Potential output in monetary policy

When it comes to “potential output” there is often a view that the economies potential to produce is determined by the labour, land, and forms of capital that are available to create this output from – and this is right!  Furthermore, each of these factors tends to produce a diminishing amount of additional output as you use more of it.  Although the factors of production are often complementary this often implies a situation where – in the long-run – the potential for output (and growth in said output) in a nation is fundamentally about technological change and the quality of institutions.

However, in a recent speech by John McDermott of the RBNZ he points out that, when it come to considering monetary conditions, the type of “potential output” we are interested in is a bit different.

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VSR: Very silly regulation?

When discussing it’s new monetary policy Labour was keen to explain why they felt a change was necessary, and why a variable Kiwisaver contribution rate should be investigated.  However, to investigate such a policy it is important to ask some specific questions – this is what Gareth Kiernan did in this article (Infometrics link).

In announcing its new monetary policy proposals, Labour has shown an admirable ability to think outside the square. …. Unfortunately, there are a lot of problems with Labour’s idea and the assumptions behind it.

His list of 10 questions are:

  1. Should KiwiSaver be compulsory?
  2. Does New Zealand really have a savings problem?
  3. How good is Australia’s compulsory savings scheme for their economy?
  4. Do compulsory savings programmes actually increase savings anyway? 
  5. What effect do compulsory and limited-access savings have on the robustness of financing decisions?
  6. Is New Zealand’s permanent current account deficit really a problem?
  7. Are our ‘high’ interest rates really caused by our rigid monetary policy framework?
  8. How much of our mortgage interest payments go overseas?
  9. Does the export sector really need a lower exchange rate?
  10. What about compliance costs for businesses?

His answers to these questions give a case for why the VSR may not be good policy at all.  What are your thoughts?




Monetary policy 2.0?

Labour wants to upgrade monetary policy, preserving inflation targeting but asking the Reserve Bank to reduce persistent external deficits. To help, the Reserve Bank might get to vary contributions to an enhanced Kiwisaver scheme and go a little further with macro-prudential policy. Getting kiwis to save more is probably a good thing. If successful, interest rates would be lower and ease the exchange rate a little. But the evidence-base is weak and there are many leaks since implementation and accountability frameworks are not clear. Better to leave the Reserve Bank to do what they do best – implementing flexible inflation targeting.

The problem as defined

Many commentators point out that New Zealand has high real interest rates and that the exchange rate is overvalued relative to an economy less reliant on borrowing from abroad (see below). That makes our exports less competitive and promotes consumption of imported goods over domestically manufactured goods.

The problem: high interest rates and an overvalued exchange rate

The problem: high interest rates and an overvalued exchange rate


Our persistent negative external balance – that nets our borrowing and imports from overseas against exports – largely reflects our savings choices. Of course, an external balance can also reflect imports of capital equipment for investment in the real economy but most likely reducing the external balance would reflect a useful rebalancing of economic conditions for New Zealand.
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In defence of the RBNZ’s upcoming hike

Although I no longer have the time to keep up with the literature on financial stability policy (and so am not commenting on it – this is due to my switch to detail income data analysis), I still spend a bunch of time looking at the national economy and monetary policy.

I see that a section of my work place thinks we need the RBNZ to be more hawkish than it is.  There are also many people who think lifting soon is madness.  I am not personally not in either camp – I actually think the Bank has got this right now!  The Bank’s decision to lift soon and get rates back to neutral does make sense given what they are facing, and that they are doing it the right way.

[As a disclaimer, I was more hawkish than the Bank during the crisis (I was wrong) - although my forecasts of economic variables were surprisingly accurate then, that was because their actions were more appropriate, not because I had any foresight ... another indication of why forecast performance isn't always the best judgment variable ;) .  From late-2011 until the end of 2012 I was more dovish than the Bank was.  Now, I find their discussion consistent with my own narrative and models - including the discussion of the risk.  So it is hardly surprising I'm so willing to defend them :) ]

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Does the BoE’s view on uncertainty make sense?

Uncertainty is an unavoidable element of policy decisions. In the words of the great Donald Rumsfeld, we must confront the unknown unknowns. In this appearance the BoE’s chief economist, Spencer Dale, discusses his approach to dealing with uncertainty in the context of forward guidance. Essentially, he says that the Bank doesn’t know how big the output gap is so it has been cautious with forward guidance. He suggests that any other course of action would risk pushing up inflation expectations.

His view is understandable, given the Bank’s inflation target, but it is probably not optimal for the UK. Read more