Why does the target rate matter?

WIth inflation heading far outside the Reserve Bank’s target band both Kiwiblog and Kiwiblogblog have had a little to say about inflation targeting.

David Farrar at Kiwiblog states that inflation outside the range is bad, and in fact our relevant target band should be 0-2%. He also states that we can act like the target is truly the point at the middle of the band – ergo we currently have a target of 2% (in the 1%-3% band). David then finishes by saying that current interest rates will have to stay high – something that will be a concern to people.

Wat Tyler (a good historical reference of a left wing blog may I add) disagrees with this way of looking at the target, states that interest rates were higher in the 90’s and so should not be such a concern, and says that a little breakout from the inflation target doesn’t matter – as long as we keep inflation in single digits.

Both sides have points – lets try to dig a little deeper and figure out what my opinion is 😉

FIrst we’ll look at the three claims of each side. First up is the inflation target – is the mid-point the same as the target band.

In this case, both sides are right. This seems weird as they are saying contridictory things, however it is a result of the fact that a “target band” is a relatively silly thing to use when we are focusing on medium-long term inflation ahead of short-term inflation (which was our initial goal, and does require a target band in order to take care of “shocks”).

David is right that the implicit target should be 2% – the 1% either way is supposed to account for random shocks to the rate of inflation. Wat is right that our current target band mechanism is not equivalent to a 2% target, just look at inflation expectations which have constantly tracked well above 2%. In a sense, the economy has seen that the inflation target is 1%-3% and it has seen that the Bank is concerned about growth etc. As a result, market expectations have moved to expecting inflation to average towards the top of the band, so close to 3%.

Next comes the interest rate call. In this case it is true that interest rates will have to stay up longer than they would if this inflation problem didn’t exist – don’t expect a mass slowdown in growth to push the RBNZ into action. Wat says that this isn’t that bad as interest rates are lower than they were in the 90’s. However, we are in a very different situation than we were in the 90’s.

Over recent years global financial trends have kept interest rates low. This has allowed New Zealand to borrow heavily from the rest of the world – which is why our current account deficit is so high. Now that global interest rates are rising again, the cost of financing this debt will be high. Note that we didn’t have as large a current account deficit back in the 90’s, which implies that even if interest rates were higher back then our level of debt with the rest of the world was lower. Given that most of this debt is private debt, the fact that interest rates are going to stay high is a fair concern to raise.

Finally we have the inflation target itself. David says set it at 1%, Wat says the target doesn’t matter too much as long as inflation remains in single figures. Now to evaluate these claims we have to look at the costs of inflation.

Higher inflation leads to more price volatility for two reasons. First, high rates of inflation are more unstable leading to varying rates of growth over time. Secondly, as Wat says, some prices are stickier than others. This stickiness can cause problems even when inflation is steady as the relative price between sticky and non-sticky items cannot be set appropriately – implying that when adjustment comes it can be more varied than required (think of it this way, if prices can only be changed at a certain date they will over-compensate the price increase based on expected inflation. If firms can’t observe whether they are having relative price changes or inflation then this timing mechanism will be sufficient to make prices jump around).

This uncertainty damages investment intentions, and creates transaction costs for cognitively limited agents such as myself 😉

Furthermore, prices are important in an economy because they help to allocate goods where they are most highly valued. If relative prices do not move effectively then we lose efficiency in the allocation of resources.

There are also other costs of inflation, such as shoe-leather costs and menu costs (see wiki 😉 ). However these costs are relatively minor in the grand scheme of things.

Now inflation becomes self-fulfilling, which is one of the main reasons why we want to avoid it. How does this work. Well if prices are rising 4%, people may expect them to rise 4% over the next year. This tells businesses that if they want to keep relative prices the same they should lift prices by 4% . Furthermore, it tells workers that if they want to keep the same spending power they have to demand a wage increase of 4%. As a result, we don’t only want to keep inflation down to avoid these costs – we also want to keep inflation down to keep these costs down in the future (see long-run phillips curve).

As a result, inflation is something it would be nice to avoid (unless we believe higher rates of inflation lead to greater levels of price flexibility – an argument I can sort of buy). This leads me to the conclusion that Wat was being a bit generous with inflation when he said it could sit in single figures, and as a result I think a target in the 1%-2% range is fine (given potential benefits of some inflation to “oil the wheels of prices” and the fact that we want to avoid any deflation passionately).

So my opinion is, either set a target band for the short run, or a target point for the medium-long term, have the target about 1%-2%. The RBNZ understands these long term costs of inflation, and is mandated to deal with it – which is why I’m confident they will leave rates elevated over the rest of the year.

  • There was a good study published somewhere once that argued against a 0-2% band as too low. The argument was that the corresponding decrease in interest rates would leave central banking authorities less room to provide monetary stimulus when needed, perhaps leading to more Japan-style problems.

  • “perhaps leading to more Japan-style problems”

    The old liquidity trap – that is indeed a good reason for having some degree of positive inflation.

    On a slight tangent, what interests me is the fact that per capita GDP growth in Japan has actually been reasonable in recent years – the reason GDP growth has been so weak is that they have had a falling population.

    As a result, I feel that a falling population may explain part of their deflationary problem – namely because the fact that a falling population reduces demand for non-tradables.

  • Kimble

    I have never heard a decent argument FOR inflation beyond the ‘oil the wheels of prices’ mentioned above. So it always startles me when I run into someone who says high inflation isnt that bad.

    Am I missing their argument, or do they not have one at all? Is there another side to the debate?

  • “Am I missing their argument, or do they not have one at all? Is there another side to the debate?”

    Well another reason to support low levels of inflation is the one given by Andrew above – in order to avoid deflation. As the inflation rate jumps around, if we set a target of zero we would sometime go under it. Economists actually fear deflation more than inflation, I can think of two reasons for this off the top of my head:

    1) As firms set prices there is a natural tendency to increase them. Deflation means that the general price level is falling, which is difficult for firms (especially given that wages are very sticky – this stickiness can then lead to bankruptcy of efficient industries because of cash flow issues).

    2) Deflation comes with the risk of a “liquidity trap”. If deflation gets entrenched in expectations (say because of a bunch of negative demand shocks), then the RBNZ may cut rates hard to try to get inflation moving. If this doesn’t work quickly then we end up like Japan (and the US right now) – with negative real interest rates. In this situation monetary policy becomes useless, and consumer activity stalls.

    However, both this and the oil on the wheels argument only do much when inflation is very small. Overall, I think all parties involved agree that inflation is a net cost – the question then is, is the monetary policy required to control inflation worth it.

    Given that inflation impacts on inflation expectations, inflation now has a long run cost – while the “benefit” from higher inflation (from lower interest rates) is only temporary (as it is a result of price stickiness). As a result, comparing the cost of inflation today to the benefit of higher output today isn’t sufficient – we should be asking if we are willing to accept constantly higher inflation (or an output sacrifice later) for the boost in output now. When you put it in these terms it becomes obvious that we want to keep inflation quite small.

  • Fred

    Matt, you may have covered this before and I have made these points on Kiwiblog as well. Essentially, if inflation is not being caused by an excess of liquidity then it’s pointless trying to suppress liquidity and demand by keeping interest rates high. In addition, when the rates were increased well above our trading partners (starting a few years ago), aided by favourable tax treatment of foreign investments, all that happened was increased liquidity, exactly the opposite of what was intended with the resultant housing boom over the last couple of years. Right now, housing construction, has come to a grinding halt, with nearly 30% of the economy dedicated to construction (approximately, and too much anyway) this is going to lead to a fair bit of pain, and action is required now. What do you think should be done?

  • Hi Fred, thanks for the comment.

    “Essentially, if inflation is not being caused by an excess of liquidity then it’s pointless trying to suppress liquidity and demand by keeping interest rates high”

    The fact to remember here is that the liquidity you are discussing is fundamentally the money supply. The Reserve Bank does not determine the money supply directly, it determines it indirectly through the interest rate. The constraint on money supply growth in this case is money demand (which is dependent on domestic activity and expectations).

    As a result, keeping interest rates high moves us further up the money demand curve and reduces the quantity of money supplied – which will diminish inflationary pressures in the economy. Sure part of our inflationary problems are the result of price increases overseas. However, it is important to note that non-tradable inflation is still in excess of tradable inflation illustrating that there is a significant under-belly of domestic inflationary pressure causing this increase.

    “In addition, when the rates were increased well above our trading partners (starting a few years ago), aided by favourable tax treatment of foreign investments, all that happened was increased liquidity”

    This is a common misconception. The Bank sets an interest rate which moves us along the money demand curve. They are willing to supply an infinite amount of money at the interest rate they set. As a result, capital inflows do not “increase money supply” as the supply of money is already infinite. Foreign capital flows limit the effectiveness of increases in the OCR, by preventing the interest rate rising by as much as it would if we had a closed economy. If anything, this implies that a higher OCR cannot be blamed for the “housing boom”.

    “Right now, housing construction, has come to a grinding halt, with nearly 30% of the economy dedicated to construction (approximately, and too much anyway) this is going to lead to a fair bit of pain, and action is required now. What do you think should be done?”

    According to my numbers only 3% of the economies production is the result of construction.

    Ultimately I think the best policy will be to let the construction industry slow. As of December, residential construction firms were still complaining that they were viciously short of staff (which is why residential construction cost growth is so high). A slowdown in activity in the construction industry won’t be that much of a big deal in NZ.

  • CPW

    “They are willing to supply an infinite amount of money at the interest rate they set… Foreign capital flows limit the effectiveness of increases in the OCR, by preventing the interest rate rising by as much as it would if we had a closed economy.”

    Would you like to take a punt at explaining why your second sentence doesn’t contradict your first? 🙂

  • dracotb

    They are willing to supply an infinite amount of money at the interest rate they set. As a result, capital inflows do not “increase money supply” as the supply of money is already infinite.

    This doesn’t appear to be true because banks have been lifting the interest rates well above the OCR to encourage overseas investors to buy NZ$ denominated bonds. If the RBNZ was willing to supply an infinite amount of money at the OCR then the banks wouldn’t need to do this as they would be able to get the money cheaper.

  • “Would you like to take a punt at explaining why your second sentence doesn’t contradict your first? :-)”

    Isn’t it just a demand curve thing, they increase the interest rate to reduce the quantity of money demanded. However, as the interest rate rises more foreign capital comes into the country (as investors that are sitting at the margin come in) which must, in theory, be available for an effective interest rate below the one that would occur if more foreign capital couldn’t appear but above the previous interest rate (as otherwise they would have sent their money over earlier). As a result, the average interest rate in the economy will be lower.

    I shouldn’t of said closed economy – I should have said, if foreign capital inflows had not changed, that was a mistake 😛

  • “This doesn’t appear to be true because banks have been lifting the interest rates well above the OCR to encourage overseas investors to buy NZ$ denominated bonds”

    Don’t all these rates of return etc have risk and time based preferences priced into them. There is no-one interest rate in truth, when I made this comment I was discussing the OCR’s impact on all other rates (which have risk, time, and length based mark-up’s included).

    As the increase in the OCR increases other interest rates, these capital flows do not increase the “quantity of money” in the economy – as it also depends on money demand.

  • Fred

    Matt, do you recall when the banks first started aggressively marketing mortgages, it was after the OCR had been lifted and we lifted our noses above the parapet. It hit the news at the time but little explanation was given as to why the banks were suddenly flush wanting to lend even though the OCR had just been lifted. Here’s what I think happened, as banks deposit money with the reserve bank (at the best rates in the world) they are then able to attract deposits (with the best rates in the world), since not all of the deposits they receive need to be deposited with the RB, what’s left goes into the domestic mortgage market. So as I said the opposite of what was intended happened, lifting the OCR did not reduce liquidity. In addition the foreign deposits have been encouraged by a tax break which a) means that the banks can take a bigger margin (and therefore be more aggressive in the domestic mortgage market) or b) as you point out, domestic interest rates are not impacted as much.

    Yes there is a demand supply curve, but when you are a small fish in a big pond it just doesn’t work.

    Hard times for the construction industry – not a bad thing? Well it won’t make houses cheaper, everyone will just piss off to Australia where they are building houses by the 100’s of thousands and are actively seeking more than 16,000 builders right now. – All because of a doctrinaire approach to inflation. It hasn’t really mattered till now because our exporters boxed on hoping for a reduction in exchange rate but F&P are closing their Dunedin plant as a result of this mismanagement.

    Anyway what would you do now, keep interest rates high because fuel is more expensive?

  • “banks first started aggressively marketing mortgages”

    The level of loans that go out depend on the demand for loans as well. We agree that foreign capital reduced the effectiveness of lifts in the OCR – but they didn’t increase the level of lending. Interest rates were still higher than they would have been if the OCR hand been lower.

    The housing “bubble” was likely the result of speculation, after strong population growth increased the price of houses. Seeing house prices go up people got a little bit excited etc. The same thing happened in the US and they kept their interest rates low – I don’t think we can blame the Reserve Bank for lifting rates (note that a significant amount of the lifting in the OCR occurred last year – look at housing now.)

    “Yes there is a demand supply curve, but when you are a small fish in a big pond it just doesn’t work.”

    The supply curve gets really flat, I agree – but the demand curve still exists. If people don’t want loans they won’t get out loans.

    “Hard times for the construction industry – not a bad thing? Well it won’t make houses cheaper”

    The industry is capacity constrained – as a result a fall off in demand will impact more heavily on the cost of building.

    “everyone will just piss off to Australia … All because of a doctrinaire approach to inflation”

    I think the other reason to go to Australia might be the strong income growth and better social services. Housing affordability is WORSE in Australia and their Reserve Bank has lifted rates to within 100 basis points of our rates.

    There are a number of structural reasons that we are stuck with higher interest rates. One is the fact that we are a small country with a shallow capital market. Another is the fact that the tax take is above what is required for social services and so the private sector is borrowing based on the belief in a lower future tax burden (Ricardian equivalence).

    As I’ve said, controlling inflation has costs in the short-term (when we have to lower output) – however not controlling inflation has long-term costs (as inflation expectations rise). If we had risen interest rates sooner a couple of years ago we would not be in this situation.

    “Anyway what would you do now, keep interest rates high because fuel is more expensive?”

    You realise that non-tradable inflation is still stronger than tradable inflation – implying that the inflation problem is a lot more systematic then you are letting on. The RBNZ does look through the food price shocks and the fuel price shocks – they are negative aggregate supply shocks and we can’t do anything about them. However, underlying inflation is still a significant problem.

    What would I do? I would tell the market that I’m mandated to keep inflation inside the target band and that I’m willing to sacrifice short-term growth to do it – that is the only responsible course of action.

  • Fred

    Matt, so we agree – interest rates and liquidity increased at the same time, you say demand for loans rather than marketing push. I say; “banks aggressively marketed mortgages, relaxed equity and income criteria” = opposite of what was intended => made the inflation problem worse.

    You say: domestic inflation is still high, can’t move interest rates, and therefore sacrifice some growth now. I say; well high interest rates didn’t do the job 3 years ago, they finally start to bite last year, and we have had three years of a propped up exchange rate, 3 years of poor quality capital investment (ie directed mainly at housing instead of towards business and productivity improvement). The brakes are well and truly on now and need to be relaxed a bit. Will be interested to see what actually happens next.

  • “demand for loans rather than marketing push”

    I don’t know, I’m not really convinced that bank’s by themselves could push demand for houses up to the level that we have seen. Personally I think the additional demand initially came from immigration – then people speculated when they saw prices rising, but the supply of houses picked up and demand for new houses slowed taking away the fundamental reason for higher prices and just leaving froth.

    I agree that we agree about most of the factors though – I just view liquidity as a supply side issue, the strength of the demand side factors is a VERY important issue that will be hard to quantify. After all it asks the question “why did the housing market get so active” – something I don’t believe the bank’s are solely to blame for.

    “high interest rates didn’t do the job 3 years ago”

    Interest rates weren’t high enough – most economists couldn’t believe that the Bank was leaving rates at the top end of neutral territory when we needed to squeeze inflation. That is why inflation expectations are so high now, and why the growth sacrifice will likely have to be worse.

    “The brakes are well and truly on now and need to be relaxed a bit. Will be interested to see what actually happens next”

    I agree with many of your points, especially about investment. However NZers seem to have a preference towards housing.

    It will be interesting to see what happens next. We might have a recession, we might not, what is more important is what happens to inflation, productivity, and the labour market. Hopefully the terms of trade shock will help counterbalance some of the downward adjustments our economy seems likely to make.

  • CPW

    There was an interesting chart in the IMF report that showed a very close correlation between liberalization of the mortgage market and ratio of mortgage debt to GDP. To the extent that the banks impacted on the crisis, I think that the evolution to easier lending standards is the relevant factor, not their access to liquidity (although of course the latter could drive the former).

    “most economists couldn’t believe that the Bank was leaving rates at the top end of neutral territory when we needed to squeeze inflation.” Ha! I wish that was the case, but sadly the economists calling for tighter policy over the last 4 years have been a tiny minority, and to the best of my recollection there has never been anyone calling for drastic tightening (ie even to the degree that actually took place). But a nice try at revisionism there Matt, keep up the good work :-).

    Now, to return to my earlier point: I accept that access to foreign funds should move interest rates in a small economy closer to the world equilibrium, all else equal. But since you’ve posited that the Reserve Bank has fixed interest rates at the short-end, how is access to foreign capital be lowering long rates below what term structure expectations imply? Do foreign investors require lower risk premiums than domestic investors?

    In the New Zealand case, I’m not convinced that “foreign capital reduced the effectiveness of lifts in the OCR”. I think that faulty (ex-post) expectations of the OCR track explain the lack of response in long rates.

    The RBNZ also has a recent research paper arguing that monetary policy is no less effective now than in the past.

  • “I wish that was the case, but sadly the economists calling for tighter policy over the last 4 years have been a tiny minority”

    Really, I was under the impression from all these ANZ and Westpac releases last year that they said policy needed to be tighter in 2004/05. I know I’ve wanted policy to be tighter over most of the past 5 years (up until July http://tvhe.co.nz/2007/07/26/one-hike-too-far/).

    “I think that faulty (ex-post) expectations of the OCR track explain the lack of response in long rates.”

    I see, very interesting – do you have a link to the paper, I would be interesting in reading about it. I enjoyed the explaination that foreign capital flows reduced the marginal impact of the OCR, but if there is a better explaination out there I’m willing to concede.

  • CPW

    Sadly not everyone can be as hawkish as you, Matt. Except in hindsight – Westpac in 2004

    RBNZ paper is here

  • “Westpac in 2004”

    Beautiful – to think that last year they were saying the RBNZ should have lifted sooner, love it.

  • Always worth remembering that infln. is a second order concern (i.e. we worry about it because of it’s impacts on things that really matter). It follows from this that we should have some flexibility in our approach to inflation targeting lest we clobber something that really matters to get under a numerical target. For example, Ben Bernake cutting Fed interest rates cut despite (IIRC) ongoing inflationary pressures – all for the simple reason that the US financial system is a little more important than an inflation target…

  • “all for the simple reason that the US financial system is a little more important than an inflation target”

    I don’t think its appropriate to look at it in absolutes. Keeping interest rates higher wouldn’t make the whole financial system collapse, but there will be a cost. We need to compare the costs of doing so to the benefits. Ben believes the costs of a weak financial market (stemming from the financial accelerator model) are more important than the long term costs stemming from inflation – that is why he is cutting rates.

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