By Gareth Vaughan
By late 2020 it was clear central bank and government monetary policy and fiscal policy responses to the Covid-19 pandemic had prevented a major economic downturn, and thus the Reserve Bank should've been looking to move monetary policy to a neutral rather than super easy setting, says Grant Spencer.
Spencer, Adjunct Professor at Victoria University's School of Economics and Finance, is also a former Reserve Bank Deputy Governor, and was Acting Governor for six months up to his departure from the central bank in March 2018.
Spencer spoke to interest.co.nz about inflation in the second episode of the Of Interest Podcast, where we delve into big issues and new developments in the economic and financial worlds.
New Zealand's March quarter Consumers Price Index (CPI) inflation came in at 6.9%, the highest it has been since 1990, and well above the Reserve Bank's 1% to 3% target range. CPI inflation is even higher in other parts of the world, reaching 9% in the United Kingdom, 8.6% in the United States, 8.1% in the Eurozone, and Australia's last reading of 5.1% is expected to rise.
Inflation, Spencer says, is always driven by persistent excess demand.
"And in this situation over the past two-and-a-half years we've had persistent excess demand resulting from an adverse supply shock and expansionary demand policies, in particular monetary policy and fiscal policy."
By about September-October 2020 Spencer says it was apparent the emergency Reserve Bank and government policies had been successful in preventing the high unemployment and "drastic economic downturn" people had feared was coming in early 2020.
"I think it was around September-October 2020 when bond rates, interest rates, that had been falling, started to move up again. And that was in response to emerging economic indicators both here and internationally, which were saying the out-turn for real activity in the global economy is not going to be as bad as we thought, unemployment's not going to be as bad as we thought."
After that Spencer says the Reserve Bank should've been thinking about moving the Official Cash Rate (OCR) back gradually towards a more neutral position rather than waiting until October 2021 to increase the OCR from its record low of 0.25%, where it had been reduced to in March 2020.
"Different countries had different sets of indicators. But I think that shape of the trend in bond rates was generalised across the major markets, it wasn't just New Zealand. So that's when the information started to turn," Spencer says.
"The key is the interpretation of that so-called inflation, price increases. Is this a temporary shock, supply side blip, or is it something that policy should respond to with a generalised firming of policy? And that's always the nature of the discussion. And it's very easy to be biased in one direction and just sit pat until you've got a convincing case that overall core inflation, or underlying inflation, is moving therefore we need to move."
"It's difficult for policymakers to turn policy because as soon as you turn policy the markets will expect that you're going to continue to tighten. And the whole shape of the interest rate curve will change and you can have a significant effect on things just by that decision to start to make one increase rather than being on an easing mode," says Spencer.
"That's why they're nervous about shifting from an easing to tightening cycle until they can see the whites of the eyes of inflation. But that's also the challenge, because as it has turned out they really should've been tightening earlier."
He says the Reserve Bank should've started shifting the OCR back towards a neutral setting sooner than October last year, but won't give a specific time when he thinks this should've started.
"They should've been moving back to neutral. The default should be seen as neutral, not as super easy," Spencer says.
The neutral OCR rate is the level where it's deemed to be neither stimulating nor constraining economic activity. The Reserve Bank currently considers the neutral rate to be about 2%. That's where it's now at, after a 50 basis points increase on May 25. It was at 0.25% as recently as October last year. Spencer says the neutral OCR may be higher than 2%.
The record low OCR wasn't the only aspect to easy monetary policy. Between March 2020 and July 2021 the Reserve Bank bought $53.5 billion worth of NZ government bonds and local government bonds on the secondary market off banks in its first foray into quantitative easing. This was aimed at suppressing interest rates.
"You know if you've got super easy policy you should be moving back towards neutral if you think that things are starting to change, and you shouldn't be just focused on one of the dual mandate objectives," Spencer says.
The Reserve Bank's monetary policy remit states that it must both maintain price stability and support maximum sustainable employment.
In the podcast Spencer also talks in detail about what is causing the high inflation, what his outlook for inflation is, the role of the NZ housing market, Russia's invasion of Ukraine and China's zero Covid policy in this, and whether we're in for a hard landing, or a marked economic slowdown or downturn.
"It's a very difficult situation to manage through," Spencer says of the current situation.
54 Comments
The Taylor Rule suggests that the funds rate in the US should be 10% now....and in the last 50 years there has never been a bigger divergence between where the Taylor Rule thinks the funds rate should be and where it really is.
https://pbs.twimg.com/media/FVQEeOQWUAAHugl?format=jpg&name=medium
The chart above also shows that the funds rate was too low for too long also post GFC....this is why I believe we now have too much debt in the system as interest rates weren't set correctly (should have been higher, limiting debt creation)....they were set in a place that protected asset holders and the existing debt pile. It also means that now that we need to raise rates...we can't....
A decade or more of poor monetary policy setting might be coming home to roost in the coming months.
"For many, the jury is out on the Taylor rule as it comes with several drawbacks, the most serious being it cannot account for sudden shocks or turns in the economy, such as a stock or housing market crash. In his research and original formulation of the rule, Taylor acknowledged this and pointed out that rigid adherence to a policy rule would not always be appropriate in the face of such shocks. Another shortcoming of the Taylor rule is that it can offer ambiguous advice if inflation and GDP growth move in opposite directions.
During periods of stagnant economic growth and high inflation, such as stagflation, the Taylor rule provides little guidance to policy makers, since the terms of the equation then tend to cancel each other out. While several issues with the rule are, as yet, unresolved, many central banks find the Taylor rule a favorable practice and some research indicates that the use of similar rules may improve economic performance."
Taylor acknowledged this and pointed out that rigid adherence to a policy rule would not always be appropriate in the face of such shocks.
Our RBNZ Governor can't even make a realistic attempt at adhering to the 1 - 3% inflation rate mandate. Plummets rates and removes safety factors such as LVR's at the first whiff of potential deflation (no statistics to support) but when we have actual high inflation data it's a snails pace to get back to where we were.
Seems to me the central banks want to play a balancing game - that is not raise rates too fast that shares plummet and the economy crashes, or not too slowly so inflation gets away on us. In other words, they want everyone to suffer in equal measure, savers and investors alike. Savers get their money eroded by inflation, and investors endure an ongoing bear market. We all lose! Maybe this is the start of the end of fiat currency, I don't know.
Great idea. I would like to see it too...We won't get it because it is those benefitting from the wealth transfer created by fraudulent interest rates, that make the rules. Turkeys are not fans of Christmas. I would like to see tax bands reduced by the inflation rate every year. That would keep them honest.
If the Gnats were " reading the room " they'd promise to adjust the lower tax bands ... the ones that affect most of us , and leave the upper hands where they are ....
.... that way , the media couldn't criticize them for giving Luxon a huge tax cut , and the rest of us a small one ...
And , the few super earners who're above $ 180 000 per year & paying 45 % .... they can take it up with the folks who put it there ... not with Luxon ...
Further to this, anytime (where I can find data) that the inflation rate has gone above 5% in the US, the effective funds rate has needed go higher than the inflation rate in order to tame the inflation. (happy to be corrected if anyone can see where this isn't true).
House Mouse might be right that rates don't go much above 3% (because of the quantity of debt we have)....but if history over the past 50-60 years is anything to go by, we may need rates a heck of a lot higher than that if inflation is now embedded in the minds of the people of the economy.
Perhaps this is more like the 1940's where we have big jumps between inflation and deflation due to the high levels of debt and evolving/uncertain global environment.
I once read Reinhard & Rogoffs' book " This Time is Different : 8 centuries of financial folly " ... and it stuck so firmly in my mind that I didn't need to read it again ...
... wish I'd sent copies to all central bankers around the world ... this time is not different ... they have created the potential of a bigger than GFC mess , by not allowing recessions to do their work & wring out the excesses from our economy...
Kicking that can down the road ... putting off the day of reckoning ...
Looks like an interesting read there GBH...will add it to my reading list...
Yeah as much as I have been laughed at and often attempts to try and belittle my views (by certain commentators) on here and in person, I still think that at some point our housing market could come crashing down around us through very poor market regulation from those who should have known better. Who knows, what we are witnessing now could be the start of it...you never really know until hindsight...as was the case when I lived in the US during the GFC...
Once you have lived through that, you are far more cautious about telling people to load up with debt against something that appears to be highly speculative.
I would agree with that. I arrived in NZ in 2014, and then I thought that the price of property in relation to earnings, and property quality, was unhinged. But since then successive governments have campaigned on doing something about it while continuing to create policy that makes thing worse. We need a complete political restructure.
Soon as one becomes an MP one become very high income earner and under all sorts of lobbying pressure. Structures prevent revolution. A sow downward spiral of social degradation and unfairness to come.
Alcohol laws are a prime example of inaction in a the face of massive health, social environmental harms/costs.
... I've learnt alot reading your postings , and those of Audaxes ... keep up the good work !
The guys at Gavel Research in Hong Kong have put out an array of small books well worth a read too ... the latest " Avoiding the Punch " by Louis-Vincent Gave is a small power packed little volume , well worth the time to read ..
Agreed. A superb read Gummy Bear. Reinhard and Rogoff have also published a lot on financial repression and how govt's on account of monetary and debt related reasons are going to find themselves pressured into using financial repression as the mechanism in which manage financial issues.
The paper Financial and sovereign debt crises: some lessons learned and those forgotten is particularly insightful
I think it is relevant to NZ as I think that this will be the only politically palatable way of managing the array of financial issues our society now faces on account of its poor leadership. I expect the NZ govt to quietly start directing Kiwisaver and super funds to buy govt debt at some point in the near future.
From the US - Complete Catalog of Chaos and Carnage
And I said it at the time. It was blatantly obvious prior to Christmas 2020 that houses prices were headed for the skay, the economy was starting bubble away nicely and that was the time that the OCR stimulus should have been removed. In reality it is probably still on the side of stimulation and still far too low. What muppets.
What incredibly overpaid muppets ! ... many of us here , regular guys & gals on a tenth or less of what Adrian Orr is paid , spotted his blunders on the OCR .... spotted & complained here about his rebooting of the property bubble ....
... now he's fronted a forum of overseas central bankers , and compared the RBNZ to Tane Mahuta , a kauri tree ... ... OMG , WTF !
You're left wondering if they do this stuff deliberately?
Mind you just about everything that comes out of the folks in Wellington is incompetent.
They cannot even look after their own, hospitals and health system, busses, roads, water and sewerage, etc, etc. They have a culture of woke incompetence, are over rewarded and have no accountability., so it is not surprising.
"Inflation, Spencer says, is always driven by persistent excess demand."
If the price of products A and B go up because of a major drop in supply coupled with some opportunistic price gouging, and products A and B are major inputs to the cost of just about everything else, then prices start to rise across the board - even if demand is low or falling. This is basically what is happening with oil and gas right now. Describing this supply side driven price increase as the result of 'persistent excess demand' is like saying that soldiers die because they walk into bullets.
I was chatting to someone who works for a large European car manufacturer over in China. Apparently when the covid app alerts a positive case the police and military just lock down the entire building for two weeks with people inside. People who cant get out in time end up sleeping on the floor in their offices. So once the app goes off everyone is absolutely desperate to escape the building or shopping mall before the police and military lock it all down. It's completely insane. Imagine what all that does to supply chains! This will lead to inflation or shortages of everything.
I would have loved to hear Grant and Gareth discuss the relativity of OCR equivalent interest rates between countries (ie RBNZ vs FED). It seems an underdiscussed narrative.
Isn't there a risk that in NZ demand is destroyed and the economy stalls at a lower equivalent interest rate compared to USA? i.e. the FED is still increasing while the RBNZ have hit a brick wall.... and then the NZD tanks making our situation with imported inflation even worse?
The vast majority of American middle class home owners now have their mortgage debt fixed at historically low rates for 30 years. Their interest costs are tax deductible. If the next period of high inflation can be endured with not too much impact on employment and wages can at least try and keep pace with prices. They will enjoy their debt being eaten away year after year.
Unfortunately for New Zealanders our debt servicing costs are repriced every 1-2 years. That is the way our banks like it and they have always tried to incentivise short term fixed rate periods.
In short. New Zealand mortgage holders are way more screwed than Americans.
In the US you can port your mortgage to a new property under certain conditions. If you are trading up you can keep your existing fixed rate mortgage and take a second mortgage for the difference. Or Port and and Blend where they combine your old rate and current rate to a rate that is a blended average of the two rates.
"Inflation, Spencer says, is always driven by persistent excess demand" So, in his view, that's the only explanation for inflation. He holds a hammer, so everything must be a nail.
In this blinkered world, there can therefore be no room for a supply side shock. He should be made to read-in fact all economists should be made to read- The Intelligence Trap by David Robson.
The one thing overlooked is the fact that household debt to GDP is more than four times what it was back in the 1980s. The idea that the RB can simply crank rates to control inflation will be met with a huge drop in economic output as households become impoverished by massive increases in borrowing costs. By the time it's realised what's going on, it will be too late. The signs are already there; huge shift in the property market in just a matter of weeks. This is only the beginning.
The problem is simply that people (and governments and businesses) borrowed too much without factoring in the risk of high interest rates. Whilst reserve banks enabled it.. the borrowers have caused it and many would love someone else to be responsible for their actions.
Rates had to rise sooner or later. The way its happened is probably too fast and way too late but to be fair there was a global pandemic to deal with. I am.accepting that fast in some ways may be better than a slow drop. Get to whereever we are going (and the pain) quickly then figure out what next.. just hope nothing siesmic (banks folding in large numberz) happens faster than we can react.
"the borrowers have caused it and many would love someone else to be responsible for their actions."
You're expecting borrowers at an individual level to be able to predict and correct for economic risk that we have several massive institutions directly responsible for, and they have all failed. Blaming the individuals at this point is perverse.
Don't forget this exact kind of financial instability is why we had an independent regulator in the first place.
Thanks Gareth for some decent reporting on the Reserve Bank’s failure to act sooner.
Thanks also to Grant Spencer for such a brilliant explanation of how poor governance by both the Reserve Bank & the Government has led to excessive inflation & debt.
The problem for this government is there is no plan to grow GDP. The only plan seems to be to re-distribute wealth to those that support the Labour Party.
The risk of stagflation is now increasing & everyone will be worse off
Interest rate rises have been slow. Saw this video where Marc Faber says FED rate needs to be above 9%.
https://www.abc.net.au/news/programs/the-business/2022-05-04/recession-…
good discussion.
Apples with apples?
Was listening to an economist in the UK....said that that the way inflation is measured has shifted (making a comparison with historical inflationary crisis a nonsense) - and that in fact its more like 15% in the UK.
Have the formulas for inflation measurement in NZ changed too? Just wondering?
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