When the Reserve Bank MPC came out late last month with its last words on monetary policy before its extended summer break, my post then was headed “Really?“. It was a commentary on the disjunction between the Reserve Bank’s inflation forecasts on the one hand, that showed quarterly inflation collapsing (not really too strong a word for it) over the next few quarters, and on the other hand the Bank’s OCR projections that showed a better than even chance of a further OCR increase early next year and an OCR at or above current levels well into 2025.
It wasn’t as if the Reserve Bank even gave us a compelling story as to why (a) they expected inflation to be just about to collapse or b) why they were talking in terms of further OCR increases. It just didn’t make a lot of sense, and they seemed doomed to be wrong on one count or another. And here remember the lags (something the Governor himself reminded people off in his press conference): whatever core inflation is going to be by the middle of next year is (unknown but) baked-in already. Changing monetary policy would make little or no difference to most of next year’s inflation.
Now, it is quite fair to note that there hasn’t been much sign so far in the official CPI data of the core and persistent parts of inflation coming down much, if at all. As ever in New Zealand, things aren’t helped by infrequent and lagging data (our last comprehensive CPI data are reading things as at mid-August). Neither the trimmed mean nor weighted median measures are done on seasonally-adjusted data (SNZ, please fix this), but the latest quarterly observations for both measures were about the same as in the September quarter a year earlier. We do have a seasonally-adjusted quarterly non-tradables inflation data, and the latest observations are down from the peak, but the September quarterly inflation rate was still no lower than June’s. There is enough in those official data to suggest core inflation has definitely peaked - which isn’t nothing - but having gotten things so wrong a couple of years ago you can understand why MPC members might still be a little nervous if they were just looking at the CPI (although if you were really that nervous why project such a sharp fall in inflation so soon?)
The issues are compounded for the Reserve Bank - and anyone else trying to make sense of what is going on now and what might happen soon – by the fact that two big and powerful countervailing forces have been at work. On the one hand, we had the OCR raised by 525 basis points in little more than 18 months, an usually large move in such a short space of time (the only move really comparable was in 1994 - focus then on the 90 day bill rate). And, on the other hand, record net migration inflows. In isolation one is a sharply disinflationary force while the other has added to inflationary pressures (although on the Bank’s forecasts net migration is forecast to be sharply lower next year, and if so that is likely to be a disinflationary shock). Since the Bank’s models - and anyone else’s – didn’t do very well at all in picking the sharp increase in core inflation, there is probably little reason for them (or anyone else) to have much confidence now.
All that said, it is getting increasingly hard not to think that inflation is about to fall away pretty sharply, and would keep doing so for some considerable time if the OCR were left at current levels or even raised a bit further.
There are straws in the wind from the partial (monthly) price data that SNZ releases. Indicators from the labour market suggest it is much easier to find staff (much harder to find a job) than was the case just a few months ago (at the level of anecdote I’ve been surprised by stories from my university student kids about how much problem many young people they know have had getting holiday jobs). The experience of several other countries is also not likely to be irrelevant - where inflation has also (finally) seemed to have begun to fall away faster than seemed to likely to policymakers earlier this year (and bear in mind that if the RBNZ was not one of the first advanced country central banks to raise the OCR in 2021 (it was about 7th), it was moving earlier than central banks in the US, the euro-area, Canada, or Australia.
But then there are things like the GDP data. This was from my post on Saturday
Now, it is fair to note that on some international estimates New Zealand had a larger positive output gap than most other advanced countries when inflation pressures were at their peak last year. On that basis, it might take more work - more loss of output - to get inflation back down here than in many other advanced economies. But when you have the second worst growth in GDP per capita of any OECD economy (and materially weaker, on current estimates, than the next country with its own monetary policy - Sweden) it might seem like a reasonable hunch that enough has been done. Of course, there will be revisions to come, but the December quarterly GDP release (ie last week’s) is generally the least unreliable because it benefits from the recent updates of the annual national accounts.
Now, is it impossible that inflation could stay high - or fall only very sluggishly - even if GDP (and GDP per capita, which is more important here) are very weak. In extreme scenarios of course not. But the economy hasn’t been suffering from really nasty adverse supply shocks over the last year, extreme political instability is not a feature (transfers of office happened as normally as ever), and……inflation expectations have stayed encouragingly subdued throughout the last couple of years, and are modest now. In a rag-tag sort of way the system seems to have worked (central banks messed up really badly in 2020 and 2021 - and that can’t be lost sight of – but when all the alternatives had been explored seem to have done what was required). The high inflation of the last couple of years is going to be a nasty memory for quite a while (here as elsewhere), but there is little sign anyone much thinks inflation is going to settle outside the target range.
Worriers may point to recent pick-ups in confidence survey measures. This (Westpac) one just turned up in my email inbox
Being off the lows here still leaves it not far above troughs in the most recent two severe recessions in New Zealand. All the confidence measures are still in contractionary territory, and the medium-term mood is about as bleak as ever.
One reason sometimes mentioned for why central banks would be cautious is that - after the mistakes of 2020 and 2021 - it would be quite unfortunate if they were to sound softer now only to find that inflation was hanging up and that renewed tightening was eventually needed to finally get things back near target.
As a psychological consideration it is no doubt real. But central bankers shouldn’t be purging their own “guilt” or past incomprehension by holding tight indefinitely. Rather they need to recognise those personal biases etc and correct for them.
Against that backdrop I found it useful to look back at some of the last big easing cycles that the Reserve Bank presided over. A couple of weren’t very enlightening: the increases in the OCR in 2014 were never justified in the first place so when they were finally unwound didn’t offer much. And in the mid 90s there was enough weirdness - and volatility - about the management of monetary conditions (for those with long memories, think of the Monetary Conditions Index). But I had a look at 1990/91 and at 2008. In both cases, short-term interest rates fell by 500+ basis points (in the first case, accommodated by the RB – this was pre OCR – and in the latter by direct Reserve Bank decision). In both cases, inflation had been or become quite a problem. In 1990 core inflation had been stuck around 5 per cent and the goal – a couple of years out - was 1 per cent (midpoint of the 0-2 per cent range), and in 2008 headline and core inflation had moved persistently above 3 per cent, the top of the target range (best current estimates have core inflation peaking in that cycle near 4 per cent).
Go back to 1990/91. The first negative GDP quarter was March 1991. That data won’t have been available until late in the June quarter of 1991, but by the month of March 1991 90 day bill rates had already fallen by about half (250 basis points) of that total fall that year. At that point, the most recent (December) quarterly inflation data were hardly better than they’d been a year earlier (although it was to fall away very sharply in the next few quarters). Two-year ahead inflation expectations were still about 4 per cent.
With the benefit of hindsight, if anything we were too slow and reluctant (for a long time) to let interest rates fall that year. Much as we expected inflation to fall, we (like almost everyone else) was taken by surprise be the speed and size of the fall.
What about 2007/08, when the inflation target was much the same as it is now, and the monetary policy implementation system (the OCR) was the same?
Going into 2008, the OCR was at 8.25 per cent, a level it had been raised to in mid 2007 (at the time on the back of rising international commodity prices, when core inflation had already got troublingly high). What was to become labelled as the “global financial crisis” is conventionally dated as beginning in the northern hemisphere in August 2007 but even by mid 2008 it wasn’t seen as a huge factor in New Zealand (within the Bank there were competing views) - the galvanising events (eg Lehmans) weren’t until September that year. The world oil price had peaked - at still all-time highs - a bit earlier that year.
The New Zealand economy could hardly be said to have been in fine good heart. The lagged effects of several years of OCR increases were increasingly evident. But the unemployment rate by mid year was only a little off its lows (3.8 per cent), there’d been just a single quarter of falling GDP published (and some of that had been weather-related), but the first OCR cut was in July 2008. Two-year ahead inflation expectations are the time were about 2.9 per cent (a touch higher than they are right now). I recall the MPC/OCRAG debates at the time, which with hindsight were a bit surreal as there was much discussion about whether just possibly we might be able to cut by as much as 100 basis points over the following year (actual 575 basis points, and probably should have been more).
With hindsight - and here I would put more stress on hindsight – we were too slow to start moving then. It was perhaps understandable given where core inflation was, and the difficulty of anticipating the full gory mess about to break on us from abroad, but it was too slow. But my point was that it was long time afterwards before it was clear that core inflation was actually back near target or even that the unemployment was back around some sort of NAIRU (it was early February 2009 before the Bank knew the unemployment rate had got to 4.4 per cent).
Have there been mistakes in the other direction? Of course. The 2020 monetary policy easing was clearly a mistake. But there have also been a couple of times when we (the Bank) thought we’d done enough only to have to resume tightening (one might think of 2005/6) but the message from the data now is becoming fairly clear. At some point - perhaps before too long - much the bigger risk is likely to be holding the OCR at peak for too long.
Go back a year or so and there was quite a bit of debate about what the neutral OCR might be? No one really had any idea, and in truth no really does now. But……the developments in core inflation globally (and in GDP and jobs ads data locally) given us a much stronger reason now to be confident that policy rates are contractionary than perhaps we’d have had at the start of the year. And central banks do purport to run a system that puts quite some weight on forecasts of inflation. In practice, there is less reliance than is implied by the rhetoric (and models), which reflects the fact that forecasting is hard.
In debates here and abroad about the appropriate stance of monetary policy one often sees mention of two things. First, the notion that “the last mile” might prove materially harder than the first steps downwards in inflation. Mostly that seems like handwaving, especially when the focus is – as it should be - on measures of core inflation. There doesn’t seem to be much evidence from past cycles (including in New Zealand when we were first securing something like price stability in the early 1990s) of a “last mile” problem, and it seems no more plausible this time when inflation expectations have been subdued (and when in New Zealand the exchange rate remains fairly high and stable). The other argument is that central banks need to be sure we are going to get back to target. That is an argument that puts no weight on forecasts at all. I’m not one with any particular confidence in published central bank forecasts, but in most past big falls in inflation it would have proved to be a mistake (as indeed it was two years ago when central banks were slow to tighten). As time passes, there is more reason for confidence than there might have been even six months ago. Even in principle, that confidence isn’t enough to suggest policy rates should be back to neutral - wherever neutral is - but it should be enough to suggest that less contractionary settings might be required to give one the same level of confidence one was seeking 6-9 months ago when policy rates were first approaching what now seems to be the peak. We don’t have any real idea as to whether the OCR settles at 1.5 or 3.5 per cent, but it seems most unlikely it will settle anywhere near 5.5.
I’m still quite deeply perplexed by the Reserve Bank’s stance last month (assuming that it wasn’t - and they say it wasn’t - just about playing games with markets to hold expectations up). It is less than satisfactory that (a) they’ve gone off for a three month summer break (in contrast, the Cabinet seems to get about four weeks between meetings), (b) that there are no speeches or serious interviews exploring the issues, outlook, and risk (without a Parliament there wasn’t even the theatre of an FEC hearing [UPDATE: Shortly after this post went out the RB put out an advisory that there will be an FEC MPS hearing at 8am on Wednesday}). We are left with no insight on the Reserve Bank thinking, or the range of risks, hypotheses etc they are exploring or how well they are marshalling evidence in support etc. It is our inadequate MPC on display again, summoning no confidence in them whatever even if (just possibly) somehow they are right.
If the meaningful dataflow this year is largely already at an end - hard to see the HYEFU or the micro-budget telling us much – the CPI data in late January, the suite of labour market data in early February, and the monthly spending indicators (including those banks are no producing of own customer activity) should be telling us (and the MPC) a lot. If things are as weak as many recent indicators have suggested and inflation pressures are (finally) abating fast, the possibility of an OCR in late February shouldn’t be thought completely impossible or inappropriate.
