Monday, 7 December 2015

The dance of the seven veils (economist version)

..and what I mean is, I'm going to show you a series of graphs, but I'm going to take my time baring all.

Here's the first bit.

This shows our actual official cash rate (the OCR, the bold black line) over the last couple of years, compared with the Reserve Bank's projections of where it thought the cash rate would need to go (the various coloured lines, which are forecasts the Bank made at different times). You'll see that recently the OCR has gone down, though the Bank had thought it would need to go up. In our 'gotcha' culture, there have been plenty of people to say the Bank made a 'mistake', but as I've said before, that's probably not the best interpretation. People make the best decisions they can under considerable uncertainty, and every now and then they get blindsided.

Right. here's the next bit.

This is the entire history of the Bank's interest rate projections, since we started on the inflation targetting caper, compared with what actually happened.

I could look at this graph for hours. No, really, I could. It's fascinating.

If you were a blame-seeking muckraker, you could go to town on this. "For over twenty years the Bank has been saying that the OCR will need to go here, or there, and the OCR has gone somewhere else. Heads must roll!" But since we are reasonable people who understand nuance, reality, complexity and uncertainty, let's try some different responses.

My first thought was that it said something about forecasting. Very often, in the financial markets, the default forecast is that something that is going up, will go up a little more, and then drop back (or, if it's going down, will drop a little more, and then rise). You see it all the time in, for example, forecasts of exchange rates. The default tends to be some kind of "reversion to the mean" - people tend to think the current trend could run on a bit more, but will eventually drop back to something more "normal". So my initial reaction was that this looked like a not very sophisticated forecasting scheme.

But in talking to some folks at the Reserve Bank's modelling workshop today, I came to the view that there's something else happening. These aren't really "forecasts" in the normal sense of "what will happen to something": rather, they're actually the RBNZ's view of what OCR will be needed to keep inflation inside the RBNZ's target range. Seen in that light, what the graph arguably shows is that the RBNZ has tended to think that monetary policy is more powerful than it actually is.

For example, over that period from 2004 to 2007, the Bank thought that modest increases in the OCR would have enough oomph to keep things under control: in fact, the OCR had to rise a lot more than that to do the job. Similarly, in the weaker post-GFC period, the Bank thought a brief period of stimulus would be enough to fire things up. In the event, it took a much longer time, and much lower rates than the Bank had expected to wield, to try and work inflation up again. And it hasn't succeeded yet: it thinks it's on track, and that today's low interest rates will be enough to get inflation back to near 2%. But on this showing it's just as likely that monetary policy still isn't as high-powered as you might imagine, and that even lower rates for even longer might be required.

You might think, why has our central bank held this overoptimistic view of the influence of monetary policy? I don't have a good answer to that, but - and here comes the next bit of the striptease - we're in good company. Here are the equivalent forecasts made by the Norwegian and Swedish central banks, in both cases dating from when they also embarked on the great inflation targetting adventure.

Interestingly, they have both tended to err in the same systematic way - they have persistently thought that interest rates would need to be higher than actually proved necessary. Part of it is happenstance: the post-GFC global economy has been a strange place, where central banks might have reasonably expected inflation to have picked up as the global economy has recovered, but it hasn't, for reasons that aren't clear yet. And part of it, in my view, is that when a central bank first sets out to be an inflation targetter, it's absolutely got to establish its credibility early in the piece. And above all, that means not letting inflation go above target. So there's an inevitable tendency to want to set rates at a conservatively high level that takes an inflation-above-target outcome out of play. You can see something much the same playing out in the early days of our own experience.

All of this, by the way, came from an excellent paper albeit with the rather opaque title, "Monetary policy forecast and global indicators", presented by Hilde Bjørnland (BI Business School and Norges Bank) at today's workshop. It's not up on the RBNZ's website yet, but it'll be well worth your while to have a read when it is. I'd also recommend "International inflation dynamics and the New Keynesian Phillips Curve: The role of the global output gap", by the Bank of Thailand's Pym Manopimoke, where she shows that global influences are playing a larger role in individual countries' inflation outcomes, and the rather inscrutably named "Foreign shocks" by Norges Bank's Drago Bergholt, where (if DSGE is your thing) he improves your workhorse DSGE model to allow for a greater influence for international linkages.


  1. Lots to disagree with there, but I'll settle for this:

    So there's an inevitable tendency to want to set rates at a conservatively high level that takes an inflation-above-target outcome out of play. You can see something much the same playing out in the early days of our own experience.

    Recall that inflation was above the midpoint of the target range, on average, in NZ for the whole IT period up to 2008. Of course, one can argue it was too tight in 1991, but I don't think that was because of hardline anti-inflation/establish credibility factors, but simply because we had the wrong model and totally missed the severe recession until it overwhelmed us. (It was a mistake. Mistakes happen)

    Michael (your system for some reason isn't letting me comment with my name)

  2. Thanks Michael. Opinions make markets.
    Don't know why you can't comment under your own name, I've checked my settings: 'Anyone' can post and there is no moderation turned on. Glitch, gremlin, whatever.