Friday, 19 September 2014

Decisions, decisions

The US Fed met earlier this week, and said what people had expected it to: if things pan out as the Fed expects, it will stop its asset buying programme ("quantitative easing") after its October meeting, and on the interest rate setting front it said that "it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends".

The financial markets quite liked the sound of it,with (for example) American shares going on to hit a new record high. But there was one item from the Fed's published deliberations which caused some markets (including both the Kiwi dollar and the Aussie dollar) to have a spasm, and that was the range of views within the Fed about the future path for the policy interest rate (the 'Fed funds' rate). It's published as a graph, which I've shown below: it's sometimes called the 'dots plot'. It shows each attendee's view of where the Fed funds rate ought to be at the end of each of 2014, '15 and '16, and there's a 'longer run' opinion which we'll come back to.

Incidentally there are 17 dots but only 10 attendees who have a monetary policy vote: non-voting attendees' views are included as well.

What caused our local currencies to sell off was that some of the attendees at the meeting thought that the Fed funds rate ought to be raised quite a lot, quite quickly. If that happened, the gap between our local Kiwi and Aussie interest rates and US ones might close faster than previously expected, reducing the relative attractiveness of our local currencies.

The substance of the decision was interesting enough, but what was more interesting to me was what it shows about how monetary policy decisions are made, and what the Fed's take is on the potential long-term performance of the American economy.

First of all, I'm glad to see that monetary decisions in most places these days are a lot more transparent than they used to be. We don't have people's names against the Fed's dots, but at least we have the dots, and we do have names when it comes to the policy decision itself (an 8-2 split for it). Ditto for the Bank of England's policy decisions (7-2 at the latest one). Typically, the European Central Bank is the uninformative one out: the official announcement is the bare bones minimum, and while the President is a bit more forthcoming at the press conference - "On the scale of the dissent, I could say that there was a comfortable majority in favour of doing the programme" - I don't think this old style secrecy is at all consistent with what should be expected in a democracy from the experts delegated to make these important decisions on our behalf.

It also gets you thinking about whether the policy decision should be made by a committee or by an individual. The distinction is a little arbitrary - even single-person regimes like ours, where the Governor formally sits alone on the hot seat, have a lot of collective advisory mechanisms going on in the background, and committees tend to have informal leaders - but it's still useful.

The strongest argument for the committee is that collective decisions are usually better decisions: the best argument for the individual is the accountability pressure to get it right. And there are counterarguments both ways too: committees get groupthink, individuals get arrogant. I generally lean towards the individual approach (even though it looks like the minority approach these days).

Looking at the dots, I wonder if they say something about the way collective decisions are made. For example, I have some difficulty with the dot that says the Fed funds rate ought to be close to 1% by the end of this year, ditto with the dots saying it still ought to be close to zero at the end of 2015, and a lot of difficulty with the dot that says it should be close to 3% by the end of next year. These are in my opinion not credible views as straight down the line analysis. Rather they're there, I think, as a kind of "devil's advocate" marker, a psychological nudge to the rest of the voting members towards higher or lower rates. Maybe the decision's all the better in the end for these nudges from the fringes. Maybe. Can't say it's shifted me from one decisionmaker giving it their best shot.

The other interesting thing that comes out of these meetings is the "long run" estimate of where the interest rate should be. It's the Fed's stab at what the "neutral" rate would be when the economy is where it ought to be, in terms of growing at its long-run sustainable rate of GDP growth and generating an acceptable long-run rate of inflation. We can see those estimates, too (on the right hand side of the graphs below).

The edges of the shaded bit show the highest and lowest estimates, and the darker bit in the middle is the trimmed set of views after dropping the three highest and three lowest (so any "nudges" don't count). In passing, it's good to know that the cyclical outlook is looking solid, with not a single attendee picking a return to recession, or anything like it, while inflation is expected to remain well contained.

The best take the Fed has on the US economy is that in the long-run it can grow at a tad over 2% a year, with unemployment (not shown here) around 5.5%, while inflation stays at 2%, and the Fed funds rate would be 3.5-4.0% (from the dots graph).

Two per cent a year isn't a lot, and there's quite a debate within the US about whether in fact it's lost its mojo, and if so, why (permanent damage from the GFC? over-regulation? diminishing returns from technological innovation? demographics? international competitors eating its lunch?).

You end up wondering how New Zealand stacks up by comparison. And the answer is, pretty well. Taking a bit of licence with the numbers in the Reserve Bank's latest Monetary Policy Statement, especially those in Table A and Table D, I'd say our long-run growth rate is in the region of 2.9%, our long-run unemployment rate is in the low 5% area, our long-run inflation rate is about 2%, and the long-run neutral interest rate is an official cash rate in the region of 4.5%. Why we come out with a somewhat higher inherent interest rate isn't too clear, but otherwise we scrub up pretty well.

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