The great interest rate debate

Do we worry about inflation, or not?

19th Feb 16, 8:31am by David Hargreaves

By David Hargreaves

I'm struggling to remember a time in recent memory when views among economists were spread as widely as they are at the moment on just where interest rates should be set.

I say again, I don't envy the Reserve Bank. Its job on setting an appropriate level of interest rates for this country could hardly have ever been more difficult than it is at the moment.

It is to be imagined that the bringing together of the RBNZ's quarterly Monetary Policy Statements is at any juncture a time of lively internal debate. But it would be interesting indeed to enjoy that mythical 'fly on the wall' status at the moment as our central bank pulls together commentary and forecasts for it's March 10 Official Cash Rate announcement.

There would have to be some massive incident between now and March 10 for the RBNZ to reduce the OCR on that day. I say that, because such a move would be so wildly inconsistent with the recently stated views of RBNZ Governor Graeme Wheeler that it would shred the credibility of the RBNZ.

But it won't be about the decision, it will be all about the outlook.

The two key things to watch for from the release of the March MPS will be what the forecasts are now for the path of inflation and what the bank intends to do about it.

The September MPS document contained what I thought at the time were outrageously 'hawkish' projections for inflation this year. These were subsequently toned down a bit in the December MPS, but still looked well overcooked to me. And Governor Wheeler's recent speech appeared to concede that.

We then come back to the central argument that is gathering steam: Does the RBNZ position itself to make further interest rate cuts in order to get its official inflation target somewhat in view? Or does it instead state categorically that, right now, it will ignore the target?

In his last speech Wheeler appeared to be moving in the latter direction, but of course it's not really his decision to make. And I think the creation of alternative measures of inflation, as the RBNZ is doing, is a rather over-cute way of ignoring your mandate without officially saying you are ignoring your mandate.

So, what is really needed I think, is a summit between the Governor and Finance Minister Bill English to either agree to throw inflation targeting out of the window - for the moment at least - or to say that the inflation target will be adhered to.

I actually suspect that if the latter course was favoured by English, then Wheeler might have to do the 'honourable' thing and step aside - since he is quite clearly personally invested in the course of NOT producing knee-jerk rate cuts at the moment.

This all seems like some sort of great philosophical argument. And on one level of course, it is. But we are talking about decisions here that have a huge impact on the performance of our economy and therefore people's livelihoods, careers, etc.

To target inflation or not to target inflation - that is the question. And we need the answer. Sooner rather than later.

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20 Comments

by Mike B | 19th Feb 16, 9:57am 1455829059

I say again, I don't envy the Reserve Bank. Its job on setting an appropriate level of interest rates for this country could hardly have ever been more difficult than it is at the moment.

It is just like parents who let their children run completely out of control, with no rules. Then complain how difficult it is trying to maintain control of the children..

by itsme | 20th Feb 16, 8:49am 1455911350

After the GFC, countries experimented on increasing production and jobs by flooding the world with cheap money.(quantitive easing ). This "experiment" was a failure as this money went into speculative investments which were non productive, such as real estate.
Now this has caused deflation and countries are experimenting with low to negative interest rates to get people spending. This has and will not work until Governments remove tax incentives etc. for money to go into real estate and speculative investing.
We are inevitably heading for another major crash and no one in power knows what to do about it!!

by Cowpat | 19th Feb 16, 10:53am 1455832413

Surely the question should not be whether to target inflation or not , but whether Graham Wheeler and the current RBNZ team should remain in their positions. Having gathered the 2014 Central bank of the year award for raising interest rates against the global flow Graham Wheeler and team have simply jumped from one fence to another. No other central bank has reversed course twice in the past five years , once into a recession , and in 2014 , as Statistics New Zealand was historically revising GDP downwards they continued to raise as their forecasts were reversing. At the same time whilst raising rates the argument was made to intervene in the currency in a perverse attempt to lower , not even the Risbank has intervened in its currency over the past fifteen years.Domestically growth in New Zealand has been dependent on a sad earthquake , which has peaked, and a housing market in Auckland . Chinas growth slowed in 2014, Australia is closer to recession than growth , New Zealand has experienced no growth over the past year, wage growth for the bulk of sectors will stagnate for years . The RBNZ has modelled its forecasts and its decisions on circumstances that no longer exist, yet at the same time have a belief that they can bully global markets into fitting within their models. The decisions the current RBNZ have taken have been flawed, it is simply unacceptable they remain . One can accept a policy mistake when external events unexpectedly occur , but when they cannot be anticipated because of a certain mindset, its time to move aside.

by cut.it.out | 20th Feb 16, 1:29pm 1455928182

I don't know why we need central banks full stop...

by dictator | 19th Feb 16, 11:38am 1455835118

I don't see any point blaming RBNZ for things that are outside of their control. The current OCR seems to be the level where we are on the margin of going deflationary. Dropping it more is not likely to generate inflation.

When the OCR drops any developer that can get finance for a project because the numbers stack up has a fight to get a building consent once the design work is done. The building consent process is a major bottleneck and primarily the fault of exceptionally poor decisions made by MBIE in 2012. If they had not made those changes money from finance would flow more freely into the economy.

In fact changes are in the pipeline for the building code and reintroduction of alternative solutions for building designs. That was supposed to happen by mid-2015. Nothing has happened and instead of freeing up building work the Councils are clogged up with idiotic bureaucracy which is holding up building projects, finance, innovation and the jobs that would come out of the work.

RBNZ adjusting the OCR would have a little more impact if it wasn't for the loopy rules holding up building consents.

by Cowpat | 19th Feb 16, 12:23pm 1455837796

The RBNZ increased rates, it dropped them , it increased rates it dropped them , at the same time it jawboned the currency. It should not accept responsibility for its mistakes.What nonsense. Globally the Fed and other central banks dictate what the RBNZ can do. The RBNZ or any Central Bank is not interested whether a developer can obtain finance because the numbers stack up, or whether there is innovation in building work or whether building consents are held up.The RBNZ committed a policy error -

by Man in the Street | 19th Feb 16, 11:51am 1455835889

I only hope that the NZ SUPER FUND has been taking short positions on the NZD every time the RBNZ GOV has made an announcement since October. This strategy would have been a nice little earner.
Or has the Fund still been pouring hundreds of millions of dollars of our money down the black holes of basket-case European banks.

by Yvil | 19th Feb 16, 1:17pm 1455841062

Since the RBNZ's last MPS;
- Dairy prices have further slumped
- The Auckland housing market is now definitely down (3 months in row)
Notwithstanding inflation, these are 2 clear signals Wheeler himself keeps talking about, to drop the OCR.
Also the high OCR (internationally speaking) fuels our asset bubble because it attracts so much foreign cash that needs a decent return in a safe country (NZ), this money must then be lent by the bank, that's their business.

by Andrewj | 19th Feb 16, 1:32pm 1455841972

Who's going to lend money at zero interest? There will be runs on banks, and chaos,exposed to OBR i won't accept zero interest and certainly will never accept negative.
Bill English is telling us, the real cost of interest is so scary the government doesn't want to borrow, so they will be forced into austerity.
Expect runs on banks, collapsing pension funds and all the problems of a third world kleptocracy

by dictator | 19th Feb 16, 1:55pm 1455843325

Talk of austerity (which has been shown to fail miserably in Europe recently) does concern me. It creates a substantial risk of a deflationary spiral.

by Caleb | 19th Feb 16, 7:48pm 1455864520

So borrow more, like a drunken sailor or more like a government... Only interested in the now and not in articulating and making any hard or long term decisions.

by Andrewj | 19th Feb 16, 7:58pm 1455865129

As Ludwig von Mises put it,

The boom is called good business, prosperity, and upswing. Its unavoidable aftermath, the readjustment of conditions to the real data of the market, is called crisis, slump, bad business, depression. People rebel against the insight that the disturbing element is to be seen in the malinvestment and the overconsumption of the boom period and that such an artificially induced boom is doomed. They are looking for the philosophers' stone to make it last.[1]

We currently find ourselves in a situation Ludwig von Mises warned against:

The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse. In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.[2]

by MortgageBelt | 19th Feb 16, 5:50pm 1455857415

If it wasn't for the 2011 Christchurch earthquake, the RBNZ would probably have the OCR at 3.5%.
Only if forced beyond reasonable doubt will they cut.
Reasonable cuts down to 2.0 over 2016 is not exactly "knee-jerk reactions". The world has been in this deflationary ZIRP, commodity slump, consumer caution mode since 2009. It is not new anymore, and the world is not returning to pre2008 mode anytime soon.
Perhaps the truth is simply too much to bear for the RB, economists and corporate leaders & Govt.

by scarfie | 19th Feb 16, 6:51pm 1455861075

David, you are finding widely varying views from economists on interest because they simply don't understand it.

Here is my modification of the quantity theory of money, which I created when looking for an answer to the interest rate question. (M.V)+i=P.Q. Consider the names that were involved in the development of the original theory, then consider that even they didn't get it.

My equation models the maths quite simply, and leads to the conclusion that interest rates must trend down.

by O.Farr-Kinnell | 19th Feb 16, 7:02pm 1455861736

Your equation in layman's terms please. :)

by scarfie | 19th Feb 16, 11:19pm 1455877185

Do you under stand the velocity of money? It is the only part that is non linear and essentially means how many times the same dollar is spent in a fixed time frame, usually one year.

PS. Velocity has been dropping, which is also predicted by the equation.

by Andrewj | 20th Feb 16, 7:52am 1455907952

Scarfie, If dairy farmers get 12 billion less for their milk, whats the effect?

by iconoclast | 20th Feb 16, 8:05am 1455908733

using a standard multiplier of 7 it will take $84 billion out of the NZ economy each year

NZ nominal GDP = $230 billion = a big hole

by scarfie | 20th Feb 16, 10:40am 1455918031

Good question, it is making me think.

Can we assume that quantity stays the same? If so then only price is contracted on the right side. But I guess we can assume the $12B is a net effect on the right side.

The equation wants to be balanced, at least over the 12 month time frame. So one, or more, of the categories on the left hand side has to reduce to match the right side. The effect is compounded because both sides have to increase over time when there is interest, so the adjustment includes what the natural increase would have been.

If you reduce "M", then you have to destroy the debt that it is matched to. This could also be seen as destroying wealth, although the wealth is artificial paper wealth since the real wealth is the product.

Iconoclast has already pointed out how velocity compounds the effect, and he is quite right in that the effect has to be reflected right across the equation.

Interest could also be reduced faster than it would naturally do so, this would ease the debt burden on those farmers that have a floating rate. Question is could interest rates be lowered enough to make up the difference? I don't think so. My guess is that the loans are subject to external funding over a longer time frame than the shorter term milk powder price.

Of course you can always come back to the core prediction. Either interest rates have to go down, or debt defaulted on.

Edit: You would hope that interest rates going down would drop the exchange rate, thus providing additional relief to farmers. But when the money supply expansion is more reliant on house prices than real production then house prices become the primary reason to manipulate interest rates(within their down trend).

by Andrewj | 20th Feb 16, 11:14am 1455920088

Incomes falling while demographics need attention.

The big population change of course is the increasing numbers moving past the age of 65 and becoming eligible for the state pension.

In the past year or two that number has started to increase rapidly as those ageing baby boomers start to hit 65. It is adding close to $1 billion to government spending each year.