BNZ's Stephen Toplis argues the world has conspired to ensure RBNZ Governor Wheeler's inflation targeting failure & weak inflation's not sufficient reason for OCR cut

BNZ's Stephen Toplis argues the world has conspired to ensure RBNZ Governor Wheeler's inflation targeting failure & weak inflation's not sufficient reason for OCR cut

By Gareth Vaughan

How could a central bank governor get it all so wrong?

So asks BNZ's head of research Stephen Toplis in a report on inflation targeting and the Official Cash Rate.

 It may be considered sacrilegious to say this but ... in the current environment, inflation targeting is probably a waste of time," suggests Toplis. "The evidence shows that achieving an inflation target has been more than a little problematic and the prognosis for the way ahead looks no better."

He notes that annual headline Consumers Price Index (CPI) inflation fell below the mid-point of the Reserve Bank's 1% to 3% target band (on average over the medium term, with a focus on keeping future average inflation near the 2% target midpoint), in December 2011 and has been there ever since. BNZ's forecasts suggest it'll remain there at least until the September quarter of 2017. Currently annual CPI inflation is a mere 0.1%. 

"How could a central bank governor get it all so wrong? Consistently forecasting rising inflation, consistently failing to achieve it. The answer is: easy really. The world simply conspired to ensure the 'Governor’s failure.' In the first instance, the NZ dollar refused to roll over, putting downward pressure on import prices. And when the NZ dollar did finally submit, global commodity prices and global inflation, more generally, dropped precipitously alongside growing excess capacity internationally," says Toplis.

And recently struggling emerging markets and more oil price weakness have added to the process.

"To put the cumulative impact of these developments in some perspective, the price of imports in the September quarter 2015 was 18.6% below the peak of Q4 (December quarter) 2008. We reckon a further 6.0% fall has occurred over the last six months and that prices will remain subdued for the foreseeable future. Between late 2008 and September 2015 export prices also fell 12.8%, putting further downward pressure on the domestic price structure. It should thus be of little surprise that tradables prices have fallen steadily for the last four and a half years. Peak to trough that movement has been a drop of 5.5%. With tradables prices accounting for 46% of the total CPI, it’s no wonder that annual headline inflation has been so low," Toplis says.

"Most importantly, tradables inflation is largely beyond the control of the Reserve Bank. Sure, the Bank has a modicum of short term influence over the currency but the extent of this influence is probably overstated. Moreover, even if it was influential, the extent of commodity price movements would most likely swamp the currency impact anyway."

Against this backdrop Toplis argues the only way for the Reserve Bank to achieve its inflation target is to stimulate domestic demand to the extent non-tradables inflation increases to compensate.

"In large part, that’s what has happened with domestic demand running very aggressively. But even this has not created price pressure, except in the price of housing, which has little direct impact on the CPI anyway," Toplis says.

Pushing any harder, he suggests, would be potentially courting disaster with excess domestic demand meaning ongoing upward pressure on house prices, increased leverage in an already debt soaked household sector, increased demand for imports, a worsening current account balance, weakening external debt position, and "a heightened chance of a future sudden stop and significant economic volatility."

"Should the RBNZ be taking this risk in the blind pursuit of an inflation target? We think not," Toplis says.

We're not alone

Toplis goes on to point out the Reserve Bank of New Zealand is far from alone in its search for inflation.

"In all of the following countries annual headline inflation is below the mid-point of the RBNZ’s target band: United States, China, Japan, Britain, Canada, the entire Euro area (including Austria, Belgium, Germany, Greece, Italy, Netherlands and Spain), Czech Republic, Denmark, Poland, Sweden, Switzerland, Australia, Philippines, Singapore, South Korea, Taiwan, Thailand, and Israel. There will be more!"

"All these countries can’t depreciate their currencies at the same time, they can’t all keep easing monetary policy, and their combined weight in the global economy means fighting the disinflation tide is a futile effort," Toplis argues.

Fortunately, he suggests, the Reserve Bank has realised it's pushing the proverbial up hill and begun to focus more on core inflation than headline inflation.

"This is entirely appropriate in our view. And with core inflation currently sitting at 1.6%, the RBNZ is defending its current stance not to cut interest rates again," Toplis says.

"This approach does not, however, come without its own set of difficulties. In particular, the Reserve Bank uses its own sectoral factor model of inflation as its preferred core measure. For the vast majority of us, the calculation of this measure is way beyond our capability. And even if you could work it out there is no way it can be forecast. We don’t deny it’s a useful benchmark but it will be an uphill battle for the Reserve Bank to convince all and sundry of its appropriateness." 

Another question Toplis wants to address is providing more leeway to the downside of the target in the current environment of "globalisation, communications advancements, heightened price discovery and technological advancements."

In a bind so what's the catalyst for action?

Toplis concludes by suggesting the "real bind" the Reserve Bank is facing at the moment is that the benefits from implementing any policy should outweigh the negatives.

He noted that in his speech last week Wheeler highlighted that the Policy Targets Agreement contains 'a requirement that the Bank monitor asset prices, have regard to the efficiency of the financial system and seek to avoid unnecessary instability in output, interest rates and the exchange rate.'

The Reserve Bank, Toplis notes, is taking this to heart.

"And, for all intents and purposes, has made the decision that, while inflation outcomes and forecasts, at least at face value, demand further easing, the costs of doing so are just too great and the chances of success  - getting inflation higher - are simply too low." 

"With this in mind, for the time being, we think that forecasters need, also, to take a slightly different approach in predicting prospective RBNZ actions. Weak inflation readings should be seen as a necessary, but not sufficient, condition for easing monetary policy," Toplis says.

"The catalyst for action will be when either (a) inflation expectations fall precipitously such that the chance of entrenched deflation becomes real or (b) real economy conditions deteriorate in such a way that the RBNZ believes lower interest rates might help avoid a period of sub-trend growth. In our opinion the latter poses more of a risk than the former."

"With all this in mind, we will stick to our view that the cash rate is on hold (at 2.50%) for the foreseeable future. If we end up further lowering, our already low, headline inflation forecasts it is unlikely that we will change our RBNZ view. However, if international events look set to undermine the economy or the negative flow on effects from the dairy sector’s current demise significantly threaten New Zealand’s growth path, we will be happy to revise our call accordingly. While not our central scenario this is a tangible risk," says Toplis.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

We welcome your comments below. If you are not already registered, please register to comment.

Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current comment policy is here.


Comment Filter

Highlight new comments in the last hr(s).

The problem is that the governor keeps citing inflation as the reason he is not lowering the OCR. It makes him look pretty stupid when the inflation doesn't occur. If we didn't get inflation from the ChCh rebuild or high dairy prices, what makes him think we will get it now?
If he cited high house prices as the reason, or keeping a buffer in case of future economic events as the reason, he might not look so silly.

Keeping our currency and interest rates artificially high by world standards just in case there might be some small amount of inflation in the distant future seems a bit daft.

Its only to try and keep auckland and borrowing subdued to a certain degree(not working)and he knows its inevitable he will have to lower but he is trying to pretend he has more wriggle room than the other zero RB's. He also knows that just a few more drops may well encourage a mass depositor withdrawal.
This really demonstrates who they really cater for now and in the future. The whole things just playing semantic games to keep any optimists happy. The RB's golden rule is to save the banks no matter what may come

Finally even the banks are admitting the Emperor has no clothes. Inflation targeting worked when there was inflation to target but it has resulted in massive debt levels. Who would have thought that reducing interest rates would lead people to borrow more?

Time for Mr English to actually do something. Reducing income taxes (including corporation tax) and introducing a bank levy sounds like a good idea to me. A 1% per annum levy on their total loan book of $404,356,000,000 would provide a useful $4,043,560,000 towards tax cuts elsewhere. Where's the harm?

The banks would shit bricks as they are unlikely to have the margin to support it. Although now is the perfect time to implement something like that, given there is such a huge amount of debt.

RBNZ have made it clear that they are trying to just keep us out of deflation so maintain the highest OCR possible. OCR is a worthless tool at this point, and now some estimates show inflation not returning to the US for up to 30 years. Other tools and restrictions are required to do the job because OCR adjustments won't be fully effective for many years.

would love to see this here JK this idea is a winner tax cuts for us
Longstanding tax breaks for investment properties are in the frame as the Turnbull government scrambles for alternative revenue sources to fund vote-winning income tax cuts in the next election.

Not tax reductions, they perform poorly, are not focused and give a less than 1 to 1 return especially if teh excess money is pumped into housing. Govn spending on the other hand to build schools might give a return as high as 1.6 to 1. ie for every $1 spend we see a $1.60 return.

The idea is to counter the tendency for income to go into wealth transfer projects like house trading by transferring some of that income back to the general population, rather than leaving it untaxed as at present. It's a vote winner.

We dont need vote winners, we need economy fixers.

The BNZ certainly thinks that the Emperor is still decked out in all his finery ! !
But then the BNZ has to tow the party line. Why? Because you will see on the RBNZ website that the BNZ is the bank that supplies the RBNZ with its raw bank data.

Ever since the 1980s there has been general accepatance that central banks should not attempt to meet two objectives with one instrument (in this case inflation and Auckland house lending with just interest rates - u cant win in that game). The Governor is forgetting another fundamental lesson which is that it is very unwise to unleash deflation (refer the Great Depression). Nearly all other central banks are on to it. For instance I found myself agreeing with nearly all Draghi had to say the other day.

The single instrument, two targets conundrum is definitely a truism of the vast majority of economic problems. I doubt the Governor fails to understand this or the danger of a deflationary spiral. If you are suggesting that he is you are basically saying he is no better equipped than a 1st year economics student.

I agree our financial system may have expended the useful life of inflation targeting, but what we lack is both the evidence and the development of balanced mandates to replace the incumbent system. We have ideas, but no real adequate basis for an overhaul. Everything we know such as nominal, exchange rate and money supply targeting is equally flawed. I dare say there would be a lot of funding available for a PhD in monetary economics at the moment.

The RBNZ are currently in the position where they are forced to make the best of a s**t position plagued by negative tradeable inflation and a dangerous housing market. You can't blame them for being risk averse and cautious in this situation. I think most underestimate the very real danger that is the Auckland housing market from a central bank's perspective.

The Governors actions and comments clearly indicate that he is clearly trying to control Auckland house prices and inflation with interest rates which must mean he has forgotten as you suggest basic economics.

From a prudential risk perspective clearly the Governor has concerns and he is doing the correct thing by target the lending risks by banks (debt/equity ratios etc). However, he is still seeing interest rates as a prudential management instrument (it can't do both monetary policy and prudential policy service).He has reached a position where both monetary policy and bank risk issues are becoming big policy issues.

Wrong. The RBNZ is not trying to control housing and inflation with the one target. They are in fact targeting inflation with the overnight rate. However the undesirable trade-off in this case is the stimulation of the housing market through cheaper debt financing.
This fact instigates the caution.
The specific tool for controlling the housing market (in the current situation) is the LVR and to a lesser extent, the CFR.

Agreed, these two factors are becoming mutually exclusive in the current environment. This hasn't always been the case since adoption of inflation targeting. The fact of the matter is that it is just as dangerous to jump on the bandwagon and purport fundamental change with inadequate evidence.
The same fundamental predicament has been endemic throughout all 20th century economics. Essentially, if we think retrospectively, we have been undertaking one big ponzi scheme for the last 100 years as monetary economics has developed.

"buffer" well there would be 2 options,

a) have too high an interest rate and cripple our economy so when a shock does occur it will be too weak to respond much.

or heaven forbid,

b) get the economy working well so its healthy and rides over events.

Seems our Governor is choosing a) for no declarable reason I can see.

"seems a bit daft."

Exactly, he and no one else has actually explained just why he has to do this. So with no adequate reason my conclusion is he is incompetent and needs to be replaced ASAP before he wrecks NZ's economy further..

When you say "get the economy working well", what do you actually mean? Real GDP growth is actually very sound at the moment.

If you just want him to increase inflation to buff nominal GDP growth, what does that actually achieve? Changing nominal variables "strengthens" nothing. If all prices and wages were to double, noone is any better off.

Fact is, the economy is chugging along OK and we have zero inflation. In days past this would be a casue for celebration, instead we have a procession of whingers.

tradeables inflation is what?

The fact is CPI is no where, if it wasnt for the housing madness we'd have no economy. Farming looks extremely sick...and you think we are chugging along OK?

Toppy has nailed it in this case (finally!).

Refer housing bubbble of the 2000s in the US. Interest rates left too low for too long, igniting a housing bubble - the rest is history. Some would say that we are seeing echoes of that here already.

Those who blithely spout about the horrors of deflation need to distinguish between CPI deflation and asset price deflation. In the case of the US, fear of CPI deflation led to a bubble, and massive asset price deflation down the road. The latter turned out to be far worse than the former.

Steady state CPI, or outright deflation, is actually the natural state of capitalism - progress and efficiency making things cheaper, either explicitly, or implicitly by quality improvements.

What it comes down to is that the damage caused by too-high interest rates is easily visible, but the damage created by too-low interest rates is invisible and insidious - until it's too late.

I totally do not agree with you here. Deflation in CPI can and often does mean stress in the tradeables sector and companies contract and can close and jobs are lost. While yes there is a % effect from getting more from technology it is I suspect over-stated. For instance getting raw materials say copper is getting harder and costs more as the mineral ore is mined out, thus costs rise. The problem is then determining "healthy" deflation v damaging deflation, for that we need to look beyond the CPI.

Low interest rates do not directly cause damage, a low interest rate is the symptom of a damaged and weakening economy and not the cause. Just consider that every country that tried to put up the OCR since 2009 and seen their recovering economy reverse and decline. So if nothing else you should be looking at the proof that raising rates is bad.

You are right that low interest rates are a symptom, but i think they're more a symptom of a previous policy error, "taking the easy way out" and postponing the day of reckoning.

Too-low interest rates keep zombie firms in business, contributing to overcapacity that ironically suppresses inflation in turn which leads to a vicious cycle. See what overcapacity has done in the oil market, and i'd argue that is in large part due to free money.

It also forces people into riskier asset classes to make an acceptable return on investment, leading to asset bubbles and creating instability in the financial system.

Again I do not mostly do not agree (except maybe the last paragraph). The problem is the model you put forward explaining how an economy works may not and indeed probably does not match the real world, it is I suspect too simple.

Low interest rates however keep all companies in business, there is no determination I can see on what is good or badly run company? If correct then a well run company should survive a bit better than a bad one as long as the burden isnt so large it overwhelms both. Lowering a rate then may help the good ones survive while still culling the bad ones. Also what is a badly run company? one that is simply not terribly optimised? Optimisation (efficiency) often is opposite to resiliency. So how are you determining what is a zombie and what isnt?

"It also forces people into riskier asset classes to make an acceptable return on investment, leading to asset bubbles and creating instability in the financial system." Why are you forced to make a bad decision? So there isnt a direct link here for me. I suppose its a Q of chicken and egg, did the low returns from business due to the downturn cause the "investors" to go and gamble elsewhere or was it low rates? For me its the former, low rates followed. Next, is there a feedback? I have yet to be convinced there is a significant one myself. As an example do professional investors care about the OCR and deposits? no the returns are just too low for them, they want 20%+ not 5~7%. if however there is no 20% they will look for the next best thing to gamble on. Hence a fixation on a "too low" OCR is simply not justified IMHO.

No, interest rates were made lower to support a weakening economy. Speculators then having no where profitable to invest, as the economy was weakening and contracting gambled in housing and indeed lots of other assets.

Including overproducing business assets that face competitors equally financed by cheap debt for equity deals under pressure from their bankers to deliver.

Only maybe only over-producing because demand is still dead in the water. The other thing is helping to keep businesses going until the economy picks up. Sadly JK etc cant see that Govn spending is probably the only way to get us going again.

JK cannot demand WMP sales to Chinese excluded from TPPA.

Do posters have any opinions on which are the most stable banks in NZ? I am worried about a banking collapse and an "open bank resolution (OBR)". Incidentally, and weirdly, when I googled "obr", all the reserve bank links are gone?? I am probably just paranoid!

"404 - File or directory not found.
The resource you are looking for might have been removed, had its name changed, or is temporarily unavailable." is the message when I click on the RBNZ links

move it to an aussie bank you have deposit insurance

but as a non-aussie are you actually covered? As a pollie and if faced with dishing out losses I'd land them fully on people who could not vote me out, foreigners.

....way to complex..not gonna happen..the idea is to create certainty/faith in their banking. The interesting thing wil be when NZ joe public suddenly realise they are naked...and look to deposit in Aussie. Whats Billy to do then?

and if OZ folds they stand to lose everything? sounds great plan that.

..its called spreading the risk...

or guaranteeing you take a loss.

Australian financial institutions (which are deposit protected, more than 100 Authorized Deposit-Taking Institutions - ADIs) cover the following sorts of deposits - up to $250,000 per person per ADI...

savings accounts;
call accounts;
term deposits;
current accounts;
cheque accounts;
debit card accounts;
transactions accounts;
personal basic accounts;
cash management accounts;
farm management deposits;
pensioner deeming accounts;
mortgage offset accounts, either 100 per cent or partial offset, that are separate deposit accounts;
trustee accounts;
retirement savings accounts; and
first home saver accounts.

The RBNZ support for NZ banking deposit protection from many of the same banks is listed below..

The RBNZ updated a lot of their website over the long weekend, which broke a lot of pre-existing external links.

All the OBR stuff is still there (, however, you just have to search from the RBNZ home page until Google updates its results to the new URLs. can you please put the correct flag on your page, until at least the people have voted...

Why? It's a private website and the owners can display any logo or emblem they please.

Huge deflation in airfares to the US. Someone get on the blower to Air New Zealand and tell them to put their fares back up.

Dropping interest rates in NZ will in no way stop global deflation. Dare I say it, I think we should move away from globalisation because it gives away control of our economy. We can't control the Auckland property market from getting overheated if we don't stop immigrants and foreign buyers. Lower rates here won't save the dairy farmers, as it won't increase demand in China or restrict supply in Europe. What is the reserve banks role?
I don't like it, because it is only going to encourage more debt driven asset bubbles and take money out of the pockets of savers. Both of these things only contribute to deflation. So what's the plan? I don't get it. Why is the RB doing this and how will it help anything? Our economy was in better shape than the rest of the world, so we embrace globalisation? To join the disaster? There are signs of dissent in the world with the rise of Trump and a possible Brexit, and we want to join the mess the rest of the world is trying to escape?

Your access to our unique content is free - always has been. But ad revenues are diving so we need your direct support.

Become a supporter

Thanks, I'm already a supporter.