Surprise! Surprise!

You've seen that the Reserve Bank has unexpectedly cut interest rates by 0.25% and has at least one more 0.25% cut in the pipeline.

For me, the most striking thing in the Monetary Policy Statement was this graph.

No matter how you slice it, it's now apparent that core inflation is, at best, systematically in the bottom half of the RBNZ's target 1-3% band, or, arguably, dropping out the bottom. And the trend, if anything, is that core inflation is still falling.

There are some who will argue that this is, in part, the RBNZ's own doing, with its interest rate increases in 2014 which (with hindsight) proved too tight a setting of monetary policy and hence subdued inflation more than desirably. Personally, I'm rather more inclined to another explanation, which is that our economy (and others) have changed in some still not fully understood way, so that the amount of inflation you get for any given degree of strength in the economy is less than it used to be (a "flattening of the Phillips curve", in the jargon).

Bernard Hickey of interest.co.nz asked Governor Wheeler a very good question at the post-Statement press conference, along the general lines that perhaps there have been structural changes in the global economy - technology? better supply chains? - that have made pursuit of 2% inflation targets a waste of space (I'm paraphrasing).

The Governor agreed that there had certainly been changes along those lines that could well be depressing inflation. But he said that no central bank had yet decided to flag away inflation targetting, and no central bank had lowered its target inflation rate. He also said that the traditional "output gap" analysis - if the economy is going gangbusters (a positive output gap) you'd expect higher inflation - is still very useful, and that the Bank isn't abandoning the traditional framework.

We'll see. For now, though, I'm rather attracted to the idea that inflation in the developed world has moved structurally lower. Throw in the additional fact that most of the major developed economies have their monetary policies set on super-easy, and you can readily get to the point of believing that there's actually no sensible setting of local monetary policy that will get inflation back up to 2%. In that light I'm not surprised that the Bank has now pushed  inflation being back at 2% out to March 2018.

A once in a generation opportunity

I'm going to be talking about infrastructure, but first let's detour back to August, 1968. President Johnson is waging the Vietnam War, the Warsaw Pact forces have invaded Czechoslovakia. In Dublin I have just turned 17, and I'm hoping that José Feliciano's Come on baby light my fire will encourage one of the prettier girls from St Louis Rathmines to have a slow dance with me (it won't).

And on August 19 1968 this concrete power pole was manufactured: the date was inscribed in the concrete by someone at the (unidentified) factory. It's one of Vector's, and it's on Albany Heights Road in Auckland.

It's a fine example of how infrastructure can be a great, enabling investment. It's not just that this pole has been giving good service for 47 years already and, based on manufacturers' blurbs and various regulatory proceedings concerning expected asset lives, that it could well go on for another 40 years. But it's also because, when it was installed, Albany was still undeveloped farmland. Now, the same pole is helping supply power to a vastly larger population than was envisaged when it first went into the ground. Indeed, already installed power poles, and other infrastructure, were themselves instrumental in enabling the development that subsequently occurred. From the point of view of overall social return, and very likely from the investor's private rate of return, this has been an outstandingly successful investment.

There's an even bigger example - the Auckland Harbour Bridge. As Motu's Arthur Grimes pointed out in a fine paper

The benefit from building the Auckland Harbour Bridge did not arise primarily because it enabled 26,000 people to travel faster into Auckland; its primary benefit was that it enabled a tenfold population increase north of the harbour, greatly extending Auckland’s urban area.

Albany was once at the end of a windy road, well north of the end of the Northern Motorway; now it is a major commercial, educational, sporting and residential node within Auckland.

And Arthur went on to make the general policy point that "major strategic investments – whether in transport or broadband – sometimes cannot be analysed solely within a traditional cost-benefit analysis (CBA) framework. CBA does not cater adequately for the responses by private agents to the opportunities that may be created by gamechanging infrastructure initiatives".

It's not invariably the case that things will work out better than expected when infrastructure gets rolled out - as you'll see if you google "the bridge to nowhere" - but it's often the case that the total, social benefits of infrastructure investment will be greater than were able to be counted at the time of the investment. Go no-go decisions will as a result be unnecessarily conservative, and less infrastructure will get rolled out than would be best for the country's overall welfare. That doesn't mean that every social planner should have free rein to add on arbitrary benefits on a "build it and they will come" basis - that's the route to every politician's pet elephant getting painted white - but it's generally reasonable to suppose that the benefits may ultimately play out somewhere better than you might think day one.

Pulling things together, we've got three things going on. One, our existing infrastructure is inadequate, especially in Auckland, and there's a great deal of investment that we will need to do: the latest National Infrastructure Plan mentions "$50 billion of forecast infrastructure spend over the next ten years". Two, we can be reasonably sure that the total benefits of increasing the stock of infrastructure will often be more than the beancounters suppose. And three, we have a once-in-a-generation opportunity to borrow money for infrastructure at an exceptionally low cost.

The New Zealand government can currently issue 10 year debt at a tad over 3%. That's exceptionally low by our own historical standards - yet still highly attractive to foreign investors. The equivalent 10 year rates overseas are -0.41% in Switzerland (yes, you read that right, a negative 10 year bond yield, where lenders are paying the borrower), -0.06% in Japan (yup, negative again), 0.23% in Germany, 1.59% in the UK and 1.91% in the US. Currently the New Zealand government could fill its boots with all the infrastructure funding it could feasibly want, at exceptionally low cost.

I gather from media reports that the government is indeed thinking of bringing forward some infrastructure projects. My advice would be: let it rip.

How 'special' are Special Housing Areas?

Three months ago I went and had a look at a Special Housing Area (SHA) that had been set up not too far away from us in Browns Bay (if you're not au fait with the whole SHA thing and the Housing Accord, you'll find Auckland Council's guide handy).

As I said then, I came away thinking that calling it an "area" was pushing the ordinary meaning of the word: it was actually one site, at 4 Bute Road. I wasn't convinced there was much "special" about it, either. Lots of other mixed retail/residential blocks had already been developed along Bute Road, and giving accelerated planning permission to something that would likely have sailed through in any event didn't seem to me to be much of a nudge towards faster housing supply. In any event, 4 Bute Road didn't seem to have benefitted much: nothing was happening on site.

Over the weekend I went back to have a look and see how things have progressed since then. And the answer is, they haven't. The big tree next door has had a good summer, but that's it.

All of which is a bit odd, as the supposedly fast-tracked SHA site is still sitting there, while further along Bute Road, non-SHA developments are coming along fine. Here's a big new five-storey one, for example, at 1/23 Bute Road.

So I went to have a look at another local SHA, at 586 and 588 East Coast Road. This is an earlier one: it was part of a batch that were designated SHAs in September 2014, whereas 4 Bute Road got the nod in August 2015. Here's what it looks like: it's the bungalow with the grey roof in the centre of the picture, plus the house with the orange roof behind the pine tree.

Again, this is stretching "area" a bit, but I suppose two average-sized sections make an "area" of some sort. Whether it needed or benefitted from "special" designation is anyone's guess. It's true that there aren't other apartment blocks in the immediate vicinity, so maybe the developer would have been attracted by faster-track consent (under the SHA process) for a 39-apartment development, instead of some more protracted bunfight. But on the other hand there's already a 2-storey business park thingie next door (you can see the edge of it in the left hand side of the photo), so putting in a smallish apartment block wouldn't be that much of a planning consent hill to climb.

In any event, nothing's happened on this site, either, though to be fair the original SHA announcement in September 2014 talked of a timeframe of "the next 24 to 36 months", and said "There is an intention to have the residential housing project completed in the early part of 2017".

Where all this leaves me is this. I'd like to believe that "Special Housing Areas" greased the wheels of the housing planning process, and either accelerated or increased new construction, or both. That would  be a great outcome on one of our largest national infrastructural challenges: skyrocketting Auckland house prices, as we know, have had ramifications all over the place.

But how will anyone definitively know? At one level, it's not that hard to create an anecdotal trail (as I've just done) of slow SHA development and as-fast or faster non-SHA development, and to convince yourself that they've had no impact on supply at all, or even held it up. It's possible, for example, that the central quid pro quo of, broadly, faster planning consent in exchange for inclusion of some "affordable" units within the development, never took off enough to make any difference.

But for a policy this important, I'd like to think there'll be some more sophisticated analysis of whether it's working. Granted, MBIE and Auckland Council have, between them, come up with a series of informative monitoring reports: you'll find the latest one, covering the period October 2104 to September 2015, the second year of the Housing Accord, here. It's got lots of useful data, such as this graph (on p15) of what's happened to housing consents since the Housing Accord kicked in.

The problem, for me, is that the data, while useful, don't really answer the question, did the SHAs make a difference? We don't know how much of this recent consenting and development would have happened in any event - in fact, while consenting has picked up substantially in the Housing Accord era, it hasn't yet consistently reached the levels that Auckland managed without Accords and SHAs in 2002-04 (and in a smaller Auckland back then, too). So I'm hoping that someone - an economic consultant with an interest in housing, maybe? - will be asked to turn their minds to a proper 'with and without' exercise: matching a bunch of otherwise similar SHA and non-SHA areas, and checking to see if the SHA ones outperformed in speed or quantity.

Incidentally, the monitoring report mentioned, in passing, a couple of truly appalling facts about the slowness of the normal planning process. It was giving some case study examples (on pp6-9) of where SHA planning processes have got things moving faster: it said, for example (p9) that "Within two years of the start of the Accord, homes are being delivered in SHAs like Weymouth and Northern Tamaki and sections delivered in special housing areas like Whenuapai Village".

Jolly good: but the report also noted that these were "processes that would normally have taken 4 or more years", and earlier (p6) it said that "Under the Resource Management Act 1991...the rezoning of brownfield sites to enable more intensive development can take between 2 and 6 years".The Second World War took six years. I don't think a planning consent needs to.

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.

Sovereign irresponsibility

There was a fine article by Deborah Hart, the executive director of the Arbitrators' and Mediators' Institute of New Zealand, in Monday's Herald, making the sensible case that the supposedly controversial 'Investor State Dispute Settlement' (ISDS) process within the Trans Pacific Partnership (TPP) is actually a good idea. Read it for yourself: the gist is that ISDS "will work well for NZ" and that "Investor-state dispute settlement is therefore not something to be afraid of. It's part of being a trading nation in a globalised world".

What's baffled me most about the strong opposition to ISDS is the notion that "national sovereignty" is something that is sacrosanct, not to be jeopardised, diminished or traded away. If national sovereignty really trumps everything else, Dachau would still be open, apartheid flourishing, and every Tutsi in Rwanda and every Muslim in Serbia would be dead.

Progressives everywhere ought to welcome international controls on appalling behaviour by "sovereigns" - a useful crutch for the world's kleptocratic tyrants to lean on - as they have since (at least) the founding of the League of Nations in the wake of another fine exercise of national sovereignties, the Great War.

What "sovereigns" are demonstrating when they resist principles-based restraints - when, for example, neither China nor the US will participate in the International Criminal Court - is that they prefer the option of unprincipled behaviour. When countries sign up to the likes of the ICC, or to the ISDS provisions in the TPP, they're saying the opposite: we'll play fair, and we don't mind being judged on it. That's exactly where New Zealand should be.

No appeal? Good

I've been catching up with stuff that's happened over the summer holidays, and I have to say I was quite encouraged when I found out that Chorus has decided not to appeal against the Commerce Commission's decisions on copper broadband pricing and on backdating the regulated price.

Chorus's statement on January 28 said that "the Chorus Board has elected not to appeal the decision, despite disagreeing with some key elements such as the lack of backdating. While we are aware that some investors feel there may be merit in further testing aspects of the determination in court, it is the strong view of the Board and Management that the best long-term value for our shareholders and customers will be achieved through the industry focussing on bringing New Zealand better broadband".

Well said. Even if there is also something of a Mexican standoff going on - "we won't appeal against some aspects of the decisions if everyone else holds off, too" (my words, not theirs) - the general idea is bang on the button. There has been a deal of opportunistic regulatory and litigatory rent-seeking in the telco, and other, sectors over the years, and it is good to see someone turning their back on it and getting on with running the whelk stall.

More companies could usefully realise the true extent to which regulation and litigation are a distraction from their core lines of business. The direct costs of management and board time, and of lawyers and economic experts, are only a fraction of the true cost of diversion of focus from longer-term performance. In my experience, across various governance roles, that item on the agenda about the regulator or the court case takes on an entirely disproportionate importance. The corporate ego gets overinvested in winning: business strategy and longer-term performance are the inevitable losers.

Chorus may well have come to another correct conclusion that others could learn from: if you play the regulatory game too hard for too long, it will bite you (as I've argued before). We might eventually have had sector-specific regulation in any event, but there's little doubt that Telecom (as was), and various parties in the electricity business, pulled their current sectoral regulatory regimes onto their own heads through their bloodyminded intransigence.

I'm perfectly happy to accept that focussing on the business was the primary motivation for Chorus flagging away any appeals.  But if in the background Chorus also reasoned that pushing their luck on backdating - they might have scooped a pot of some $140 million - on top of a halfway decent outcome on the price, would have been a bad strategic move, given that the whole regime of telco regulation is currently under review, then they made a good call.

Did we ask the right question?

Normally I'd take time out early on, to explain some of the telco/regulation jargon, but as I suspect virtually everyone likely to read this post already knows what UCLL, UBA, WACC and TSLRIC are, I'm going to plunge right in.

Unless there is some diehard with a large legal budget to burn, last month's final decision by the Commerce Commission setting the wholesale price of copper-based broadband at $41.19 brings the curtain down on a long, complex and contentious process.

I'm not going to spend much time revisiting the details of the Commission's decision, other than to note that in an exercise like this one, with so many moving parts, there is inevitably going to be room for even reasonable people to disagree.  In their place, I might well have gone a different way on aspects of WACC, for example, or taken a different position on the challenge of digging trenches through New Zealand's allegedly idiosyncratic topography, but so what: overall it was a reasoned, careful piece of work.

The end result looks to have ended up in the right area, and I say “area” advisedly: there is no single “true” point-estimate answer to these sorts of questions. You only have to glance at Figure X1 of the decision, for example, to see how second thoughts on various component bits can have significant impacts on the final price. I was comforted in particular, as I thought it was a realistic result, by the Commission's calculation (in paras X34-5) that its price on a “like for like” basis came out lower, at $31.60, than the entry-level UFB price of $37.50. And no, I don't want comments from conspiracy nutters who think the Commission was steering its decision to within cooee of the UFB price.

But let's step back from the specifics and consider some broader picture issues.

For me, the big one was the task the Commission was constrained to do. By law, it had to set a forward-looking TSLRIC price, and it did. But that task answers the question, “what would be the cost to use a shiny new whizzbang broadband network rolled out efficiently today”, not the question, “is Chorus ripping off my broadband provider, and, at one remove, me?”. Or as the Commission summarised it

E109 … our task is to set a price according to TSLRIC which we and submitters agree is best set relative to the forward-looking efficient costs of the hypothetical efficient operator, rather than the past costs of the regulated entity.

E110 Putting that another way, we do not consider that concepts such as “windfall gains” or “windfall losses” are particularly relevant. A price determined according to TSLRIC does not attempt to regulate the incumbent’s revenues such that it earns a normal return on its actual investments. Rather, it attempts to set a forward-looking price based on modern technology and irrespective of the incumbent’s past investment decisions.

The Commission is completely correct in saying that its hands were tied, and that any financial impact on Chorus was beside the point. And I know that TSLRIC is a good price to use if (for example) your main issue of interest is whether retail broadband providers (or others) are given a fair go at getting into the wholesale broadband business for themselves. And that's an important point if you believe that consumers are best served in the long run by competing suppliers deploying a choice of infrastructures.

But I'm still not convinced that the Commission was asked the right question in the first place. There was a good consumer case for an alternative approach, the one the Commission described in the extract quoted above as an “attempt to regulate the incumbent’s revenues such that it earns a normal return on its actual investments”, and which is standard in many regulatory proceedings.

Consumers, for example, are wearing the cost of a hypothetical brand new network. It's as if the government had decided to regulate the price of cars, and as part of the exercise decreed that only the latest new models in the showroom would be made available. Many of us, however, would prefer to get our cars from Honest John's Japanese import yard. Instead, we're being asked to pay the depreciation costs of a brand new car, and we've lost the option of paying a lower price for an already depreciated second-hand one.

So yes, I'm still concerned that the inherent design of the regulatory regime had the capacity to deliver windfall gains to Chorus (at consumers' expense) or windfall losses (at Chorus's expense). The whizzbang modern technology element probably counts against Chorus if it is still using some earlier generation gear, as does the efficiently deployed element, if it is still carrying inefficiencies from its dominant incumbent Telecom days. But the depreciation aspect is a clear bonus for Chorus: the price is based on a brand new network, with its deployer entitled to a reasonable rate of return on the whole amount invested. Chorus, on the other hand, has already recovered some proportion of its investment, through depreciation, and should only receive a reasonable rate of return on the funds still invested. To that extent Honest John is being paid the new car price.

There's another aspect that also leaves me wondering if the TSLRIC question was the right one to ask.

Earlier, the Commission had provisionally set the broadband price on an international benchmarking basis. It's an approach which I hope survives the current review of telco regulation, as I remain convinced that it can in many circumstances provide a decent enough approximation of what the New Zealand price ought to be. But it didn't work on this occasion: the Commission was (again) constrained, and could look only at the overseas prices in countries that also costed broadband on a TSLRIC basis. And the answer to that quest was – Sweden.

Understandably, various parties weren't happy that New Zealand prices were going to be set on the basis of an overseas sample of one, we moved smartly into the final pricing process that concluded last month, and the initial benchmarking exercise became moot. But it still leaves a big question unanswered: how come there are only two countries in the developed world that are setting broadband prices this way?

I know, there will be times when there are just a few enlightened countries ahead of the pack, and most everyone else is doing it wrong. I'm not sure, though, that this is one of those times. While we're in the mood to have a rethink of our telco regulation regime, why don't we ask ourselves if we can live with mainstream overseas practice – especially if the alternative is fractious, protracted, complicated, and expensive.