Dear Adrian: Please go easy on us
Bernard Hickey argues the Reserve Bank should look to cut the Official Cash Rate early next year to drive unemployment below four percent and put some heat under wages, because inflation is dead, dead, dead.
It's time, Governor.
Until now, new Reserve Bank Governor Adrian Orr has been very careful about sticking to the script of decades of monetary policy orthodoxy. That means prioritising low inflation as the main game and treating full employment as incidental. New Zealand's central bank was a pioneer of strict inflation targeting and was born in its current guise in the fires of high inflation in the mid 1980s. Its guiding light was an obsession with beating back the dragon of high inflation.
But the dragon is now slain. It was beaten into a comatose state globally by the shock treatment of high interest rates in the late 1980s and the global recessions of the early 1990s. It was finally killed off by the Global Financial Crisis in 2008 and the launch of the iPhone in 2007.
To steal from a Monty Python skit, this dragon is no more. It has shuffled off this mortal coil. If the Reserve Bank had not nailed it to its perch, it would be pushing up daisies. It is an ex-dragon.
That's part of the reason why Orr's policy targets agreement now includes a second major focus of "contributing to supporting maximum sustainable employment." Inflation is no longer the existential threat it once was. Frustratingly low wage inflation and relatively high under-utilisation are the issues of our age, which is now dominated by structural deflation in many goods and services now available at a millisecond and in high-def from the devices in our hands.
To be fair, this new focus is as vague as necessary for anyone who wanted to ignore. You could substitute "world peace" for "maximum sustainable employment" and the Governor could claim he was doing his job by avoiding acquiring nuclear weapons.
But maximum sustainable employment does matter and it is being written into the Reserve Bank Act. Treasury and many in the Reserve Bank still want inflation to have priority over full employment, but the Government's aim is for monetary policy to have a true dual mandate, just as it does in the likes of Australia and America.
And we're certainly not at full employment yet.
344,000 people want more work
Unemployment rose in the June quarter to 4.5 percent and there are still 124,000 people ready and able to work, but unable to find a job. John Key used to talk about a group of people that could fit into Westpac Stadium in Wellington as going to Australia every year and how that was a crisis.
There are four Westpac stadiums of unemployed people. Still.
There are a total of 344,000 people who are either: unemployed and looking for work right now; would work more if they could find work; or would like to work but aren't looking for work right now. That is an under-utilisation rate of 12.0 percent. This is not nothing.
"The under-utilisation rate is equally as important as the unemployment rate," Statistics New Zealand wrote in August. "It provides a broader gauge of untapped capacity in New Zealand’s labour market," it said.
The last time our economy was running at full steam and starting to generate inflation pressures above the middle of the Reserve Bank's one to three percent target range was in 2007 and 2008, at the end of the last Labour government. The unemployment rate got down to 3.3 percent in the December quarter of 2007 and the under-utilisation rate got down to 9.0 percent.
No one is suggesting that full employment is 0.0 percent, but it would be depressing to say that maximum sustainable employment is an under-utilisation rate that is a full three percentage points above where it was that last time the economy was at full tilt. If the economy were to get to that measure of full employment, then another 86,000 jobs would need to be created for that pool of underutilised people.
'We're already stimulating'
I asked Orr in August about whether 4.5 percent was as good as it gets and whether the RBNZ was doing enough.
He said he hoped it wasn't, but that the bank was already stimulating with an official cash rate at a record low of 1.75 percent for nearly two years. He said it was still well below the 'neutral' rate of around about 3.5 percent and therefore stimulatory.
The trouble with that argument is that estimates of the admittedly non-observable neutral rate have been falling for a decade and the Reserve Bank (and most other economists) have behind the curve of the latest surprisingly weak inflation figures.
Along with many other central banks over the last decade, the Reserve Bank has underestimated the deflationary effects of the structural changes in the global economy that have added extra labour capacity and extra goods and service capacity to meet demand.
Under the previous Governor Graeme Wheeler, the Reserve Bank was more worried about an outburst of inflation and hiked interest rates prematurely. It ran an 'asymmetric' policy that essentially had a hairier trigger on the inflation side than on the employment side. It meant the bank ran policy tighter than it should have.
Inflation well below the mid-point
How do we know that policy was too tight?
The Reserve Bank's preferred measure of the underlying inflation rate has been under the 2.0 mid-point of the bank's target band for almost nine years and is a full 1.5 percentage points below where it was in 2007 when we were last at full employment. Wage inflation is stuck below 2.0 percent and there are few signs the big pay equity and minimum wage increases are surging through into bigger wage increases elsewhere.
The bank has been asymmetrically hyper-senstive about inflation risks over that time to the detriment of reaching full employment. It did not give faster economic growth the benefit of the doubt when it came to monetary policy. It repeatedly reckoned the economy was running at full tilt when it wasn't. It said it could have forecast our migration-led population shock or the structural effects of new technology, but it's been long enough now of being surprised by inflation on the downside.
Now it is time to be asymmetrical on the other side of the bank's dual mandate.
Give full employment a chance
This week's business confidence figures show businesses are genuinely worried about their own future orders prospects. This is not just a political tantrum by National-voting employers. They are as concerned now as they were in the depths of the global financial crisis. They experienced weak employment and investment in the September quarter. Retailers are particularly nervous. Even consumers, who should be in party mode at supposedly full employment and after a big dollop of cash from the families package, are more nervous about buying big ticket items than they have been in three years.
Some of this is structural. Retailers can see the likes of the FAANGs (Facebook, Amazon, Apple, Netflix and Google) eating their lunch, and this is filtering through the economy and into the psyches of employers and consumers. They are nervous about their sales and their wages because they can see the pressure building on the screens in their hands. Everywhere they look, there's app for the work and the products they used to do, and often at much lower or no cost.
The Reserve Bank should be blowing back against this headwind of structural deflation. And it should look not further than its last monetary policy statement for guidance.
The downside scenario is here
The Reserve Bank included a downside scenario in its last monetary policy statement in August that included GDP growth falling to around 2.8 percent through 2019. It said that would mean the Reserve Bank would be likely to cut the Official Cash Rate by as much as another one percentage point or 100 basis points to around 0.75 percent by early 2020.
This week's business confidence and a range of other figures suggest growth is slowing towards 2.5 percent later this year and will be below the Reserve Bank's central forecast of around three percent next year. That means the downside scenario is here.
A few economists are beginning to talk about the prospects of more cuts as soon as early next year.
"At face value, this survey suggests annual growth could potentially slow from its Q2 2.8 percent annual pace to just 2.4 percent by the end of the year, and that growth may struggle to reach 3 percent over 2019," ASB Senior Economist Jane Turner wrote, adding the labour market may have lost momentum too.
"If the growth and employment figures released over the rest of the year are consistent with soggy business confidence, we see it becoming increasingly likely that the RBNZ will pull the trigger and possibly cut the Official Cash Rate (OCR) early next year," Turner wrote.
Senior ANZ Economist Liz Kendall also saw the experienced business activity figures consistent with slowing of growth in the second half, potentially as low as two percent. That would challenge the Reserve Bank's assumption of a pick-up in growth.
"Today’s data will add to concerns about the current degree of economic momentum, providing a timely reminder that OCR cuts remain a distinct possibility," Kendall wrote.
"The RBNZ stands at the ready to support the economy should they deem it necessary to get inflation sustainably back to the midpoint in an acceptable timeframe. Accordingly, today’s data have the potential to move the RBNZ’s rhetoric further into dovish territory," she said.
"We continue to believe that on balance the next OCR move is more likely to be a cut than a hike, though more “hard” evidence of a slowdown would be required to shift us from our flat track."
Go easy on us Adrian
The next monetary policy statement on November 8 will be a great opportunity for Orr to drop his avowedly neutral stance (he says rates could just as easily be cut as hiked) and adopt an easy stance that signals rate cuts as soon as February or May next year.
There's a good argument for the Reserve Bank to prioritise full employment in its thinking to make up for the over-prioritisation on keeping inflation (too) low over the last five years.
Even if inflation does heat up a bit, there is still plenty of headroom before it gets anywhere near the top end of the target band.
And those 100,000 or so people who should be working, including many of the most vulnerable in our Māori and Pasifika communities, would have a better chance of a job.
But what about the house prices?
This call for even lower rates may surprise a few people worried about the effects on already sky-high asset prices and house prices in particular.
OCR cuts would see mortgage rates fall even further. Many of the longer-term fixed rates have already fallen in recent months in line with expectations of future inflation.
But the Reserve Bank is well within its rights to keep the pressure on banks not to lend willy-nilly to rental property investors. For example, it's now clear the slight loosening of the loan to value ratio rules by the previous interim Governor Grant Spencer have played a role in heating up provincial housing markets. They should be reversed.
The big Australian-owned banks also face their own headwinds from tougher capital requirements on both sides of the Tasman and heavier regulatory restrictions on fast lending over in Australia.
Lower mortgage rates may well just offset a tightening of credit conditions driven by the banks themselves.
And what about the smaller buffer?
Others also argue that cuts to 0.75 percent would leave the Reserve Bank too little room to stimulate if there was a big new global financial shock or recession here.
That seems true and certainly the ability to stimulate gets restricted the closer you get to zero.
But more can be done once you get to zero. Quantitative easing (where the central bank invents money to buy government bonds and push down long term interest rates) and negative interest rates are now conventional policy options for the likes (still) of the European Central Bank and the Bank of Japan. Both the Bank of England and the Federal Reserve have previously used quantitative easing.
This is not funny money stuff anymore.
A conventional view of our situation right now would say a move to an easing bias and potential cuts next year are completely sensible.