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.

Those high petrol prices - another view

There's a graph, Figure 3.8 on page 82, in the Commerce Commission's petrol market study that's puzzled me. And not for the first time: it also puzzled me when I first saw an earlier version of it, in MBIE's 2017 go at an inquiry into the petrol industry (where it was Figure 4 on p3). Here is ComCom's one.

It shows the price at the pump of a litre of premium petrol in a wide range of higher income countries, standardised by being converted into US dollars. Eyeballing the graph, you see New Zealand is there at roughly US$1.47. At the exchange rate of the time (March quarter '19) of 68 US cents, the price converts into NZ$2.16, which looks right. All good.

Because the price at the pump is heavily affected by local taxes, for competition policy purposes you need to focus on the price ex taxes, which is shown in blue in the graph. New Zealand does not show to advantage, with the third highest petrol price. Cue song and dance about how bad we are.

But what's been puzzling me is the weirdness of the country rankings. Your first inclination is to go looking for some underlying explanatory patterns - transport costs from major oil fields or refineries? - but it's hard to spot any. The three countries at the top - Mexico, Korea, us - are as odd an assortment as you'll ever see. The three at the bottom - Slovenia, Chile, Finland - don't obviously have much in common, either.

The ordering could of course reflect differences in local competitive intensity. You look at Mexico's top billing, for example, and you wonder about Pemex, a state owned monopoly up to 2013 which still has nearly three quarters of the petrol stations. You wouldn't know about the rest of them without some intensive investigation along our own Commerce Commission's lines.

But I'm also wondering whether the somewhat jumbled pattern mightn't partly reflect the fact that the petrol prices have been converted into US dollars at market exchange rates, rather than at purchasing power parity (PPP) exchange rates.

If this whole 'which exchange rate to use' thing isn't your bag, let's backtrack for a moment. If you're comparing, say, the price of an Apple i-Pad Pro 11" Wi-Fi 256GB, you'll find it's on Amazon at US$799.99 and you'll find it's NZ$1648 at JB Hi-Fi. At today's exchange rate (63.7 cents) the Amazon one costs NZ$1256. Good deal cheaper in the US.

But market exchange rates are fickle beasts and move around a lot. Because an iPad is expensive locally today doesn't mean it mightn't be locally cheap next Tuesday if the Kiwi dollar were to fall sharply against the US dollar over the weekend. You shouldn't be drawing any long-term policy conclusions about iPads - or petrol - on the basis of an exchange rate that might make a fool of you in no time.

Which is why these international comparisons are more normally done on a different basis. Supposing you went out and bought a wide bundle of stuff in the States, and it cost you US$100,000. You do the same in New Zealand, and it costs you NZ$150,000. It would then be fair to say that US$1.00 has the same buying power as NZ$1.50. In that case you wouldn't be in the least bit surprised if a litre of petrol cost US$1 in the States and NZ$1.50 here: that's just what you'd expect, because anything that costs a US dollar in the States is on average likely to cost NZ$1.50 here, as we discovered on our shopping expedition.

Long story short, people making international comparisons tend to use that US$1-equals-NZ$1.50 exchange rate, called the purchasing power parity rate (obvs). And here's what happens when you do that same chart of ex tax prices in blue above, but at that PPP rate instead. I've used the latest (2018) PPP rates as calculated by the OECD (you can find them if you fossick here).

In New Zealand's case, the pre-tax petrol price doesn't change much. It was around 77.5 US cents before (again eyeballing the number from the ComCom graph, as I'm not going to pay the €900 the International Energy Agency wants for the exact data). At the March quarter market exchange rate of the time, 68 cents, that was NZ$1.14. The PPP exchange rate wasn't very different: it was 67.6 cents. So our local price translated into US$ at PPP was 77.1 US cents, rather than the 77.5 US cents price you get at market exchange rates. Same diff.

But other countries' prices move around quite a lot when their PPP rates are used instead of their market exchange rates. And the end result is that our relative position drops quite a bit. We were third highest out of 33 on a market rate basis: on a PPP basis we're 14th out of 33. There's a bit of imprecision here, as I've used eyeball data rather than precise ones, so I wouldn't obsess over whether it's 14th or 13th or 15th*. This PPP ordering also makes a bit more intuitive sense than the market rate one: the bottom three, for example (now Norway, Finland, Iceland) look like a more coherent bunch.

There are still good reasons for having a market study look at the petrol market: those rates of profitability that ComCom found, in particular, need some explaining.  But one conclusion from this exercise is that I wouldn't get carried away by the "we're one of the dearest in the OECD" line of argument.On this, entirely conventional, alternative way of making the comparison, we're a little bit on the expensive side of middle of the pack.

*If you want to see the data I've used, and maybe check I haven't got the wrong end of any sticks, it's here (assuming I've got Dropbox working right).

What do devaluations achieve?

Perhaps unwisely, over the week-end I queried a bit of logic I saw on Twitter which had argued that a lower domestic currency makes a trade deficit worse.

The reply that came back to my query said that a lower dollar makes imports more expensive, QED.

And although I tried to point out that other things start happening, too, to my surprise I got further pushback in support of the the lower-dollar-makes-a-deficit-worse theory.

Maybe it's a generational thing. Back when I was starting out in economics, exchange rates were typically fixed or managed, currency changes were an actively deployed policy tactic, and the conventional thinking was that you reached for a devaluation to improve your trade deficit.  These days, exchange rates typically float, and the effects of devaluation as an option have, maybe, been forgotten about.

So here's a numerical example of what I always thought was the orthodox way of looking at it. It starts with New Zealand running a small trade deficit - our export revenue from wine doesn't quite match our import bill for oil - and it traces what happens when the New Zealand dollar drops against the US dollar. For dramatic effect I've made it a big fall, from parity with the US dollar to only 50 US cents.

The first panel is the starting point. The second panel shows the immediate impact of the fall in the Kiwi dollar. As the people on Twitter rightly feel, the first impact is of course to make imports more expensive, and the trade deficit does indeed get worse. What we're seeing at that point is the downward, or worsening, part of what used to be called the 'J curve' effect, and these days would probably be called a 'hockey stick' or 'Nike swoosh' effect - things get worse before they get better.

If that's all that the Twitter people were saying, fair enough, though I get the clear feeling that they also believe that the lower dollar will lead to a permanent worsening of the deficit, and that things won't actually get better later on.

But get better, they do, thanks to two responses to the lower dollar.

Panel three shows adjustment on the import side. Oil used to cost NZ$60; now it costs NZ$120. That's a powerful incentive to use less of it - by car pooling, by trading down to smaller car engines, by putting in solar panels, by using more energy-efficient public transport, whatever.

One respondent on Twitter argued that "How do you propose we "cut back" on imports without local industry to meet the demand? Should we just tell people to have less goods and medicines because they've become more expensive?". Well, the answer to that is that people routinely change their patterns of consumption to big price changes. If tickets to the big match get too pricey, you do something else for the weekend. If avocados are $7 each (as they were), you don't make guacamole. But I'll come back to that behavioural response at the end.

In panel three I've assumed that a variety of energy-saving measures in response to much more expensive oil lead to a reduction in demand from 400 barrels to 300. And we saw precisely that response in the real world to successive jack-ups in prices by OPEC, though it took quite a while for people to reorganise their affairs (eg by junking gas guzzlers and designing more fuel-effective engines).

That alone starts to eat into the initially higher trade deficit, which comes down from NZ$28,000 to NZ$16,000. The exact numbers don't matter: what does matter is that we've started going up the swoosh.

But there's also a response on the export side, which I've shown in the bottom panel. Before, the American buyer of our wine was paying US$200 a case. After the devaluation, he's only paying US$100 - it's a complete steal. He could well increase his order significantly - if he was profitably shifting New Zealand wine at US$200 a case, he'll have them flying off the shelves at US$100.

Or it's possible that the winemakers will raise their prices a bit. In the panel I've assumed they raised the Kiwi dollar price from NZ$200 to NZ$250, which for the US buyer means he's still paying a lot less (US$125) than the US$200 he used to pay. I've assumed that there's a mixture of more wine sold, as they are now a lot cheaper in US$ for US buyers, and a somewhat higher NZ$ price.

And hey presto, the overall outcome after both imports and exports have adjusted is a small trade surplus.

"Hey presto" may get you thinking this is all a sleight of hand, and indeed there is an assumption in the background here that those behavioural responses actually happen, and happen strongly enough, to turn things round. And there's a bit of economics (the 'Marshall-Lerner condition') that's figured out exactly how strong those responses need to be.

If you're what used to be called an 'elasticity pessimist', you don't believe the responses will in fact be large, and maybe that's where my Twitter correspondents are. Maybe, on the import side, we're always going to have to buy those medicines, and we can't skimp; maybe, on the export side, some wowser wine-shunning import monopoly won't order more cases then it used to. There's nothing logically wrong with that line of thinking, and at the end of the day the actual effect will turn on the size of the responses. Me - I'm more of an elasticity optimist, and especially over the longer run.

Before leaving what will be ancient history for some and the bleeding obvious for others, I'd just add that back in the day I was never a great fan of devaluations as a policy option. Can they improve the trade deficit? Yes, over time. But should you go there?

Mostly no. Devaluations can come with unpleasant side effects, including the ever-higher-inflation ever-lower-dollar spiral that New Zealand actually fell into. They can degenerate into tit for tat zero sum games (everybody can't simultaneously devalue against everyone else). And they encourage - or at the very least perpetuate - the idea that price is the best way to compete in world markets. So, at most devaluation makes an expedient policy tactic, but it's a poor economic strategy.

A cork in choppy seas

Every now and then I like to resurrect the Monetary Conditions Index (MCI), which was an attempt to combine both interest rates (the 90 day bank bill yield) and the exchange rate (as measured by the TWI) into a summary measure of the overall tightness of looseness of monetary conditions. It's not perfect - you could argue for including more measures or other measures (such as longer term interest rates) and for building the index differently - but it's better than a simple focus on interest rates alone.

Here's what it looked like at the end of 2016.

Yes, the Reserve Bank has set short-term interest rates on "very easy": the official cash rate (OCR), at 1.75%, is some 2.25% to 2.5% below the 4% or so that the RBNZ would regard as a neutral level. But overall monetary conditions aren't "very easy". The absolute level of the MCI doesn't translate in a straightforward way into "loose" or "tight", but given that it's currently well above its long-term average, you probably wouldn't be too wrong if you said overall monetary conditions were somewhere on the tighter side of neutral.

Focusing on the MCI is a good reminder that our overall monetary conditions are only partially under our own control: we're a small open economy in a world where the big guys' interest rate and currency policies are the ones that matter.. The RBNZ can set the OCR, but it doesn't have a lot of say about longer term interest rates (where our bond yields are set to a substantial degree by overseas yields plus a credit premium), and still less over the TWI, which is the resultant of a myriad of global variables.

Last year, for example, the NZ$ dropped a little against the yen (which strangely had become the 'safe haven du jour'), but rose a bit against the A$ (we offered higher yields and a faster growth rate), rose rather more against the euro (where the ECB is still in full negative interest rate / quantitative easing mode) and soared against the post-Brexit pound. Our ability to steer the TWI to where we'd prefer it is close to half of five-eighths of the proverbial.

It's also a reminder, as a corollary, that achieving our targetted 2% inflation rate can't be wholly under our own control, either. That doesn't mean that we shouldn't hold our RBNZ Governors accountable for making the best decisions they can under the circumstances they inherit. But sometimes - and the last year or two is one of those sometimes - I suspect that, given the macroeconomic hand they've been dealt by the overseas croupiers, there may not be any realistic setting for domestic policy that will meet the target,

A picture is worth...

What is it about graphs?

We're supposed to be living in a new world of 'dataviz' journalism where bright young things are taking data and doing clever stuff to it and turning it into attractive visualisations with insight and oomph. And some people are, like the folks at figure.nz. But as far as I can tell nobody in the major mainstream or social media has run with any of the graphs that the Reserve Bank's John McDermott included in his speech on Tuesday, 'Understanding low inflation in New Zealand'.

So here are some of the more interesting ones.

This is where inflation (or the lack of it) has been coming from, by sector.

Ex sin taxes on fags, and ex anything to do with housing (admittedly a fairly large 'ex' to 'ex'), there's precious little inflation around. Some of that is pure luck (world oil prices). And some of it, I'm pleased to say (wearing my 'competition is good for you' hat), is down to stronger competition in areas like air travel and (especially) telecommunications.

Here's another way of looking at it - roughly speaking, how much of our inflation is coming at us from world markets ('tradables') and how much we're creating in our essentially domestic markets ('non-tradables').

You'll notice that we're not generating much inflation of our own. John's not convinced that there's anything long-term about this, and reckons that there's cyclical stuff happening that explains it. Me - I'm not too sure. I suspect that the GFC put the fear of God into many business decision-makers and households, and the impacts haven't worn off yet: we could have inherited a change in behaviour that is more 'structural' than cyclical. It could be that greater caution about raising prices or asking for a pay rise helps explain why we're raising prices more slowly than we would have in previous cyclical upturns. We'll see.

Another interesting one is this age breakdown of net migration

You might have had some preconception, especially given the publicity around the government's recent move to tighten up on 'family reunion' style bring-in-your-mum-and-dad-too immigration, that there was a lot of it about. There is some, and the number of older people coming in has been rising, but the reality is that by far the largest parts are younger people, and people in their prime earning years. John raised it in the context of different age breakdowns having different effects on inflation: more younger people (as at the moment) have a smaller impact on inflation than more older people.

And finally, there's this, which shows the Reserve Bank's history of trying to guess where the Kiwi dollar is going next (in overall trade-weighted value).

There will be those who will use this to poke the RBNZ in the eye, and I'm kinda bemused myself. It's odd that everywhere you go, from central banks to surveys of businesspeople, people (and I've done it too) keep making the same rather mechanical forecast: if the exchange rate is going up, it'll go up a little more, but then fall, and if it's going down, it'll drop a bit more, and then go up.

But it's a seductively easy thing to do, especially if you believe the exchange rate has wandered away from the One True Level where it needs to be, and that sooner or later it will revert to it. Easy - yes. Accurate? Not so much.

Are monetary conditions too tight?

The Reserve Bank's latest quarterly survey of expectations popped up in my inbox the other day, and as usual I was at a loss to answer the question 'What is your perception of monetary conditions'.

It's the 'conditions' bit that throws me. The question is intended "to capture respondents' broad perceptions of current monetary policy settings and their expectations of the future stance of policy in one quarter's time and one year out", which looks as if it is probing about the interest rate setting side of monetary policy.

But interest rates are only part of overall monetary conditions as experienced by firms and households: the other big factor is the exchange rate (and arguably there are others - the willingness of banks to lend, the ability of firms to raise capital through bond or equity issues). So I'm never too sure what (say) the CFO at a big company might be feeling overall about monetary conditions: is the crimping effect of low export profit margins when the exchange rate might be high more important than the availability of cheaper finance when interest rates might be low?

And so every now and then (last time was in February) I'm driven to power up the spreadsheet and recalculate the old Monetary Condition Index (the 'MCI'), which attempts to blend interest rates and exchange rates into an overall assessment of the tightness or looseness of monetary conditions. Here is is, using RBNZ monthly data up to June and last Friday's data (after the RBNZ's economic update) for July.

It looks as if we are experiencing overall monetary conditions that are modestly on the tight side of our long-term average: going by the MCI alone, you'd say that the RBNZ definitely ought to cut the Official Cash Rate at its next opportunity on August 11. You'd want overall monetary conditions to be on the easier side, not the tighter side, when inflation is tracking below target.

"Going by the MCI alone" is a big qualification, though. For one thing, businesses don't seem to be feeling very squeezed by the exchange rate, as you can see in this chart from the ANZ's latest Business Micro Scope survey of small businesses. The exchange rate is listed there as a problem for a few, but it's well down their list of worries compared, in particular, to finding skilled employees (and compared to the burden of regulation, which is a topic for another day). And of course there's the potential impact of lower interest rates on floating rate mortgages and the housing market (aggravated by the fact that lower bond yields are feeding through to lower fixed rate mortgages as well).

So who knows - maybe the RBNZ will stay its hand on August 11. But if the be-all and end-all of monetary policy is overall monetary conditions conducive to getting inflation where it ought to be, the MCI logic says, cut the OCR.

Is our monetary policy stance right?

Having indulged in a little flight of fancy in my previous post about a stonking easing of monetary policy, it's time to get realistic again. So here's my latest occasional update to the actual stance of monetary policy - that old warhorse, the Monetary Conditions Index (the 'MCI'), which combines the level of interest rates and the level of the NZ$ into an overall measure (based on the RBNZ's monthly figures up to January, and current market levels for February).

Turns out, the flight of fancy may not have been so fanciful after all. Monetary policy, on this measure, is slightly on the tight side of average, and that doesn't seem to make a lot of sense at the moment: it's meant to be "accommodative" (as the RBNZ put it in the latest review of the Official Cash Rate). Unless as a central bank you're very confident in your call that everything's hunky-dory over a medium-term perspective, and that inflation will get back to around 2% on present monetary policy settings, you'd think the lesson from this graph is that policy should be starting to ease.

Which is also where the ANZ Bank has got to in their latest Market Focus, where they now think the RBNZ will cut the OCR by 0.5% this year (the publication isn't up on the ANZ website yet, but interest.co.nz have a commentary and a link to the publication itself). Interestingly, ANZ have their own 'financial conditions index', which is a different way of assessing the overall policy picture and which includes house prices, credit spreads and the NZ$: it's saying the same thing as the old MCI, namely that conditions have tightened recently. However you get there, the analysis is pointing towards the need for a lower OCR.

A modest proposal

The Reserve Bank has been taking some stick recently about not getting inflation up to 2% - you have your choice of posts on Michael Reddell's blog, for example - and yesterday Stuff's Vernon Small weighed in with 'Monetary policy is bust, so why are we still banking on it?'

So here's a modest proposal to get us back on track.

First, we cut the Official Cash Rate to 2%, the same level as the Australian policy rate. Nice big demonstration effect right there, with a 0.5% move instead of the usual 0.25%, plus it would be a genuine surprise (the futures market has only one 0.25% cut in the pipeline).

Second, we signal we'll match any future cuts in the Aussie rate (the futures market figures the RBA will cut by 0.25%, some forecasters think there are two cuts on the way).

Third, we do some quantitative easing (QE). The RBNZ buys enough government stock to drive down our current 10-year yield (3.04%) to the level of its Aussie equivalent (2.40%). It would help if Treasury cancelled its scheduled bond tenders and instead placed Treasury bills direct with the RB.

At that point, no sensible investors will pick New Zealand over Australia (the Aussies have a slightly better credit rating, so if the interest rates are the same, you'd pick them). Investors in New Zealand will clear off, and the currency will depreciate. It wouldn't hurt to give it a judicious nudge with some thin-market currency intervention.

If that doesn't get us nearer 2%, well maybe Vernon's right, and nothing ever will, but we'll never know unless we give it a go.

Course, the Auckland housing market will have turned incandescent, but you can't have everything, can you?

More seriously, I can't help feeling that it's theoretically possible, in the current collapsing-commodity, competitive-devaluation, out-QE-the-other-guy world, that there may be no feasible or desirable setting of local monetary policy that is consistent with 2% local inflation.

I've had a go in the past at trying to put this into some kind of formal framework (if you don't mind some simple graphs). My conclusion back then was that, if there was overseas monetary policy loosening (and a great deal more has happened since I wrote in 2013), and the RBNZ wanted looser policy but would prefer if it didn't exacerbate the housing market, then something had to give:

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.

It's possible that the sub-2% undershoot that we have indeed experienced isn't such a bad result, in the round. It could be the best we could realistically achieve in current world market conditions - or at least the best we could achieve short of having slavering buyers stampeding from auction to auction to snap up the last house under $3 million.

What drives the A$?

Exchange rate forecasting, as we all know, is usually a decidedly iffy proposition: the authors of this new Discussion Paper from the Reserve Bank of Australia point to "the well-documented difficulties in empirically explaining movements in exchange rates" and "the imprecise nature of exchange rate modelling, which is well established in the literature".

I'll just pause for a sec (before I get anyone into trouble) to point out that in any Discussion Paper, "Views expressed in this paper are those of the authors and not necessarily those of the Reserve Bank. Use of any results from this paper should clearly attribute the work to the authors and not to the Reserve Bank of Australia".

Right. Carrying on, and despite the well-known difficulties, they've done a pretty good job of modelling the behaviour of the (real) trade-weighted index (TWI) of the Aussie dollar. Here's how their model fits the data: if I'd managed that, I think I'd be retiring to the pub for a beer after a good day's work.

It's an error-correction model, where the TWI tries to move towards an equilibrium level determined in this model mostly by Australia's terms of trade, with a smaller supporting role for a real interest rate differential ("the real policy rate differential between Australia and G3 economies"). And it explains about half of the quarterly changes in the TWI over 1986-2014.

The authors were a bit exercised by those periods where the actual A$ TWI was well away from the modelled band - below, during the GFC, and above, more recently - and they've had a go at seeing whether various ways of modelling the impact of the recent Australian resource investment boom and of unconventional monetary policy overseas would explain those deviations. There were some suggestive hints, but no knock-out discoveries: "Taken as a whole, while the results from these augmented models support the notion that there have been some additional influences on the real exchange rate in recent years, they do not fully account for the behaviour of the exchange rate during the period". The existing model did more or less as well (and more simply) than potential alternatives.

Incidentally, if you're a student, or hence or otherwise would like to get up to speed with where the economics of exchange rates has got to in recent years, there's a very useful bibliography at the end of the paper.

You're probably wondering, is there a Kiwi dollar equivalent? And yes there is, give or take (the Aussie graph shows the modelled A$ TWI versus actual, the Kiwi graph shows an explanation of why the actual rate is away from its long-term average). Here's what it looks like, and I wrote it up in more detail here.

Takeaways? Two main ones. The story that the A$ and NZ$ are 'commodity backed' currencies is oversimplified, but not wrong. And exchange rate forecasting may be problematic, but I'd say not so problematic that you can't get something useful out of it.

Time for an interest rate cut?

"At 3.5 percent", said last week's Monetary Policy Statement, "the OCR" - the official cash rate - "is still providing support to demand".

Now, there's a sense in which this is true: a "neutral" rate, neither supportive nor contractionary, is reckoned to be around the 4.5% mark, so 3.5% is clearly on the stimulatory side.

But in terms of the overall tightness of monetary conditions, you can't look at the cash rate in isolation. It's the combination of interest rates and the exchange rate that makes life easier or harder for people and businesses. An OCR of 3.5% may be "providing support", but that doesn't mean a lot if the Kiwi dollar is so high that exporters are severely constrained. True, it would be better than 4.5% and a high Kiwi dollar, but that would be a rather moot consolation.

So here once again is my calculation of the overall tightness or otherwise of monetary conditions, as captured by the old Monetary Conditions Index, which mashes together the 90 day bank bill rate and the trade-weighted index of the Kiwi dollar into a single overall number.

The reality is that overall monetary policy conditions are tight. Tight, tight, tight. They're on a par with periods in the past when we were dealing with reasonably serious inflation pressures.

Not that there's a lot the Reserve Bank can do about it, as there's no feasible OCR that would bring monetary conditions back to neutral, let alone to the stimulatory side of neutral.

If you said that "neutral" is some kind of long-term average of the Monetary Conditions Index, then neutral would be about 500 (averaged over the whole history of the series since mid 1986) or about 350 (if you start in January 1991 after the initially brutal disinflationary period). The current MCI is around 1200: to get it to a neutral level around the mid 400s, you'd need a negative OCR at -4.0% or so.

Alternatively, if the OCR stays at 3.5%, you'd need the Kiwi $ to be roughly 14% lower for overall conditions to be neutral - say in the high 60s against the US$ rather than the current high 70s.

However, you look at it, though, you begin to come round (as I also did a wee while back) to the conclusion that, with the best intentions, and on the best decisions made in the light of the best info at the time, we've nonetheless ended up tighter than we ought to be. I've a great deal of sympathy for the view (as put by John McDermott, the RBNZ's Chief Economist, at last week's MPS press conference) that monetary policy making in real time is an evolving process of learning and adaptation as you go along. I'm beginning to think that the next step in the process ought to be a few steps backwards for the OCR.

Purchasing power parity? I don't think so

The Commerce Commission, as I blogged a little while ago, has come out with its latest benchmarking report on retail mobile telecommunication services. Produced for it by Teligen, it uses OECD-sourced power parity (PPP) exchange rates to convert overseas currency prices into NZ dollar equivalents, because, as the report says (p7), "The use of PPP rates was preferable to using spot exchange rates as PPP rates are a more stable measure".

I've got no problem with that - quite the reverse. It's the right thing to do, and it's absolutely standard operating procedure for international benchmarking reports like this.

But I do have an issue with one of the OECD's calculations. I don't think its PPP estimate of the NZ$/A$ exchange rate is right.

Before I go any further, what's your estimate, however rough and ready, of the NZ$/A$ PPP rate? If, for example, you were to go to Australia for a week's holiday, would prices in Oz seem about the same as at home if the Kiwi/Aussie rate was 70 Aussie cents? 80? 90? Parity? Above parity? What was your instinct?

My own guess is that things in Australia start looking on the cheap side when the Kiwi is somewhere into the higher 80s, and are definitely looking cheap over there when the Kiwi is above 90 cents. And if you told me I could swap my Kiwi dollars for Aussie dollars one for one, I'd be in Sydney every other weekend. Or to put it another way, my estimate of the PPP rate is around the 80-85 Aussie cent mark. Maybe I should go all Bayesian and call it my "prior".

Right. Now let's have a look at the PPP A$/NZ$ rate that Teligen used. Or must have used, since the link they gave in the report to the OECD data (http://www.oecd.org/dataoecd/48/18/18598721.pdf) is broken and I've had to look for the OECD PPP data some other way. I found them here.

Here's a summary of the OECD PPP calculations for the Aussie and Kiwi dollars. The first two rows show the PPP exchange rate in terms of local units per US$, which is how the OECD likes to write them, whereas we like to use US cents per local dollar, which you can see in the next two rows. And the final row is the OECD's estimate of the A$/NZ$ PPP rate, again expressed the way we usually do.

On the OECD's calculations, the Kiwi dollar's PPP exchange rate is - wait for it - approximately, parity with the Aussie dollar.

Frankly, I don't believe a word of it. It's way too high.

As a practical matter, if one of your interests in reading the Commerce Commission's reports has been to see how much better or how much worse prices are in Australia, I would put up a large health warning against the bilateral comparisons. The PPP rate is making things in Australia look less expensive than they really are. Something that costs A$100 will supposedly cost NZ$100: no way. At what I'd say is a decidedly more realistic 85 cents PPP, the cost in Australia would actually be NZ$117.65.

How tight is tight?

Everyone is primed for higher interest rates: some folks thought the Reserve Bank would even start the process last week, but in any event there's a near-universal consensus that the next Monetary Policy Statement (March 13) will see the first hike in the Official Cash Rate.

Over at The Visible Hand In Economics, the question's been asked, ''Should we hit inflation hard and fast?', if you'd like to contribute to the discussion. My own view is that we've got some potential inflation problems emerging - non-tradable, domestically generated inflation is 2.9% already, and rising -  but even so I'd be concerned about a sharp and quick rise in interest rates, mainly because I'm not sure everyone realises how much monetary policy has effectively tightened already, through the mechanism of the higher Kiwi dollar.

Here's that old measure of overall monetary policy, the Monetary Conditions Index, updated to the present.

It combines the 90 day bank bill rate and the trade-weighted index of the Kiwi dollar into an overall measure of the bite of monetary policy. I know, it's not perfect, but it's a better view of the policy setting than you'd get by looking at interest rates alone. And what it shows is that we're already near the kind of monetary policy tightness that was appropriate towards the end of the strong economic cycles of the mid 1990s and mid 2000s. So in my view it would be easy to overtighten by mistake - especially, as seems likely, if rises in the OCR translate into an even stronger Kiwi dollar.

Follow the money...

I know I've said it before, but there really are so many business surveys around these days that even dedicated economy-watchers can't keep track of all of them. Inevitably some slip under the radar.

One you might have missed (and I came across it only accidentally while foraging a while ago for something else on the bank's website), is the quarterly ASB Kiwi Dollar Barometer. It's well worth having a look at: it's quite a decent sized survey (390 firms with turnover of at least $1 million) of businesses' exchange rate expectations and their forex hedging plans.

The latest one came out last week. The headline result was that businesses (averaging out both importers’ and exporters’ views) expect the Kiwi dollar to peak against the US$ around the 81 cent mark  in the March ’14 quarter, and to decline to 76.5 cents by the end of next year. Currency forecasting, many would say, is a complete waste of time, and perhaps these businesses' expectations will prove just as wide of the mark as any other forecaster's. But I doubt it.

For one thing, consensus forecasts across wide groups tend to do better than a single guy with his spreadsheet.

And for another - and this, to me, was the really interesting bit - the businesses are putting their money where their mouths are, as this graph shows.

Notice that the percentage of importers planning to hedge has hit a new high: in real time, with real dollars, import businesses are increasingly taking out protection against the Kiwi dollar falling.

You might wonder (as the ASB economists did) why the proportion of exporters planning to hedge also ticked up a bit in this latest survey - if they really believed the Kiwi dollar is going to fall, they'd be planning to do less hedging. The ASB team commented that "It is likely the recent strength in the NZD has seen exporters look to protect themselves against further increases in the NZD, even if their core view is that the currency will ease over the year ahead".

I think this is absolutely right, because I've seen this happen before. Years ago I worked for a forex consultancy business in London, and our customer list looked like a hospital ward: every corporate in Europe that had run into financial grief appeared to be on our books as clients. Why? Because they were already in such a difficult position that the last thing they wanted was to have forex losses on top of everything else.

And that's where Kiwi exporters are right now. They might believe the Kiwi dollar is going to fall - but they can't live with the risk that it might tighten the screws even further on them with another bout of appreciation.

Why the Kiwi dollar is so high

Last Friday John McDermott, the Reserve Bank's Head of Economics, gave a speech, 'Understanding the New Zealand exchange rate'. Most of the media coverage focussed on John's idea that the best way to get the Kiwi dollar down from its current overvalued level is to increase our domestic savings rate. None of the coverage, though, appears to have reproduced an interesting graph (below) that John had included, and which in turn is an updated version of the results found in a 2012 Analytical Note from the RBNZ, 'Kiwi drivers: the New Zealand dollar experience'.

The red line is the real exchange rate (i.e. the exchange rate after allowing for relative inflation differentials with our trading partners - you can think of it as our export price competitiveness if you like), expressed as a percentage deviation away from its long-run average. So the first take-away point, obviously enough, is that yes, the (real) Kiwi dollar is unusually high.

The second take-away point is that two factors (those green and blue contributions) explain virtually all of the Kiwi dollar's high value (I know, I know, and John said so too, strictly speaking these are correlations and not necessarily causation, but I'm quite happy to believe the causation story, too).

The green one is the biggie, and that's the unusually high level of world commodity prices. No surprise there - and that makes for the next take-away point, which is that barring any unexpected shock to world economic activity (and to China's in particular), high world commodity prices and the high Kiwi dollar aren't going away anytime soon. Which is consistent, by the way, with some other RBNZ research - 'New Zealand’s short- and medium-term real exchange rate volatility: drivers and policy implications' - which found (p2) that "Departures of the exchange rate from its longer-run trend can be quite large and prolonged".

The blue contribution is 'Relative real house price inflation', but before you get on your high horse and start thinking, "It's all those blasted [insert your least favourite foreign bogeymen here] buying our houses - that's what's killing our exporters", what's actually happening here is that the house price inflation measure is standing in effectively as a proxy for the expected strength of domestic demand. In one hit it's capturing elements of expected demand, expected inflation, and expected interest rates. You'd also conclude that nothing is going to change on that front either, any time soon.

As John said, in one sense the Kiwi dollar isn't overvalued - from one perspective, as the graph shows, it's pretty much where you'd expect to find it, given our commodity export prices and the strengthening economy - but from other important perspectives (notably, rebalancing the economy more towards exports), it is. From those perspectives, it needs to be substantially lower - but on this evidence, I can't see it happening anytime soon.