In today's email we looked in detail at a landmark speech by acting Reserve Bank Governor Grant Spencer.
1. Grappling with structurally low inflation
Reserve Bank Acting Governor Grant Spencer was refreshingly frank yesterday in a speech about the bank's failure to forecast surprisingly low inflation over the last decade and how some of that shift was structural.
He acknowledged the bank had now changed its default approach to shifting the dial on inflation, saying it was now placing relatively more weight on employment, output and financial stability because influencing inflation was more difficult.
Spencer, who is due to retire in late March once Finance Minister Grant Robertson has approved the Reserve Bank board's choice for a Governor for a five year term, will not be able to carry through on the apparent shift in approach. But his emphasis in the speech about surprisingly low inflation and the potential for the central bank to lower rates again was unusual.
The previous Governor Graeme Wheeler warned for most of his five years about the risks of higher-than-expected inflation. His signature move was a series of official cash rate hikes to 3.5 percent in mid 2014 that he had had to unravel through late 2015 with rate cuts. He then had to extend those cuts to the current level of 1.75 percent in 2016 when the inflation forecast by the bank didn't arrive.
The chart above shows the Reserve Bank over-estimated domestic inflation (and therefore held the OCR higher than it should have) for most of the last five years. The black line is actual inflation and the blue lines are Reserve Bank forecasts.
For an inflation-targeting central bank that invented the practice of focusing laser-like on keeping inflation low and stable, Spencer's comments about the Reserve Bank's monetary policy losing its inflation-shifting power and moving some emphasis to other things such as employment and output indicated a change of tone at least within the bank.
Spencer talked a lot in the speech to the Institute of Directors in Auckland about the global supply-shocks seen over the last decade that were keeping inflation lower for longer, and even how the Phillips curve may be flattening.
This was a milestone comment for a central bank that built its modern inflation-fighting core around a downward-sloping Phillips curve, which was, after all, created as a model by New Zealand's most internationally renowned economist -- Bill Phillips. (The Phillips curve normally shows inflation rising as unemployment falls, and vice-versa. A flat curve suggests the negative correlation has broken down.) There was a downward curve for 2001 to 2011, but a flat line after that.
Spencer referred to the globalisation of supply chains, the rise of China's manufacturing output and the growth of the digital economy over recent years as structural factors keeping inflation low. He pointed to the supply chains used to make the iPhone, which involve 123,000 workers in the United States and 700,000 world wide.
"Outsourcing and supply chain integration of this sort has lowered the price of a wide range of manufactures sold across the world," he said.
"It has also placed downward pressure on the wages of lower skilled jobs in advanced economies. Both have translated to less inflationary pressure in the advanced economies."
2. Migration played a role too
Spencer acknowledged the link between measures of domestic slack (the gap between actual and potential output) and inflation had proved elusive in recent years, and that measuring slack was becoming more difficult, particularly for the labour market.
He pointed to the high levels of temporary work visa arrivals in net migration as a factor keeping wage inflation low.
"An increasing share of the inward migration has been on work visas, thus contributing to higher productive capacity," Spencer said.
"In this way, emerging excess demand for labour has been moderated on the supply side as a result of increased international labour mobility."
Spencer said New Zealand's increasing integration with the global economy was consistent with a flattening of the Phillips curve.
"New Zealand has always been a price taker for goods traded in the international markets. It now appears that, with labour mobility and globalisation effects, we are increasingly a price taker in “non-traded” goods and services," he said, referring in particular to education and tourism services.
3. A move to the Singaporean way?
Spencer was cautious about declaring the death of the Phillips Curve yet, but he said the bank needed to consider the implications if it had flattened permanently.
"However, if this change is long lasting and New Zealand firms are increasingly integrated with global markets, then domestic ‘non-traded’ inflation may become less responsive to monetary policy changes," he said.
"In the extreme case, New Zealand would be a fully open economy with all prices and wages set in international markets. The exchange rate would become the main conduit for monetary policy to achieve its price stability objective."
Spencer did not say this, but this use of the exchange rate as the main monetary policy tool is how Singapore's Monetary Authority does it, and the way Winston Peters would like to run it. In this case, the Reserve Bank would be able to leave the OCR at a particular level and then either let (or use) the exchange rate keep inflation within its target band.
This is the first time the Reserve Bank has suggested an eventual shift to a Singaporean way of running policy, albeit as a matter of necessity rather than choice.
However, Spencer said that any apparent lack of responsiveness between monetary policy may mean the Reserve Bank is more patient and flexible in future.
"While the extreme case of a flat Phillips curve is more expositional than real, it may be the case that deviations from the 2 percent CPI inflation target will be harder to close, in the sense of requiring larger policy changes and larger movements in economic slack, as measured by unemployment and the output gap," Spencer said.
"Given that the PTA says we must avoid unnecessary instability in output, interest rates and the exchange rate, and also have regard to the efficiency and soundness of the financial system, this suggests that we should be patient in bringing CPI inflation back to the 2 percent target. This indeed is the approach we have been taking in recent years," he said.
Spencer pointed to the November Monetary Policy Statement's forecast that non-tradable inflation would pick up from late 2018.
"If this response does not eventuate then we would have to consider a further easing of policy to generate additional domestic demand pressure, particularly if global inflation remains low in line with our forecasts," he said.
"However, we would need to be careful not to generate unwarranted instability in output, the exchange rate or indeed household debt.
"It is fair to say that our flexible inflation targeting approach is becoming more flexible. In pursuing our long term price stability objective, relatively more weight is being attached to the stabilisation of output and employment in the short to medium term."
Spencer said the Reserve Bank’s direction was consistent with the new Government’s plan to introduce a dual mandate for monetary policy that included maximising employment alongside keeping inflation stable.
4. Admitting inflation was below 2%
In concluding his speech, Spencer noted the bank had tended to look through the positive supply shock, although low global inflation was included in the bank's future track. This had meant inflation had been running below the bank's two percent mid-point target for some time, he said.
This is the first indication that the bank failed to meet its Policy Targets Agreement target under Wheeler of keeping inflation around that mid-point. Previously, the bank had adhered to the view that inflation expectations were well anchored around two percent when defending the fact that headline inflation had been under two percent for a long period. In his final speech, Wheeler also defended his record and pointed to the anchored inflation expectations.
However, Spencer spent some time on how research was showing the way inflation expectations were set was also changing, with increasing emphasis on past low inflation in price and wage setting in particular. That effectively increases the dangers of running inflation below the target band for long periods because it 'embeds' low inflation.
"This research shows that, in an environment where inflation has been low for some time, businesses have been placing greater weight on past inflation in setting prices," Spencer said.
"That is, in a low inflation world, businesses tend to use last year’s inflation outcome as a reasonable estimate of next year’s inflation. This adds further momentum to low inflation and reinforces the role of inflation expectations in the flattening of the Phillips curve."
5. Briefly in our political economy...
Free elder care - The Government finally announced the details of its first year of free tertiary education with less than four weeks to go before the policy is due to kick in. Newsroom's National Affairs Editor Shane Cowlishaw covered the announcement here for Newsroom Pro, including that older students with less than six months of tertiary education previously would have access to the one year of free education, and that there would be no age limit. Education Minister Chris Hipkins said 80,000 people would be eligible for the first year of free fees and 130,000 students would get an extra $50 a week in student allowances, which would cost $380 million in the first year.
Building again - Statistics New Zealand reported that the volumes of building work put in place rose 2.7 percent in the September quarter from the June quarter. This was higher than market expectations of about 2.0 percent growth and a bounce-back from falls in the March and June quarters. The figure is closely watched as a component of September quarter GDP, which is currently expected to have growth around 0.3 to 0.4 percent for the quarter.
On track - Treasury reported Government financial accounts for the four months to the end of October that showed the operating balance excluding gains and losses (OBEGAL) in deficit to the tune of $308 million, which was just above the May Budget forecast for $217 million. Corporate taxes were $0.2 billion above forecasts, while expenses were $0.2 billion above forecasts, with some spending brought forward.
6. Coming up...
Auckland Council, Auckland Transport, Watercare and Panuku Development Auckland are scheduled to release a report on Wednesday afternoon with the results of research they co-commissioned by the National Institute of Water and Atmospheric Research (NIWA) on implications for Auckland of the climate change projections developed through the Intergovernmental Panel on Climate Change (IPCC) Fifth Assessment Report.
The report incorporates information on a range of climate variables for 2040, 2090 and 2110, including changes to temperature and precipitation; changes to evaporation, soil moisture and drought; changes to pressure, wind and storms; oceanic changes and sea level rise.
The Government is scheduled to release its Briefings to Incoming Ministers (BIMs) on Thursday.
7. One fun thing
I couldn't resist reproducing this piece of very dumb fun from the excellent Youhadonejob
8. The daily political links
These are available in the daily subscriber email