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It was lost but now it's found; the Reserve Bank appears to be getting its collective head around where inflation is living in the modern world - and what it is likely to do in future

It was lost but now it's found; the Reserve Bank appears to be getting its collective head around where inflation is living in the modern world - and what it is likely to do in future

By David Hargreaves

It is perhaps a product of the slightly grey and understated way in which the Reserve Bank operates that a couple of significant developments that have occurred in and around the RBNZ’s sphere of influence recently have not been widely noticed.

The first is that our central bank seems to have got a better grip on what does or does not cause inflation these days.

And the second is a corollary of the first; the RBNZ is now picking inflation better.

This is very important because the RBNZ sets the tone for the interest rates we pay according to how it believes it is doing in meeting its target of 1% to 3% inflation and therefore whether it needs to be lowering interest rates, or raising them.

And there have been notable missteps in the recent past – particularly the ill-starred series of four interest rate hikes the RBNZ implemented in 2014 when it ‘saw’ future inflation that turned out to be a mirage.

So, back in the present, yes, the RBNZ did by some margin over-pick (though by no means alone in that) the recent quarterly inflation figures, forecasting a 0.3% rise when the figure was in fact flat.

However, it has seemingly picked up correctly the extent to which the inflation spike early in the year was one-off in nature.

There now seems much greater reason to believe that inflation will indeed (as the central bank is forecasting) be back right at the bottom of the RBNZ’s 1%-3% target band by early 2018.

A few economists out there haven’t been picking that, while the ‘markets’ have been steadfastly expecting that interest rate rises will be forced on the RBNZ starting next year.

Sticking to its guns

The RBNZ has stuck with late 2019 as the time when it expects it will have to lift rates again and for all that the market has not believed it, perhaps it will now have to start believing it.

I confess, I did not believe it – but now I do.

In one of those almost excruciatingly raised-eyebrow, read-between-the-lines, speeches that are a hallmark of RBNZ communication, this week the central bank’s Assistant Governor and Head of Economics John McDermott said, without really saying, that there is no sign of inflation increasing and secondly, monetary conditions in this country have not been as ‘easy’ or stimulatory as the RBNZ has previously thought.

The second part of that is somewhat esoteric and hard to get your head around – but nevertheless actually very significant.

It relates to what a ‘neutral’ interest rate is.

Finding neutral ground

The central bank needs to have it clear in its own collective head where the dividing line stands between low interest rates that will be stimulatory for the economy – and therefore generate inflation and between higher rates that will rein in the economy, take heat out of it, and restrain inflation.

At a time when global interest rates have been going lower and lower it has been increasingly difficult to pick just exactly where that magic ‘neutral’ rate is. The last time I can really recall the RBNZ making big specific prognostications on the matter, two years ago, it was giving the neutral rate as 4.5%.

Up till June 2015 the Reserve Bank had the Official Cash Rate at 3.5%. Now, if the theory is that the ‘neutral’ interest rate is 4.5% then at 3.5% the official interest rates are mildly stimulatory.

Of course drop that neutral rate down to 3.5% (and some economists did disagree with the level that the RBNZ was seeing the neutral rate at in 2015) and the prevailing interest rates are not actually stimulatory at all. Essentially, if you’ve got your interest rates set too high then you will be squeezing the economy and inflation harder than you need.

And there would certainly be observers who would say the RBNZ did just that.

Stimulatory - but not wildly so

By now lowering the ‘neutral’ interest rate as it sees it the RBNZ is effectively saying that the current OCR of 1.75% is on the stimulatory side of the equation – but not wildly so. That’s significant for how it views interest rates ahead.

So on the one hand we have the RBNZ with, I reckon, a better perspective now of the extent to which it is either being expansionary or restrictive in its interest rate settings. So, what about the picking of inflation?

As stated earlier, that has been a problem. Now, our central bank’s not been alone in that. The world is changing – fast. The extent to which technological developments and things like globalisation of trade are casting pervading downward pressure in inflation are hard to quantify.

The RBNZ, it’s got to be said, has stubbornly – and definitely not to its credit – refused to say the interest rate hike cycle of 2014 was a ‘mistake’. People, it was.

Okay, you can look at how our economy is travelling now and say that maybe it didn’t do any harm – but really without being able to see a counterfactual of what would have happened without those erroneous rate rises, you can’t actually say no damage was done.

What's happening?

For the RBNZ though, its actions since then have been louder than its words. Clearly it bugged the hell out of the organisation that it was not getting a proper handle on what was happening to and with inflation.

Last year’s Statement of Intent document for the RBNZ actually put as the biggest priority for the central bank in the year ahead to: "Continue to deepen our understanding of the current drivers of low inflation and their consequences for the economy and monetary policy".

So, moving into this year and we had a situation where the economists and the ‘market’ were not believing of the RBNZ when it set out its stall and said it wasn’t raising interest rates till 2019.

To this point however, and recent developments have been suggesting it more and more, the RBNZ is looking right on the money with the stance it has taken.

Time will tell of course, but if the RBNZ continues to be pointing everybody in the right direction then there will be increased confidence in its forecasts and in its interest rate settings.

That has to be good for stability in our economy.

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

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".. if the RBNZ continues to be pointing everybody in the right direction ....That has to be good for stability in our economy."
If the RBNZ or any other Central Bank had a clue what they were doing not only wouldn't we be where we are today, but we wouldn't have been where we were in 2007.
As a Collective, they have no idea what they are doing. Capitalism works just fine if it's left alone. It's when it's mucked about with that problems not only occur, but are magnified and made worse. Get the Central banks to step aside, recognise that they don't have a clue and maybe after what is an inevitable period-of-reckoning, we might have a better system afterwards.


San Francisco Fed President John Williams expressed Friday the same wonderment with apparently decreasing understanding. In other words, the Fed knew somewhat of eurodollars in 1979 and has been growing only more ignorant as time has passed:

“I see this as more of a warning, a red flag that there’s something going on here that isn’t in the models, that we maybe don’t understand as well as we think, and we should dig down deep deeper and try to figure this out better,” he said during a panel discussion at the Brookings Institute in Washington.

He was speaking about “low neutral interest rates” which is nothing more than orthodox econometrics for an economy that doesn’t respond to the Fed’s prodding. These economists assume that the fault lies in the economy itself (secular stagnation or natural rate theory) rather than in their monetary thinking which still finds some kind of traditional “pyramid” structure; even though the great “clue” about how that no longer applies can be found in how M2 never found the great and biblical housing bubble.

The(y) assume hierarchy of the orthodox foundation stands as John Exter’s inverted pyramid, only with gold and hard money no longer at its founding apex. In less-restrained envisioning, the Fed sits at the top ready to change the quantity and “cost” of reserves, which then is supposed to act on “money supply” including deposit quantities, all leading to regular and direct conditioning of the economy (excluding, notably, asset prices and the full measure of credit creation because orthodox economists take no responsibility for anything outside Fisher’s quantity theory of money). Read more

An erroneous example of RBNZ think - The Reserve Bank, private sector banks and the creation of money and credit

"As a Collective, they have no idea what they are doing. Capitalism works just fine if it's left alone"

No. They know exactly what they are doing - which is starve off the next financial crash as long as possible - because there is nothing to throw at the next one. The financial system is now alive only on fumes from central bank money printing ... take that away and the emperor has no clothes.
Capacity everywhere and weak demand. How exactly will "a period of reckoning" do anything when interest rates are low , commodity prices are low ... and growth is flatlining?
All a reckoning can achieve is massive wealth write offs (hitting pension funds etc), weaker demand and even lower commodity prices...

Capitalism only works just fine if growth in resources isn't limitless. Otherwise, a model where continual growth is required cant work in a resource limited world.

Indeed, capitalism does rely almost totally on growth, another name for it could be 'More', and I believe everyone with a couple of brain cells to rattle together knows it is not possible. What we are seeing now is capitalism's attempt to keep itself going, it is beginning to consume itself and the perfect illustration of it is the rise of the rentier class, I reckon

If only they included houses in the CPI then inflation would be running at 10%, the OCR would be 9% and my term deposits would be paying 8% (** thought I would get the standard interest forum rant in before the usual suspects show up**)...

Post ed: bw beat me:(

I think it is stupid that they aren't including housing in the figures because it is giving false results not to. Consumer goods are only decreasing in price for any things, like TVs. Food is going up in price by more than inflation shows, because manufacturers are decreasing the size of the packets. Not unless they are taking this into consideration.

I like poor people – they keep official inflation down so I can binge buy more assets. They also increase my relative wealth. Can we have more poor people please, just nowhere near me. (tongue in cheek).

Which prices, and which part of consumer buying behaviour is the OCR of 1.75 stimulating?
Or is 1.75 OCR actually neutral?
Or is 1.75 actually suppressing inflation, since it is much higher than most developed economies.

A comment still living in the past - OCR 1.75% which is 50 basis points above the hugely bigger, stronger and more liquid US markets, the Fed funds rate at 1.25%, which is probably about to become 1.50% In Dec.

However, you avoided attempting answering the first question:
"Which prices, and which part of consumer buying behaviour is the OCR of 1.75 stimulating?"
It may well be stimulatory - but how? Is it inciting and encouraging increased consumer spending?
Then how are corporations disguising their price inflation? E.g. Shrinkflation, etc

The absolutely stunning obvious - asset prices, especially HOUSING

Is monetary policy then ineffective in its influence on consumer non-housing spending levels and non-housing prices?

And how subdued would housing prices have been if the OCR had been, say, 2.5 or 3 or 3.5% over the last few years?

The RB has no control over interest rates anymore. Bank interest rates are about 4% higher than the OCR. The RB could drop it further but we wont see bank interest rates drop. I think theyve almost maximised mortgage debt in NZ now they just want to keep their margins up.
Our economy like the rest of the western world is in a debt toilet. We know that 9% interest rates would cause an economic disaster in NZ. Governments and private debt is driving the economies.
Our government has let banks feed us debt that has driven our great house price inflation(nominal wealth) and will continue to suck more and more of our income. The only good thing I guess is that low interest rates look like the new norm. The problem is if we cut off immigration and our economy dives how is the RB going to stimulate us out of that with record rates now. Do we just keep borrowing more?

If we didn't have growing inequality our economy might be able to find some of that demand it needs to keep a suitable inflation rate. Especially with such low interest rates. It's really time to address demand side, not just supply side.

Right now with house prices falling I've already noticed things like heat pump install prices fall through the floor and profits evaporating. This next 6 months is a dangerous time.

seems relevant... from this link

We all know what a hyper-financialized economy looks like--we live in one: central banks create credit/money out of thin air and distribute it to the already-wealthy, who use the nearly free money to buy back corporate shares, enriching themselves while creating zero jobs. Or they use the central-bank money to outbid mere savers to scoop up income-producing assets: farmland, rental properties, etc.

This asymmetric wealth accumulation and avoidance of risk creates a self-reinforcing feedback loop, as the super-wealthy financiers and corporations use a slice of their income to buy political protection of their income streams, creating cartels and quasi-monopolies that are impervious to competition and meaningful regulation....

Days to the General Election: 22
See Party Policies here. Party Lists here.