A brief defence of a (temporary) cut

I’m not sure if today’s rate cut was the right decision – I understand the justification for it, it is just hard to get past my inherent hawkish personality 😉

Still, I think that the rate cut is being slightly mischaracterised by those disagreeing with it – so I’m going to discuss it a little here.

In the Herald Bernard Hickey suggested (ht Kiwiblog and interest.co.nz)that the rate cut was inappropriate, quoting from the Bank’s statement and then commenting.  As a result, I will take the conclusion and comment 😉

There is a danger that just as this monetary policy easing is flowing into the economy in earnest in 12 months to 18 months time, the inflation from the rebuilding effort and inflation from higher commodity prices globally hits the economy in a double whammy.

I think the Reserve Bank should have waited for more data on the true impact of the earthquake and put a bit more faith in the resilience of the New Zealand economy.

It has now opened up the risk that a slow growing economy is burdened by inflation and higher unemployment. Today’s cut may be seen as the day New Zealand invited in stagflation.

Let’s think about what the Bank did, what it said, and what it expects.

The Bank cut the OCR now by 50 bps.  BUT, the Bank said it will increase the OCR by 50bps more than it was going to during the tightening cycle.  By the time construction activity is really ripping – the OCR will moving into restrictive territory.

Given this path of interest rates, it has forecast that inflation will stay well within the band.  As a result, it is consistent with its inflation mandate.

Are there risks – yes, hell yes.  But, given current uncertainty and expectations having TEMPORARILY lower interest rates while output is depressed allows the Bank to “smooth the economic cycle”.

Also – I don’t think the 50bp cut will “cause” unemployment, there is nothing to suggest that and in fact almost all literature would suggest that a rate cut will still reduce unemployment.

But the literature suggests …

I recognise there are papers that say that you should tighten policy following a natural disaster – I have read them.  They make sense.

However, they are generally premised on the economy being in “equilibrium” to start with – the New Zealand economy is currently very depressed.  When an economy is depressed a negative “demand” shock carries a greater risk of leaving the economy is a poor state (corridor hypothesis).  As someone that grew up learning microeconomics, I find this view appealing – although it is subjective.

This is why the Bank needs to respond to new information – I agree with Bernard here that if it turns out the confidence effect doesn’t exist they need to respond.  However, ex-ante their justification for cutting makes sense (I am bound to say that, as I felt that this would be the given justification).

Furthermore, I would have expected rates to be HIGHER further out – giving us a much steeper yield curve.  However, even with this and my inherent hawkishness I felt today’s decision by the Bank was sensible – demand is a nebulous concept, and when domestic demand is already very weak the downside risk associated with another decline is substantial.

Trust me – this “hysteresis” type path is one of the two main paths to stagflation.  The Bank’s actions reduced the likelihood of this possibility – they didn’t increase it.

  • Cheers Matt
    Is the NZ economy currently “very depressed”
    We’re also about to be hit by an inflationary surge from record high commodity prices and a lower exchange rate.
    Oil prices are going through the roof.
    A rate cut does little to help Christchurch. In fact, it hurts pensioners and retirees who depend on their interest payments.
    Also, I wonder how quick the RBNZ can reverse.
    The percentage of the mortgage book on floating is barely 50% and although the duration now is much shorter there is a risk the RBNZ’s rate cut will take effect in 18 months to 2 years time just as the inflationary surge of all that reinsurance money slams into Christchurch and the rest of the economy.
    cheers
    Bernard

  • @Bernard Hickey

    Hi Bernard,

    All good questions – ones that deserve answers for sure. Let me take each one in turn:

    “Is the NZ economy currently “very depressed””

    Money supply and lending growth is virtually nil, unemployment is pinned well above its natural rate, GNE is well below its pre-recession level still, and GDP is well below what NZ is capable of producing.

    These facts in themselves tell us that our economy is well away from “equilibrium” at present – hence a demand shock is riskier.

    “We’re also about to be hit by an inflationary surge from record high commodity prices and a lower exchange rate.
    Oil prices are going through the roof.”

    A price level surge is different from an inflationary surge. Scarcity of food and oil is driving up fuel prices, while the exchange rate is responding to our worse economic prospects. Price changes like this hurt people – I don’t disagree, but they are not the thing we can control. It is just part of the world environment.

    Inflation is persistent growth in prices, unrelated to scarcity. The RBNZ has said that their forecasts show that their target for rates avoid breaking their inflation target – which is what they have to aim for.

    Again, a jump in the price of what we have to pay involves transfering resources from us to people who make the stuff – that stings! But, monetary policy can’t and shouldn’t try to do anything about that. Competition law should, industry policy might be able to, not monetary policy.

    “A rate cut does little to help Christchurch. In fact, it hurts pensioners and retirees who depend on their interest payments.”

    Indeed, the rate cut WASN’T for CHCH, it was for an expected drop in confidence and activity in the rest of the economy due to shock regarding the crisis – this is one hell of a subjective thing, and the RBNZ made a call that it would be a big shock. If it isn’t they need to move back – but personally I just don’t know either way.

    “Also, I wonder how quick the RBNZ can reverse.”

    Hopefully they will respond appropriately given all the available information – we can’t ask anymore.

    “The percentage of the mortgage book on floating is barely 50% and although the duration now is much shorter there is a risk the RBNZ’s rate cut will take effect in 18 months to 2 years time just as the inflationary surge of all that reinsurance money slams into Christchurch and the rest of the economy.”

    This is a commonly raised point – but the primary role of monetary policy is to function by changing marginal lending in the economy, not so much the average rates persee. The marginal rate is what matters for additional lending.

    However, something that has become obvious is the “income impact” of average interest rates. Which is why the Bank is paying more attention to the “shape” of the yield curve, and their projection for interest rates. Notice that longer term rates rise pretty sharply – this implies that those borrowing for, say, two years will not really get much of a cut for fixing now.

    They have lowered near to terms to stimulate marginal lending and kept longer term rates higher – this should be relatively easier for them to reverse … if they decide they want to.

  • Miguel Sanchez

    Strange times indeed when Bernard Hickey is castigating people for not having “more faith in the resilience of the New Zealand economy”.

    But then he promptly contradicts himself by talking about stagflation, so… never mind, as you were.

  • andrew coleman

    “The primary role of monetary policy is to function by changing marginal lending in the economy, not so much the average rates persee.”

    Are you sure this is correct, Matt? As a matter of logic, monetary policy can operate perfectly well without inducing any marginal lending. In an economy comprising overlapping generations, a reduction in current (short term) interest rates induces a change in the price of existing assets (equities, loans, land) that creates an incentive for the owners of those assets (the old) to bring forward their consumption plans and increase spending. This can take place without any new loans at all. Suppose young people suddenly decided to start saving more. If they did so by buying the existing assets of old people, it is quite plausible that the decline in interest rates prevents total output from falling as old people sell their assets at a premium and spend more.

    Of course, a decrease in interest rates may induce firms to borrow and increase investment. But this does not need to take place for monetary policy to be effective.

    Irving Fisher, (The theory of interest, 1907) argued this point at length (and I do mean at length, for he repeats everything three times) before The Federal Reserve was a twinkling in Aldrich’s eye, and long before central bankers started fiddling with interest rates to induce new investment.

    It follows that whether monetary policy has its greatest effect by inducing new debt and investment, or whether it has its greatest effect through changes in asset prices that induce changes in consumption is an empirical matter. In an economy where there is a very large net foreign debt position, it is possible that the income (old asset) effects matter just as much as the substitution (new debt) effects.

    Andrew

  • @andrew coleman

    For one, role was the wrong term – this is what I get for writing. I meant mechanism – however, you decided to just ignore my poor choice of word so thanks 😀

    Now in terms of what you have suggested, yes of course – lending is not the only channel we should ultimately view monetary policy in. And I can see why you are saying it is relevant for a country with a small open economy with a large stock of debt which has been used to fund investment in an asset class.

    However, I’m not convinced that the income effect will be strong enough.

    For one, it is a direct transfer. If there was no transfer the argument relies on either credit constraints on the asset rich or a lack of income smoothing – both things I am leaning against. However, that is not that case you are making – it is just a point to start with.

    However, more importantly for me is the general way a said asset can be viewed. A lift in house prices (using this as the asset class) is a positive wealth shock for owners, but the implied lift in rents and future house prices is a negative lifetime wealth shock for people who do not own property. I’ve always been of the view that owning one house places you in a “neutral” position with regards to prices – and that not buying is the equivalent of going short.

    So in conjunction with the first point – as long as expectations of house prices are formed ‘rationally’ the shock to house prices is just an income transfer and the substitution effect should dominate on average UNLESS we assume something inherently different about the preferences of the two generations right?

    In the current case of New Zealand we have see a run up in house prices – but doesn’t that have more to do with issues regarding expectations rather than the setting of monetary policy persee. If expectations of house prices become unrealistic (typical bubble) we have an issue – but I don’t see how monetary policy has anything to do with this. Although I would be happy to be shown otherwise. This is the thing, as long as I view the bubble as an unrealistic premium on house prices I don’t think the income effect can dominate – if it popped the bubble then maybe, but if monetary policy can’t cause the bubble it can’t pop it either.

    Even with all my talk about marginal lending the main channel of monetary policy is really through expectations – and although many people accept this I’m always surprised of the paucity of literature trying to figure out how expectations are formed. I guess maybe that is sociology not economics …

  • raf

    I have to admit I felt this move had a whiff of political expediency. I thought they shouldn’t have raised rates in the first place so not too worried about them being back at 2.5%. In terms of the help to Christchurch, it’s hard to imagine it’s even registered. People literally don’t know whether they are coming or going and that’s not likely to change for some time. As Andrew says interest rates themselves are not the one and only inducement to invest, save or borrow.

    50% of the country has experienced no wage growth in the last 20 years. Most people have more pressing issues to contend with. As far as the overall economy goes this cut probably helps but the reality is that we are in a long term deleveraging process and the economy is flatlining.

    I also don’t see that the RB’s forecasts have been anything to worry about for some time. They (and others) have constantly overestimated the strength of the economy so really why should we worry about where rates are. There are larger forces at work and monetary policy is becoming more of an irrelevance as time goes on.