Scene-setter for tomorrow's RBNZ decision

Tomorrow we get the latest Official Cash Rate (OCR) review from the Reserve Bank, so by way of a scene-setter here's my latest calculation of the overall tightness or looseness of monetary policy, as measured by the Monetary Conditions Index (the MCI), which combines the impact of interest rates (90 day bills) and the exchange rate (the TWI) into one summary index number. If the MCI is all news to you, there's an older post about it here.

This time round I've just shown the last 10 years and a bit, including my estimate for October (based on bills at 2.9% and the TWI at 72.9).

The latest consensus from polls of economists is that the Bank will leave the OCR alone at 2.75% tomorrow - a change from an earlier view that another 0.25% cut was almost a certainty. The main reason appears to be that the economic forecasters are placing quite a bit of weight on the keep-the-powder-dry bit in the Governor's recent speech where he referred to "the need to have sufficient capacity to cut interest rates if the global economy slows significantly".

It's possible too that the recent improvements in business and consumer confidence, and robust results from the BusinessNZ/BNZ surveys of manufacturing and services, mean that the RBNZ doesn't need to be in such a hurry to provide some extra stimulus to the economy, which seems to be coming out of its dairy-price-slump attack of the glums.

Me? I can see some value in hanging about till the next Monetary Policy Statement on December 10 and getting a better bead on the economy, and what's six weeks in the great scheme of things anyway, but for what it's worth I'd cut tomorrow.

For a start, there's been that recent sharp rise in the TWI: the Kiwi dollar is up by nigh on 7% in overall value from its low point on September 23. And as the MCI graph shows, that move in the exchange rate has been enough to take the overall bite of monetary policy onto the tighter side of neutral. You can't keep fiddling with interest rates every time the dollar ducks and dives - which is why the MCI was abandoned as a policy tool - but equally you can't be completely indifferent to overall monetary policy being tightish when it actually needs to be loosish. The big picture here is that we (like many other countries) have been undershooting our inflation target: monetary policy needs to move into a modestly stimulus/inflationary space. Standing pat won't get us there. If it's steady tomorrow and a cut in December, no great harm done. But there needs to be a cut sometime soon, and especially if the Kiwi dollar keeps strengthening.

Are the rates out of control?

Last week's write-up of the latest CPI by Stats NZ included this graph. It showed how the prices of various components of central and local government charges have been behaving since 2006.

The colours aren't that easy to tell apart, but the top line is local authority rates, which appear to be on an inexorable rise, through good times and bad. The line that drops sharply at the end is 'other private transport services', where you see the big impact of recently lower ACC levies on the cost of licensing your car.

That remorseless rise in the rates bill got me thinking, so I've done a little bit of research, and here is how the rates, average weekly total earnings, and overall inflation have behaved over the same period, all rebased to 1000 in mid 2006, and all seasonally adjusted. Over the whole period, prices in general rose by 20%, weekly earnings rose by 35%, and the rates - well, the rates rose by 60%.

Maybe we shouldn't be worried. The rates, after all, are subject to some sort of political discipline, and presumably the voting citizenry either don't mind what's happened, or even asked for it, if they felt (for example) that councils finally needed to get on with building adequate local infrastructure.

But I can't help feeling that there's an argument that the electoral discipline doesn't look very binding. At a national level, it's true that politicians can generally no longer get away with bribing the electorate with its own money - there's a great deal more transparency about the costs of lolly scrambles - but is the same scrutiny as effective at local authority level? And even assuming that all is politically hunky dory, did councils really deliver a 33% real (above inflation) increase in services to us all over that period? Doesn't feel like it. And I don't see any efficiency dividend from Auckland amalgamation in the rates graph*.

I don't have the answers, but I do have a question: are rates rises out of control?

*Addendum Oct 28 - Subsequent (separate) comments have pointed out that Auckland has had one of the lowest increases in rates since 2006, and that total rates collected in Auckland have fallen since 2009, so there may be an efficiency dividend after all.

A smorgasbord of competition topics

Last weekend's annual workshop of the Competition Law and Policy Institute of NZ had a series of good sessions. They were all interesting: I got a lot out of  Professor Brent Fisse's very balanced analysis of the recent Harper competition review in Australia (even if we agreed to differ on changing the test of 'abuse of market power' in our s36 and their s46 of our respective competition laws), and from the session on whether broadcasting is ripe for regulation, where Buddle Findlay's Tony Dellow and Covec's John Small concluded (correctly) that it wasn't.

Here's an assortment of other stuff that I found interesting.

Princeton's Bobby Willig spoke on 'Merger Analysis', mostly about the application of the 'GUPPI', or 'Gross Upward Pricing Pressure Index' (yes, cue for fish puns...). Willig is one of these top-rate US economics professors who manage to combine elite academic credentials with top teaching skills and a wide commercial consultancy practice (he's been involved, in NZ alone, in Air New Zealand/Qantas, air cargo, and Fonterra's milk pricing), with synergies all round. I was left convinced that the upward pricing principle approach "is a valuable source of more granular and extensive insights into merger impacts than are available from an accurate qualitative articulation alone".

Or to put it another way, look at the data. If, after a merger, a business would own both product A and the newly acquired but previously competing product B, and would be tempted to jack up the price of A knowing that some of the sales lost will come back to it as increased sales of B (that's how the "upward pricing pressure" on A works), a competition authority concerned about potential post-merger price increases ought to look at exactly how much of a substitute B is for A, rather than taking a qualitative guess. It ought to get to grips with whatever data or natural experiments are available to calculate how much leakage of sales will occur between A and B.

The good thing is that not only will there be better-informed merger decisions, but in today's 'big data' world the opportunities to estimate diversion ratios between A and B, or, same diff, cross-price elasticities, are getting better all the time - a conclusion I'd also come to last month at the LEANZ presentation AUT's Lydia Cheung gave on quantitative techniques for competition analysis (write-up here).

There was a terrific session on "Vertical restraints", where a first class paper by Russell McVeagh's Troy Pilkington was followed up by an equally impressive comment paper from the Commerce Commission's David Shaharudin. Vertical restraints, and the courts' and economists' take on their legitimacy, are one of those things that, as Troy and David pointed out, have been all over the place, from explicitly legal to explicitly illegal and all points in between (retail price maintenance has been similar). Currently, things appear to have setted down where they should probably have always been - permissible, subject to a net benefits test.

And then there was the fascinating presentation by ACCC Commissioner Sarah Court on "Unconscionable conduct and supermarkets", where the ACCC had pinged Coles for a series of unilateral strong-arm abuses of its suppliers. We don't have "unconscionable conduct" in our competition law - there's the odd similar sort of provision here and there, such as the ability to re-open "oppressive" credit contracts under Part 5 of the Credit Contract and Consumer Finance Act, but not any overarching provision - and at first blush, based on Sarah's account of the Australian goings on, you'd be tempted to think we ought to have the same tools to knock any New Zealand business thuggery on the head as they have for theirs.

But as Bell Gully's Jenny Stevens argued in her commentary reply, if you're going to legislate or regulate, the first thing you've got to do is define the problem you're trying to deal with, and  it's not a given that we do, in fact, have the same sorts of standover issues that the ACCC have had to confront. I'd have to agree: I wouldn't say all of our businesspeople are lining up for canonisation, but on the other hand we also generally tend to be a high trust society where many transactions are handled equitably on a handshake basis, or close to it. If that gets abused, let's act, but in the meantime it's not a bad way to run our particular whelk stall.

Cartels? What cartels?

I spent last weekend at the latest Competition Law and Policy Institute of NZ's annual workshop, and I'll write up some of the (interesting) proceedings when I've got a moment. But as a hold the fort exercise, I'll just ask this, based on some thoughts I had at the workshop.

Where are the cartels? Or more specifically, where are the Aussie cartels?

The reason I raise it, is that Australia criminalised cartels in 2009. And since then, I'm told, there hasn't been a single criminal prosecution of a Aussie cartel. None. Nada. Zip.

Why could that be?

Proponents of criminalisation will no doubt feel they know the answer: the prospect of sharing a cell in Long Bay with Mad Reggie.

But it might be happenstance. Cartels don't get rumbled to order. They're like buses - none for ages, next minute you've got your pick of them.

Or - or - criminalisation might have driven cartels into deep, deep cover.

This is definitely one of those unknown unknowns, but it's at least possible that criminalisation, plus recent terabuck penalties in the US and Europe and the associated humongous civil liability, have altered the calculations for price fixers who might otherwise have ratted out their co-conspirators. Now, you have to be very, very, very confident indeed that the regulators' leniency policy will see you right.

Especially on the criminal side, where you don't want to run into some grandstanding crown prosecutor who isn't too sold on all this leniency stuff.

'Cos Reggie, he ain't much into leniency either.

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.

Protected, or exploited?

If you're interested in markets, competition or regulation, you're bound to have a few eye-opening and brain-opening moments along the way: for me, one of the key ones was The Commerce Commission v The Ophthalmological Society of New Zealand Incorporated And Ors, a 2004 High Court judgement known in some circles as 'Eyes 1'.

The case, which the Commerce Commission won,  was about some Southland ophthalmologists and their professional body. They had acted together to intimidate some (highly qualified) Australian surgeons from dealing to the backlogged waiting list of cataract operations in Southland, and at a cost much lower than the fees the incumbent Southland doctors wanted to charge. And one of the deplorable tactics they used was declining to provide 'oversight' to the Australian medics. Supposedly, these eminent Australian doctors required 'oversight' to operate safely in New Zealand, and since their New Zealand colleagues refused to provide any, their plans got scuppered.

It was a brutal example of how regulations brought in for one, worthwhile, and even necessary purpose (patient safety) can be piggybacked into an anti-competitive rort. As the judge in the case said, “I do not accept that the defendants had any proper foundation to believe that the proposals would put patients in jeopardy”. On occasions, the alleged worthwhile basis for a regulation or practice can be very flimsy indeed, and little other than a convenient cloak for protection of a professional market.

It seems to me that this is going to be an increasingly fraught issue across a wide range of services, including education and health, for a whole range of reasons. Services in general are becoming an ever larger share of modern economies, some services such as health are becoming more important to us as we live longer, and there is a general trend to greater credentialism and professional/occupational licencing, which gives ever greater leeway to gatekeepers to abuse quality standards to protect their own patch.

It's even cropped up as a (somewhat peripheral) issue in the current US presidential primaries. Last month the Committee for a Responsible Fiscal Budget, an independent non-partisan think tank in Washington, looked at the policy plans Hillary Clinton and Bernie Sanders have come up with to tackle US prescription drug costs. Both of them have identified a "safety" provision they'd like to deal to. In the Clinton plan, she "would allow Americans to safely and securely import drugs for personal use from foreign nations whose safety standards are as strong as those in the United States". In the Sanders plan, he would "Allow individuals, pharmacists, and wholesalers to import prescription drugs from licensed Canadian pharmacies".

There is, of course, no good pro-consumer reason why American (or other countries') consumers shouldn't get their prescriptions filled in Canada or the UK. As Hillary Clinton puts it, "it’s unfair that drug companies charge far lower prices abroad for the same treatment, while imposing higher prices on Americans", and - while I wouldn't normally give you tuppence for Bernie Sanders' views on anything - you've got to admire him when he says that in 1999 he "became the first Member of Congress to take a busload of Americans across the border into Canada to purchase prescription drugs. Americans should not have to pay higher prices for the exact same drugs than our Canadian neighbors simply because Congress is bought and paid for by the powerful pharmaceutical industry".

The same tension between competitive provision and real or fantasised patient safety crops up all over the place. I recently read in the Harvard Business Review, for example, 'Why Health Care Mergers Can Be Good for Patients'. The author says, and I'm sure he's right, that "Patients who undergo complicated operations fare worse when their hospitals or surgeons rarely perform them", and his response is that hospitals should bulk up so that there are high volumes of lower-risk operations being performed all the time. The flipside, though, is that there are all sorts of clear competitive downsides to wholesale health mergers: as the American Medical Association recently said, 'Health-Care Mergers: Good for Health-Care Companies, Not So Good for Patients and Doctors' (though in this case it wasn't a completely pro-consumer stance, as the AMA was also concerned about the enhanced countervailing power of merged insurers against doctors).

Maybe it's time for competition authorities to be given the job of riding shotgun on some of these 'patient safety' and 'professional qualification' arrangements?

Neutral, or too high?

Last week the Reserve Bank came out with the latest of its Analytical Notes - a series I highly recommend. They're pitched at the intelligent citizen, and they also have a 'non-technical summary' at the front, so even if monetary policy or macroeconomics isn't your go-to choice for a light read, you'll find the material both accessible and interesting.

This latest one is more interesting than most - "Estimating New Zealand’s neutral interest rate", by Adam Richardson and Rebecca Williams. Obviously the Bank needs a view on the neutral rate so as to know whether its setting of the cash rate is on the side of policy stimulus or on the side of policy constraint, but it's also interesting for the rest of us, as it's a pointer to whether borrowing costs are relatively low or relatively high.

Intuitively I think we all know what a 'neutral rate' is, but it's harder to pin down an exact definition. The paper says that the neutral rate is "a level of the nominal 90-day bank bill rate that it [the Bank] believes is neither expansionary nor contractionary" and "the interest rate that would prevail once all business cycle shocks have dissipated and inflation is expected to remain at target". The paper doesn't mention where the exchange rate would be at the time, but I suppose we have to assume that the exchange rate is at some middle-of-the-road, purchasing-power-parity sort of level.

The interest rate that would prevail in 'normal', neither boom nor bust conditions, and that would be consistent with inflation steady and the Bank being able to stand pat, is, as the paper says, not directly observable, as things are never going to stand still long enough for you to measure it. So you've got to sneak up on it, and the authors did so from five separate directions. Unsurprisingly the different perspectives give different answers for the neutral 90 day bank bill rate: the range of answers is shown in the graph below. The average is 4.3%, and the Bank's current operating assumption for its policymaking is there or thereabouts, at 4.5%. The Bank's take on the neutral floating mortgage rate, by the way, is 7%, or the neutral 90 day bill rate plus a 2.5% margin.

It's interesting that four of the five approaches have the neutral rate falling. One approach has it bottoming out around the end of the GFC, in 2009-11, but rising quite strongly since, which seems on the implausible side. The ones that have the neutral rate falling, generally have it falling most during and post the GFC period, which seems reasonable: the world seems to be a different place since in a number of respects (including, for example, wage-setting).

But it may not all be down to the GFC: one of the approaches has the neutral rate falling steadily since around the turn of the millennium, and that also makes some sense to me. You'd expect that the Bank would have garnered some increased policy 'credibility' (as the jargon has it) over that period. People would have come to believe more strongly - the odd misstep apart - that the Bank was on top of its inflation-targetting brief. And as they did, the Bank would have been able to exert more effective pressure with less effort, the proverbial 'bigger bang per buck', which is another way of saying that the neutral rate must have gone down.

If anything, I'd say the Bank's operating assumption of 4.5% is a bit on the high side. For one thing, it would be near the top of that target band in the graph, if you discounted the one approach that has the neutral rate rising (and which is responsible for the 4.8% top of the shaded band). And for another, if I put a fund manager's hat on, I'd say that there ought to be a low, and maybe close to zero, long-term after-tax real return to holding cash. At 2% inflation (middle of the target range) and a 28% corporate tax rate, bills at 4.5% would offer a tax paid nominal return of 3.24% and a real after tax return of 1.22%. Or for holding cash (say 20 basis points below bills) an after tax real return of 1.07%. In current circumstances, that looks a return that's on the high side for a liquid risk-free asset.

Who's been 'buying up' New Zealand?

There's a huge interest in foreign investment in New Zealand - it's front page news when Chinese investors aren't allowed to buy farms, or Asian investors are supposedly snapping up Auckland houses, and the piece I wrote about Statistics NZ's data on foreign direct investment has had by far the biggest number of pageviews of anything I've written recently. Yeah, yeah, yeah, I know, they're not Krugmanesque numbers, but still.

Yesterday Stats released an update to the numbers, showing the situation at the end of March '15 (the spreadsheet with the numbers is here). First, here's the total stock of foreign direct investment in New Zealand, which includes the likes of those farms.

One country overshadows everybody else. Australia has more invested here ($51.4 billion) than the rest of the world put together ($48.2 billion). There are bite-sized chunks from the US, Hong Kong, the UK and a range of other Asian and European countries, but the story starts and ends with Australia. Most of Australia's interest is the banks: I don't have a complete industry-by-country breakdown, but given that there's $32.1 billion of overseas investment in our 'financial and insurance services' sector, and that by far the bulk of that will be the Aussie-owned banks, you can say that about 60% of all Australian investment is in the finance industry.

And what about all those farms being sold out from under the feet of our own farmers? Nah. Total FDI in 'agriculture, forestry and fishing' is $5.9 billion, a small proportion (5.9%) of the total investment, and roughly on a par with foreign investment in the retail trade ($5.7 billion). 

It's also a very small proportion of the total value of farms and forests, which at a heroic guess (as I'm no expert on the data in this neck of the woods) I put at around $340 billion. That's 14.4 million hectares (2012 Agricultural Census, here) times an average price these days of some US$15,000 a hectare (which I got from this article), or NZ$23,500 or so at today's exchange rate. So roughly only 1.7% of agriculture is owned overseas, and of that I'd guess a fair slab is foreign institutional fund ownership of forests. The proportion of the archetypal family-run sheep and beef or dairy farms owned by overseas interests must be very small indeed.

For those who might be agitated that we're all in hock to the People's Bank of China, that doesn't show up, either. Here's the picture of total foreign portfolio investment - everything from government stock to listed shares to unlisted equity to money lent to New Zealand entities. Essentially it's the UK, the US and Australia, with roughly equal amounts, and there's a modest bit from Japan. Everything else is relatively insignificant.