Matt Nolan

Discussion on how to screw up a terms of trade increase

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According to Statistics New Zealand our terms of trade is now at its highest point in almost three and a half decades. To some degree this lift appears to be structural, with growing demand for protein goods from Asia and the increasing prevalence of biofuels two of the main factors driving up prices permanently.

However, Berl and the Hive have identified what they believe to be the main policy factors that could mess up our chance to take advantage of this national increase in income (h.t. the Hive). These factors were Inflation targeting (Berl) and the Emissions trading scheme (the Hive).

Here I aim to discuss the Berl argument – the warning is that it might sound a bit technical (more down to my inability to explain myself clearly than anything else 🙂 ). After that I will do another post on the argument that the Hive raised, and maybe even state what I think is a major policy risk 🙂

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Matt Nolan

Inflation targeting failure: Why inflation targeting?

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Article from Dom Post on Saturday is here (*).

Other New Zealanders discussing inflation targeting can be found here (*) and here (*).

In order to make justify the defense of inflation targeting let me note down a few points about why inflation targeting is used and how it should work.

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Matt Nolan

Why might the Fed lift rates?

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There is talk that the US Federal Reserve may begin lifting interest rates again in August.

Now this is something that some commentators find unusual (*) (*). However I think it is consistent for Dr Bernanke to slash rates as he has and then turn around to tighten, given the way he views inflation targeting.

Fundamentally, we have seen two very different reactions to a domestic economic slowdown in Europe and the US. In Europe inflation targeting means sticking to your guns on the annual growth in price measure in the economy – and just looking at other economic variables as a secondary concern.

This view of inflation targeting is justifiable given the inherent commitment game that is required to stabilise growth in the general price level in the economy – however, from a welfare maximising point of view it “may” be too black and white.

In the US, Dr Bernanke is also a proponent of inflation targeting (book and a good speech). I get the impression that he enjoys inflation targeting for its ability to anchor inflation expectations – giving the bank the chance to “deviate” from its mandate temporarily to ease economic conditions.

However, this view of inflation targeting has one major catch – the Bank must stay credible! Read more

Matt Nolan

June 08 OCR review and MPS

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The Reserve Bank left the official cash rate unchanged today at 8.25% – inline with the expectations of most if not all market analysts. However, as always, the devil was in the detail.

Starting with the statement, the language surrounding potential cuts changed completely. In March (*) we had “the OCR will need to remain at current levels for a significant time yet” then in April (*) “the OCR will need to remain at current levels for a time yet”. However in June we got:

Provided the economy evolves in line with our projection, we are now likely to be in a position to lower the OCR later this year (*)

With the RBNZ picking an annual inflation rate of 4.7% by September they are effectively stating that if the June CPI number is weak (or even moderate), rates will be cut by July.

Further detail was in their Monetary policy statement for June (effectively their forecasts).

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Matt Nolan

The currency market – small menu costs matter

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Immediately following the release of the overseas merchandise trade data today the dollar slumped by about 20 basis points, however it didn’t stay down for long, more than recovering from this low point:

Source NBNZ

You might wonder why this fall and rise is even interesting – but the reasons behind it imply that issues such as “menu costs” can be important.  Why?  Well the headline number of today’s result provided a bad headline (monthly trade deficit biggest in 26 years!), but for a small time investment (reading the Statistics New Zealand news release) it would become obvious that the headline number was deceiving and in fact today’s result was relatively positive (as a significant proportion of the additional import activity was the result of one-off capital imports for further oil production).

The menu cost mattered in this case as the opportunity cost associated with time it would require to read the release was high – if a bad headline comes out it is in the dealers interest to react before everyone else!  As a result, a situation like this truly does have a substantial menu cost (which results from the first-mover advantage implicit in the situation) even though, on the face of it, it would initially seem difficult to view spending a minute reading a free release as a significant cost!

Why does all this matter.  Well menu costs can be the basis of price rigidity (although I doubt this in the case of currency trading) and also can be the basis of what we may view as “irrational” behaviour in the marketplace.  If small information asymmetries can have such a large impact on the behaviour of agents, and the equilibrium price, it dilutes the power of the price as an efficient signal to allocate resources.  This does not mean we should give up on prices – it merely shows us the importance of the provision of information in the economy.

Matt Nolan

Tax cuts and interest rates

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Given my belief that these tax cuts, without corresponding cuts in (unproductive types of) government spending, will lead to greater inflationary outcomes I’ve decided it is important to argue the complete opposite case – namely that tax cuts will not impact on inflationary pressures and interest rates.

The common view I work off when stating that tax cuts increase inflationary pressure is that tax cuts increase “aggregate demand“, which in turn will lead upward pressure on prices, and therefore an upward shift in interest rates.

However, there is another popular view that has been raised by Stephen Kirchner of Institutional Economics. Specifically this view states that tax cuts have supply side effects on the economy (which increases the supply of goods in the economy and so reduce inflationary pressures) and some degree of Ricardian equivalence holds – such that any increase in budget surpluses will lead to borrowing from the private sector, as they expect tax cuts later. He makes these arguments here and here (I made a similar argument here).

Furthermore, tax cuts may reduce wage pressures – thereby leading to lower inflation. How? Say that the nominal wage is fixed and there are tax cuts – it this case the whole tax cut immediately goes to the employee. However, unless the employee has significant market power, the employer will be able to extract some of the surplus gained from tax cuts over time, by offering smaller wage increases.

Given these supply side arguments why am I still concerned about inflation?

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