semi-detached, large garden at the back, rather rundown in decor (my ageing mother wasn't up to much house maintenance), but a good, solid, family home in a decent neighbourhood. During the house price madness, all the talk among my mother and her friends was about how much their house would likely fetch. Going by some local prices actually achieved, and the informed guesses of the neighbours - in a property craze, everyone becomes an expert - the house at the peak of the boom would have been worth something like 1.1 million or 1.2 million Euros. At the exchange rate of the time, that was about NZ$2.1-2.2 million.

That in itself gives you some idea of the scale of the madness. Over NZ$2 million for a  middle of the road family home? Even at Auckland's fancy prices, you can still get good family homes for a third of that.

And today? Dublin's housing market is rather moribund, but my spies tell me the family home would be lucky to fetch 400,000 Euros.

Second story: last time I was back in Ireland, a friend said, "Here, come and have a look at this". "This" turned out to one of the infamous "ghost estates" - farmland speculatively  redeveloped as housing during the boom, and in this case (as was typical of the others, too) consisting of tightly packed, high density houses in the middle of nowhere. Like many of the others, this development came on the market after the boom had started to implode. Not a single house sold: the entire development is empty.

Housing problems - lessons from Ireland (1)

Today's OCR review from the RBNZ repeated the Bank's concerns about frothy housing markets in some part of the country. You may well wonder whether the Bank's worries are justified. After all, New Zealand hasn't had the huge booms and busts that have occurred in recent years in residential property markets overseas, and maybe you're of the view that they can't happen here, or that, if they did, it wouldn't be the end of the world.

Just by way of a consciousness-raiser, here's what happened in another small island economy, Ireland.

Irish house prices, 2005-12

The graph, from Ireland's statistics agency the CSO, shows that prices peaked in late 2007 (and an earlier, unofficial, house price series showed that prices had roughly trebled in the decade leading to the peak) - and then halved over the next five years. When a serious house price boom  turns into a serious house price bust, you're not talking the 5% or 10% or 15% price fall that people could arguably live with. Rather, you're staring at something that can potentially be a serious disaster for personal and national finances.

Today's OCR

As expected, the RBNZ left the Official Cash Rate (OCR) on hold today, at 2.5%. Whether it should have, though, is debatable. As the Bank noted, the NZ$ was already overvalued, and has recently become even more overvalued after Japan's government embarked on a massive monetary easing. This has led to a lower yen and a higher Kiwi dollar - the Kiwi is up from around 65 yen six months ago, to around 84 yen today. Logically, Japan's easing ought to have led the RBNZ to ease policy here: if local monetary policy was set correctly before the yen's rise, then it is too tight now at this new, higher level of the Kiwi dollar. And it was arguably already too tight in the first place, as the chart below shows.

It resurrects the old Monetary Conditions Index - for people who may have forgotten, this is the measure that the Bank used to steer by, and that combines both interest rates and the exchange rate into a single measure of the overall bite of monetary policy. Today's index is at a level appropriate to a boomtime economy, one generating the sorts of inflationary pressures that were around in the robust economy of the mid 1990s and again in the pre-GFC years of 2005-07. But we're manifestly not in a boomtime economy: growth's modest, and inflation low. Policy looks on the over-tight side.

This suggests some possibilities. One is that the Bank doesn't appreciate or believe that monetary policy is too tight - unlikely. Another is that it knows policy is too tight, but it's not able in current market conditions (notably ultra-easy monetary policy in many of the major OECD countries) to move the NZ OCR/NZ$ mix to where it would like it to be - possible. Most likely, though, is that the Bank doesn't mind too much, and that it is placing considerable weight on the pressures in the housing market. It has been, and was again, upfront about these pressures - "House price inflation is high in some regions, despite prices already already being elevated. The Bank does not want to see financial or price stability compromised by housing demand getting to far ahead of supply" - but my take on the whole thing is that house prices are looming ever larger as the Bank's greatest policy concern.

Deregulation - how quickly we forget

New Zealand's in a regulatory and re-regulatory frame of mind these days - witness the recent Labour/Greens proposals for the electricity market - and to some degree that chimes with what is happening overseas, too. Many commentators have blamed the GFC, at least in part, on excessive or poorly executed deregulation of the financial markets, for example, with some  recent comments after Mrs Thatcher's death tracing it all the way back to what they say was the ultimately malign effect of the 'Big Bang' deregulation of the City of London in 1986. Re-regulation of the financial sector is consequently on the agenda pretty much everywhere, and by extension the supposed role of deregulation of financial markets in spawning the GFC has justified a general push towards more regulation of other markets as well.

To be sure, there were indeed fallibilities and excesses in the financial markets, and some reform is indeed needed. But how quickly we forget the real and ongoing benefits of deregulation. I was reminded of this by an excellent graph in last week's Economist, (print edition of April 13, not sure if this website link works for non-subscribers but it's http://www.economist.com/news/business/21576136-quiet-success-americas-freight-railways-back-track).

It shows the outcomes after the US railroads were deregulated in 1980, and they were just as you'd expect -  large declines in (real) prices for railroad customers, large increases in tonnage carried, and a huge increase in productivity (to two-and-a-half to three times the pre-deregulation level). And while the deregulated companies have had to fight much harder for business - (real) operating revenues are only just back to pre-deregulation levels - they are investing heavily in new infrastructure and making an acceptable rate of return on equity.

The GFC may have complicated the picture, but the big picture is still the same - if you want utilities or any other services delivered sustainably and at competitive prices, the first-best solution is still likely to be a workably competitive market based on rivalry between competing infrastructures.

General note

The opinions expressed here are my own, and not those of any other organisation I belong to, or work for.