Thursday, 11 June 2015

Where are we? Where are we?

We got a somewhat unexpected interest rate cut from the Reserve Bank this morning - though having been wrong on enough occasions about the macroeconomic cycle, I think I'm allowed to say that I personally wasn't too surprised - and inevitably the question arose for the folks at No 2 The Terrace: you raised interest rates back in 2014, and now you've had to change direction. Did you take a misstep last year?

The Bank came prepared for the criticism with Box A in the Monetary Policy Statement. Here are two of the graphs from that Box.

The first one (below) compares the Bank's expected track for 90 day interest rates at the time of the December '13 Monetary Policy Statement with the expected track in today's. Back then, the prospect was for a series of increases (with 100 basis points of increase actually delivered by the Bank in the first half of 2014); now, the prospect is for lower rates, with one 0.25% cut already in the bag and another likely. So there's no getting past the fact that what the Bank thought it had to do has gone through a complete turnaround, and the rises in 2014 now look rather odd. What happened?

That brings us to the graph below, which shows the Bank's perceptions of the output gap in December '13 (red line), its take on the state of the output gap as of today (blue line), and the difference between the two (the grey bars). The output gap is a measure of how close the economy is to full capacity, and positive output gaps (i.e. the economy going especially strongly) tend to bring inflationary pressures in their wake.

And as you can see, back at the end of 2013 the Bank thought that the economy was already bursting at the seams, and would become increasingly more strained again. Hence the need for interest rises to cut off the inflationary pressure that would be likely to follow. On more recent estimates of the state of the economy, however, we weren't actually at full capacity in late 2013 (mostly because labour supply was expanding faster than thought, thanks to sharply higher immigration and a higher participation rate), and it's only around now that we've got there.

So, not a mistake, just the best decision you can make on the best, albeit fragile, evidence in front of you at the time. And as I've said before, I have considerable sympathy for policymakers making these important decisions in what is essentially an economic fog. What's more, you can't rule out that there may be similar changes of direction in the future: self-evidently, these output gap measurements are fickle beasts, and you can't be sure they're telling you the right thing today, or won't tell you something different tomorrow.

Here's another chart (from p21 of the Statement): it shows the Bank's estimated range of uncertainty around the location of the output gap. Right now, their best guess is that we're roughly around full capacity, but for all we really know we could be somewhat below it (1% of GDP below) or quite a bit above it (by some 1.75% of GDP).

So while it's tempting to take pot shots at Reserve Bank governors backtracking - or Finance Ministers not quite getting to surplus, for that matter - hold your fire. Bag them if they make decisions at odds with the info at the time, sure. But they're not: this is what making sensible decisions under uncertainty looks like, and, unless there's a miraculous leap forward in the art of output gap assessment, probably always will.

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