By Keith Woodford
There are two key institutions that drive New Zealand’s economic policies. First, there is the elected Government which, through the Minister of Finance and with Parliament’s approval, controls fiscal policy. Second, there is the Reserve Bank which controls monetary policy, largely independent of the elected Government.
Fiscal policy is widely debated, both inside and outside Parliament. It is all about how much the Government should spend and on what items, and from where should the Government obtain the necessary money. If taxes are insufficient, then the balance has to come from borrowings such as Treasury bonds that are sold into the market.
In contrast, monetary policy is discussed and debated a lot less. Instead, the Reserve Bank simply tells citizens the policy measures it intends to apply. The major tools include:
- the Official Cash Rate (OCR),
- maximum loan to value ratio (LVR) restrictions on bank loans to investors
- reserve ratios that the trading banks themselves must hold
- quantitative easing (electronic money printing) which soaks up Treasury and other bonds out of the market, and
- direct lending to banks by the Reserve Bank of newly created money for the purpose of on-lending, called ‘Funding for Lending Programme’ (FLP)
These monetary concepts lie firmly within the discipline of macro-economics, but they lie well outside the thinking of most citizens. Yet it is these concepts that help determine many of the basics of daily life, including the cost of housing, the cost of everything else, interest rates, inflation and the availability of jobs.
It might seem remarkable that there was close to zero comment on monetary policy by any of the political parties during the recent 2020 election campaign. When asked, the major parties demurred from comment, saying this was the territory of the so-called independent Reserve Bank.
If there is an exception to the statement that monetary policy lies outside mainstream citizen thinking, then surely it has to be at Interest.co.nz. It appears to be the one media platform where widespread commentary on monetary policy is currently to be found. The leading citizen blog on monetary policy, but from a very specific perspective, is Croaking Cassandra from former Reserve Bank staffer and critic Michael Reddell.
Within the last three decades, it has become both the rhetoric and the reality in most Western nations that Governments do not get directly involved in monetary policy. Instead, in each country there is a separate entity of the State which has Central Bank functions and which is run by officials. In New Zealand, this Central Bank entity is the Reserve Bank.
This creates the remarkable situation in most Western nations, including New Zealand, that it is officials who are not only determining economic policy, but also societal outcomes. It is New Zealand officials who are setting the policies that currently are making New Zealand property investors richer, that are making savers poorer, and which make debt leverage the biggest game in town.
The role of monetary policy
The original notion with monetary policy was that its purpose was to dampen the effects of economic cycles on the overall upward projection of the economy. It was there to lessen the effects of recessions and it was also there to prevent excessive exuberance.
The logic of keeping monetary policy away from the politicians and in the hands of the Reserve Bank has always been that monetary policy is technical. History provides multiple examples of how politicians cannot be trusted with the tools of money creation.
Mr Mugabe could never have run amok with the Zimbabwe economy without control of monetary policy and the associated power to create money. But there were many predecessors whose path Mr Mugabe was following.
Back in 1974, I was in Argentina when the Argentinian peso was dropping in value every day for exactly the same reason – too much money was being printed. As a consequence, as foreigners we would never change more US dollars into pesos than we needed for just a few days. With inflation at about one percent per day, prices were doubling every ten weeks, and increasing more than 30-fold over a period of a year. That is what daily inflation of one percent does!
Back in the 1920s, there was hyperinflation in Germany from massive money printing, leading to trillion-fold inflation over a period of just a few years. This set the preconditions for the German extremism of the 1930s, which in turn led to the Second World War.
The problem right now is that, both in New Zealand and across the Western World, monetary policy is being determined by technocrats in an environment that lies well outside traditional economic cycles. This means that the technocratic economic predictions are based on empirical models structured on behaviours from another time. Those models cannot even approximate current reality if the historical behavioural underpinnings and the historical global settings no longer apply.
Central Bank economists are trained in econometrics, which is the quantitative arm of economics. These economists are strong on statistics and economic modelling. Every econometrician is taught not to extrapolate beyond the limits of the data. However, in the current world, econometricians are left with no tools if they follow that rule.
I am told that the Reserve Bank has no behavioural specialists with expertise in psychology and sociology. If this is correct, then it is hardly surprising that the Reserve Bank has been caught out by what is happening to house prices right now.
It is pretty simple really. With interest rates on fixed deposits dropping down to levels not seen since Babylonian times, and with share prices looking inflated and highly risky, many savers perceive they have no alternative to property investment. Unfortunately, Reserve Bank models are currently only able to view this through the rear-vision mirror.
The world has changed
Independent of short-term economic cycles, the so-called developed world has been struggling for at least the last two decades to maintain economic growth rates that were achieved throughout the second half of the previous century. If it were not for the massive growth rates achieved by China, and to a lesser extent India and some other developing countries, then world growth would have been particularly anaemic throughout this period.
Here in New Zealand, and despite being a relatively developed country combined with low growth in productivity, we have benefitted greatly from being in the slipstream of Chinese growth. China wanted the primary-industry products that New Zealand was producing – dairy, meat, timber and kiwifruit – and we sailed along nicely.
The advent of COVID-19, coming on top of the declining economic growth that was already occurring, is a mega disruption unlike anything experienced since the Second World War. It is an environment in which the standard tools of monetary policy no longer work in the way past history might suggest they should work.
Inflation and the Reserve Bank mandate
Although the Reserve Bank operates independently of the elected Government, it does operate within a mandate set by that Government. Every few years, that mandate gets tweaked. Right now, the mandate says that the Reserve Bank has to try to keep inflation between one percent and three percent per annum, and aiming for the mid-point, but also has to try to maintain maximum sustainable employment.
When inflation targeting was first brought in some three decades ago, the target was zero to two percent, and the focus was totally on lowering inflation. The thought that inflation could be too low was not on the radar.
Right now, the notion is firmly embedded within Reserve Bank thinking that deflation is a greater economic threat than inflation. The Reserve Bank Governor has made that explicit on multiple occasions.
The theory seems to be that if prices turn negative then citizens will actually buy less rather than more, because a delayed purchase will be cheaper. However, the evidence for that is very limited.
A good example is petrol for which the price has declined in recent times. Is there any evidence that people have bought less petrol because it has been cheaper? Or have petrol-buying decisions between driven by other factors such as lockdowns and loss of jobs? If anything, low petrol prices have helped people buy more petrol.
There is also an important distinction between inflation of tradables versus non-tradables. Tradables are items such as oil, machinery and foods that can be are traded internationally. Non-tradables are items that do not trade across international borders. Local body rates, taxi fares, house rentals and restaurant meals are all non-tradables.
Right now, the low inflation that New Zealand is experiencing is driven by the tradable sector, with oil having a particular effect. But that won’t be long term. If and when the world economy stabilises post-COVID, then oil prices will undoubtedly experience major increases.
There is a further irony in that non-tradable inflation has been approximating three percent in New Zealand in recent times. Any effects of Reserve Bank stimulus will be on these non-tradables which hardly seem in need of stimulus.
As for fixed-asset inflation, which lies outside the consumer price index (CPI) on which the Reserve bank relies to judge its performance, there can be no doubt as to what is happening. Housing prices in particular are travelling on a rocket ship.
Recently, I was an attendee at a seminar for valuation professionals (urban, rural and commercial) where I was one of the speakers on the economic environment. One piece of advice from within the valuation industry was that for any housing sales more than two weeks old, the prices are already out of date as a measure of current value. The most cogent market advice of relevance for vendors was that the only way to know the current value, where supply and demand might intersect, is to put a property to market via auction or tender and see what happens.
Further inflation is coming
The mantra from both the Reserve Bank and economists from within the banking sector is that right now there are minimal signs of inflation. What is not being publicly acknowledged is that considerably higher inflation must surely be close to inevitable somewhere down the track.
The key reason that inflation will rise is that the Reserve Bank has a suite of policies in place that are creating money. These policies are successful in lowering interest rates to such an extent that deposit holders feel forced to become property investors. How else can they protect their savings?
The theory says, with that theory developed in another time, that low interest rates should stimulate investment in the economy. Yeah, right! It is starting to sound like a Tui billboard.
The alternative perspective is that with interest rates so low and going lower, these policies are having no effect on new investment in productive assets that create new jobs. At the big end of town, this is seen as a time to trim the sails, convert bank debt to long-term bonds wherever possible, and then sit tight.
The Reserve Bank, looking in its rear mirror, now acknowledges that its removal of LVR restrictions last May may be starting to create some issues. However, if the Reserve Bank understood more about the real world rather than being a prisoner of its models, then they would have realised from the outset that their suite of policies was a recipe for asset inflation.
The key problem with housing inflation that is driven by excessively low interest rates is that excessively low interest rates are highly unlikely to last for ever. And how will those people who are currently in their teens and early twenties ever be able to climb in future on to the property ladder unless they have parents who can hoist them up? Unless, of course, the bubble bursts and the current first-home buyers, and perhaps some investors, fall off the ladder.
Regardless of which way it goes, the inequality issue is mind numbing. There is no pain-free way of reversing excessive asset inflation. But essentially, the Reserve Bank is saying that to the extent this is an issue, then it is something for the future, whereas their focus is on the present.
It takes time for inflation to build up steam
The massive program of quantitative easing (QE) being undertaken by the Reserve Bank has greatly lowered interest rates, with further reduction in interest rates being almost certain. These effects will be driven by the existing policy of QE and the foreshadowed policy of Funding for Lending (FLP). However, the immediate effects on inflation as measured by the CPI are muted. In times like this, it takes considerable time for money creation and hence inflation to build up a head of steam.
A key reason for this right now is that the velocity of money circulation has declined. Citizens have responded to the current situation by saving more rather than less because of caution about the future. This means that there is lots of citizen-owned money sitting in the trading banks. These trading banks in turn have lots of reserves sitting at the Reserve Bank. The Reserve Bank, with its models constructed from a different world, and its rear-vision mirrors spattered with mud, apparently did not see this coming.
How is money created?
There is considerable confusion within society as to how money is created, with this money creation eventually leading to inflation.
It starts with the Government giving a mandate to the Reserve Bank, with this setting up the preconditions. Next comes the actions of the Reserve Bank via quantitative easing together with a whole range of tools that affect the amount of reserves the banks are required to hold in support of their lending.
Then come the actions of the trading banks that create credit according to the rules of the game set by the Reserve Bank. Linked into that are the wishes of consumers and savers in terms of their desire to spend or save. These consumer wishes don’t directly create money, but they do influence the velocity of money and how it circulates within the economy.
In summary, money is created as a consequence of credit creation by the banks, but this can only occur according to the rules of the game as laid out by the Reserve Bank, underpinned by the Reserve Bank mandate from the Government, and also influenced by citizen behaviours.
A spring has been loaded
Currently, everything is in place for high inflation except that consumers, savers and real investors (with real investors being the people who make new investments and don’t simply purchase existing assets) are not doing what the Reserve Bank wants them to do. And so, the Reserve Bank continues to pump the balloon, working on the philosophy that the pump always worked in the past.
Eventually, with only the timing being unknown, the residents of New Zealand will decide that it is time to change their behaviours. So first, let’s be clear as to what are these current behaviours. Very simply, it is to invest in the property market. It is the dominant game in town.
The only other game is the share market, but to many that seems riskier than property. Also, there are more restrictions on borrowing for shares than borrowing for property.
One possible change in behaviours would be through further reinforcement of the notion that property is the only game in town. This is on the cards as consumers take a while to respond to historical actions of the Reserve Bank. Those behaviours could go on for quite some time, until the Reserve Bank comes to its senses.
Unfortunately, property price bubbles do not deflate without a lot of pain to someone. It’s much kinder to stop the bubble inflation at the outset.
Another alternative is that consumers eventually decide to save less and go on a spending binge. At that point nothing can stop consumer inflation except quantitative tightening. That will bring its own mayhem, most likely stagflation.
The other alternative is that key behavioural changes flow in from overseas. Assuming that Europe and the US eventually recover from the COVID mayhem, then oil prices are going to increase greatly. That inflation will be imported into New Zealand and it will inevitably flow through into considerable internal cost inflation. In turn, that will create demand for wage increases that will be very hard to manage. In all likelihood, those demands will not be managed.
The big end of town can see all of these scenarios. It is precisely why, right now, the focus is on trimming of the sails and avoiding any long-term investment apart from property.
Asset inflation does not soak up the increase in money supply
It is remarkable how often I hear that inflation of fixed assets soaks up money. It does not. The money is still all there circulating around and around. This is why bubbles can keep on going for a long time until herd psychology finally cries ‘enough’.
When one person buys shares that already exist in the share market then someone else has to sell. The money transfers from Person A to Person B, who then has to find a new home for the money by buying another asset - either shares or property – from Person C.
Once inflation takes off, then no-one wants to be left holding the hot potato of dollars that will buy less assets tomorrow than they can buy today. And so, the velocity of money circulation increases, and the after-burners on the inflation-rocket burners fire up.
Getting out of the muddle
It all comes back to the Government and the Reserve Bank mandate. The Government has to say to the Reserve Bank to stop being fixated on lowering interest rates in its attempt to stimulate inflation. The simple step of lowering the inflation target by as little as one percent to where it was set as an aspirational target some thirty years ago, would send a strong message.
The Government might also say to the Reserve Bank not to be fixated by issues of employment. The Government could say that ‘We, the elected Government, will deal with employment matters and associated social welfare through our fiscal policies. We want you, the Reserve Bank, to focus on monetary stability’.
I first planned the writing of this article more than two months ago. At that time, it seemed evident that the Reserve Bank was flying blind. Indeed, the underpinnings were laid out in an article that I wrote back in June, where I focused on the reality of flooded capital markets and the dangers of excessive QE. In July, I then focused on whether low interest rates could really stimulate the economy. However, I subsequently held back both with tongue and pen as we were moving into election mode. I knew that it was not the time when politicians and most other people would be in listening mode in terms of fundamental economic policy.
To jump from sailing and driving analogies to flying, during this time I thought I saw aspects of a Boeing 738 in relation to monetary policy. The plane refused to do what the Reserve Bank pilots wanted it to do because they were pushing the wrong levers, doing what they had been trained to do in a previous era of the Boeing 737.
Right now, the plane is still in the air. But things are more than a little unstable, and they have got a lot more unstable in the four months since I first penned that article on quantitative easing and flooded capital markets.
The reason that I now focus on the Labour leaders is that they are the Government. If National had become the Government then my message would have been the same. This is because in terms of monetary policy, the electoral options were Tweedledum and Tweedledee.
During the election period, Prime Minister Ardern was resistant to the notion that current monetary policies are increasing social inequalities. In response, she chose to focus on increases in the minimum wage, which in many ways is just a sideshow to the big issues of poverty and inequality in New Zealand.
Similarly, Finance Minister Robertson was quick to say that it was not his role to interfere in monetary policy. But neither the Prime Minister nor the Finance Minister can hide from the reality that they are responsible for the Reserve Bank mandate.
One has to wonder at the depth of economic expertise on either side of the House when it comes to monetary policy. It is less than evident that many in the House have studied macroeconomics in any formal context beyond, at best, Stage 1 Economics. And once politicians get into Parliament, they have little time to come to grips with the complexities of money creation, inflation, and interest rates.
It is also highly questionable as to whether either the Reserve Bank or Treasury environment is conducive to independent thinkers who question the adequacy of the flawed economic models. I know a little about how the bureaucracy works. It is very hard to argue from within an organisation as an independent thinker. In general, it is not a good career move to travel that path.
Three steps forward
Finally, I come back to three linked steps that Government needs to be addressing.
The first is to move the inflation target back to a range between zero percent and two percent. That will immediately give the Reserve Bank a framework for modifying some important policies.
The second step is to advise the Reserve Bank that their mandate should focus primarily on monetary stability. The role of simulating the economy and managing unemployment is one that the Government will address through fiscal policies. That statement would give the Reserve Bank a good reason to reassess the extent of its current Quantitative Easing policy, and also its forewarned statements about a new ‘Funding for Lending Programme’ (FLP).
The third step is to state very clearly to the Reserve Bank that the Government is concerned with the current undeniable level of asset inflation that is impacting in particular on housing, and ask the Reserve Bank to urgently take steps to consider policies that will bring that under control. The immediate imposition of LVR restrictions on the existing investment housing market (but not necessarily for new-build investors or first home buyers) would seem a good place for the Reserve Bank to start in its response to such a request.
In suggesting these three steps I have made no reference to the official cash rate (OCR). If New Zealand’s OCR gets markedly out of step with other Western nations, there will be profound issues relating to exchange rates. I might have more to say on that, together with the management thereof, at another time.
*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 email@example.com