A new look at the rate setting history of the Reserve Bank of New Zealand using the well-respected Mankiw Rule suggests our central bank may need to raise rates fairly aggressively through to the end of 2014.
The RBNZ has held the Official Cash Rate low for a long time. It has been at 3% or lower since March 12, 2009. It is currently 2.5%.
Some people think it should go even lower to stimulate an economy that they see as struggling.
Some think the focus should shift to "employment"; some to the "exchange rate", managing it down to help our export sector.
But it is Graeme Wheeler who will decide its future direction. He has given every indication that he will maintain a focus on managing "inflation" between its target bands.
Taking him at his word, a possibility opens up to forecast where the OCR might go in the future.
Every bank economist - and a few others - do their own forecasting.
But we were impressed by a Research Note from ASB's parent Commonwealth Bank Australia (CBA) who have tried to simplify the process by using a variation of the Taylor Rule. In fact, The Taylor Rule has been simplified even further by heavyweight Harvard professor, Greg Mankiw (pronounced MAN-Q). (HT to Martin R for the link.)
In 2001 Mankiw wrote a paper on monetary policy in the 1990s. In it, he estimated the following simple formula for setting the federal funds rate:
Federal funds rate = 1.4 (core inflation (y/y) – unemployment rate) + 8.5
Core inflation was calculated as the CPI inflation rate (excluding food and energy) over the previous 12 months, and unemployment was the seasonally-adjusted unemployment rate. The formula was derived by using the same coefficients for CPI and unemployment. The parameters in the formula were chosen to offer the best fit for data from the 1990s. Using the CPI and the unemployment rate to model the cash rate is logical because the Federal Reserve’s mandate is stable prices and maximum employment.
The CBA economists updated the calculations for the US and found the Mankiw Rule interest rate turns negative from December 2008. This is when the Fed began QE, which is exactly what the model indicates should happen if the previously observed relationship holds. Indeed, the US Mankiw Rule interest rate has been negative since December 2008, implying that QE should be the Fed’s course of action which is exactly what we have observed.
By any measure, the Mankiw Rule is a very good explainer of US Federal Reserve rate setting policy.
Then the CBA economists ran the same calculations for Australia.
This time they also got a close fit between the Mankiw Rule model and what happened - but got a bit of a surprise when they added their forecasts for inflation and unemployment.
When they did that, the model suggests strongly that the RBA will raise rates to about 4.25%. This is different to popular expectations that Governor Stevens will lower them again soon.
So we decided to run the same Mankiw Rule model for New Zealand. This is what we found.
Again Mankiw explains the RBNZ rate setting decisions pretty well. Maybe Alan Bollard did not need to be as aggressive in his 2009 rate cutting, but Mankiw shows he was probably too late in starting the reductions. And he ended up where Mankiw suggests he should have targeted.
What we did next was add the average of the quarterly forecasts for inflation and unemployment from ANZ, BNZ and Westpac to the model. We use these forecasts because the are quarterly forecasts, whereas the other bank economists (while similar) only have annual forecasted values available online.
Now it gets interesting.
What we see is that while there is a current case for Wheeler to cut the OCR (probably all the way down to 1.5%), he may quickly then need to reverse course and raise it.
In fact, the Mankiw Rule suggests the RBNZ will probably need to keep raising it until it gets to almost 5% by about the end of 2014.
Your view?
Updated: Spreadsheet with workings attached
31 Comments
Good and interesting analysis, thanks.
The sudden and steep rise back up suggest to that it is more likely that the bank economists are being too optimistic on both inflation and employment, rather than interest rates will need to shoot up quickly, but time will tell.
That was my thought....ergo if the rule is good then the bank economists are badly wrong....given their lack of success over the last 4 years, I go with them being clueless.
So the Q is just how long can the RB ignore the data....we should be at 1.5% so whats the justification for not....blind optimism it seems.
Good thing about going to 1.5% is it can be backed out easily....delay may mean it has to drop to 0.5% and even then be too little too late.
regards
There are global pressures that constrain NZ from dropping our OCR to as low a level as the USA or UK. Along with Australia, we have been designated 'commodity export economies' and thus must follow IMF, World Bank & G20 rules to play our part as a 'high interest' economy.
Even if the RBNZ wanted to - they cannot lower our OCR below 2.0. He will not try to save the NZ economy because his loyalty is not to a sovereign state (that is anathema to Global loyalists) but rather his loyalty is to a new world order - that is why we see treasonous behaviour from our top politicians & central bankers (& commercial bankers).
It wil take a 'so-called' "Shock" to allow them to start any sort of economic stimulus. Very sad that it took 2 major earthquakes and loss of life to get the RBNZ to finally act & make any sort of move to attempt to rescue the NZ economy - remember at that stage they were trying throttle the economy by raising rates again - absolutely unbelievable stupidity, locked into their narrow Spreadsheet models.
Many NZ householders are still only just coming out of the 8.25% OCR phase where they were locked into 9% fixed rates 2008-2011/12.
The primary reaon why our OCR is relatively (but not historically) high is because of price appreciation in the housing sector. Those who are prepared to take on large debt and high leverage in the property market are playing a high stake game with all of the risks that entails.
Thats not my experience. I was around in the late 70's and 80's when inflation was out of control .My friends with high debts all went broke because they couldn't afford the debt. There were lots of farms and houses for sale. The problem is the debt, if you get inflation then interest rates go up and your income doesn't always go up with it,then its curtains. If you get inflation and the government forces interest rates down then Id expect a raft of other problems and none of them would lead to a healthy outcome.
I remember in the 80's thinking I knew how to prosper in an inflationary enviroment, now I don't think whats coming is going to be like last time.
I thinking of what would happen if we got squeezed between a 'deteriorating terms of trade for our commodity export earnings and a soaring debt service ratio'
Then we have 180 billion of foriegn debt, which would have an interesting effect in a large NZ currency devaluation.
id keep your tin hat on.
Gotta shake my head when people suggest letting inflation run up again. Short memories. The horrors of managing in a high inflation environment are not to be underestimated for both households and businesses. Advocating inflation is just a kneejerk reaction, made in the absence of skill and absence of historical recall.
Private Bankers & Central Bankers simply do not know what is going on. They are being pulled along by hooks they are not even aware of:
http://www.centralbanking.com/central-banking-journal/feature/2231998/t…
"In private, central bankers readily conceded they were a long way from reaching a full understanding of what was happening. They were still flying blind.
What had gone wrong with the functioning of the international monetary system itself? Was there not a possibility that the adverse side-effects of their policies would just store up more trouble for the future? Where had central bank policies taken a wrong turn?
One who gave public utterance to the misgivings of many was Graeme Wheeler, the new governor of the Reserve Bank of New Zealand. The comment, made in a speech soon after the IMF meetings, summed up the mood of many as they left Japan: “It is a sign of desperate times for central banks, who in some instances are shouldering the burden of domestic policy paralysis over fiscal policy. Since the onset of the global financial crisis, the Federal Reserve has expanded its balance sheet by 13% of GDP, the European Central Bank by 16% of GDP, the Bank of Japan by 10% of GDP, and the Bank of England by around 20% of GDP. In all four cases, the official cash rate is 0.75% or less. In all four cases, there is little evidence of any appreciable impact on economic growth.”
Obviously Wheeler does not believe in attempting stimulus - it's failed elsewhere in his opinion so why bother? But how much worse would the USA & UK be if no ZIRP or QE?
Mankiw is the guy who was walked out on by Harvard students in his Econ 101 (or whatever they call 1st year economics there) class during the course of the 99% movement. Not that that discredits his 'rule' - the problem the students had with him was that he taught only orthodox economics as if it were a one and only 'truth' in relation to that branch of philosophical thought - because let's not forget, economics is a branch of the social, not the natural, sciences.
David, if inflation is currently 1% and unemployment is 7%, then doesn't 1.4*(1-7)+8.5=0.1??? Not 1.5%!!
Also to reach 5% assuming inflation at 2.0% then as 2-(5-8.5)/1.4=4.5, we need 4.5% unemployment!! Just who is anticipating that by 2015???
More importantly the corollary to the Mankiw rule would be:
Inflation Rate = 0.7*(cash rate) + unemployment rate - 6.1
which assuming the bank mortgage rate is 250bps above the cash rate gives:
Inflation Rate = 0.7*(bank mortgage rate) + unemployment rate - 7.9
which of course means that the REAL bank mortgage rate (ie the bank mortgage rate less the inflation rate) can be given as:
Real mortgage rate = 0.3*(nominal mortgage rate) +7.9 - unemployment rate
Hence assuming an unemployment rate u: 4% < u < 9%
Then the real mortgage rate m(real): 0.3* m(nom) - 1.1 < m(real) < 0.3* m(nom) + 3.9
Which of course means that a 9% mortgage effectively only costs between 1.6% and 6.6% and a 12% mortgage effectively costs only between 2.5% and 7.5% and a 15% mortgage rate effectively costs only between 3.4% and 8.4%.
So the actual cost of borrowing (when the capital gain of the mortgaged asset is taken into account) is much lower than the nominal cost - which is exactly what history tells us - and it is exactly why owning property is makes such financial sense.
Chris_J
The actual math is a bit different to what you are saying. The slope and intercept for NZ are actuall y = 1.1326x + 0.0861 - I only included the US data in the story because it was part of the original Mankiw Rule calcs that CBA used. Paul Krugman has updated them as well for the US. But plotting Australia data gives different variables for the Rule, and the same for NZ. I will put the full calc spreadsheet for NZ online, probably Monday.
Thanks David, that explains the discrepancies.
The interesting thing with that formula is that when you do the same calculation of what the real mortgage interest rate is (nominal less inflation) you get that approximately:
Real mortgage interest rates = 0.1 * (Nominal mortgage interest rate) - unemployment rate + 10
Hence in that scenario the real mortgage rate has very little to do with anything except the unemployment rate.
Which is interesting...
Of course that relationship breaks down if unemployment is too high and interest rates would need to be negative as per in the US since 2008.
However it does mean that you would expect real interest rates to be in the 2-5% range virtually always (which has been the historical case for 100+ years). Hence the case for owning your own home gets even stronger...
Chris
David must have assumed 2% for inflation - that would give 1.5%.
I agree with your scepticism about unemployment getting to 4.5 % by end of 2015. The bank economists have been way off the mark the last 3 years so why should we trust them now.
I expect unemployment to be around 7-7.5% by the end of this year. I don't know what it will be end of 2015, it's too far out. However, I will be surprised if its below 6% by then. If we assume 6%, and inflation of 3%, then interest rates, acording to this formula, should be 4.3% at end of 2015
Hence the problem of too high an exchange rate and too high an unemployment rate until something gives.
http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/98197…
I seem to come to a similar conclusion to you re property ownership, but its not the equity part where the money is made, its the loss of purchasing power of the debt over time. My guess is the real long term interest rate on property borrowing varies between 0-2%. So booms and busts are baked in the cake.
The problem seems to be how to ride the booms and avoid the busts, how can it best be done?
My approach was to take nominal GDP (ie GDP + inflation) as the rate of increase in purchasing power in the country and assume this is equal to house price inflation over time. So 2% GDP + 3% cpi inflation = 5% house price inflation. If mortgage interest is 7% this gives a 2% real interest rate - so buying beats renting most of the time (but not always).
The other crucial observation is that house price declines generally lead to a change of government in a democracy.
I cant see 6% un-employment and 3% inflation either, not without lots more jobs and wage increases. What that calc says to me is the banks look badly wrong, and if its what the Govn thnks, them to.
I dont understand why un-employment will drop and drop at a rate that looks quite fast. To do so would mean a boom somewhere and to do it in 2 years surely we'd see solid recovery now? yet we are weak as. It cant come from exports even if you ignore the exchange rate issue everyone else out there is in bad way....so surging demand?
Are we going to go crazy on house building? that would absorb labour but geiven costs to build how many ppl are buying?
4.3% OCR is I think the expected peak more of less, the Q is how many years away that is...5? 6? 10?
regards
exactly
the bank economists are either dumb or sinister
think about it, each year there are more than 100,000 high school or uni graduates entering the job market. The economy is weak, and older people are generally working longer, meaning less jobs for youngsters (my dad at age 72 is still working 25 hours a week and loving it)
The aussie economy is relatively OK but getting weaker, with unemployment quite high in two of the main centres that kiwis emmigrate to - Melbourne and Brisbane. So Aus will not provide the same employment safety valve for NZ that it has done. And not only will fewer kiwis move to Aussie, more kiwis who are not permanent residents will return to NZ when they lose jobs, and guess what.....many of them will go on the dole
House building in Auckland won't truly recover in Auckland until the Unitary plan is operative, at least another 3-4 years. If Labour get elected and implement their policy then at least we might get some decent construction and new jobs happening sooner
I'm sure the economists are banking on christchurch but its beneficial employment effects will be minor-moderate on a national scale.
NZ has a massive youth unemployment / underemployment problem which is a ticking time bomb. I think people tend to underestimate the underemployment factor - all these uni students working 20-30 hours per week in retail, low hourly wages, living with ma and pa, throwing much of their income at huge student loans rather than investing or consuming. And these types of retail / hospitality jobs are getting even more competitive because traditional jobs for graduates in areas like architecture, engineering, government, law etc are getting that much rarer. So its a compounding problem.
But who knows where things will be end of 2015, A lot can change. For me, I'd say there's a 25% chance unemployment will be more than 9%, a 25% chance it will be between 7.5 - 9%, a 40% chance it will be between 6 - 7.5, and a 10% chance its less than 6%.
If the govt had shown more urgency 2-3 years ago in freeing up planning restrictions and actually building more homes - as I have been consistently advocating for the last 4-5 years - then things could have been significantly improving by now. Unfortunately they have seriously dropped the ball
Nope , it's obvious to me that it's only a 3 % chance that unemployment will be over 9 % by 2012 .... January 2015 you mean ? .... that's just a 2.7 % chance .... But I am going out on a limb here in predicting a 4.2 % chance that it will fall between 6.5 % and 8.4 % .... yup ...
...... sometimes I think that steven and you don't get enough horsemeat in your diet .... here , have a McHorsie burger .... yummmmmmmm ....
Harrrrrrrrrrrrrrrrrrrrhahahaaaahaahaaaaaaaa http://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=10864384
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