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.
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.
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