Matt Nolan

An important warning regarding the monetary policy fine-tuning

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A recent opinion piece in the Herald, pitting Don Brash and Brendan Doyle in to debate the issue of monetary policy was good.  They seemed to agree that, ultimately, any issue is one of the real exchange rate – which is due to real economy factors.  A point I’ve heard a number of times before 😉

However, all this debate reminds me of a speech by Bernanke back in the day.  The choice quote:

Although a strict rules-based framework for monetary policy has evident drawbacks, notably its inflexibility in the face of unanticipated developments, supporters of rules in their turn have pointed out–with considerable justification–that the record of monetary policy under unfettered discretion is nothing to crow about. In the United States, the heyday of discretionary monetary policy can be dated as beginning in the early 1960s, a period of what now appears to have been substantial over-optimism about the ability of policymakers to “fine-tune” the economy. Contrary to the expectation of that era’s economists and policymakers, however, the subsequent two decades were characterized not by an efficiently managed, smoothly running economic machine but by high and variable inflation and an unstable real economy, culminating in the deep 1981-82 recession. Although a number of factors contributed to the poor economic performance of this period, I think most economists would agree that the deficiencies of a purely discretionary approach to monetary policy–including over-optimism about the ability of policy to fine-tune the economy, low credibility, vulnerability to political pressures, short policy horizons, and insufficient appreciation of the costs of high inflation–played a central role.

Is there then no middle ground for policymakers between the inflexibility of ironclad rules and the instability of unfettered discretion? My thesis today is that there is such a middle ground–an approach that I will refer to as constrained discretion–and that it is fast becoming the standard approach to monetary policy around the world, including in the United States

“Constrained discretion” is (arguably) very much the flexible inflation targeting framework we use now – the determination to “fine tune” is one that is coming out increasingly, and is based on an illusion of understanding and control regarding the macroeconomy (that and a few fallacious ideas of how things have panned out 😉 ).

No-one is arguing against having a further look at financial regulation, and trying to understand what has happened there.  However, this provides no case for messing around with the way the RBNZ performs monetary policy and the existence of a floating exchange rate – and in their determination to “do something” there are a set of politicians, journalists, and other analysts/economists trying to take us down a dark path.

Matt Nolan

What has been driving the real exchange rate?

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For anyone that has been looking at posts over here, or carefully listening to Reserve Bank speeches, the topic of the real exchange rate is an important one for understanding the New Zealand economy.  Many of the “concerns” or “issues” being raised at present are really just a function of some view of the real exchange rate.

Via the RBNZ we have a graph of the real exchange rate (RER) here:

Now this drives the question, what has caused the change in the real exchange rate – what shocks have we experienced that have pushed it up, and what proportion of the increase was due to these shocks.  Chris McDonald at the Reserve Bank decided to have a go at answering that question.  With so many factors driving the dollar, “causation” is hard to appropriately appropriate between causes – and so his primary focus is on the correlations and their magnitude, albeit within a framework that will help to show what the more important drivers are.  So what is his conclusion:

  • International factors relevant to New Zealand explain more (60 percent) of the exchange rate variance over our sample than idiosyncratic and domestic factors.
  • The most important international factor is likely to be export commodity prices, though our empirical analysis is not conclusive. For instance, high commodity prices can explain why the exchange rate is at current high levels. But, high commodity prices may be partly a result of current low foreign interest rates.
  • The best domestic indicator for the exchange rate is house price inflation. While this indicator also reflects international factors, its movements over and above the impact of these appears to capture some key domestic information for the exchange rate.

Now this doesn’t tell us anything about the key issue of the New Zealand dollar being “persistently overvalued” or not.  But it does indicate the commodity prices have been a major driver of the increases we have seen.  On top of that another interesting point was raised:

The RER response to the other domestic shocks suggests some of them may not be well identified. Notably, an unexplained fall in the 90-day interest rate and an unexplained fall in the output gap both have little impact on the RER. Practically, we expect these shocks to cause quite large movements in the RER. However, once we allow for the correlation of these variables with the international and New Zealand real house price inflation variables, these shocks (despite being not so well identified) have a relatively small impact on the results.

So within this decomposition, the impact of a monetary policy shock (change in 90day bill rate) or exogenous change in AD (fall in output gap) are poorly identified – and seem to have little impact on the RER.  The author believes thsi result doesn’t pass the smell test, which is fair enough – after all the author has the best knowledge of what their empirical model is saying (especially since no empirical results are included).  However, if we were to take it at face value it would suggest that the RBNZ’s ability to actually change the RER with monetary, even in the relatively short term, is limited.

Matt Nolan

Why I shouldn’t read the paper

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It appears that much of the media (some parts excluded) wants to make the discussion of monetary policy a titianic battle between opposing forces – rather than informing the public of the trade-offs that exist, and the issues that are currently being looked into.

There are two issues currently being debated – only the first one has been influenced by to the financial crisis (although it was an issue that was being looked into well prior to the GFC):

  1. How should financial regulation, and the goal of financial stability, be put in place?
  2. Why is NZ’s real exchange rate persistently so high?

The “orthodoxy” in New Zealand has been discussing these issues and trying to improve policy the entire time, in fact there was nothing wrong with the instituional settings we had in place through the Reserve Bank (hence why the PTA was little changed) – many of the problems that have occurred are to do with other things … and many of the “issues” that are being raised are in fact fallacies that show a fundamental confusion about the issue in the New Zealand context (such as the constant confusion about the nominal and real exchange rates, or the view that QE creates a “prisoner’s dilemma” between central banks).

If we had more articles like Brian Fallow’s, that aim to discuss the issues and ideas involved, instead of the type ideological drivel that often appears, we might be able to have an adult discussion on how to genuinely improve outcomes for New Zealanders.

Matt Nolan

New RBNZ PTA

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The new policy targets argreement is out today.  What have we got?

For the purpose of this agreement, the policy target shall be to keep future CPI inflation outcomes between 1 per cent and 3 per cent on average over the medium term, with a focus on keeping future average inflation near the 2 per cent target midpoint.

Oww I like this – actually stating the the implicit target IS 2%, not somewhere between 1-3%.  Improvement for sure.

In pursuing the objective of a stable general level of prices, the Bank shall monitor prices, including asset prices, as measured by a range of price indices. The price stability target will be defined in terms of the All Groups Consumers Price Index (CPI), as published by Statistics New Zealand.

I can understand including asset prices/credit growth in the PTA – its inclusion here seems a bit strange though.  Note that it is still only saying “look at how asset prices/other price indicies can forecast future growth in CPI”.  This change is on the face of it small, but maybe they see that the inclusion of asset prices itself could give them more scope to discuss it in statements.

In pursuing its price stability objective, the Bank shall implement monetary policy in a sustainable, consistent and transparent manner, have regard to the efficiency and soundness of the financial system, and seek to avoid unnecessary instability in output, interest rates and the exchange rate.

Explicitly mentioning the Banks implicit role as the lender of last resort and as responsible for the stability of the financial sector.  I always felt that we should have “two PTA’s”, and “two institutions” to split these roles – but having it explicitly mentioned is an improvement.  Now, in this context it is still seperate from monetary policy – so the financial stability reports and monetary policy statements will continue to focus on seperate things.

In the news release with the statement:

Mr Wheeler also emphasised that the macro-prudential policy tools currently being developed by the Bank should be separate from, but complementary to monetary policy. “The primary purpose of such tools will remain to promote stability of the financial system.”

Excellent – as it helps to improve the clarity of communication, which helps to guide expectations.

“In addition, the PTA’s stronger focus on financial stability makes it clearer that it may be appropriate to use monetary policy to lean against the build-up of financial imbalances, if the Reserve Bank believes this could prevent a sharper economic cycle in the future.”

I don’t really like this comment much – and I would say there is no consensus about whether such a comment is appropriate at present … namely the linkage between monetary policy in of itself (apart from other regulatory tools) and financial stability is highly debatable.

However, I gave my view of it to Alex from Rates Blog:

It is a sticky comment – but I would interpret it along with the fact that macro-prudential and monetary policy tools are complements.  As a result, the full impact of both monetary policy decisions and choices on macroprudential policies will be taken into account when ensuring that the financial system is sufficiently “stable”.

It is the comment I’m least happy about, as it is the issue that is likely to cause the most confusion, and where we have the least understanding – however, their determination to keep “communication” of the issues separate solves most of the problem I have with it.  After all, monetary, fiscal, and financial stability policies are all “complementary” in some sense – they all require co-ordination – and they should all focus on clear goals.

It’s one of those things where we won’t actually know whether there is any effective change until we see him in action – the December MPS will be interesting.  In of itself, this PTA is more “hawkish” than the previous one – both changes (2% target, focus on financial stability) imply tighter financial conditions over time IMO.

Update:  Bernard Hickey comments.

Matt Nolan

Reframing the monetary policy debate: Some notes

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Update:  Given all the links in this post, I’m adding it to the rarely used “inflation debate” tab.  An area where I rant incoherently about monetary policy in a way that is aiming to help this debate – rather than just be critical.

From what I can tell, the current debate about monetary policy taking place in the public makes little sense.  While I am sure we all mean well with our opinion pieces, the issues, the problems, the causes, and the tools aren’t really being discussed in a way that someone with an open mind can sit down and look at.  Sadly, I lack the time – and probably the ability – to give this a fair go.  As a result, instead I will just list down some things we need to keep in mind here.

David Parker has recently said two things which he used to justify the RBNZ scrapping inflation targeting, and moving to targeting a bunch of stuff:

  1. The RBNZ needs to help exporters – as other countries are helping exporters
  2. The RBNZ is to blame for our “persistently high exchange rate”

I discussed a similar post of his earlier.  But right now, I want to state that neither of these things is really true – I can 100% understand how someone could come to believe this given what we see going on around us.  However, they aren’t facts – they are fallacies.

Note:  He does mention “protecting financial stability to help exporters” – this statement doesn’t make sense.  The RBNZ does focus on financial stabilty in a seperate role, and with seperate tools – a role that is related to, but seperate from monetary policy (just like fiscal policy).  In none of this is, or should, the RBNZ look at a certain sector in NZ and say “we’re giving you stuff” – that is just wrong.

Sidenote:  If you say “but helping exporters with monetary transfers helps all of us” I will laugh – if NZ goes down that path, I look forward to having my views vindicated in 20 years time 😉

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Matt Nolan

The upcoming PTA

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With Graeme Wheeler set to take over as RBNZ govenor on the 26th of this month, it is clear that a new PTA will be signed.  Westpac did an excellent piece discussing this.  I’d suggest reading it.

Some key points I took out (and agreed with, so was easy for me to pick them up 🙂 ):

  1. If anything changes it is likely to be along the lines of “credit growth” – increasing discussion of credit growth by the Bank, as well as outside it, makes this plausible.
  2. Large scale adjustments to the PTA, or functioning of the Bank, from what they are currently looking at are unlikely.
  3. The Act doesn’t set the tools – just the mandate.  Related point – the Bank has been researching macoprudential tools for a long time now, and will understand how to use them in context.
  4. Using multiple tools in a “cyclical” manner will make policy more difficult to understand and more complex.

For me, the last point is pretty essential and there is a lot of debate around it.  I’m still not a fan of the concept of discretionary countercylical macroprudential tools – when we start going down that round we are assuming we have a lot more knowledge about the macroeconomy than I believe we actually do as economists.  However, we will see – and research will keep being done that will help to improve policy and the communication of policy (which is an incredibly important thing) over time.

If only we had the same transparency with fiscal policy.