The Reserve Bank is losing its lodestar
The Reserve Bank's key tool for understanding the economy may be broken and it has lost some of its confidence about controlling inflation. Bernard Hickey looks at what this historic admission might mean for monetary policy.
It's as if someone has taken away the Reserve Bank's compass. It's not quite sure anymore about where to look for inflation or whether it can do anything much about it when it finds it.
But even more importantly, this compass was built by New Zealand's most famous economist and played a key role in making New Zealand a pioneer in central banking -- an independent central bank that targeted inflation alone. Suddenly (which in the history of economics means about five years) the Reserve Bank has found the Phillips Curve has lost its power to explain the relationship between inflation and unemployment.
This was the curve found by New Zealand economist Bill Phillips in the late 1950s that showed an inverse relationship between unemployment and inflation. As unemployment rose, inflation fell -- and vice versa. It was a crucial insight that helped central banks understand that they could stimulate the economy by cutting interest rates to boost inflation when there was too much unemployment, and the other way around when there was too much inflation.
This insight and its creator are so important as the guiding lights fore the Reserve Bank that the former Governor, Alan Bollard, published an acclaimed biography of Phillips and arranged for Phillips' water-powered MONIAC computer to be restored and put on display in the central bank's museum.
But this week the Reserve Bank has admitted the Phillips Curve seems to have lost its predictive power and is forcing the bank to think again before it moves interest rates to try to shift inflation around.
Reserve Bank Acting Governor Grant Spencer was refreshingly frank in a speech on Tuesday about the bank's failure to forecast surprisingly low inflation over the last decade and how some of that shift was structural. He detailed how the Phillips curve was flattening out in this chart.
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 Phillips.
A structural change in inflation
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."
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.
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.
Admitting inflation was below 2 percent
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."