Matt Nolan

A couple of good articles on monetary policy reform

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Here are a couple of good articles on the monetary policy debate.  First from Australia (and this fine blog with more discussion here and here):

Meanwhile, the central bank’s primary focus on inflation recognizes that monetary policy needs to be based on a single instrument and policy objective. Pursuing multiple objectives with multiple instruments, as Labour now suggests, is a recipe for incoherent policy and poor economic performance such as New Zealand experienced before its path-breaking reforms of the 1980s.

And then there is BK Drinkwater, who has gone full hog discussing monetary policy issues with the Standard here and here.

I didn’t take Marty G’s post—or Cunliffe’s—seriously, because for all the storm and stress about “hot money” coming from overseas, there’s a certain obliviousness to the fact that for debt to happen, for mortgages to happen, for credit to happen, someone has to borrow in addition to there being someone willing to lend. Why ignore half of supply & demand?

This is THE point that is CONSTANTLY being ignored.  Never have I seen so many smart people ignore a demand curve for so long. 

Update:  I should point out that Westpac is also making the point on demand, good on you guys 😉 .  I don’t actually receive weekly updates from any of the other banks, if any of them are saying it as well could someone tell me in the comments and I’ll link.

Good work everyone.  Hopefully someone is listening …

Matt Nolan

One thing to keep in mind …

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I have noticed a lot of talk about how we need to change the monetary policy paradigm (like here, here, here, here, and here).  Comments here, and here, have been especially vocal.  There has been a lot of talk of monetary policy being “20 years old” so we should “fix it”.

However, what is monetary policy.  At heart it is policy regarding money.  As we discussed, in the long-run this doesn’t matter – as all prices adjust.  In the short-run, we have a trade-off between output and inflation because some prices in the economy are inflexible (read wages).

Monetary policy at heart isn’t about “unemployment” or “output” or “the exchange rate” (which is a relative price).  Monetary policy is about money, it is about the supply of money, it is about the price level and inflation.  The “interest rate” is merely an instrument central banks use to control the money supply and keep “inflation stable”.  By keeping inflation stable we increase certainty and we help make sure that money remains a good indicator of the relative value of REAL goods and services.

The idea that we should mess around with this to tinker with other things misses the point – if our exchange rate is funny, unemployment is high, or output is below potential we have to ask “what issues in REAL economy are causing this”.  Monetary policy in itself is irrelevant – monetary policy IS about money, it IS about inflation, it IS about expectations regarding these nominal variables, it IS NOT about real economic variables.

I am not saying that monetary policy hasn’t moved real variables – but in a world where monetary policy IS solely focused on inflation and consistent expectations is a world where monetary policies impact on the real economy is at its best.

Saying we need to change the monetary policy is equivalent to saying “we don’t know what the real issues are in the economy, and we are going to use the money supply as a political instrument to hide this lack of knowledge”.

When the Reserve Bank Act was made they recognised these facts.  They realised that the focus of monetary policy was money (funnily enough) and they kept it there.  Other policies (fiscal and prudential) can be used to deal with other issues in the economy, but monetary policy IS the policy of growth in the money supply – that is all.  It seems that this knowledge has been lost along the way – lets not let this gap in our memories lead us to dumping the Reserve Bank Act and forgetting the real issues that exist in the NZ economy.

Matt Nolan

Good on you Brazilian central banker

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Here is some sense talking from a central banker and trade representative from Brazil:

Senior Brazilian trade representative Mario Marconini from the Federation of Industries of Sao Paulo, says there’s a growing realisation from Brazilian businesses that trying to control the exchange rate is fruitless.

The long-term answer can only come from concerted international action to apply pressure on China to allow more flexibility in its exchange rate, Pundek says.

By removing China’s artificially low exchange rate, the massive trade imbalances created by that rate can be corrected.

This is point number one on our list of issues causing an imbalance (list at the bottom of this post).  I am loath to blame China for the whole imbalance – after all they are artificially selling their own stuff cheaply by devaluing their dollar.  However, currency pegging has to be seen as part of the PROBLEM in the current economic environment – not the solution!!

And on the idea of capital controls being fruitless, this becomes obviously when we look at one very simple fact – there has to be DEMAND for the capital for it to flow in.  The fact people want to lend is only half the story, people inside the country have to be willing to borrow at the given interest rate.  This is a little fact that seems to be continuously ignored pretty much everywhere …

Matt Nolan

Cunliffe on Labour’s shift in monetary focus

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David Cunliffe has done a guest post on the Rates Blog looking at Labour’s change in monetary policy … policy. [We have discussed this here, here, and here already].

As far as I can tell (tell me if I’m wrong), the content of the post boils down to this paragraph:

More importantly, acting alone it has not achieved inflation control alongside reasonable stability of exchange rates and money supply. Combined with an imbalanced tax structure, high real interest rates helped suck in hot money that drove the housing bubble.

Now, I don’t know why he’s mentioning the money supply unless he’s going back to inflation – so lets ignore that.  Exchange rate stability is not important – if the dollar is moving because commodity prices are moving (which they have been) then it helps to stabilise movements in the value of export prices.  This is a good thing.

So we are left with the housing bubble.  I commented on the post with this:

Imbalanced tax structure – yes.

High interest rates – no.

An imbalanced tax structure with a lower OCR would have lead to a larger housing bubble. We are a small open economy, the supply of credit is infinite – the housing bubble stems from credit demand, which is declining in the OCR.

This is something people forget.  We are a small open economy.  The supply of credit at the world interest rate is infinite, no matter what our OCR is.  As a result, everything falls back to our “demand curve”.  Demand for housing credit is falling in the domestic interest rate – therefore, if our RBNZ increased the opportunity cost of bank lending by lowering the OCR it would lead to less borrowing to fund housing relative to otherwise.

We cannot blame monetary policy for the housing bubble (unless we feel they should have increased interest rate more).  I remember BERL making the same claim a while back, I was a bit unhappy with it then and I still am now.

Matt Nolan

Translating Labour’s goals for monetary policy

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Labour has stated four goals for their special monetary policy.  Let me discuss what these mean in turn. [Note we already have two posts on this issue today].

Labour goals were:

  1. a stable and competitive exchange rate;
  2. reduced interest rates for businesses and home owners;
  3. continued priorities of price stability and low inflation;
  4. to guard against expectations of price rises.

So, with goal 1 they want to reduce the flexibility of NZ$ prices, which will lead to higher unemployment and a worse allocation of resources.  Furthermore, they want to keep the dollar low which implies subsidising exporters to the cost of households in the short-term.

With 2 they want to punish savers.

And with 3 and 4 they want to contradict themselves – as by limiting price flexibility and holding the exchange rate and interest rates down they WILL drive an increase in inflation expectations, dump price stability, and remove any chance of a low inflation environment.

Matt Nolan

Discussing inflation targeting and our exchange rate concerns

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In a recent speech (ht Rates Blog) Goff committed to destroying monetary policy independence and damaging the New Zealand economy if he gets into power.  That is all well and good.  However, I think part of the reason this issue has occurred is because of a lack of understand around the necessity of monetary policy independence and inflation targeting, and how all these other factors (like the exchange rate) are determined.  Lets discuss them a little bit here:

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