The case for not cutting

There is a growing call for rate cuts to the OCR in New Zealand given the high unemployment rate, indications that the September quarter was very weak, and the fact people are pissed off that the weakness in the New Zealand economy has been so persistent!

Now I’m not going to go one way or the other on this – after all I don’t really want to second guess the Reserve Bank.  However, the case for a rate cut appears to be weaker now than it was earlier in the year.

How can I say this?  The unemployment rate is undeniably higher.  Well remember that unemployment is a lagging indicator – usually the economy is well into picking up before we see a sustained drop in this.  You may retort (I know I would) with the hours worked figures, which have been very weak.  Hours worked is usually the first thing to pick up (either with or a bit after productivity) during a recovery.  For this all I can say is that hours worked are not as weak as they appear in the HLFS, but we would need to forecast them picking up soon!

Ultimately, we need to ask ourselves what a RBNZ forecast would need to look like to prevent a cut.  We would need them to first forecast no cut, and then to forecast an economy moving back to it’s “potential” level.  This will then be consistent with a forecast of inflation around the target band.

Why might we believe that the economy is heading back to potential (and without a lift in structural unemployment this would imply a swift drop in the unemployment rate in the coming years as well).:

  1. The lift in house sales and (soon to be) house construction – this rebound in durable good spending and investment tends to lead the economic cycle.  Generally households willingness to get involved in these things tells us that demand in the economy is on the up.
  2. Durable good sales to households have risen (although part of this is to builders and plumbers rather than consumers), and business investment has risen … business investment has dropped off in recent months, as part of the prior spike was “rebuild related”.
  3. A similar rebound in the US – with the prospects for the US picking up, underlying demand for a number of our export commodities (dairy, meat, logs) will firm.  Let’s not forget that the US is a big market for our (likely mismeasured) IT services export industry.  Why mismeasured – well if you know anyone who sell services online, you will know that they often avoid tax or business registration ;)
  4. Signs China has found its feet again
  5. Commodity prices are recovering sizably
  6. Easing bank funding costs.  The growing competition between banks in recent months is likely due to easier access to credit – there are reports this is flowing into businesses, albeit not evenly.
  7. The rebuild is now really getting underway.

This isn’t to rule out cuts – I’m avoiding taking a position here, as I want to save that for clients, and generally avoid upsetting people on the internet right now (what can I say, I’m a bit tired).  All I am saying is that, given the time it takes for a lowering of the cash rate right now to flow into the domestic economy, a rate cut when a lot of indicators have turned up in the last couple of months.

Also remember, if the Bank had been able to foresee what occurred through the middle of this year they would have cut earlier on – but they couldn’t foresee it.  This is not a criticism at all, because the Bank does have incredibly good “on average forecasts”, and as a result their actions can minimise the cost of policy mistakes.   But it does indicate that the Bank’s actions aren’t infallible, and that they should publicly explain what happened when we experience a situation of below target band inflation and rising unemployment to the public – instead of leaving all the commentary up to people who want to undermine them.

  • http://brennanmcdonald.com/blog/ Brennan McDonald

    Cutting the OCR won’t change anything. The incentives around job creation and skills training still aren’t there so I think unemployment would barely budge. Perhaps a slim increase in construction sector employment as marginal projects get green lights?

    No one ever thinks about savers! Retirees on already low incomes can’t afford to lose another 1% in gross interest. That increases their likelihood of voting for Winston First and therefore higher superannuation, so the long term costs of a short run attempt to boost demand are much higher than we might think.
    There are so many unintended consequences that come from lower interest rates, besides making it marginally more likely investment will go ahead.

    • http://tvhe.co.nz/ Matt Nolan

      I think the key thing to remember here is that the RBNZ isn’t really “setting the interest rate” – it is trying to adjust the marginal cost of lending to match the rate of interest rathe would set “supply and demand equal” in some sense.

      The return to savers is low because the expectation of future growth is low, and so the return on investment is low – this isn’t the RBNZ’s fault in of itself.

      The idea of whether the RBNZ should lower the OCR is a discussion around where the “natural rate” of interest has gone given what is going on in the underlying economy, so we need to ask what is happening with things such as capacity pressures and the economies natural ability to adjust to “create” work and output – as we can push the rate of interest below the natural rate insofar as we think there is capacity to move consumption and investment forward.

      Sure we shouldn’t act like its a silver bullet, but the Banks actions will be determined by what is going on in the economy, and what is expected to happen, and what this means for the appropriate term structure of interest rates – rather than them setting this term structure directly.

      • HJC

        Hi Matt, it would be more accurate to say that the central bank sets the average cost of borrowing, but I don’t know if that makes much difference to your answer.
        I assume that you don’t mean the natural rate from the loanable funds theory because then you’d be meaning that the money market isn’t clearing. So you must mean the natural rate that ensures that the economy is operating at the steady state. Is that right?
        Isn’t it curious then, assuming that rates are set correctly (at the natural rate that gets the economy back to inflation less growth), that there is still “the expectation that the future rate of growth is low”? Don’t these expectations mean that the interest rates are wrong?

        • http://tvhe.co.nz/ Matt Nolan

          Heya,

          I mainly go for marginal rate in my answer, as that is the type of mechanism the OCR is meant to work through – as its supposed to change the price.

          “Isn’t it curious then, assuming that rates are set correctly (at the
          natural rate that gets the economy back to inflation less growth), that
          there is still “the expectation that the future rate of growth is low”?
          Don’t these expectations mean that the interest rates are wrong?”

          The reason why the relatively forward looking rates are so low is interesting. We can always knock in a couple of other factors for kicks such as “a wedge in credit markets increasing funding costs” or “a change in time preference” but even then it may indicate that we believe “potential output” growth is pretty low.

  • http://www.tvhe.co.nz/ jamesz

    I think you do a great job defending the Bank on their behalf! If I were them I’m nto sure I’d waste resources trying to match you ;)

    • http://tvhe.co.nz/ Matt Nolan

      I am sure that writers from the RBNZ could write something far more literate and get it to a much wider audience ;)

      • http://www.tvhe.co.nz/ jamesz

        Is downvoting your reply equivalent to ‘unlike’, or does it actually have consequences beyond that?

        • http://tvhe.co.nz/ Matt Nolan

          One major consequence – it makes me a sad panda