Institutional status report

The jump in unemployment, and the fact that the labour market has been weak for a long time, is leading to understandable angst.  The government has been blamed as you often expect, the world has been blamed as it should, and the RBNZ is increasingly being blamed.  I would like to cover off a few things – just so when we discuss the issue of the economy, we are on the same page.

Update:

For the tl;dr audience, Kimble put together a neat summary:

Cliffs:
> The RBNZ bases their policy on forecasts, not the current state of the economy.

> Blaming them for the current state of affairs is to blame their previous forecasts.

> The argument they should take action to remedy the current state of the economy implies that you disagree with their forecasts.

> Making that argument without mentioning those forecasts seems completely insane.

Both Gareth Morgan and Danyl from Dim Post have come out and squarely attacked the RBNZ following the latest unemployment figures.  I am going to focus on the concepts raised over at the Dim Post – as I think they give the clearest way for me to discuss what is going on.

Danyl said:

If I understand the new RBNZ Governor Graeme Wheeler – already dubbed ‘Asleep at the Wheeler’ by financial journalists – correctly, he doesn’t need quantitative easing or any other macro-prudential tools because he still has room to cut rates, but he can’t cut rates any further because it would probably lead to increased indebtedness in the household and dairy sectors.

So we have high and rising unemployment, an over-valued currency, very low inflation, our central bank won’t lower rates and it doesn’t want any additional tools to address this situation. That seems completely insane.

This is indeed a common view.  However, we need to be a bit more precise about things before we can evaluate it.  The RBNZ isn’t doing QE because it can cut interest rates – yes.  As they are effectively the same policy.  QE is not macroprudential policy, it is a way of trying to create the same “intertemporal substitution” by consumers and businesses as cutting interest rates.  An IMPORTANT point here is that such policy won’t lower the high unemployment we’ve already experienced – that is sadly done – the point of policy is based on what they will expect will happen in a year or so when the impact appears … we will get to this more later.

Macroprudential policies would involve things such as lifting loan to value ratios on mortgages – this doesn’t “ease policy for the economy” but may well limit the appreciation in house prices stemming from lower interest rates.  The kicker is, the lift in house prices and the corresponding increase in consumer spending and investment is one of the primary channels that higher interest rates are supposed to help “boost” the economy.  We may use such a thing in conjunction with lower interest rates in order to “lean against” something that is going on in the housing market (eg if we believe there is a bubble) … but if it is really the issue of supply holding up house prices then this is really just blunting the signal to build more property 🙁

Another area may be “counter-cyclical capital ratios” … but this wouldn’t do much as it would involve telling banks in the current environment that they don’t have to hold much in terms of reserves … when they want to hold reserves.  It wouldn’t be binding.

These sorts of policies are things that come in “over the cycle” and are to deal with “systemic risk” … fundamentally the concern that the failure of a financial institution may impact on other financial institutions even without impacting on “fundamentals”.

So with all this blabbing, why is the Bank not cutting interest rates to stimulate demand!  As Danyl says, inflation is low and unemployment is high – furthermore, borrowing growth does remain weak.  Monetary conditions seem tight so something should be done … right?

This is a fair point – a point people should ask, and should be answered IMO.  A point that should be answered by the Reserve Bank with an article discussing what it does, and what is going on.  But given there is nothing there, let me have a go.

The Reserve Bank is setting policy based on what it expects will happen (as it cannot change the past, and has little impact on the very near term).  Just like Treasury’s advice is due to what they expect will happen.  As a result, they are slaves to their forecasts!

There is no need for alternate tools, and all the other fancy stuff being stated – in truth forecasts have just been flat wrong.  Knowing WHY they have been wrong, and asking whether the forecast was balancing risks appropriately is how we can judge whether the “Bank is to blame”.

Economists know forecasting is a mess – we have imperfect data, missing data, “too many” potential hypotheses, and constant “structural changes”.  This is part of the reason economists are very reluctant to “do something”, as its very hard to forecast the cardinal impact of that something.  Economic concepts are great for telling us the impact of policy, or the way thing may change, in an ordinal sense, but if we go to apply data and come up with measurements we wonder into a much more difficult area.

Even so, as a discipline we have decided that if we are very careful we can use forecasts to do something in terms of fiscal and monetary policy – specifically the management of medium term inflation and long-term balance budgets.

This is all well and good, but the key point is that a forecast is filled with assumptions – explicit and implicit – about the world.  The supposed advantage of the way economists discuss things then is our transparency about these assumptions.  But this hasn’t been the case around the world.  Understandably, central bankers get sick of people arguing about their assumptions constantly with no evidence – even as a private sector analyst I get called constantly by people who just want to tell me how the world works based on their relationship with their neighbour or dog.  But, tbh that is part of their role – and if someone is wrong the Bank should be able to say why.

Ummm, what does this have to do with now

We are in a situation where forecasts were wrong – not in terms of the September quarter UR.  I have a bunch of little models for unemployment that I run for the quarter.  One is solely based on the view the unemployment is a lagging variable – so I tie it to prior growth, prior unemployment, and the cost of labour.  Off that, my model was suggesting 6.9% for the unemployment rate.  I recognised that this had no “behaviour” in it, and that a lot of the growth in the first half of the year was due to a “temporary supply shock”, so  I stripped that out and my number found it’s way up to 7.1%.  I added 0.1% for the fact that many new Christchurch workers aren’t being captured in the HLFS and I had 7.2% – a bunch of other empirical and more structural models suggested other things, and I would not have subjectively picked that model.

The September quarter result wasn’t “shocking” just because of that quarter – its the fact the unemployment has stayed high for so long … high when policy makers have been setting policy based on a belief that the labour market would start clearing.

The RBNZ current believes that, after loitering at a high level for a few more quarters, the unemployment rate will come down sharply.  Furthermore, they believe that current high unemployment IS due to weak demand – so if they could go back in time they would cut rates but RIGHT NOW cutting rates looks inappropriate.

It is this forecast of the output gap closing, which is shown by the sharp fall in the unemployment rate (combined with a view that there is no “structural unemployment”), that is behind the Reserve Bank’s action – and if this assumption doesn’t hold up to scrutiny then you could criticise current action.

Now to people reading this who instead want to defend the Bank – I’m not criticising them here.  I’m just pointing out that, for all the talk and bluster at the moment, this is the key point of difference.  The output gap assumption here is extremely important – a factor I have seen many people realise on their own, even if they haven’t used that language!  If anyone from the Bank reads this, then if you have a spare moment I would suggest writing something to try and explain monetary policy to the intelligent lay people around – at present your lack of public comment helps to drive the commentary against your actions IMO.