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Gareth Vaughan takes a look at how and why central banks, including the Reserve Bank of New Zealand, use the stars to help meet, and try to meet, their monetary policy remits

Gareth Vaughan takes a look at how and why central banks, including the Reserve Bank of New Zealand, use the stars to help meet, and try to meet, their monetary policy remits
Photo: Digital Nights Wellington - Van Gogh Alive.

By Gareth Vaughan

What do central banks, including the Reserve Bank of New Zealand (RBNZ), have in common with legendary Dutch painter Vincent van Gogh?

Van Gogh, in a letter to his brother Theo the year before he created his breathtaking Starry Night painting in 1889, wrote; "Hope is in the stars." Central banks also take hope from the stars, albeit not the same stars as those van Gogh painted.

Their stars aren't found in the night sky. Inflation targeting central banks, such as the RBNZ, look to their stars to help them determine how tight or how loose monetary policy is and should be. These stars are economic measures such as the neutral interest rate, the level and growth rate of potential output in the economy, maximum sustainable employment, and the equilibrium real exchange rate. These stars are benchmarks that the setting of monetary policy can be measured against.

Peter Williams, a research analyst at the International Monetary Fund who co-authored a recent working paper on the stars, recently told Bloomberg the stars are useful for policy makers to give them a sense of how much their actions are affecting the economy at any given point in time.

"A good analogy might be driving if you can't see the speedometer in your car. You have some other indicators but you don't really know how fast you're going and if you are actually appropriate for the space around you," Williams said.

"So we can think about the neutral rate and the stars helping give us a bit more context for where we are relative to where we should be based on the rest of the economy. It helps us make sure we're going at the appropriate level and we're not over stimulating the economy."

In a 2017 speech John McDermott, RBNZ assistant governor and head of economics, said to set monetary policy the central bank needed to know where the key macroeconomic factors such as interest rates, output, and the exchange rate are tracking relative to their equilibrium levels, denoted by its stars, which he noted were unobservable and complex to estimate.

"Like the night sky, our stars keep moving. To respond to an evolving macroeconomic environment and set monetary policy appropriately, we keep track of the changes in the underlying state of the economy. Regularly explaining our view of the stars helps financial market participants and others better understand our analytical framework and policy decisions," McDermott said.

'The location of the stars have been changing significantly'

In a 2018 speech US Federal Reserve chairman Jerome Powell noted the stars had been shifting in a changing world, well before Covid-19 came along.

"Navigating by the stars can sound straightforward. Guiding policy by the stars in practice, however, has been quite challenging of late because our best assessments of the location of the stars have been changing significantly," Powell said.

As an inflation targeting central bank the situation has been similar for the RBNZ. The neutral Official Cash Rate (OCR) is the level at which the OCR is seen as neither stimulatory nor contractionary for the economy. As the RBNZ chart below shows, this has been steadily declining for some years now.


The RBNZ's monetary policy remit is to;

Keep future annual inflation between 1% and 3% over the medium term, with a focus on keeping future inflation near the 2% midpoint; and

Support maximum sustainable employment, considering a broad range of labour market indicators and taking into account that maximum sustainable employment is largely determined by non-monetary factors.

NZ at maximum sustainable employment with 112k unemployed

In its February Monetary Policy Statement the RBNZ said a range of indicators suggested employment continued to rise relative to its maximum sustainable level over 2019.

"Our judgement is that employment is around or slightly above its maximum sustainable level," the RBNZ said.

Statistics NZ data put unemployment at 112,000 as of December last year. This was with an unemployment rate of 4%, and the labour force participation rate at 70.4%.

In terms of the dollar, McDermott noted in his speech that of all the prices within the economy, the real exchange rate is one that is not subject to short-run rigidities.

"Indeed, the real exchange rate can and does move rapidly over time, as economic developments such as a rise in the terms of trade – the ratio of our export prices to import prices – are quickly reflected in its relative price. The fast-moving nature of the real exchange rate means it plays an important role in absorbing shocks to our economy. But while part of the movement in the real exchange rate over time reflects persistent fundamental developments, such as structural improvements in the terms of trade or changes in relative productivity, much of the movement in the real exchange rate reflects deviations away from its medium-term equilibrium level. This feature of the exchange rate to ‘overshoot’ or ‘undershoot’ its equilibrium stems from the fact that currencies can react to incoming news instantly, while other prices, besides interest rates, are slower to adjust. These deviations may result in mis-allocation of resources between tradable and nontradable goods," McDermott said.

"There are various definitions of the equilibrium real exchange rate, which tend to focus on the drivers of the exchange rate over a given time horizon. The medium-term notion of equilibrium tends to be based on the value of the real exchange rate that would be consistent with internal balance (output at potential) and external balance (the current account sustainably financed). One of the several models that the [Reserve] Bank uses is the macro-balance model, which assesses the degree to which the exchange rate is currently too high or too low in order to stabilise the net foreign liabilities to Gross Domestic Product (GDP) ratio at its current level," said McDermott.

In its February Monetary Policy Statement the RBNZ said potential output growth was assumed to average 2.4% over the projection period to 2022. And with GDP growth rising above this rate by the end of 2020, capacity pressure in the economy was expected to increase.

How significant will Covid-19 related changes be?

The Covid-19 pandemic, and accompanying economic fallout, is leading to questions about how many things are done. Could the way inflation targeting central banks use the stars be among these? And with governments around the world making greater use of fiscal policy to combat the impacts of the crisis, could the days of governments outsourcing economic policy to central banks even come to an end?

Neel Kashkari, president and CEO of the Federal Reserve Bank of Minneapolis and a member of the Federal Open Market Committee, recently hit out at economists' obsession with the natural rate of unemployment, and acknowledged the Fed got it wrong by raising interest rates from 2015. Kashkari doesn't have a typical central banker's background having started his career as an aerospace engineer.

"Why is it that economists always assume when there's a recession the natural rate of unemployment ratchets up, and it only falls down gradually over time? And they come up with all sorts of dislocations, fancy words, skills mis-matched, skills diminished. Boy this is an enormously costly error that we keep making. People want to work and that's one of the things that we've learned. And if we just allow the economy to recover I think they will continue to surprise us. And so yes, I do think that me not being an economist has helped me to see that, but that's not to say an economist can't see that too," Kashkari told Bloomberg.

In a second article I'll look deeper into these issues.

*This article was first published in our email for paying subscribers early on Tuesday morning. See here for more details and how to subscribe.

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The RB can add star-gazing to their previous pathway of following the tree god (recent symbolism).
Looking for some kind of values base but limited tools.

Unlike Vaughan I heard Mr Orr prefers navel lint gazing.
So much less effort required than getting out of bed and actually seeing how the real world operates.
Yep lets just keep going down in OCR, hey well its never worked before in history but hey we might be the first.

Exactly, let's repeat the same mistakes done by Japan and Europe, and hope that the outcomes will be different in NZ to the abysmal results seen by them. The RBNZ is the perfect example of delusional thinking in action.

Granted that they have a limited tools, the problems raised with the current RBNZ team is plain sight, linear thinking, herd/follower of overseas policy, expected & very predictably (usually cartel/mates driven input) - If only they're 'creative & have the periodical of unpredictability/randomness' then they can win the public confidence, Banks on the other hands.. will be very cautious, true prudency.


The clear consensus of opinion in this forum is that the RBNZ is failing severely in it's remit to manage the economy. I might add that I agree with that consensus. However as far as the identified remit is concerned, that opinion is clearly wrong, based on the current models of economic management. But I have concerns.

First of all, why is there a supposed "maximum level of employment"? What principle drives this that remains valid today? And does that mean that if for example 80% of the country were employed in minimum wage jobs, that remit was still being met? This is the example that expresses where my concerns are. If the example I give above were true, what would the wellness of our societies likely be? And this points to one of the areas where the RBNZ, and our Governments who assigned that remit, are failing - the housing crisis. The RBNZ has come out openly admitting that it is acting to prop up 'asset' prices. Primarily this is clearly housing and property. But the cost of putting roof over the heads of our population is one of the single biggest contributors to poverty, especially child poverty. So who are the beneficiaries of this policy?

It is the wealthy (do not dare say these are the boomers, as there are many boomers who are victims of this policy just as there are many non-boomers who are reaping the rewards.), and the private banks, while the taxpayer is being forced to subsidise these to the tune of $billions per year. Yet the Government will tell us they cannot fully fund Health, Education and Defence, and our Justice and Corrections Departments struggle to deal with high levels of crime. Will the Government act to address this?

Being the RBNZ Governor is a thankless task.
As you point out, I along with other commentators on this blog suggests that. But that's because: (1) You only got the job because there was no one else available that was better than you and (2) Those that are better, are actively engaged in fighting against you to make money. Just given the sheer weight of number, guess who will win?!
Expecting one, or a small group of individuals, to 'beat or control the market' with the vague set tools they have been given is nigh impossible.
What's needed is a strict, distinct set of rules that do not require interpretation or Medium Term guesswork. Rules that operate today in whatever environment today is. The RBNZ has to be the Master and the Banks the servants ( again). It's the reverse at the moment, and the longer that's left in play, they further from 'saving' our economy gets.

The only entity profiting from negative interest rates at reserve bank level are the banks that are taking these funds and lending them out.
All other players are losers
at +1.0% at RBNZ level the banks add 2 percentage points and lend at +3.0%, sending the profits to their shareholders
at -1.0% at RBNZ level the banks add 2 percentage points and lens at +1.0%, sending the same profits to their shareholders
but 50% of that that profit is now coming ultimately from the NZ taxpayer

Note recently the push by IRD to get disclosure on all cryptocurrency assets and trades by requiring brokers to give up the information.
Note recently the increased discussion about removing all cash from circulation

You think these things are not linked.?

Ultimately when both are completed and all transactions are totally monitored where are your individual freedoms to do anything.?

Back to barter....

I'm pretty unhappy with some of the recent comments and decisions of the RBNZ and Mr Orr.
But -- I must reluctantly acknowledge the limitations they act under. Their mandate is simply too narrow -- and it also assumes too much. Parliament ties the RBNZ's hands in some ways (eg. not allowing them to use DTIs) while also expecting them to have a magician's power over the complex mess we call an economy. I think the time for central bank independence has come and gone.

Don't underestimate the power of making a scene in political circles. If Orr really wanted to change things, he could. How? He could demand change, stating all the issues that he must be cognisant of. The stick he holds is his own resignation and angrily worded statements that the government is forcing the RBNZ to act poorly in a way that is not fit for purpose. This can be accompanied by statements of what reform is required and why, what it will enable the RBNZ to do if enacted. Clearly he is not bold enough (or too comfortable in his position) to make a stand.

Again, Orr is the worst kind of civil servant. One that bumbles along, seemingly more entranced with the robes of authority rather than doing good public service. Being "constrained by the existing law" is no excuse, use your power to make a difference or get out of the way so someone better can make the hard calls.

Not sure that RBNZ's got a 'remit to manage the economy'. Regulate and moderate bank actions, yes, determine OCR, yes, but there's no such thing as 'an economy' as a discrete, manageable object. What we term 'the economy' is an epiphenomenon which emerges from the billions of transactions we humans have with each other. Broadly speaking, Gubmints and Reserve Banks can only set a very few of the parameters by which said transactions come into being: laws, commercial conventions and constraints, operations of a few major actors. Talking about 'managing an economy' is a bit like 'managing' weather........mitigating, adapting yes. Managing - no.

Waymad and Tim below, I'm not expecting the RBNZ to 'manage the economy' per se, but I do expect them to be cognisant of the consequences of their policies and actions, and to advise the Government, along with Treasury, on the potential consequences of policies they are proposing. And to do that with some degree of transparency. For Orr to openly admit that he is trying to prop up asset prices is to me, a shameless admission that the collective actions of the RBNZ, Treasury and the Government are fundamentally failing the ordinary people of this country. The only people who can change this are the Government, but so far apart from rhetoric I see little willingness to actually do so. This could be because they are ignoring the advice of their 'experts', or that advice is wrong, and that they are wilfully ignorant of history. But I would expect that at least some who have been elected to Government to have the courage of their convictions and to challenge the status quo, or has the level of corruption got so much that they've all just breathed a big sigh of relief and are now holding their hands out for what is in it for them?

Does the remit of the RBNZ need to change, I believe it does. It is too narrow, but then that is a big question too, because of the 'unintended consequences' issues.

Govt is not going to change anything, they are one of the bigger debtors and appointed Mr Orr.
OCR is meant to represent the risk in debt which Mr Orr clearly has instructions to ignore.
Does the current Govt benefit from low interest, yep.
Do banks massively benefit from NO risk low interest, yep.
Who does Mr Orr work for, yep govt and banks.

Gubmints and Reserve Banks can only set a very few of the parameters by which said transactions come into being

Have you ever seen The Truman Show? This is a brilliant film and a good metaphor for modern-day govt and life.

Murry you greatly overestimate the RBNZ's ability to control the economy by fiat. It has a few leavers, ropes and switches of which none have be tested in the current conditions and may have variable effectiveness or unexpected results.
What tools does the RBNZ have to create jobs? Lowering interest rates and maybe changing risk weights are not effective. If you cant pay the current borrowing rates you don't have a viable business. All they can do is for this maximum employment remit now is keep unprofitable business going hoping that the economy will recover. In my opinion this part of the remit is harmful as it ignore the long term and purely political.
The politically set remit is the problem they are not achieving it so they cut rates as that's the only real lever they have. If this does not work they are mandated to pull harder and ignore the economic problems.

I think it is also important to account accurately for the economic reality and realistic economic potential of New Zealand in order to be a position to meaningfully assess the action of the RBNZ.
I totally agree with your comment about employment. But, how can you employ Kiwis in a meaningful way in meaningfully paying jobs? What are your underlying economic models? a closed model (mercantilist, protectionist) or open economy (globalist)?

Globalization invariably plays to competitive advantages of players. Competition creates inequality, but it also enhances performance. The alternative is protectionism and intervention. That creates equality but sacrifices performance. Peaceful, desirable conditions often require protection, the gain from going further may not worth upsetting the boat. But if you believe you need to get stronger, you will need competition and competitive drive.

Where should we go in NZ? to our protectionist older days or continue our globalist's aspiration of recent decades? Chosing each path will have its serious negative side effects. but a choice you have to make nonetheless.

I vote twice previously to blue team, learning the inside inefficiency of public service bloated by red team, just to learn that to cover the plug hole of $ numbers, the blue team only have one answer for overseas money injection, at the massive housing inflation in short time. Then back this red team, I'm puzzled as how the leader uttering one factor just to address the current housing issue that is 'increase supply' it's clearly an attempt Not to acknowledge any other factors at play - basically, it won't happening, even if it does? at the flick of finger? RBNZ can furthering it's QEs/FLPs/double-triple digits of negative rates, if they wish to prop the RE market, for sure the cosmetic mandate of 'employment' by RBNZ+Govt will choose forever subsidy (money from thin air of 'imaginative/future production) - So, C'mon young healthcare/professional Kiwis, move out - this place is not worth it. - Across the ditch compare this: wages/salary, TD guarantee, willing to take RE corrections, your grocery bills, etc. and lastly? if you're Asians ethnicity descends? OZ recognize where they need to liaise with regional wise, NZ? despite Asians is the third largest ethnicity by census? - will always be discriminated by the current NZ systems, anywhere despite born & raised here. Training seats, placements & jobs. Bite the bullet, border already open there. Nice ads by OZ states going on tv right now, contribute to something that can give more meaning to your life/family endeavor.

As an inflation targeting central bank the situation has been similar for the RBNZ. The neutral Official Cash Rate (OCR) is the level at which the OCR is seen as neither stimulatory nor contractionary for the economy. As the RBNZ chart below shows, this has been steadily declining for some years now.

Which is highly correlated with rising house price values (see RBNZ Box A page 10 (16 of 60).pdf), but not substantial economic growth and sustained upward CPI inflation impulses.

Repeatedly cutting the OCR seeking to find a magic level which triggers these latter missing economic growth factors while acknowledging the collateral damage is relentless rising residential property prices is the road to financial madness.

We will have neither houses or jobs for the majority while banks are empowered to extend 60 % of their lending to one third of already wealthy households to speculate in the residential property market because the RBNZ offers them an RWA capital reduction incentive to do so.

Take a copy of your post and staple it to Mr Orr's forehead, please.
Everything that is wrong with the way 'we' are going about things and what needs to be done is in those few sentences.

Perfectly said, Audaxes.
If only Orr listened to this fact-based analysis, the NZ economy would be so much better off in the medium term.
But it aint'g going to happen.

The Federal Reserve is the current contender for taking the crown from the Japanese. Central bankers, in particular, are like hoarders; they never throw any policy idea away. It doesn’t matter how many times it fails, or how spectacularly. Japanese policymakers have stuck with QE for now double-digit attempts without anything to show for it.

There is now, apparently, a third entrant in the increasingly crowded field for insanity supremacy. Admitting failure is not something any global official entity appears capable, so, as you should expect, there had to be a Communist entry into the race. Link

Perhaps a consulting astrologist will propose better outcome than just gazing at the stars.

The good thing is that there is so much information available to everyone that when we are told that central banks look to the stars for policy guidance we don't need to believe them. Even in irony. Anyone paying attention knows that the Phillips curve is a dead duck. Even the Fed no longer believes in it. The primary function of monitary policy has been to make houses unaffordable and the owners of capital richer. Much richer. And they have done brilliantly.

Ps the ads on this site are now so obtrusive im unlikely to visit again