The current policy of the Reserve Bank is very clear. It is to reduce interest rates. The underlying theory, or perhaps ‘notion’ is a better term, is that low interest rates will stimulate the economy, either directly by stimulating investment, or indirectly by stimulating inflation.
To the extent that there is evidence to support this notion about low interest rates, that evidence is opaque and even then comes from times very different to the current situation.
It started with the Phillips Curve
There was a stream of economic work, starting with the Philips Curve of the late 1950s, that showed that unemployment rates were inversely related to inflation, at least in the short term. The empirical data was clear but that evidence was atheoretical. It did not prove what was cause and what was effect.
Subsequently, Milton Friedman, Robert Solow and others developed a theoretical framework that purported to show that in the long-term inflation was ineffective in raising employment. It was Friedman who invented the term ‘stagflation’. Subsequent events did seem to prove, at least on this point, that Friedman was correct. Of course, Friedman remains controversial in relation to some of his other work and perspectives.
Despite the lack of evidence that modest inflation is good, the notion remains embedded within monetary policy both in New Zealand and overseas. All of the Central Banks in the Western World beat to the same drum despite the lack of evidence. In New Zealand, the Reserve Bank is supposed to try and keep inflation between 1% and 3% and aiming generally for a mid-point of 2%.
New Zealand was the first country in the world to explicitly target inflation through its Central Bank. That was in 1998. At the time it was widely perceived as a tool to keep inflation down. The notion that inflation could be too low as well as too high seemed of little relevance back then.
More recently, the Reserve Bank has also been required to keep in mind the need to minimise unemployment. That in effect also reinforces the conventional wisdom from more than 50 years ago that low interest rates combined with some inflation were important for economic growth.
For many years the main weapon of the Reserve Bank was the official cash rate (OCR), this being the rate that the Reserve Bank pays on money that the broader banking system holds at the Reserve Bank. In theory this OCR only has a direct impact on very short-term rates but it also has a strong messaging element, as well as an indirect influence through into the longer-term yield curve.
I recall a seminar I attended about ten years ago, perhaps a little more, where a very senior official of the Reserve Bank acknowledged, under Chatham House Rules, that the OCR could only be effective within very constrained limits determined by where the broader market wanted to go. He acknowledged that the OCR would lose credibility as a tool if it travelled too far away from the views of the broader market.
During these last ten years there has been increasing use internationally of the so-called unorthodox policy instrument called ‘quantitative easing’. In essence it is a policy implemented by Central Banks to put more money into the economy through money creation. It is intended to lower interest rates, bring about modest inflation, and stimulate investment.
Although the term ‘quantitative easing’ only came into the lexicon within the last thirty years, the concept has been around for a very long time. Various South American presidents were well versed in it by the 1970s and President Mugabe of Zimbabwe also saw it as the honey pot policy. During the inflationary times of the 1970s and 1980s, the New Zealand Government was also adept at increasing the supply of money, although without the exuberance that some others showed.
In those pre-digital times, it was all done via the printing presses. Now all it requires is entries in electronic ledgers.
In times of crisis such as the present, there is clearly a role for some level of quantitative easing. It helps the Government deal with a huge deficit, where its expenditure is much greater than the taxes that are coming in. But the question has to be around the balance.
Right now, there can be little doubt that quantitative easing is contributing to declining interest rates. The policy is very effective in that regard because it is helping to create a flood of capital looking for a home. It is all about supply and demand.
These exceptionally low interest rates have to be good news for mortgage holders who are paying less interest. Unfortunately, it is not so good for those who are funding those mortgages by their fixed deposits at the banks. Nor is it good news for those who are still trying to get on the property ladder. Some would say it is contributing to the financial craziness of the world we find ourselves in.
Central Banks seem particularly slow to recognise that once interest rates get close to zero people do not actually save less. Rather, excessively low interest on savings leads people into a state of concern that they need to save more as the rainy day threatens to turn into a destructive storm.
I hope that the Reserve Bank has a research programme to better understand these human behaviours. They certainly won’t learn anything from their econometric models that reflect a time when things were very different to now. The possible exception would be to reflect more deeply on the experience of Japan in the last three decades since its economic bubble burst.
I know that in my family, and many of the people I talk to, we are now looking more closely at expenditure. This is linked to the ongoing decline in interest on fixed deposits. If everyone in New Zealand does that then the economy is going to tank and unemployment will rise more than otherwise.
Conversely, I know of no-one who is encouraged by the low interest rates to undertake more investment. The entrepreneurs that I know are saying predominantly that this is a time to sit tight. In any case, the banks are not interested in anything that has an element of risk.
Tradables versus non-tradables
Headline inflation is currently very low but that is only because of so-called ‘tradables’. These are the items that are tradable across international borders, and for which there is a corresponding ‘world price’ mediated only by trading barriers including logistical costs.
Right now, with the New Zealand dollar strengthening in recent months, linked at least in part to the enviable situation that New Zealand is in with respect to COVID compared to most of the world, the inflation rate in tradables is indeed negligible. However, with all of the world engaging in quantitative easing that is unlikely to remain the situation. Also, independent of any quantitative easing, international oil prices are not going to stay this low in the long-term.
Scratch below the surface of the headline data for inflation and it is readily apparent that there is significant inflation for non-tradables under way, currently at slightly above 3% over the last year. These are the items such as rates and many of the services supplied ‘by New Zealanders to New Zealanders’. These non-tradables are already suffering from stagflation.
Financing Government deficits
In arguing for the brakes to be put on quantitative easing, that is not necessarily to say that the Government needs to slow down on its own expenditure, be that on infrastructure or essential needs in social welfare. That is a separate issue. My focus here is not on the expenditure itself but how should the appropriate expenditure be financed.
When Governments run deficits, with expenditure exceeding taxation income, then somehow those deficits have to be financed. The standard way that Treasury does this is by issuing of bonds which are purchased by the financial institutions using their reserves.
As long as the Reserve Bank does not intervene through itself purchasing these bonds, then the bonds will stay in the market and interest rates on retail savings by citizens will rise. That may well be the necessary precursor to the building of some consumer confidence among savers that they can think about spending again. A return on fixed deposits of say 3% per annum might well be enough to change attitudes, as long as inflation is low.
In contrast, what is happening right now is that the Reserve Bank is sucking these bonds out of the market. The Reserve Bank funds this with digital money that it creates.
In the magic financial world of bank ledgers, everything balances with countervailing entries, but let there be no doubt that the first and key stage of money creation has occurred.
From the perspective of the commercial financial institutions, two things have happened. First, they have purchased bonds from the Treasury using their own bank reserves. Second, these bonds have then been transferred via the secondary market to the Reserve Bank, collecting an intermediation fee along the way. The reserves that the commercial institutions initially used to purchase the bonds from the Treasury have now come back into their institution accounts at the Reserve Bank.
From the perspective of the Treasury, they now have the funds to run the Government, balanced by a liability to the Reserve Bank which holds the bonds. So, in terms of where the created money has ended up, it is now with the Treasury.
If we think of the combined entities of the Treasury and the Reserve Bank, which we will call ‘the State’ then the payments of interest on the Treasury bonds by the Treasury to the Reserve Bank are internal transfers. Overall, it costs the State nothing.
Of course, this apparent magic can never be the full story. The key issue is whether the newly created money has really been used by the Government to turn unemployed resources into productive resources. Otherwise we have more money chasing the same amount of goods and that is the definition of stagflation. And that means that everyone in the economy, except perhaps those who are firmly aboard the pumped-up leveraged property market, is bearing the cost.
The question therefore in the current situation, is not whether or not the concept of quantitative easing is right or wrong, but how much quantitative easing is appropriate and how much of the Government deficit should be left in the market to be funded by private savings. The related question is how large a deficit should the Government be running in an effort to reduce unemployed resources. And that raises the questions as to the specific projects that will indeed use unemployed resources rather than fighting for resources that are already being used in the private economy.
Earlier in this article I said that quantitative easing by the Reserve Bank represents the first stage of money creation, leading to the Treasury being funded by money which has thereby been created. But of course, this too is not quite the full story. What happens if the trading banks get nervous about lending and allow their own reserves at the Reserve Bank to build up? This is important because it is exactly what is happening right now, driven by money pouring in from citizen savers.
The consequence is that there is a lack of credit to potential borrowers, driven not by a lack of liquidity but by perceived risk. Also, banks attempt to minimise their lending risk by maximising their interest rate margins. The consequence is that in the short term at least the reduced economic activity will hold any inflation at bay.
However, this constraint on inflation is only temporary, lasting for as long as the recessionary forces are dominant. Once COVID is eventually overcome, then the inflationary forces will truly be unleashed as banks once again use their augmented reserves to create credit which multiplies its ways through the system.
Getting the balance right
So, the question comes back to how much quantitative easing should the Reserve Bank indulge in.
My current perspective is that they are indulging in too much and that this is leading to more saving and less spending by those who rely on fixed deposits for their income. Also, despite the increased savings behaviours, there is no appetite in the commercial sector for genuine investment. All we seem to be seeing, pumped by quantitative easing combined with an exceptionally low OCR, is a flight to the ponzi-style share market and the long-term safe haven of property.
In all of the above I have largely looked at New Zealand as if we New Zealanders are in control of our own future, either directly through our private decisions or by decisions made by Government on our behalf. One key simplification is that I have thereby ignored that New Zealand has an open financial system with funds sloshing in an out as the global financial wizards from afar try to maximise benefits for themselves.
If New Zealand is to take control of its own future, then there has to be a regulatory mechanism such that the majority of Treasury bonds must be held by New Zealand entities. That is entirely feasible, and it would be one step towards bringing our foreign exchange rates under the influence of trade flows rather than dominated by the whims of overseas financial derivative traders.
Given all of the above, I think I can see another article forthcoming that looks at the role of international capital in dominating our economy, including whether New Zealand needs to direct more of its own savings to productive investments. The logic of allowing foreign entities to buy-out our elderly-care facilities might be a good place to start. How does that build New Zealand? That has to wait for another article.
*Keith Woodford was Professor of Farm Management and Agribusiness at Lincoln University for 15 years through to 2015. He is now Principal Consultant at AgriFood Systems Ltd. He can be contacted at firstname.lastname@example.org