Matt Nolan

Central Banks: Second best policy and operational separation

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Following a major crisis, such as the one we’ve just experienced, it is easy to get into a situation where the goal of policy is to “avoid another crisis”.  However, this is not a trap that our fine readers fall into – so we don’t need to worry about it here 😉 .

This isn’t to say that we shouldn’t take things from a crisis – far from it.  A crisis gives us information about the behaviour of the macroeconomy, about the feed-back loops that may exist that we may not previously pay attention to, and about the process people use for forming beliefs.  But we still need to say why these things occur – and hopefully make our given hypothesis testable – before we can decide to do anything.

So well prior to the crisis there was a string of micro-prudential policies introduced.  In truth, the retail banks have been grappling with the introduction of many of these policies during the crisis – and the Reserve Bank has stated that part of the reason the OCR is so low is because these policies have, in of themselves, tightened credit conditions.

Now all this is fine, when it comes to cyclical policy the impact of both micro and macro-prudential regulation has been widely discussed.  However, what bugs me is the lack of heavy discussion and analysis is the lack of significant discussion around the structural impact of said policy.

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Matt Nolan

Understand before you tinker

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I would be lying if I said this didn’t depress me.  Economists, great economists, economists I idolize stating that there are “imbalances” we must solve – and then telling us how to solve them without actually describing what the imbalance is and why it exists.

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Matt Nolan

Remember what inflation is

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There are a larger and larger number of analysts and journalists complaining about inflation at present.  The view seems to be that since the price of some goods are increase (fuel and food primarily) there is an inflation problem, and “something must be done”.  Because people have heard the RBNZ mention inflation they figure that the Bank should do something.

But I’ll tell you right now, as one of the most hawkish people I know I still do not see an inflation problem.  Yes, GST has pushed up the price level.  Yes, food and fuel prices have spiked – and they are hurting peoples real incomes!  But none of this is inflation.

What is inflation?  Inflation is the trend rate of growth in the price level.  In less wonkish terms, inflation of x% is when the price of all goods and services rise consistently by x% excluding any changes in “relative prices”.

The increase in GST was one-off, so its not inflation.  The increase in petrol and food is a relative price increase because petrol and food are relatively more scarce.  Does the increase hurt the economy and the people in it – hell yes.  Does it lower our real incomes and welfare – yes.  Can we do anything about it – no.

Unless the Reserve Bank can discover a large oil deposit and process it for our use they can do nothing about this.

So what we have at present IS NOT an inflation problem.  What we have is a negative economic shock, where we are being forced to reduce our standards of living because the resources we use are more scarce.  Having the price represent this scarcity means that we will take that into account, try to substitute away from the good, and hopefully come up with technologies that reduce our reliance on it.  But there is nothing the Bank can do about this.

Matt Nolan

A brief defence of a (temporary) cut

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I’m not sure if today’s rate cut was the right decision – I understand the justification for it, it is just hard to get past my inherent hawkish personality 😉

Still, I think that the rate cut is being slightly mischaracterised by those disagreeing with it – so I’m going to discuss it a little here.

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Matt Nolan

Post quake OCR cut

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The Reserve Bank cut the OCR 50 basis points today, primarily on the back of the Canterbury earthquake.  Their justification was based on a negative national confidence hit, on top of an already weak national economy.  This framework was consistent with the thinking of many economists – so even with all this uncertainty, it appears that policy was relatively pick-able this time.

I suspect that they waited to cut at the meeting instead of doing it prior to the earthquake so that they could indicate this was “one-off”, and prevent a sharper drop in the currency and expected rates.  However, no-one said that so I’m just guessing 😉

Demand is a nebulous concept, and they cut today as there is uncertainty regarding how heavily “demand” around the economy will drop following the earthquake.  Economists will not have a good idea what is going on here for some time – so the Bank should be ready to respond once it is clear that this demand shock has worked through.  We will see what happens.

Matt Nolan

The Fed and policy: Temporary but not permanent

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Via Arnold Kling at Econlog we see this paper regarding the impact on Fed policy.  It is an interesting paper in an economic history sense, I would suggest reading it.  However, the passage I want to focus on is the same one Arnold mentioned:

First, spending and pricing decisions are assumed to be based on long-term assessments of real income and real rates of return. Second, changes in monetary policy can only change real interest rates temporarily. Ultimately, the forces of productivity and thrift determine them, not changes in nominal magnitudes on the central bank balance sheet. Combining the two propositions implies that the Federal Reserve’s interest rate policy, as long as it stays within the narrow range of experience, would not be expected to have a significant or long-lasting imprint on markets or activity.

This is a great result.  It suggests that the central banks ability to change the “structure” of the economy, or make any long lasting changes to economic conditions, is negligible.  Without any “long-run costs” of Fed policy this suggests that monetary policy CAN be used to stabilise activity in the very short run – so it reforces the view that a central bank should look at “smoothing the economic cycle” by keeping underlying inflationary pressures near a certain target.

This is consistent with the orthodox way of viewing monetary policy.  However, interestingly Arnold Kling states that this paper is something he agrees with, but it “puts (him) at odds with Scott Sumner and John Taylor, among many others.” – people who are also part of the orthodoxy.

I believe that the issue here is that people are talking past each other a little – in terms of strict monetary policy, the views that Scott Sumner and (originally) John Taylor focused on were short-run, and as a result they were interested in the stabilisation role of monetary policy.  Kling appears to have ignored the idea of the short-run to focus on the relevant view of the long-run – something we can’t do in the face of price/wage stickiness.

Now I agree with Arnold that many people give the idea that central banks can create miracles FAR too much weight.  I think that central banks should not be involved with structural policy, or if they are it NEEDS to be separated from their stabilisation role for the sake of transparency – but this issue is separate from the focus on thinkers like Sumner.