By setting the OCR the RBNZ commits to borrowing an infinite amount off banks for 25bps less, or loaning an infinite amount too banks for 25bp more than the OCR.  Of course, this is now constrained by prudential regulation – but at the margin, the RBNZ sets the opportunity cost of bank borrowing and lending, and so can move around interest rates (which also depend on borrowers risk profile etc).

The increase in the “margin” on top of this has been assumed by many people to be permanent.  The main calls are:

1. It is the result of higher risk, which is not going to abate soon
2. It is the result of new prudential regulation

In part these are true.  However, is the assumption that this increased margin will remain forever really the best assumption when looking at how the OCR translates into interest rates?  Furthermore, as the OCR rises, is it fair to expect that the margin will remain unchanged, and marginal costs will keep rising by 25bps?

I’m not so sure – as I’m not convinced the Bank completely controls the marginal cost of funding right now.  Here are a few reasons off the top of my head:

1. The Bank also focuses on financial regulation – as a result, borrowing from and lending too the Reserve Bank provides a signal of an individual banks quality.  Even though the RBNZ is willing to borrow and lend an infinite amount does not mean that individual banks will work on this basis – and marginal funding may infact come from other sources for new loans.
2. Individual banks are constrained in setting lending rates on what they have set for deposit rates.  As deposit rates have been pushed up due to prudential regulation this has set a “floor” on lending rates – even when the marginal rate is lower, implying that the reaction to a rising OCR will be muted.
3. International interest rates, even for moderately long maturities, are low.  This will, in turn, have an impact both on demand for funds from banks and the cost of funding from banks.  Note that, even with the new prudential regulation longer-term foreign lending can still often be used – and so could help to determine the marginal price for longer term lending.
4. The new prudential regulations (will) mean that a bank has to fund 75% of a loan (currently 65%) from outside the RBNZ right.  So if they loan a new $1, the marginal cost of that dollar will be 3/4 set by the underlying market and 1/4 set by the OCR – at least this is my impression of how banks have to respond.

Ultimately, any factor that ensures that the “marginal $ borrowed or lent” is not coming from the RBNZ could also provide an explanation for why this “margin” has grown.  If this factor is the result of the OCR being historically low, then we can expect the OCR to have LESS punch as it rises.

This is fascinating – and I’m surprised that we haven’t seen more work come out about it.  By the end of next year, it will be very interesting to see how rates have responded to a rising OCR.  I am currently not convinced that the working assumption a perfect feed through is Bayesian rational

Listen to this:

Labour would broaden the Reserve Bank’s monetary policy targets, adding a requirement to aim for a stable currency, full employment, and the economic prosperity and welfare of the people to its existing inflation target

Yes, because determining how quickly to run printing presses can do all these things.

And has Labour figured out how to measure welfare in society?  If so I would like to meet them and congratulate them – that has been a vexing issue for economists AND psychologists for centuries.

Also:

“The Reserve Bank Act needs to be clarified to ensure the bank can use such tools primarily for the purpose of supporting Monetary Policy,” Labour’s associate finance spokesman David Parker said.

“Labour will make that change. Faced with rapid credit expansion, such as that in recent years, the change would cause the Reserve Bank to use prudential ratios, rather than rely solely on interest rates.”

Yes because, ex ante, when we have little information on the nature of the economy relative to its potential the Reserve Bank is incredibly well placed to determine the level of risk banks should take on.

Also, prudential regulation will change interest rates – acting like this is a “cost free” way to change monetary conditions is weird.

I realise the Bank is introducing prudential regulations, and I can see some potential for it theoretically.  However, I’m still not convinced at this level – and as a result definitely don’t think it should be made a central part of their mandate yet.  As I’ve said before, I think the organisations that determine monetary policy and prudential policy should be kept separate on transparency grounds.

You want more discussion on these issues – search the blog, we’ve written about these things repeatedly.  One day soon I may come back to it.  And if you think this “change” in policy make sense, feel free to email me/comment etc, but there is only the slimmest of chances I’ll ever agree with you – so keep that in mind.

It was almost entirely in line with expectations so there isn’t much to say, except:

1. They more explicitly discussed Eric’s concerns regarding the impact of ETS increases into inflation expectations.
2. They put table 5.2 in which talked about “who got what” from tax cuts.  OMG, seriously – this table was unnecessary.
3. The continued to state that there is no real reason for our TOT to hold up – so a lot of the issues I’ve viewed as “structural” (rising commodity demand from China’s middle classes, Biofuels, falling subsidies on agriculture around the world) are being viewed as temporary by the Bank methinks.  This is why I will always disagree with their medium term forecasts …

Eric Crampton raises some important points regarding the Reserve Bank’s view on the ETS in New Zealand.  Essentially, they are ignoring it – a policy decision that a lot of analysts have disagreed with.  However, this is one of those cases where I would tend to side with the Reserve Bank, lets work through the discussion to figure out what value judgments I’ve made to get there

Update:  Eric discusses further here.

In the initial post Crampton stated:

As I’d understood it, there would be both a level and a rate effect [from the ETS]: implementing the system gives a level shift that RBNZ would rightly look through, but if the thing’s going to be effective, it’ll also have to have a rate effect. Why? Even if they don’t put a declining cap on the trading scheme, economic growth will make the cap increasingly binding and consequently will raise the trading price and consequently will force prices up and consequently will raise inflation expectations in the medium term.

It is true that rising inflation expectations would lead to a response from the Reserve Bank – so I agree here.  And, if we say that the price of emission permits rises over time this does imply that measured price growth will be faster.  But I felt:

Persistent relative price shocks aren’t inflation either – unless we believe they will feed into inflation expectations. As a result, the Reserve Bank is effectively just saying that they don’t expect inflation expectations to change markedly in the face of the ETS.

Eric responded to my relatively empty point by saying:

Agree that a persistent relative price shock isn’t inflation, but ETS isn’t a carbon tax: if this were a carbon tax plus commensurate tax reductions, all would be fine: definitely then just a relative price effect.

Now I can discuss where my head is at in more detail

In essence, the final version of the ETS is similar a carbon tax – in so far as the optimal tax would have to be set at the market price for emission permits and the income generated from an ETS goes directly into lower income taxes (relative to what they will be given our agreement with Kyoto).  The transition to this optimal level is just a series of relative price shocks.  Furthermore, if the price of emission permits rises through time the optimal carbon tax would have to do the same – in essence, the fact that the optimal carbon price is rising through time, and so permit prices are rising, is just a series of relative price shocks – and so this shift doesn’t have a clear impact on Bank policy.

The main thing that makes it “not just relative price shocks” is Kyoto.  If we have a net liability under the Kyoto protocol this would be equivalent to a negative terms of trade shock (something I would term a negative supply shock) – so the Bank would optimally want to partially accommodate that (given their implicit quadratic loss function).  Note:  I am really just saying that they wouldn’t respond to an increase in the price level directly – I did not mean to infer that they would be willing to let inflation expectations rise, which is what this sounds like.

The main question has to be how an ETS impacts on inflation expectations (these would be the second round effects).  The Bank must believe that the gradual nature of the ETS’s introduction, and the negative direct income effect stemming from any Kyoto liability, will be sufficient factors to prevent them having to do anything – they don’t think inflation expectations will move.  If anything, the common belief that we will end up with a liability as a nation (when all the figures are finally together) implies that Bank policy should respond by EVEN LESS than it would in the face of a compensated relative price shock – as it is a negative supply shock. Update My logic was off here, as explained by Seamus in the comments.

Finally, my impression is that in the initial article they were simply stating that they wouldn’t directly act on the jump of the price level – they were not saying that rates would not be different than under a counterfactual situation with no ETS

So my value judgments in agreeing with them are:

1. Can’t see inflation expectations moving (this presupposes the Bank will move on inflation expectations – so is virtually tautological )
2. In less tautological terms, the path of interest rates may differ from the no ETS counterfactual – but it will not be explicitly because of the initial price level shift from the ETS.  Telling people that the optimal path through the medium term may differ because of impossible to quantify second round effects (as the Bank will be reacting to expectations and monetary aggregates, not the ETS directly) may come off as overtly wonkish

We now see herd behavior in the markets that are really pack behavior, wolfpack behavior

Relevant picture:

Shirt source.

My question as a New Zealander who has experience the vicious swings in currency myself – why protect the value of the euro?  The euro is falling to help buffer the painful adjustment Europe is about to go through given their banking crisis, and they want to waste money trying to prevent this?  I don’t understand. Note: Krugman seems to feel a similar way.

This makes sense, previously people purchased the junk on the basis that someone else would pay for it – high return low risk!  Now that they have to face the real risk profile they are like “f**k that”.  However, Bloomberg (or at least David Kovacs) stated:

The reason the market is horrified now is Trichet said it’s not even being discussed. Smart investors are basically selling risk(y) assets

No s**t.  An asset appeared low risk, and now it is high risk, and the expected return is (at most) unchanged – so the risk adjusted return is lower.  No wonder they want to sell.

Now we are in a crisis, and if there is a run on good quality debt because of concerns we have to do strange things – sure.  But we need to come up with a system that rips this moral hazard out of the system.  It is the moral hazard that helps to drive crisis after crisis ultimately.

Bernard Hickey recommended sticking to floating mortgages for the long haul on Rates blog recently.  This is in stark contrast to Tony Alexander’s suggestion that, in a few months, fixing will be the way to go.

Now fundamentally, I think these two authors AGREE on the track for the official cash rate going forward.  The difference stems from the expectations for floating and fixed rates.  Personally I agree with Tony.  Why?

Bernards argument, in my opinion, hits a certain flaw right here:

If, for example, the Reserve Bank starts increasing the Official Cash Rate from its 2.5% to around 5% by the end of next year, then variable rates are expected to rise to around 8-8.5%. Given fixed rates are also expected to rise by a similar amount to around 9-9.5% the choice is clear for those simply looking for the cheapest rate.

This isn’t how floating and fixed rates work per see.  The current official cash rate influences interest rates now by providing some opportunity cost in sourcing funds.  The future official cash rate influences fixed interest rates now, by changing the opportunity cost of sourcing funds in the future.  As a result, the fixed rate depends upon expectations of the OCR in the future, while the floating rate only depends on the OCR now.

Given that everyone expects the OCR to lift appreciably in the coming quarters, it makes sense that the current floating rate is below the fixed rates.  However, as the OCR increases floating mortgage rates will lift by a greater amount than fixed rates.

Bernard Hickey is absolutely correct when he says that the world is different, and the make up and structure of interest rates will be different than we have experienced in the past.  However, as we move through the upward swing of the economic cycle I would expect fixed rates to become “relatively cheaper” than floating rates in a static sense.

I have argued many times that the Fed should have two roles. It should conduct monetary policy, and it should be the primary regulator of the financial system. However, not everyone agrees. When I was at the What’s Wrong with Modern Macro Conference in Munich recently, I met Hans Gersbach — we were on a panel together — and he passes along his argument that monetary policy and banking regulation should be conducted by separate bodies

So the disagreement here is not about the two instruments for central banks – in fact in the monetary policy community there is a strong degree of agreement regarding these two roles.  The disagreement stems from who should be in charge of the instruments – should we have one authority controlling both, or separate authorities.

This is a fascinating issue, and I have previously said I am on the side of SEPARATING.

My reasoning is that separating “monetary” and “financial stability” issues is essential in order to create transperancy in the public regarding policy movements.  If we can make sure that changes in the Bank’s cash rate are related to “monetary” policy and changes in prudential regulation/settings are related to “financial stability”.  By doing this, the actions/intentions of the individual institutions are more obvious and are more likely to anchor expectations – which is the point.

Of course monetary and financial stability policies, and these instruments (interest rates and prudential policy) are heavily related.  But of course, we know that monetary policy and fiscal policy is as well.  The fact is that in order to signal policy and control expectations we NEED individual instruments to be targeted at individual variables – and having separate institutions helps to clarify this fact.

However, in the same way I don’t believe the difference in these games is just the product of “framing”, I am not sure if the call to arms against using interest rates as a focal point is necessarily that compelling.

On quantity and price competition

Back in the 19th century some economists called Cournot and Bertrand came up with separate models of firm oligopoly behaviour.  In the Cournot model firms picked quantities, and they kept some market power – albeit less than in the monopoly case.  In the Bertrand model firms picked prices – and we got this crazy result that merely having two firms in a market provided perfect competition.

As a result, economists became concerned.  We had two models, one which seemed to fit data better (Cournot) and one which had assumptions we felt were more realistic (Bertrand).  A multitude of ex-post imperfections could be introduced to a Bertrand game to create “supernormal profits”, such as heterogeneous goods, transaction costs, and imperfect information – but there was still the problem that, if we had only two firms competing and they decided to “play” in prices instead of quantities we had a different outcome.  Given that the demand curve is the thing along which both price and quantity were picked, and given that the firms in both cases were seen as equivalent, this didn’t seem consistent.

Eventually economists realised that there was something else at play here.  The Cournot and Bertrand firms were not equivalent at all.

In the Cournot game the question is:  if I LIMIT myself to producing a quantity how will other firms react – and given that reaction what level of quantity would I want to limit myself to.

In the Bertrand game the question is:  I have an unlimited ability to produce.  As a result, if I set a price how will other firms react – and given that reaction what price would I charge for the produce I will be able to make.

So in the Cournot game you build things first, set the price later.  In the Bertrand game you set your price and immediately satisfy this demand.  As a result, economists realised that the Cournot game was simply a Bertrand game with capacity constraints.

What in the hell does this have to do with the point on monetary policy!

I was getting there.  Fundamentally, in the same way that Cournot and Bertrand games were discovered to only give different results because they were fundamentally different, I believe that any difference between an interest rate target and other targets only differs if “effective policy” is different – I don’t believe in a framing issue persee (although framing explanations can be funky).

Now I don’t disagree with the idea that just talking about the nominal interest rate would be silly.  But central banks don’t just talk about a nominal interest rate – they also discuss an inflation target, which anchors inflation expectations.  In essence the current “focal point” for policy is the real interest rate.

Furthermore, since they control a real interest rate, and have anchored inflation expectations, they can print money which in turn increases demand for goods and services.  As Nick states:

And most of the power of a central bank comes from its ability to influence people’s expectations of the future. Like governments, police, armies, and referees, most of central banks’ power comes from belief in their power

The fact that inflation expectations are anchored implies that people believe they know the future price level, given that a significant portion of any nominal increase in income will be confused for real income – leading to extra spending activity.  That is the very power of an inflation target – an inflation target that is easy to communicate and explain to the public by discussing interest rates.

Targeting arbitrary variables that are positively related to an economic recovery, but not appropriately related to “monetary policy” seems both sort of aimless and potentially dangerous.  A central bank can keep discussing interest rates and its inflation target, and even at a “zero bound” it could stimulate activity by printing, printing, and printing.

Finally, I think it is important to note that this subject only really matters in the rare occasion that it really matters .  Outside of zero interest rates and a steep, depression like, drop in demand the interest rate (or some indicator of “monetary/financial” conditions) is an amazingly effective tool for communication.

However, my belief is that this effectiveness continues even in the extreme conditions.

As a result, to fill in time we will put up a recent discussion between TVHE writers.  The one thing this conversation shows:  we all agree that arbitrary policies that are introduced to indirectly target a problem (eg changing the minimum wage to target inflation) tend to do more harm than good.

Am I missing something? Cost push anyone?

http://www.newsobserver.com/340/story/287265.html

Increasing the minimum wage is a one off increase in the wages for one part of the labour market right, and it would reduce employment, which would reduce “demand”, which would reduce growth in prices (which is inflation).

Any increase in inflation would have to come from inflation expectations – where the increase in cost passes into prices and then the higher price level is “confused” for inflation.

As a result, if we can say that an increase in the minimum wage will:

1. Be in industries where demand for the product is relatively elastic so the change in price is minimal,
2. Be in industries where demand for labour is relatively elastic so that employment falls reducing demand

Then we can say a higher minimum wage will reduce inflationary pressures.

Of course, this seems like a fairly suboptimal way to reduce inflationary pressures – as when demand is elastic (as it would be in the labour and goods markets here) the direct welfare cost of the minimum wage is very high …

how likely is it that the set of circumstances you outline will eventuate? It seems quite far fetched to think that it will hold across all industries that heavily utilise minimum wage labour.

Well then there is a trade-off – its impact on inflationary pressure vs its impact on economic efficiency and direct impact on welfare.

I’m suggesting that the trade-off might not even exist:  it may hurt efficiency and thereby exacerbate the inflation problem.

True.

However, they only way I can think of really getting that result is:

1. Using a capacity model of inflation,
2. Saying that the corresponding lift in the price level for a negative supply shock will feed into inflation expectations.

Although this will limit the inflation vs efficiency trade-off I’m not sure it will make it reverse direction, although it could.