Wednesday, 13 November 2019

Good call

We've just had the Reserve Bank Monetary Policy Statement. In the pre-MPS poll that Daniel Dunkley ran for the Good Returns website I'd reckoned that it was a 50:50 call, but on balance (and in the minority who lucked into making a correct forecast) I leaned towards leaving the OCR at 1%. It's the right decision.

I'd been worried that another cut would risk the same counterproductive effect on consumer and business confidence that seems to have followed the Reserve Bank of Australia's latest cut to their cash rate - "if the RBA thinks things are bad, I'd better panic too" - and there were other factors suggesting doing nothing. Local business activity seemed to have bottomed out in the latest ANZ business survey; it could be a good idea to leave some monetary policy ammo in the locker rather than creeping ever closer to zero interest rates; and in any event in current global geopolitical conditions it might pay to wait and see how things unfold.

Plus domestic non-tradables inflation had gone over 3% in the September CPI (as shown below in blue, with the 2010 GST hike taken out): I like to look at it ex housing and housing utilities (in red), but either way it looks as if local inflation is already heading towards where the Bank would like it to go, and has been for two years. So sit on your hands, I thought, made sense for the Bank.

In responding to the survey I forgot to add that the RBNZ itself thought, at its August MPS, that inflation would get back to 2% by late 2021 with the OCR effectively unchanged. The forecast OCR track in August's MPS isn't easy to interpret - there are, for example, three successive quarters where the OCR is shown as 0.9%, and if you can explain the OCR track that gives rise to that pattern you're smarter than I am - but essentially the RBNZ thought we looked to be headed for 2% inflation last time without doing anything much extra.

Since then, two other things have occurred to me. One is that I wonder whether the distortions involved in driving inflation up from its current 1.5% to the target 2.0% are worth it. And the other is whether easing monetary policy further (and in Oz they now appear to be contemplating unconventional tactics as well - 'Reserve Bank gets the money printers ready') would be effective: what if we ventured even further into unknown territory and we still couldn't get a 2% inflation outcome? What would be the point?

On the distortions, I'm leaning towards the view that there is precious little effective difference between a 1.5% and a 2% inflation outcome: both are low enough not to distort economic decisions, but both are high enough to allow that little bit of lubrication that allows relative price changes to take place without some prices having to be cut in absolute terms. I wouldn't therefore invest a lot of effort in pushing 1.5% to 2%, and I note that the Monetary Policy Committee's 'remit' says "a focus on keeping future inflation near the 2 percent mid-point" not "the focus" (my emphasis).

So there's little upside benefit from straining harder for 2%, but there are costs. Current settings are already undermining, for example, much of the rationale for retail investors to invest in term deposits, and market commentary suggests that much of the recent sharemarket price gains reflect Mr and Mrs Bloggs taking money out of the bank and plonking it in dividend-paying equities. I can't say I'm hugely enthused about the incentives on the other side of the ledger, either, for corporate treasurers to tank up on artificially cheap debt.

There has to be some risk of inflating asset or debt bubbles. On Standard & Poor's calculations, the S&P / NZX 50 index at the end of October was trading at 24.8 times expected earnings. That's even more expensive than the U.S. market. Looking at the MPC's remit again, it says at 2(b)(i) that "the MPC shall ... have regard to the efficiency and soundness of the financial system": have any members started asking questions about the allocative efficiency consequences of where we are?

Even if that's a hard question to answer, I think it's pretty clear that whatever the distortionary costs are, they're likely more than deploying fiscal policy would involve. There's plenty of efficiency-improving infrastructural investment (including building the human capital skills of the unemployed and underemployed) that could push on our output gap and generate the desired inflationary pressure.

And can we even be sure, given the state of the rest of the world, that there is any sensible setting for local monetary policy that would actually deliver the 2% target? By sensible I mean a setting that does not have the exchange rate a long way away from purchasing power parity, or interest rates at very high or very low levels in real terms. The assumption has been that all we have to do is push the official cash rate to some non-absurd position on the dial, and 2% inflation will follow in due course. As the old DB ads might say, is that right?

The reason I ask that question is that I think there is some risk of forgetting the fact that we only have a limited control of our own monetary policy destiny. As Friedman's 'trinity' put it, you can have two, and only two, out of the following three: control of your own interest rates, control of your own exchange rate, and control of cross-border money flows. We've opted for our own interest rates, and free capital flows: the exchange rate which we can't control will be whatever it will be. What guarantee is there that the autonomous exchange rate will settle at a level compatible with 2% local inflation? None at all.

Chuck in the fact that we have only partial control of our own interest rates in the first place - we're effectively squeezed into the territory constrained by the zero lower bound and other countries' currently ultra-easy monetary policy settings - and it may well be that our limited room for interest rate manoeuvre (combined with that free-ranging exchange rate) isn't compatible with a 2% outcome. There's room to be sceptical about pushing ever harder on a piece of string.

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