Matt Nolan

Fiscal policy and the ZLB

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Some links.

Marginal Revolution.  Mainly Macro.

Summary:  The implied impact of fiscal policy at the ZLB is the same channel as direct monetary policy (such as QE).  Response is, yes but we have more certainty about the impact of fiscal policy.

Sidenote:  As the central bank directly does balance sheet management instead of changing the cash rate, “monetary policy” looks closer to “fiscal policy”.  There are four key differences though:

  1. Central banks have the incentive to reverse out unconventional policies once their job is done – politicians don’t.
  2. Central banks will respond to the data more quickly than politicians.
  3. The “inflation target” gives us the approved mandate of the central bank through the policy process.  As a result, central bank action based on this view are appropriate – as long as the instrument used is assumed to not redistribute over the economic cycle.
  4. Central banks don’t have a direct mandate to redistribute – elected officials do.  For central banks to use a tool that redistributes, they have to be given permission by a democratic government.
Matt Nolan

Institutional status report

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The jump in unemployment, and the fact that the labour market has been weak for a long time, is leading to understandable angst.  The government has been blamed as you often expect, the world has been blamed as it should, and the RBNZ is increasingly being blamed.  I would like to cover off a few things – just so when we discuss the issue of the economy, we are on the same page.

Update:

For the tl;dr audience, Kimble put together a neat summary:

Cliffs:
> The RBNZ bases their policy on forecasts, not the current state of the economy.

> Blaming them for the current state of affairs is to blame their previous forecasts.

> The argument they should take action to remedy the current state of the economy implies that you disagree with their forecasts.

> Making that argument without mentioning those forecasts seems completely insane.

I will have the post itself where I talk about these things, and justify why I am talking about them, below the fold.

Read more

Matt Nolan

Circling the square: House price lift and high unemployment

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On Breakfast this morning I heard the presenters querying why house price growth is so strong (5.7%pa in October) while unemployment is at a 13 year high (7.3% in September).  What is especially perplexing is that the house price growth is primarily in Auckland (with Canterbury also important – but this is due to the earthquake reducing the stock of property) so has the increase in unemployment!

How can this be?

Well I’d note a few things:

  • House price growth is strong in Auckland especially the old Auckland City.
  • Growth in rents is relatively strong in Auckland.
  • We know there has been very little building in Auckland.
  • Occupancy rates have been pushed up in recent years at a relatively rapid rate.
  • Credit growth is still slow (albeit picking up).
  • We suspect that job loses are focused in Manukau and Papakura, given the weakness in wholesale trade and manufacturing employment.
  • Although jobs have been lost, underlying “real wage” growth has been good relative to recent years – giving households with income a bit more money to spend.  Banks are competing like there is no tomorrow to give out mortgages.
  • House sales volumes relative to population are still “low” relative to history – even after rising sharply.

Now, the lift in house prices is starting to boost building activity in Auckland, as you would expect.  However, there is a significant supply shortage.  In the face of that, houses are more scarce and so we would expect prices and rents to rise.  Furthermore, there are people with jobs and with access to credit at very low interest rates who are interested in moving or changing house – while there are people with houses who are relatively unwilling to sell in the face of uncertainty and the knowledge that there are “too few houses”.

In many ways this doesn’t look like, or at least is largely not, a bubble – as borrowing and investment in housing is still so low, and so is turnover.  Instead this is an indication of the supply issue in Auckland.

This does not mean that we should expect rapid house price growth going forward, or that unemployment and house prices aren’t linked – it just tells us that there are other factors going on that explain the difference, other factors that indicate the importance of supply side constraints in the building industry.

Matt Nolan

Expectations formation, inflation, and a role of inflation targeting

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Ever since the Lucas Critique forced economists to recognise that we could not use data for policy in a purely theory free way, the concept of expectations, and how expectations are formed has become important.  The growing interest in behavioural and neuroeconomics are all in part a response to this realisation, and a clearer understanding of these issues will help give economists an idea of what to study, what to measure, and what policy trade0-offs exist.

It is encouraging then to see this study on the formation of inflation expectations.  In it they look at how shocks to food prices impact upon individuals expectations of future general inflation.

Our results suggest that consumers incorporate information about past food prices in forming and updating their own-basket inflation expectations but not their overall inflation expectations. The issue of pass-through to inflation is of particular concern during times of large supply shocks. Our finding that information about past food price inflation has limited pass-through to consumers’ expectations of the “rate of inflation” suggests that the RI question (and not the PP question, which as mentioned above is similar to the one used in the Michigan survey) is a more stable survey question (in the sense that it is less susceptible to volatile price changes), and that it should instead be used to elicit consumer inflation expectations.

This is all well and good, but we need to ask whether we are really gauging inflation here in the way we mean it when we discuss monetary policy.  We are interested in the way prices in general move together that is unrelated to “fundamentals”.  A lift in food prices is a change in those fundamentals, and tells us that there is a change with regards to how scarce food is relative to other goods and services and relative to labour.

This general “comovement” we are talking about is anchored by an inflation target, and as a result we want a description of how a “shock” to the price of one good has an impact on this over the complicated beast that is the economy.  We need to seperate out the bit that is due to households feeling “poorer” or “richer” following a change in the price of one good or service (a relative price, or supply shock) from the impact it has on the general price setting of households and firms (our inflation).

This is easier for us to think about if we assumed the “inflation target” was zero – in that case, as decision makers we know that a rise or drop in prices represents a lift or decline in scarcity relative to other goods and services.  Furthermore, a increase in wages represents productivity – or may represent a change in bargaining power.

However, with an inflation target, which is followed by decision makers, we can say the same thing by just taking off the inflation target from price growth.  This is one of the conceptual reasons why an inflation target is an attractive thing – we are helping to make price signals in the economy a clearer representation of underlying scarcity.

As the gold standard period showed us, inflation/deflation in itself can be very unstable, so an inflation target through inflation expectations can be used to help “co-ordinate” decision makers.

In this sense, it is nice to see expectations formation being discussed here – but I’m not sure the study is truly capturing “inflation” following a relative price shock, and is instead also capturing other factors related to economic fundamentals.

Matt Nolan

It’s about the “right” counterfactual

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In a recent post, Mark Calabria from the Cato Institute took aim at the idea that the Lehman Brothers crisis was the “trigger” for a big crisis.

Now I do not disagree that there was, and would have been, a recession without Lehman Brothers – and even without the uncertainty caused by the lack of clarity around insurance of the shadow banking system which grew post August 2007.  However, these issues, and in turn the failure of Lehman Brothers did make the crisis significantly more severe than it would have been.

He appears to say that the failure of Lehman Brothers was a good thing (Note:  There is nothing wrong with wiping out the company – but the way it was handled, was a big driver of the global slowdown that was to come), and that the US was on the road to recovery post this.  So here we are focusing just on the US, not the contagion to other countries.  His evidence is the following graph:

Employment and consumption stopped declining not long after Lehman Brothers failed, and although the largest declines occurred WHEN Lehman Brothers failed this doesn’t mean the failure caused them – in fact, employment tends to lag the cycle and the drop may well have been the result of prior economic weakness … and the amazingly high fuel prices through the first half of 2008.

Now I agree that there were factors driving a recession prior to the failure of Lehman Brothers – but the impact of Lehman Brothers as an event is captured by asking what would have happened in the absence of the Global Financial Crisis that stemmed from it, and the full blown “bank run” on wholesale financial markets that had been building pressure from the start of 2008.  Going to FRED, grabbing consumption and population, and running a basic time regression in excel no less (so it’s easy to copy) we can get an idea of what the “trend” rate of consumption per capita was during the 1952-2012 period.  Armed with that, we can ask what the percentage difference is between this trend and actual consumption per capita outcomes.  This is:

Something is broken here – I will try to fix that up tonight.  The strange thing is that I can see the graph when editing the post … but it then wont let me do anything with it

Now we can start arguing that consumption per person was too high and a whole bunch of other things if we want to here.  However, this basic analysis clearly shows that the gap between trend consumption and actual consumption, something that should have a tendancy to head back to zero after a recession, actually deterioarted further … and has continued to deteroriate.  We look at business cycles “around trends” not “around levels” given that our counterfactual involves growth – and this makes this post by the Cato institute a bit misleading.

Saying that the downturn, or even the crisis, started with Lehman Brothers is wrong, I agree with the author here – however Lehman Brothers failure started a new dangerous stage of the crisis which, when combined with the persistent institutional failure in Europe, has made sure that the US economy has remained below potential.  A market monetarist would say that the Fed is truly responsible for this in terms of policy action, but even if we were to accept this it is undeniable that it is the “shocks” that have occurred in financial markets are the very things the Fed needs to respond to by “loosening policy”.

It’s failure is indicative of what was underlying the crisis, and the evidence shown in no way suggests that allowing its failure and initially ignoring the quiet, and then full scale, bank runs in wholesale financial markets was good policy.

Matt Nolan

Supply or demand – why not both?

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I’m a little perplexed to see Gareth Morgan come out railing against the Productivity Commission’s report on the housing market.  Now when it was released, I thought the focus and justification were a bit funky – but that the analysis seemed largely sound.

Gareth’s posts have been found here and here.  He says that supply is not the issue, its demand due to the tax status of housing and the Reserve Bank.

Seamus Hogan at Offsetting has covered off why this critique of the PC seems weird, so I’d suggest reading that.  As Seamus says, it is incredibly strange to treat the supply and demand factors as mutually exclusive – both can exist.  In fact to justify house prices being “too high” while the volume of the housing stock is “too low” REQUIRES a large supply impediment.  If what Gareth said was the whole story we would be experiencing overbuilding!

Why is that?  Well if something is boosting the demand for existing housing beyond what is “socially optimal” this bids up the price for existing houses while the cost of making a new house is unchanged.  As a result, there will be a lift in demand for new houses as well, leading to a lift in building activity (and building costs) such that we are building more houses than is “socially optimal”.

We could well debate whether this was the case pre-crisis – we know that expenditure, and volumes, or residential investment were very high between 2002-2007, but we also have some suggestions that much of this was due to increases in the size and quality of housing.  We were buying “more house”, rather than more houses.  Even during 2007, there were still concerns that there was not enough houses in some key regions – unlike the US experience there was not a wide view that we were “oversupplied” in terms of our housing stock.

Come to the post-crisis period and it is widely believed that we have a massive undersupply of property in Auckland (and Canterbury, but that is due to the quake).  House prices are still elevated, RBNZ policy is still “friendlier to mortgage debt”, but building activity is damned low!  This is far more than a cyclical downturn – there are significant issues of financing and co-ordination in the industry. “Reducing demand” doesn’t change this – and doesn’t make policies that are looking at the supply-side issues irrelevant!

The key point against supply side issues will be the fact that rental growth hasn’t gotten scary at any point – is there are “too few” houses, then we should really see the cost of housing services/rent pick up.  This suggests to me that any perceived demand side issues are also important, and should be taken into consideration [Note:  Think of demand issues in this context as things that increase the wedge between the individual rate of return on housing and the social rate of return – as this leads to people being more willing to use housing as an investment vehicle for a lower relative rate of return, the rent 🙂 ].  Once again though, supply and demand are not mutually exclusive.  The fact we are looking at one doesn’t mean we throw the other away.

One final note – the Productivity Commission spent a long time getting together facts and figures in order to make its case for why the supply issues were dominant.  And they also made note of perceived “misallocation” issues and the such stemming from the demand side.  Gareth’s decision to just out of hand dismiss what they are saying and state that the answer is “obvious” is a touch grating.  I don’t think the Productivity Commission (or myself for that matter) would disagree with the points he raised … as they aren’t mutually exclusive – I’d say I just weight them less severely than he is because I am willing to accept that there are supply side issues which are behind part of the price lift.  And I think this is the reason the supply issues are being attacked … just to increase the “weight” people place on the demand side.  I’m not sure I agree with this.

Note:  Remember that show Heroes, where they say “save the cheerleader, and save the world”.  The building issue in NZ has had a significant impact, both in terms of the run up of debt and the allocation of resources – in many ways people have been “saving” in a vehicle that might not give them the return they expected in terms of future goods and services!  Given this, understanding these issues is important.  You could even say “save the housing/building industry, save New Zealand”.  I’d avoid that though, because “saving things” always seems to involve subsides and bailouts which is not really what analysts are suggesting …

Update:  Seamus cleans up some of the places where my language is too loose.  His clarifications are entirely right.