Matt Nolan

Crisis and policy: A couple of notes on NZ policy

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Christchurch has had an earthquake, and this has lead to the discussion of a couple of policy issues.  Lets discuss.

RBNZ will likely cut the OCR.  However, I can see them waiting till their meeting – so they can fully explain what is going on.  The reason this matters is:

  • They will want to cut to help restore confidence – the demand element of the shock, not the supply/capacity element.  As a result, they will want to explain how they will reverse policy, and why they are doing this (in order to avoid overreaction).
  • They may want to manage expectations with regards to the exchange rate and other nominal variables – a sudden cut, without a full set of forecasts, may not be the best way for the Bank to say “hey, we are cutting rates now but will reverse this emergency cut once consumer confidence has stabilised”.  With their MPS so close, they must have decided to wait – or perhaps they have decided that the impact on confidence will not be sufficient to justify a cut.  We will have to wait and see.

“Rebalancing policies can be poorly timed too”.  On Twitter Alex tweeted “the basic issues on imbalances nz faces are as relevant today as last week key says”.  However is this really true?

In part it is, we are still in a position of deficient demand and so it is still a poor time to be instituting these sorts of structural issues.

What do I mean?  Well, the point of “rebalancing” is shifting NZ away from consumption towards exports and some types of investment.  I don’t really agree with everything that has been said, but if I did there is an issue – why are we aiming to knock down consumption when we already have weak domestic demand and elevated unemployment.  Even if the structural change is right in the long-term the transition path matters – and ignoring it will merely lead to a repeat of the mistakes of the late 1980 and early 1990s.

Why do I say mistakes – well because many of the policies instituted during this period were technically “right” but the timing was poor.  When unemployment is near normal levels, and economic activity is back towards trend, THEN we can think about structural change – introducing such change now will simply exacerbate a cyclical slump.

Matt Nolan

More on commodity booms

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After today’s discussion on food prices, it was interesting to see a speech out of the Reserve Bank.

The speech was painting risks – so stating things that could occur that were both positive and negative (risks are not just negative things when your current forecasts “balance” risks).  It was good, it raised issues, and it gave me an idea for a post for next week.

But, who the hell picked the wording on this:

New Zealand farmers are still recovering from the last commodity boom

And I suppose employees are still recovering from the large increase in wages during 2007, and oil drillers are still recovering from the record high oil prices in 2008 …

Yes, farmers overborrowed, sure.  But it wasn’t so much the commodity boom that did it – rather the expectation that land values and high commodity prices would make highly leveraged farm buyouts economical … when some were not.

I imagine farmers are really still recovering from the commodity slump during the GFC, weakened access to credit, and a sharp decline in farm values.  The statement “recovery from” is not the first thing that comes to mind when thinking of a period when incomes were high 😀

… You might think picking up on this is pedantic – but seriously, the wording the Bank uses is analysed in detail.  And statements are constantly compared to try and get a feeling for where policy is moving.  Saying that farmers are recovering from a period of high income gives the impression that they expect farmers to expose themselves again if commodity prices stay high – which is a big call.

I can (and constantly do) mis-speak, because I am not important.  The Bank is important – it sets policy – and the train of thought that is betrayed by their language dictates how the market forms expectations of their policy

Matt Nolan

Keeping financial stability and monetary policy together

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I have long stated that targets of “financial stability” and “price stability” (monetary policy) were important – but should be performed in separate, yet independent, operational terms (here and here).  Namely, keep the central bank focused on monetary policy while another organisation/operational entity solely focuses on the more long term goal of financial stability.

In my view separation is important for communication – by separating the two people can tell when actions are framed towards certain goals.  By having one organisation/entity trying to attempt both, you risk muddying the waters – which in turn will lead to worse outcomes.

However, this piece at VoxEU makes the opposite case:

Interestingly, empirics tells us that bank risk not only responds to a rate cut, but that it also matters how long rates are kept low (Maddaloni and Peydro forthcoming, Altunbas et al. 2010). This relates to the argument that in the years leading up to the crisis rates were kept low for too long. Our model can provide some reasoning for why this can be damaging. We make the model dynamic and add a crucial feature, maturity mismatch.

In contrast to their short-term liabilities, banks’ assets are long-term. Because of this, banks will only adjust their portfolios if they foresee that a change to their environment is of long duration. A short-rate cut will not push them to take more risk. But a long lasting cut will. A monetary authority that considers financial imbalances therefore has a different timing of policy than an authority that cares only about inflation and output gap stabilisation.

This argument is compelling, and if you have a central bank with only one tool (the cash rate) I think I would be convinced.

However, if central banks are also willing to put in place measures to try and reduce maturity mismatch, and adjust the cyclical nature of banks reserves – then I believe we have multiple instruments.  In this case, the use of each individual instrument should still be directed at a specific target – to make communication clear.

Yes, these instruments are related, and the choice of a financial stability institution will influence the choice of a monetary institution.  But this is already the case with fiscal and monetary policy – and yet we believe we can keep monetary policy independent.

The fact is that the balancing of expectations, and the ability to communicate policy to manage these expectations, is the key part of monetary – and even financial stability – policy.  As this is the case, I continue to find it important to keep these two policy targets operationally separate.

This is an issue I find fascinating, and I’m looking forward to seeing how things develop over the next decade – and why.

Matt Nolan

QE2: Is the Fed “mistaken” on purpose

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There is an excellent article on QE2 by Robert Barro (ht Greg Mankiw), I suggest you read it.

However, there is one point – where it goes from descriptive to a little more forward looking about policy – where I might see things in a slightly different shade:

The downside of QE2 is that it intensifies the problems of an exit strategy aimed at avoiding the inflationary consequences of the Fed’s vast monetary expansion. The Fed is over-confident about its ability to manage the exit strategy; in particular, it is wrong to view increases in interest rates paid on reserves as a new and more effective instrument for accomplishing a painless exit.

I see QE2 slightly differently.  QE is partially a means of getting the Fed to commit itself to lower interest rates in the future, by introducing the “loss on bonds” in their objective function.  In essence, the Fed KNOWS that this policy will lead them to overshoot their inflation target.

Now I agree with Barro when he says that, by using different instruments the “future Fed” can reduce the relative losses – but if they have really introduced QE to commit to a lower path of short-term interest rates this is a mute point.

This is the key question for me here – are the Fed using QE as a commitment strategy, or are they just using it as a way to directly increase the money stock or directly push down longer term rates.  Personally, I don’t think the uses are independent and I think that some form of “commitment” is implicit in what they are doing.

Matt Nolan

On the competitive devaluations

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I like this post by Menzie Chinn at Econbrowser – primarily because I agree with it 😉  It is well worth a read on its own.

I will however take some bits out for those who don’t want to leave right now:

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Matt Nolan

Why QE will (and should) lead to inflation past the Fed target

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I think QE was necessary, and I think the Fed has done a good job implementing it.  But one thing we have to be honest about is that it WILL, if it is done right, lead to inflation past the target at some point in the future.

There are many ways we can view the process of the Fed expanding its balance sheet and buying up a mix of Treasury and risky private debt:

  1. They are increasing the money stock directly, which if it gets spent will increase the money supply stimulating the economy,
  2. They are buying up long term debt, pushing down longer term interest rates directly,
  3. They are taking on risk at a point in time where people may be too “risk averse”.

All these considerations have their pro’s and con’s – but none of them directly imply that the Bank will deviate from its inflation target in the future.  Instead it is a fourth, and arguably the most important, part of QE policies that ensures they will do so – their use of the Fed balance sheet to influence their own future behaviour, making the “optimal path” for monetary policy time consistent.

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