Matt Nolan

Discussion on policy in NZ for the week

/4 Comments/in , /by

This is a list post – so make of it what you will.

Bill Kaye-Blake has been discussing the macroeconomy in New Zealand (*,*,*), and hunting for a way to make the narrative clearer – I’ve been chatting about it with him in commetns, and Eric Crampton listed up some points here.  Reframing the narrative is important to me, and has led me to experimenting with ways of communicating ideas about the macroeconomy.  Brian Fallow shows the importance not just of clarity, but of indicating that there is no “silver bullet” in his great op-ed.

Grant Spencer has also made a point of communicating about “other tools” that the RBNZ might use, and why they would do such a thing.  The Bank knows that outside their role as protectors of monetary policy, they have to take into account the general stability of the financial system – and they want measures that they use for this to be as transparent as possible.

On the not of communication and narrative, Norman Gemmell has started a series of articles on the NZ Herald discussing issues of the day.  He is an awesome economist, and I’m greatly looking forward to these posts.  The first post tries to lay out the idea of asset sales on more objective grounds!

This brings me to Treasury.  They have noted the mixture of calls about austerity, the economic cycle, structural problems, and decided to spark things off with a piece that looks at the impact of “fiscal policy” in a macroeconomic sense.  This is a piece I intend to go through and write about in time 🙂

All in all, a good week for discourse.  Nice.

Matt Nolan

Inflation stickiness, demand, and judging the success of monetary policy

/7 Comments/in , , /by

I am still a fan of flexible inflation targeting.  I agree with Nick Rowe that explicit inflation targeting has made inflation outcomes “stickier” – and that knowing inflation is in a range of the inflation target is therefore insufficient for telling if the central bank is truly achieving “socially optimal policy”.

For all the time I’ve spent reading monetary economics books and sitting in classes where macroeconomics has been discussed, I still remember a clear (albeit very partial) description of why we do inflation targeting that came in 100 level economics.

I distinctly remember my tutor saying that the point of inflation targeting in the form we use it in New Zealand was to pin down “inflation” (price growth that is shared between all goods and services that is independent of the “relative” value of these goods and services).  With people setting prices based on this view of inflation, central banks with a clear very of the economies “ability to produce” can move around “aggregate demand” in order to prevent recessions that are due to short-falls in demand.  The flipside was often that inflation stickiness was “asymmetric”, with excess demand translating into rising prices, while insufficient demand translated into falling output – this is our good friend the upward sloping, U-shaped, short run AS curve.

This story is massively oversimplified, especially in its treatment of expectations.  But an overarching goal of anchoring inflation expectations was always part of what central banks were aiming to do.  Given this, then in so far an central banks had an idea about economic capacity (which is a very debatable point in itself) they could help to manage “demand” in a macroeconomic sense.  When I was tutoring, this was very much how active monetary policy is taught to first years, and I doubt terribly much has changed.

And this is the point – economists have always know that, if their announcement of a 2% inflation target was the sole determinant of inflation, this does not mean “success” … it just means that they can focus solely more heavily on how the actions of monetary policy have a short-run impact on output.  Deviations of inflation from their target provide information that is useful information about the state of “demand”, but as the NGDP targeting proponents point out it does not capture the whole story.  Variables such as NGDP, and unemployment, provide significant information … something central bankers already recognise and incorporate, contrary to the “narrative” of them being closed minded (Nick isn’t saying this – I’m talking about the more general stories from the media).

This is consistent with flexible inflation targeting – and it does come with one massive hole.  Judging the “success of monetary policy”.  As of course, flexible inflation targeting can only be judged on a forecast, forecasts that are determined by the central banks themselves – and filled with unobservables such as “future economic capacity”.

NGDP targeting differs from this in only three ways:

  1. It changes a partially discretionary rule based process with a fully rule based process.
  2. It targets levels instead of growth rates – making policy “history dependent”.
  3. It gives guidance, and will make “stickier” growth in nominal income – compared to flexible inflation targeting which does this for price growth.

On that final point, at the moment inflation targeting lets a firm say “with competition and the such, I was able to increase my prices 2% this year – this is the same as inflation, and so in reality my “price” is the same”.  With NGDP targeting the firm will say “I increased revenues by 5% this year – this is the same as the growth in nominal spending/value add, as a result my real “revenue” is performing as well as the average firm”.  The right “guidance” will depend strongly on what we think is the most important factor for firms and households to have certainty about (to extract appropriate “market signals”).

To put all this another way – inflation stickiness isn’t an unintended consequence, it is a feature of central banks trying to improve the “sacrifice ratio” associated with active monetary policy!

Matt Nolan

Menzie Chen on currency wars

/1 Comment/in , , , /by

You know I don’t believe that the “currency war” is a negative thing in a world of insufficient demand (*,*,*,*,*).  But Menzie Chen from Econbrowser has the same view – and to be absolutely honest their view is significantly more reputable than mine 😉 .  Furthermore, it was a point that Chen made all the way back in 2010!

The post I have linked to is excellent, I would suggest reading it the whole way through.

The global economy is not a zero sum game.  The fact that we have significant “output gaps” (unused labour and capital) is the justification for trying to get private agents to “bring forward” consumption and investment now – which is what monetary easing in all its forms does.

In New Zealand, the hard question seems to be “how close are we to filling our output gap” – as if we are close (a popular, even mainstream, view in NZ, that I am not sold on) the current high dollar is indeed indicative of NZ inoculating itself from this global monetary easing.  This is a separate issue again from the “persistently high real exchange rate” that New Zealander’s are concerned about – this is an issue largely unrelated to monetary policy, where as a society we have to start being more honest about the trade-offs from different policy settings we have put in place.

Matt Nolan

A hypothetical chat – exchange rate overvaluation

/5 Comments/in , /by

With people in NZ constantly yelling about the dollar, and yelling at the Reserve Bank, I thought I would host a hypothetical discussion that hopefully helps to explain the issues – and why inflation targeting isn’t the cause of any of the perceived problems.  Here it goes:

Intelligent non-economist (INE):  The dollar is too high, and its destroying New Zealand’s economy.

Nolan (N):  Rightio, why.

INE:  When the dollar is too high, productive industries don’t have an incentive to produce or be here, so it hollows out the country.

N:  The dollar is a relative price.  If the price is too high, we need to ask why it is too high – and we need to take into account what other countries are doing.

INE:  Exactly.  Other countries are devaluing their currency and we are not because we are obsessed with inflation targeting.

N:  Not really.  Other countries are setting monentary policy to reach their inflation mandate, and so are we.  With a whole bunch of countries all targeting inflation outcomes of “2%”, and setting monetary conditions appropriately, this isn’t the cause of any big disjoint in the dollar from its “fundamental value” (unless you believe the RBNZ is setting policy too tight, or other economies are setting it too loosely, for their mandate – which would imply low inflation here, or high inflation overseas).

INE:  But you are missing the point.  It is obvious that the RBNZ is setting an interest rate that is too high for the economy, just to meet its inflation mandate!

N:  This is where I think you are a bit confused on what the RBNZ is doing.  By meeting its inflation mandate, it is partially setting the opportunity cost for bank lending (the OCR), which helps to guide the interest rate towards its fundamental level.  However, the fundamental interest rate isn’t set by the Reserve Bank, it depends on savings and investment in the economy, the expected rate of return, the time preference of individuals, the stance of fiscal policy, and the structure of the tax system (and its impact on rates of return).  If non-inflation accelerating real interest rates in NZ are higher it has nothing to do with the Reserve Bank – and it has everything to do with these issues, which are influenced by government policy, industrial policy, competition policy, and the efficiency of financial markets.

INE:  But, the Reserve Bank sets interest rates and the exchange rate!

N:  Not really.  They are “managing our fiat currency” in such a way that the real value of a dollar erodes at a constant and predictable rate – this increases certainty for households and businesses, and helps them interpret what changes in market prices mean.  They also try to limit the variability output in the general economy in the short term, by taking advantage of aspects such as “money illusion” through the way they change the OCR (although, things get a bit more complicated as we add in expectations and time consistency – these things can be left to the side for now 🙂 ).  However, none of this has to do with any long-term, persistent, shifts in the New Zealand economy.  In so far as we are concerned about the exchange rate being “too high” for a long period of time, and the current account deficit being “persistently large”, this is the result of the fundamental savings-investment issues in the New Zealand economy.

INE:  But if the RBNZ cut the OCR, and interest rates fell, and the dollar fell, we’d be “more competitive”.

N:  Then prices, including costs, would rise.  Within a few years, our exporters would be just as uncompetitive at the new “lower” exchange rate – implying that these persistent imbalances would simply return.

INE:  But exporters are complaining about the exchange rate.

N:  Exporters are complaining about the low rate of return – the exchange rate is a symptom of this not the cause.

INE:  So you are saying that these issues have nothing to do with inflation targeting, and even the impact of the exchange rate itself tends to be overstated.

N:  Yes.

INE:  I don’t believe you.

N:  That’s a pity.

Matt Nolan

Mark Carney points out the currency war myth

/9 Comments/in , /by

In this piece on Bloomberg, Mark Carney (the govenor of the Bank of Canada, and soon to be governor of the Bank of England) points out that the criticism of the BOJ for the drop in the Yen isn’t fair:

Speaking on the same Davos panel, Bank of Canada Governor Mark Carney commended Japan’s focus on beating deflation. Carney, who will move to the Bank of England in July, said Amari had been “very clear and the Bank of Japan (8301) is clear in terms of the policy focused on a domestic inflation target.”

As long what is going on is consistent with an underlying inflation/NGDP target this is just normal monetary easing, not “beggar they neighbour intervention”.  I noticed that a lot of people keep throwing out this currency war myth, even in NZ, but as we have discussed in a number of posts listed here it is simply a myth.

Truly, if people are concerned about the “plunging Yen” they need to ask why – is it because they have left monetary conditions too tight in their own countries?  If so, that is really just their own fault.  If domestic monetary conditions aren’t too tight we actually have to ask what the issue is – and if there is an issue it will be to do with direct market failure or government policy, it will have nothing to do with rule/expectations based monetary targeting.

Sidenote for New Zealand:  If you are really worried about our “competitiveness” instead of going on about the currency – ask why New Zealanders are so willing, and able, to borrow from overseas.  It is the fundamental drivers of that phenomenon that are inherently related to any lack of competitiveness – the nominal currency is a symptom, a by-product, of the fact that New Zealand consistently invests more than it saves … and tends to not make a sufficient social rate of return on that investment.  To “solve” any perceived problem, we need to actually ask why in this context, rather than arbitrarily attacking things.

Matt Nolan

The currency “war” myth that won’t die

/6 Comments/in , , /by

Over on Rate’s Blog I’ve seen an approving link to an article discussing the “currency wars” that are going on around the world.

As Lars Christensen says here, and as we’ve said on many occassions ourselves given that monetary policy is pegged to an implicit inflation target this isn’t “beggar thy neighbour” policy at all – this is just standard monetary easing.

Now in New Zealand the big complaint is about the exchange rate – many people feel that the New Zealand dollar is “too high”.  However, there are two issues here:

  1. Monetary policy – has NZ monetary policy just been too tight?
  2. Structural policy – are there structural reasons why our exchange rate has been (potentially) persistently over-valued.

We have discussed this before here.

This isn’t a currency war, let me requote something we’ve said before:

Central banks are not breaking the rules, this isn’t a prisoner’s dilemma – competitive devaluations HELP when demand is suppressed … just look at the Great Depression, and the choice of countries to go off the gold standard!

Yes, there likely are structural issues in the New Zealand economy.  But policy makers should be focused on those specifically (why is there insufficient residential building activity, why is the real exchange rate so high) – they cannot be solved by monetary policy or the Reserve Bank.   Even when we think a policy issue is clear we need to be careful, as Noah Smith points out:

It’s important to belabor this last point. Economists know some things, maybe a lot of things, but this is absolutely dwarfed by the size of the things we don’t know and don’t understand. If this blog has had one “unifying theme,” it would be the depth of our ignorance. So when economists urge caution in using policy to change large sectors of the economy, this doesn’t necessarily mean “We know that the free market is always perfect and good and that policy can’t help.”

Instead, caution about policy is very similar to doctors’ maxim of “first, do no harm.” As a doctor, you wouldn’t say “I can’t figure out how this organ is helping the body function, so let’s just take it out.”