Download Recent global developments in monetary policy and lessons for

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Recent global developments in monetary policy and lessons for
New Zealand
Stephen Grenville
Lowy Institute for International Policy
Treasury Monetary Policy Framework Workshop
Wellington
18-19 October 2016
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Synopsis
By the turn of the century, inflation targeting had become the near-universal ‘bestpractice’ approach to monetary policy. But the 2008 crisis and its aftermath took
many central banks outside the inflation-targeting framework in an attempt to
support a recovery held back by severe headwinds from the collapse of the
financial sector, damaged balance sheets and strong fiscal contraction. With the
standard monetary policy instrument – the short-term interest rate – already at zero,
central banks undertook unconventional monetary policy (UMP): quantitative
easing, forward guidance and negative policy rates.
While most policy-makers see these measures as having been effective, the
attractive simplicity of the inflation targeting framework has been lost. In this
paper it is argued that these UMPs are state-contingent and uncertain in their
impact, distorting the normal operation of financial markets, banks and
saving/investment decisions. The challenging task of unwinding UMP measures
and normalising policy interest rates still remains. These UMPs should be seen as
measures of policy desperation which would not have been necessary if fiscal
policy had done more to support the recovery.
New Zealand did not experience a financial crisis but did have a recession which
required unprecedented vigorous use of monetary policy. Policy, however,
operated within the traditional inflation-targeting framework and the policy rate is
still well above the zero lower bound. UMP is not among the options. The
inflation-targeting framework remains appropriate, with its proven track-record of
anchoring inflation expectations. There seems no need to contemplate the sorts of
changes suggested elsewhere – to raise the inflation target or replace it with a
nominal income target.
What, then, might be the relevance of the international experience? Just as the
international experience suggests that the interest rate instrument is not as powerful
in affecting inflation (and output) as it had been, New Zealand inflation also seems
to have remained less responsive to low policy interest rates than was expected.
The simple inflation-targeting framework uses forecast inflation as the principal
policy guidance, but if inflation is less responsive to the state of the output-gap
(perhaps due to the success of inflation targeting in stabilising inflation
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expectations), the central bank might need to give more weight to indicators of
output. In filling out the ‘back-story’ of forecast inflation, the RBNZ could include
detailed discussion of different measures of inflation (including core and nontradables), the output gap, and macro-shocks. All this makes a richer story of how
policy is formulated, without losing the powerful core narrative of the inflation
target. As well, it may be useful to recognise that return to equilibrium after a
substantial shock will be slower than in previous experience.
The post-2008 experience has highlighted the importance of the international
monetary policy linkages. Monetary policy has always included an exchange rate
channel, but since 2008 this seems to be stronger (compared with the usual
interest-rate channel). As well, some central banks have been tempted to use this
channel actively to support domestic activity. New Zealand (like Australia) has
found its exchange rate under unwelcome upward pressure. Resisting this
appreciation by lowering interest rates exacerbates domestic asset-price pressures.
This tension may persist.
If, as some argue, interest rates in many advanced economies are likely to remain
low in the future because of secular stagnation or chronic demand-deficiency, more
dynamic economies like New Zealand will have a persistent tendency to attract
capital flows and experience over-valuation, which will adversely affect the
tradable sector, often the source of dynamism and productivity increases. There is
not yet any consensus on an appropriate response, but the international policy
discussion seems more prepared to contemplate discouragement to short-term
capital flows.
At a risk of pointing out the obvious, two powerful lessons from the 2008 crisis
might be noted. First, central banks may fail to see a financial crisis coming.
Second, a financial collapse inevitably does huge harm, even if central banks
respond well to the crisis itself and its aftermath. The earlier view that asset-price
booms should be left to run their course (with policy cleaning up afterwards) now
seems much less attractive. Central banks have always had a mandate for financial
stability, but this should be explicitly given more prominence henceforth.
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Introduction
In the decade before the 2007-08 global financial crisis, monetary policy seemed to
have arrived at the ‘end of history’, where the near-universal dominant policy
paradigm was inflation targeting. Even countries without a formal target (e.g. the
USA) were de facto flexible targeters. The ‘great moderation’ – with both inflation
and output at satisfactory levels - seemed to confirm that policy had achieved a
satisfactory ‘best-practice’.
The 2008 crisis changed this. In its aftermath, central banks in the crisis-affected
economies were presented with unfamiliar circumstances:
• Central banks had not seen the crisis coming: there was a need to accord
financial stability higher priority.
• The recovery from the very sharp downturn in 2008-09 was quite weak. Not
only was there no quick return of output to the pre-2008 trend line: there was
a step-down in potential output and the prospect of a flatter trend growth of
output.
• Interest rates have been ‘low-for-long’, well below the usual
‘natural/neutral’ rate and below the setting suggested by a Taylor Rule.
Central banks which have spent three decades fixated on fighting inflation
found inflation persistently below target, with the threat of inflation replaced
by the threat of deflation. Policy was less effective than central banks
expected, with inflation (and output) forecasts consistently under-achieved.
• Inflation targeting seemed to be failing in two respects. The unexpected
nature of the crisis demonstrated that looking at the rate of inflation was not
enough, in itself, to indicate that the economy was in macro-equilibrium.
Second, the instrument of inflation targeting – short-term interest rates –
seemed inadequate to the task of restoring macro-balance.
• The policy response to this apparent ineffectiveness was to ‘increase the
dosage’: to push harder on monetary policy (taking rates further below the
setting implied by a simple Taylor Rule). This put policy rates in most crisisaffected economies at or close to zero (even negative in some cases). Much
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of the discussion implied that policy rates would have been taken down even
lower, if it were not for the constraint of the zero lower bound (ZLB).
• Despite low CPI inflation, asset prices increased, especially for housing.
• Macro-policy settings were unbalanced, with tight fiscal policy and
accommodative monetary policy.
• International capital flows were volatile and sensitive to perceived policy
changes. As a result exchange rates moved sharply, with some countries
experiencing unwelcome appreciation.
The core challenge was the lethargic recovery. While the source of the 2008 crisis
was in financial fragility and inadequate prudential supervision, macro-policy
responses were largely in monetary policy. A fiscal stimulus would ordinarily have
played a central role in supporting the recovery, but after the short period of global
stimuli in 2009, concerns focused on budget deficits and government debt levels.
Deficits were cut back in most countries, imposing a strong contractionary impact
on GDP. Monetary policy was left as ‘the only game in town’. Even pushed to the
limit (with near-zero policy rates common), lower interest rates could not deliver a
powerful impact. Companies and households whose first priority was to restructure
their balance sheets were not going to be induced to borrow more by lower interest
rates (although these were helpful in taking some of the pressure off stretched
balance sheets). With demand weak and uncertainty high, investment in expanding
productive capacity, even with low interest rates, was unattractive.
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Figure 1: US potential and actual GDP
Summers (2014)
In responding to the pressing need to lift the economy onto a faster recovery
trajectory, monetary policy was taken outside the usual inflation targeting
framework and into radically new operational techniques. Quantitative Easing
(QE), negative interest rates, enhanced forward guidance and the discussion of
‘helicopter money’ all changed the way monetary policy is thought about and
implemented. Can these UMP now be unwound and put back on the shelf, with a
return to conventional policies (see Bernanke (2016a))? Even in countries like New
Zealand that did not resort to UMP, the core simplicity and universality of inflation
targeting approach have been upset and the possibility of more complex versions
of inflation targeting has been raised.
We look first (Section I) at the unfamiliar challenges faced by the crisis-affected
central banks, and then (Section II) at the unconventional measures deployed in the
crisis-affected countries. Section III tentatively explores whether any of this is
relevant to New Zealand and Section IV concludes.
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I.
Lessons from abroad
(a) Why did central banks miss the impending 2008 financial crisis?
Perhaps the core problem was that central banks compartmentalised financial
stability issues, separating them from inflation control, which after the experience
of stagflation in the 1970s was seen as more challenging. Central banks (even
those with no responsibility for prudential supervision) understood that they were
responsible for financial stability. This seemed an easier responsibility - provided
prudential authorities were competent in monitoring the financial system at the
micro level, financial stability could be maintained. While individual institutions of
the financial sector might get into trouble, the system as a whole would remain
sound. This was all the more likely if the central bank succeeded in achieving its
inflation-control mandate without the stop/start cycle of pre-inflation-targeting
policy.
Even before the 2008 crisis, some (especially the BIS) were arguing that the
financial cycle had characteristics (causation and periodicity of its own) not
coinciding with the usual business cycle. This was a macro-issue (i.e. concerning
the interaction of the financial system as a whole with the broad economy), so
would not necessarily be addressed by the usual micro-prudential measures. To the
extent that the financial cycle was part of the pre-2008 broader inflation-targeting
discussion, it was usually couched in terms of how monetary policy should respond
to asset-price increases. Should central banks ‘lean’ against such asset price
increases by raising the policy rate, beyond what was needed to keep inflation on
target? Or should these asset-price bubbles be allowed to burst in their own time,
with the central bank ‘cleaning up’ afterwards. This was the ‘clean or lean’ debate
(White, 2009), largely settled in favour of the Greenspan (2005) view that asset
busts were unpredictable and could be easily cleaned up afterwards at minimum
cost to the macro-economy.
Credit was an important element of this financial cycle, but credit was not one of
the core indicators in conventional inflation targeting, was not a leading indicator
of inflation and was not consistently associated with financial crisis1. But credit
1
Dell'Ariccia et al (2012) note that two out of three credit booms were not associated with a
bust.
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growth had clearly been an important element in the 2008 crisis2. From a post2008 perspective, leaving it outside the central bank policy framework looked like
a serious error (especially considering the financial stability mandate).
Thus the 2008 crisis gave credence to the earlier work done by the BIS, which was
now able to illustrate the issues with the actual experience of 2008 (BIS (2016)).
The pre-2008 period represents the peak of a financial cycle, with different
periodicity and amplitude from the usual business cycle (see Figure 2). In this
view, interest rates should have been substantially higher to contain the growth of
credit. The adverse effect this would have had on GDP was the price which had to
be paid to offset the financial imbalances of the time 3.
Figure 2: the BIS Financial Cycle
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Drehmann et al (2012) use co-movement of credit and house prices to identify the financial
cycle.
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With a smaller crisis in 2008, monetary policy would have been more effective in the postcrisis period, the recovery would have been faster (a shorter period to restructure balance sheets),
and the end-point would have been a higher level of GDP.
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Whatever the arguments about alternative policies, the 2008 crisis showed that the
cost of a financial crisis (and perhaps its probability as well) had been vastly
underestimated before 2008. The ‘lean or clean’ debate had hugely underestimated
the cost of cleaning up and the lasting damage to potential output. Leaning was not
enough – it would respond too late and be blamed for the bursting of the bubble. A
further lesson was that inflation expectations might be so well anchored that a
positive output gap can occur, adding to financial vulnerability, but without
inflation triggering a policy response.
Responding to this new-found understanding would require policy settings to take
account of financial cycles (which would be identified in terms of indicators such
as leverage, default/NPL rates, credit growth and house prices), as well as
inflation. If this implies that finance-cycle factors would influence interest-rate
policy settings, the beautiful simplicity of inflation targeting would be
compromised. This could be avoided if the response is by way of macro-prudential
measures.
Lesson 1: don’t have a financial crisis
(b) Ineffectual monetary policy
Policy in the crisis-affected economies reacted prompt to what was clearly a
serious recession. By the end of 2008, US interest rates were close to zero in
nominal terms and substantially negative in real terms. Other crisis countries were
not far behind (with only the ECB lagging). If the actual settings are judged against
those suggested by a Taylor Rule, there was a short period in 2009 when the
Taylor Rule for advanced economies (RH panel of Figure 4) would have suggested
a negative nominal rate, but for almost all of the post-2008 period the actual policy
rate was lower than the Taylor Rule.
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Figure 3: Inflation-adjusted bond rates and policy interest rates
Figure 4: The Taylor rule and policy rates
Hofmann and Bogdanova (2012)
Even with this strong expansionary setting, inflation consistently fell below
forecast (and below target) in advanced economies. Output was also below
forecast, with a slow return to potential (to the extent that the output gap was
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closed, much of this came from a reduction in the calculated output potential) 4.
Central banks were consistently overestimating the power of their policy setting.
Figure 5: Inflation below target
BIS (2016) Chapter IV
BIS model-simulations illustrate the weakening power of a 2% change in the
policy setting in the USA. Was policy weaker because parameters (including the
neutral rate) had changed; because policy is less effective at low interest rates; or
because the ‘headwinds’ were much stronger than anticipated? 5
4
This often reflects the way potential output is assessed, using some version of H/P
extrapolation, with serious end-point problems.
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For a detailed discussion of how the US Fed made its decisions in the post 2008 period
(including the case for policy discretion to handle ‘non-rulable information’, see Kocherlakota
(2016)
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Figure 6: Weaker response to interest rates
BIS (2016) Chapter IV
The recovery remains disappointing, even eight years after the crisis. Per capita
income in Europe has barely returned to 2007 levels and unemployment is still
over 10%. Even in the strongest of the large economies – America – the recovery
has been disappointing and unemployment is low only because labour-force
participation is down, especially for prime-age men. The issues (if not the answers)
can be found in post-crisis ‘headwinds’, secular stagnation symptoms and a
possible fall in the natural/neutral/equilibrium interest rate
(i) Headwinds
The obvious headwind after 2008 was the bursting of the US housing bubble,
leaving households overextended. Banks, too, were overleveraged (and not just in
the USA) and under great pressure from the prudential regulators to strengthen
their balance sheets, which they could do most easily by contracting (or not
expanding) credit. The banks’ sources of market-based funding dried up with a
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heightened awareness of counterparty risk and fewer riskless securities to use for
collateral.
The slow recovery may simply reflect the long process of balance-sheet repair
(especially damaging if bank balance sheets need repairing and it’s hard to raise
capital). This has left investors cautious and risk averse, not ready to undertake
investment even if returns are still adequate for those projects which are actually
undertaken.
Conventionally, the credit channel of monetary policy might be expected to have
the greatest impact, but seems largely blocked in the crisis-affected countries.
Household wealth has only just recovered to its pre-crisis level: in the US
households have been running down borrowing. Thus, after many years of
increase, credit/GDP has hardly moved in Europe or the USA.
Figure 7: Debt
WEO April 2016
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Figure 8: Global debt
BIS (2016) Ch I
Figure 9: Investment
Banerjee et al (2015)
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Investment hasn’t recovered. Why didn’t low interest rates, combined with good
profits, spur investment? Company borrowing costs didn’t fall as much as the
policy rate, and credit conditions were adverse. Some analysis (e.g. Banerjee, Kearns
and Lombardi, 2015) suggest that interest rates (especially the short-term rate) are not
important in explaining investment. When demand is inadequate to justify a
project, no interest rate - however low - will trigger implementation.
Perhaps low investment figures also reflect the fundamental changes which have
occurred in the nature of investment in recent decades. Many types of physical
capital have become cheaper. A larger share of output is produced by the services
sector, often with much less capital compared with a more industrial GDP. Google
and Facebook, for example, need little investment of the traditional kind. Uber uses
already-existing capital. The financial sector (accounting for 10% of GDP in the
USA and the UK) requires little physical capital. Financing is needed to fund the
cash-burn of start-ups, and for the successful ones, this is eventually recorded as
equity but not as conventional investment in the national accounts (again, Uber
provides the example). Substantial income is now earned from ephemeral types of
capital – intellectual property, brands, and highly specialized skills (sports-stars).
More generally, the simultaneous presence of historically high profits with a fall in
investment/GDP might also reflect a greater degree of de facto monopoly, where
the incumbent producer has little incentive to invest up to the point where ‘normal’
returns are obtained on the marginal investment.
Changes in management priorities and the greater importance of ‘financialisation’
(pressures on companies to perform in ways that meet shareholders’ and
financiers’ expectations) may have also altered investment behavior, especially in
times of heightened risk perception and slow growth. Project appraisal becomes
more rigorous and investments which previously might have gone ahead (and even
been successful) are weeded out in this process. The hurdle rate for projects hasn’t
adapted to the fall in inflation and the fall in the neutral rate of interest. Managerial
incentives (particularly though bonuses) have shifted towards short-term outcomes
with immediate effect on the bottom line and share prices, which, again, might
eliminate projects which previously might have proceeded to successful
implementation. The managerial incentive is to return capital to shareholders rather
than invest.
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This is consistent with the observed pattern that credit expansion flowed, not into
new investment, but to boost asset prices (just as bond prices rise when interest
rates fall, so too do other asset prices). Mergers and take-overs are seen as more
attractive than new investment. Without the prospect of extra demand, capacity
expansion through new net investment is not justified 6.
The fiscal response to the crisis also helps explain the weak recovery. After the
near-universal fiscal stimulus of 2009, most crisis-affected countries responded to
their greatly-expanded budget deficits by cutting back on spending, a stance which
was maintained until 2015. The US, for example, reduced its budget deficit by
more than 5% of GDP over this period. There was an ongoing debate about the
effect (with some, including the head of the ECB, arguing that tighter fiscal policy
would expand demand through a confidence effect). Even those who accepted that
cutting the deficit was contractionary mis-estimated the size of the budget
multiplier, understating the damage that austerity would do 7.
Figure 10: Fiscal impulse
IMF WEO 2015
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Lo, S. and K. Rogoff (2015): ‘Summing up the diverse range of ideas presented in this section,
we can say that there is a surplus of plausible explanations for sluggish post–financial crisis
growth, and a paucity of decisive evidence.’
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Blanchard and Leigh (2013).
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(ii) Secular stagnation
In addition to the essentially-impermanent cyclical ‘headwinds’, an additional
explanation (associated with Larry Summers 8) gives a key role to long-standing
and persistent demand-deficient stagnation. The story is now well known, with its
main element being increased ex-ante saving (emerging economies’ foreign
exchange reserves; income maldistribution towards the high-saving rich; and
demographics). We return to this when we come to discuss the neutral interest rate,
below. The policy relevance is that ‘headwinds’ will abate over time, while the
secular stagnation causes may remain, requiring a different policy response.
In discussing secular stagnation, there is a supply-side counterpart to Summers’
demand-deficient view. Aging populations and slow productivity increase (both of
which are apparent in the data) would lower potential growth. Many of these
causal factors are found on both sides of the demand/supply demarcation, but in
thinking about the role of monetary policy, the supply-side factors are less
relevant. Whatever the reduction in the growth of potential supply so far, the global
economy is still operating below potential (as indicated by persistently belowtarget inflation). In any case, monetary policy is essentially a demand-side
instrument which can’t do much about supply-side constraints such as diminished
workforce growth and productivity.
(iii) A lower natural rate?
A related possibility has attracted much recent attention: the ‘natural’ or ‘neutral’
rate may have fallen 9. If so, one implication from simple models is that potential
growth has also slowed. Of course this would be important in itself. But more
relevant to the issue of ineffective monetary policy, a fall in the neutral rate might
help explain its apparent ineffectiveness since 2008.
8
Summers (2015)
See Holston, Laubach and Williams (2016), IMF (2014), Rachel and Smith (2015), Kiley
(2015), Juselius, Borio, Disyatat and Drehmann (2016), Hamilton, Harrison, Hatzius and West
(2015), Constâncio (2016).
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The neutral rate is the real interest rate consistent with ongoing macro equilibrium,
with output steady at potential and inflation stable and on target 10. Much of the
power of monetary policy comes from setting the short-term interest rate above or
below the neutral rate. Another way of making the same point is to note that the
neutral rate is in effect the intercept term in the Taylor Rule, so a lower neutral rate
would lower the relevant line in Figure 4, with actual policy settings less
expansionary than suggested in this chart.
One reason why this idea has attracted so much attention is the stylized fact that
real interest rate (as measured, say, by the inflation-adjusted 10 year bond rate,
which might seem to be a reasonable proxy for the neutral rate), has fallen steadily
and very substantially since 1980 (by 400bp or more) and is now zero or negative
in many advanced economies.
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This is a long-run concept: when the economy is operating at the desired inflation rate and
with neutral output gap, without cyclical or other shorter-term influences, what setting of the
short-term policy rate would keep it there? Some of the current discussion seems to be based on
a different concept: what setting of the short-term policy rate would get the economy back to
desired inflation and neutral output gap in a reasonable time. This latter concept seems more
usefully called the ‘optimal policy rate’, as it is the question which policy-makers ask themselves
when they make a policy decision: ‘is there any reason for not setting the policy rate at this
optimal rate?’ It is a policy behaviour rule, much like the Taylor Rule. It differs from the neutral
rate in that it reflects current and temporary conditions. This optimal policy rate would fall
substantially in the downward phase of the cycle and would be lower if there are financial
‘headwinds’, strong but temporary risk aversion or contractionary fiscal policy.
For an early definitional discussion, see Ferguson (2004). ‘What is needed is a benchmark
summarizing the economic circumstances - including, among other variables, the underlying
strength of aggregate demand, the level of aggregate wealth, and economic developments in our
trading partners - combining to shape the expansion of activity and the extent of pressures on
inflation. One way of providing that benchmark is to consider what level of the real federal funds
rate, if allowed to prevail for several years, would place economic activity at its potential and
keep inflation low and stable.’ This would seem to be an optimal behavioural rule for policymakers rather than the long-term neutral rate: anything higher than this would be ‘too high’ and
anything lower would be ‘too low’.
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Figure 11: 10-year bond and inflation
IMF WEO 2014 Ch III
While the real bond rate might be a rough proxy for the neutral rate, others have
used more sophisticated methods to produce estimates, such as the following chart
for the USA, from Laubach and Williams (2015).
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Figure 12: Laubach/Williams Natural Rate
This substantial fall is sometimes attributed totally (or almost totally) to structural
factors which are likely to remain. Laubach and Williams attribute all of the 400 bp
fall in their study to changes in preferences and changes in trend growth 11, while
Rachel and Smith (2015) explain 400bp of the 450bp fall in terms of non-cyclical
apparently permanent changes in saving and investment behaviour.
Some of the differences of interpretation depend on what is regarded as
‘permanent’ and what is ‘transitory’. Laubach and Williams (2015) use the
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Laubach and Williams (2015) define the natural rate as ‘the real short-term interest rate
consistent with the economy operating at its full potential once transitory shocks to aggregate
supply or demand have abated. Implicit in this definition is the absence of upward or downward
pressures on the rate of price inflation relative to its trend. Our definition takes a ‘longer-run’
perspective, in that it refers to the level of real interest rates expected to prevail, say, five to ten
years in the future, after the economy has emerged from any cyclical fluctuations and is
expanding at its trend rate.’ Elsewhere, Williams (2016) describes it as ‘essentially what
inflation-adjusted interest rates will be in an economy at full strength’. Much of the discussion,
however (and the estimation approach) seems to refer to a different idea - given the current
cyclical circumstances, what setting of the policy rate would be neutral in its impact on the
output gap and inflation.
The US FOMC publishes a ‘central tendency’ for r* - the Committee’s estimate of where the
nominal Fed funds rate will be when conditions return to normal. This estimate has fallen from
4.25% in 2012 to 3.0% in June 2016
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following chart of the ten-year moving average of short-term interest rates (Figure
13) to argue that the interest rate can be very persistent (‘spend long periods away
from its unconditional mean’). But the same chart could be used to illustrate that
periods of persistent low rates are succeeded in due course by more normal periods
when this measure of the neutral rate is clearly positive.
Figure 13: Real short-term interest rate
Laubach and Williams (2015)
Others (e.g. Hamilton et al (2016)) see much of the downward influence coming
from persistent but intrinsically temporary factors. ‘Our narrative approach
suggests the equilibrium rate may have fallen, but probably only slightly.
Presumptively lower trend growth implies an equilibrium rate below the 2%
average that has recently prevailed, perhaps somewhere in the 1% to 2% range.’
One other factor that would argue against a dramatic fall in the neutral rate is that
profits actually increased during much of the post-1980 period, when the real bond
rate was falling. It’s hard to make a convincing case that the Wicksellian neutral
rate has fallen dramatically if profits are strongly positive and not far from
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traditional levels - Wicksell thought of the natural rate as a reflection of the
marginal return to capital. Whether measured in terms of global profits (calculated
from aggregated company data by McKinsey 12), the return on equity (based on
dividends and stock-market prices) or the profit share of GDP (from the national
accounts), the return on investing, while perhaps slightly lower in the post-2008
period, is still strong.
Figure 14: Measures of profitability
12
McKinsey-Global-Institute (2016).
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IMF WEO
This profit-oriented evidence can be reconciled with the stylised fact of the fall in
the inflation-adjusted bond yield if we add a wedge between demand and supply of
loanable funds, reflecting the various financial factors which stand between the
policy rate and the hurdle rate which investors use in their decision-making 13.
First among these ‘wedge’ factors is the impact of monetary policy. Ten years
might seem long enough to get beyond the impact of monetary policy, but this is
clearly not so. The very high real bond rate in 1980 (which is routinely the starting
point for those who make the case that the natural rate has fallen dramatically)
reflects the inflation spurt in the previous decade. By 1980 bond-holders, burnt by
the rise in inflation in the 1970s, demanded a high nominal return. When the
Volcker deflation put an end to inflation in 1980 (with the Fed funds rate rising to
20%), bond-holders, whose inflation expectations were slow to adapt to the new
low-inflation world, still demanded a high nominal return. It was not until the
second half of the 1990s that the bond market came to accept that inflation had
been tamed. After 2008, the real bond yield increasingly reflects the ‘low for long’
stance of policy, QE and the shortage of risk-free assets in financial markets.
Hence, in looking at the 35-year period often chosen to demonstrate the fall in the
neutral rate, the high real bond rates early on and the low rates towards the end
largely reflect the impact of monetary policy and not simply a change in the natural
rate.
13
See Chart 1 in Hall (2013).
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The second financial ‘wedge’ factor is ‘financial conditions’ - the ease of
borrowing, reflected in both the margin over the policy rate that intermediaries
charge and the non-interest ‘credit-conditions’ factors such as readiness to lend.
Banks were clearly very accommodative pre-2008 (even to NINJA borrowers!),
succeeded by the much greater caution (and harsher regulatory constraints) in the
period after 2008.
Figure 15: Credit conditions
Banerjee et al (2015).
This puts the apparent substantial fall in the neutral rate (as measured by the real
bond rate) over the past 35 years in better perspective. Accurately measuring the
true long-term neutral interest rate is problematic, and this discussion doesn’t
preclude the probability that it has fallen, particularly since 2000 when growth
prospects appear diminished. A rise in savings (China, income distribution) might
explain Greenspan’s (2005) bond-rate conundrum, but a rise in savings alone can’t
take the neutral rate to the very low levels commonly reported (see Figure 12),
provided there are good prospects for profits. However, what could explain why
the economy is so slow to react to the ‘low for long’ policy setting is an increase in
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the financing wedge (including a measure of banks’ diminished readiness to lend)
between policy rates and effective borrowing rates.
It doesn’t seem possible that the properly measured neutral rate could be negative
(as shown for the Laubach and Williams (2015) measures in recent years). Long
ago, Paul Samuelson effectively dismissed the idea of sustained economy-wide
negative interest rates by noting that if investors could borrow at negative rates for
long duration then any project with the most minimal return would be profitable14.
In so far, what has happened has not really tested – and certainly not refuted -Samuelson’s intuitive scepticism about negative rates.
In short, it is hard to accept that the world has run out of profitable investment.
Even in the unlikely event that advanced countries have met all their capital needs,
the developing world clearly has many high-return projects that are awaiting
administrative and financial infrastructure to link their potential with rich-country
funding sources eager to find a positive return on capital.
For the advanced economies such as the USA there are some concerns that a lower
natural rate has limited the scope for monetary policy to apply stimulus when
needed - hence the argument for a higher inflation target. But others see the Fed as
still having enough room (albeit with help from QE and forward guidance)15
Lesson 2: Other persistent but impermanent factors (headwinds, fiscal
consolidation) may be so strong that monetary policy seems to be ineffective.
Policy-makers should acknowledge their limitations and be patient.
Lesson 3: If the natural rate is significantly lower, monetary policy will have
less scope for strong action, but a lower neutral rate would signal more
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“As Larry’s uncle Paul Samuelson taught me in graduate school at MIT, if the real interest
rate were expected to be negative indefinitely, almost any investment is profitable. For example,
at a negative (or even zero) interest rate, it would pay to level the Rocky Mountains to save even
the small amount of fuel expended by trains and cars that currently must climb steep grades. It’s
therefore questionable that the economy’s equilibrium real rate can really be negative for an
extended period.” Bernanke (2015)
15
See Reifschneider (2016).
26
fundamental problems elsewhere in the economy, notably in pensions and
provision for retirement.
(c) Inflation may no longer be an adequate guide for monetary policy
The inflation targeting framework relies on inflation to provide the unique
indicator/signal that the macro economy is in balance - policy responds to this
inflation signal. The inflation process has clearly changed in important ways over
recent decades. Wage-earners have seen their bargaining power weaken 16, the
institutional support for wage setting has been dismantled and the degree of price
competition has changed substantially. Some producers too have lost their pricesetting power. Does this diminish the key role of inflation as the key policy
indicator?
It seems quite likely that these changes have altered the relationship between the
output gap and inflation and may have reduced the natural rate of unemployment
and flattened the short-term Phillips Curve17. It is too early to know, and there are
serious end-point problems in drawing strong conclusions from post-2008 data.
Time should resolve whether these pricing effects are temporary or permanent.
If the short-run expectations-augmented Phillips curve has flattened (thanks to the
credibility of the inflation targeting framework), then this might suggest monetary
policymakers should give more regard to the output gap in order to avoid testing
the enhanced stability of price expectations to snapping point.
The usual concern expressed regarding deflation is that spending will be deferred
awaiting lower prices, creating self-reinforcing demand deficiency. For the
16
The constancy of the wage share in GDP used to be regarded as one of the stylized facts of
economics. Over recent decades the wage share has fallen, probably by close to 10% of GDP.
Since 2008 wages in most advanced countries have not kept pace with both inflation and
productivity increases. For producers, globalisation (the arrival of China as the ‘manufacturer to
the world’), deregulation, competition legislation and technology (with the internet allowing easy
price comparisons and on-line supply) have all sharpened competition and reduced (or even
taken away) firms’ pricing-power.
17
See Blanchard (2016).
27
moment, there don’t seem to be serious concerns about this degree of deflation
except just possibly in Japan. The price falls that have occurred so far have been
largely ‘good’ deflation resulting more from extra competition, cost-reducing
technology and improved functioning of markets rather than ‘bad’ deflation
(resulting from persistently demand-deficit markets).
Nevertheless, this concern about deflation is a reminder of how much things have
changed since inflation targeting began. The concern then, and the challenge, was
focused on getting inflation down. There was so little concern about deflation that
zero was included in the range for some inflation targets (including New Zealand).
There was some discussion, even then, about the advantage of having some modest
inflation to facilitate relative price changes in an environment of downward
price/wage inflexibility.
What about inflation expectations? One of the stylised facts of the post-2000
period is how well anchored inflation expectations have been. Is it possible to have
price expectations too well anchored? If so, it hasn’t happened yet, as lower-thantarget inflation has in fact correctly signaled the continuing presence of an output
gap. That said, the greater stability of inflation expectations suggests that inflation
may give a muffled reading of macro imbalances.
Figure 16: Inflation expectations
BIS
28
Lesson 4: While inflation targeting requires priority to be given to inflation
stability, a flatter Phillips curve makes it all the more important that
policymakers also keep one eye on the output gap.
(d) Do persistently low interest rates harm the economy?
The persistence of below-target inflation has fostered ongoing pressure on some
central banks to respond at each policy meeting to the latest evidence of slow
inflation, rather than maintain the long-term perspective focused on the forecast of
inflation some years ahead. The short-term focus of financial markets may distract
policy from this longer perspective and might result in the policy rate being pushed
too low.
Central banks have often been uncomfortable with these low rates. As an example
of this, the ECB was initially reluctant to ease as much as the circumstances of
2008 required, and then implemented a short-lived rise in the policy interest rate in
2014. The US Fed has consistently confused financial markets by implying that it
was ready to ‘normalise’ as early as possible (demonstrated in the ‘taper tantrum’
of May 2013 and the implicit ‘dots chart’ forecast in December 2015 of four
tightening during the course of 2016).
There is some academic support for policy-makers to respond to this pressure.
Orphanides and Williams (2002) argue that, given the uncertainty about just where
the natural rate is, central banks should think in terms of a ‘difference’ version of
the Taylor Rule, which lowers the policy rate whenever the response to earlier
settings is not producing the desired result in terms of returning to the inflation
target (and potential output).
The danger here is that when policy lags lengthen or there is a long period of
headwinds, interest rates can get very low18. Even when operating normally (say,
following a Taylor Rule), setting the policy rate away from the neutral rate causes
some distortions in the price signals given to savers and investors. This is the
accepted cost of using monetary policy to bring forward or delay expenditure. But
18
See Hamilton, Harris, Hatzius and West (2012).
29
there might be practical limits on how far away from the neutral rate the policy rate
should be, and for how long.
What problems might arise from an overly low policy rate? Insurance and pension
balance sheets are put under pressure. The value of pension liabilities is boosted
and return mismatches deteriorate. Pensioners find their savings are inadequate to
provide the expected standard of living in retirement. Savers lose income and
‘search for yield’ takes them into risky portfolio decisions. Bank profits are
squeezed by low margins 19. Distorted price signals are given for investment, assetpricing and risk-taking. Low interest rates stretch asset values, leaving them
vulnerable to disruptive reversals (the bond market is the best example). ‘Zombie’
enterprises (perhaps including zombie banks) are not weeded out 20. With this in
mind, why would we be sanguine about ‘low for long’?
Figure 17: UK pension underfunding
BIS
19
See Box 1.3 in IMF Global Financial Stability April 2016.
The distortions that might arise are illustrated by the pre-2008 period in the USA, when low
interest rates and easy credit availability (particularly for ‘honeymoon mortgages’) distorted
decisions.
20
30
Furthermore, lower interest rates may not help what some see to be the central
macro-imbalance - a high saving rate. If pension-oriented savers have a target
income stream, lower interest rates will encourage them to save more. Mortgagees
finding themselves with lower interest costs might repay their loans faster, rather
than increase their spending. Whether saving rises or falls in response to lower
interest rates is an open question.
Two related issues might be included in this discussion. Firstly, whether the
transmission of interest rates might be asymmetric, with low or negative rates less
effective in boosting output and inflation than high rates are in constraining output
and inflation. Secondly, whether the transmission mechanism changes when
interest rates are negative.
The discussion of the first issue rarely gets past the ‘pushing on a string’ analogy.
Perhaps more helpful would be to note that there is a higher degree of confidence
that there is some positive interest rate which will constrain expenditure, whereas
the same cannot be said for the ability of low interest rates to foster substantial
expenditure in a demand-deficient environment. That said, there is little doubt that
the near-zero rates put in place at the end of 2008 were helpful in softening the
impact of the crisis and if there are concerns, it would be that rates have been
maintained at these unusually low levels for so long.
As for the negative interest rates, some central banks have demonstrated that
modestly-negative rates are technically feasible (see later discussion in Section II).
From the viewpoint of the effectiveness of policy there may be no particular
significance in crossing the threshold from very low positive rates to mildly
negative rates21. But if low positive rates create distortions, these arguments carry
over more strongly for negative interest rates.
Raising the inflation target to enable policy rates to be set even lower in real terms
(as has been suggested by Williams (2016)) might address the trivial issue of shifts
from deposits to currency at the ZLB, but leaves the basic rationale for
significantly negative real rates unexplained.
21
After all, policy rates have often-enough been negative in real terms, and it is real rates that
will usually be relevant.
31
Lesson 5: Policy interest rates that are persistently a long way from the neutral
rate will probably cause distortions and unhelpful price signals. When the dust
settles from the UMP experience, a research priority should be to assess how
much harm was done by distorted financial price signals.
(e) Exchange rates.
Of course the exchange rate has always been one of the channels through which
monetary policy operates but exchange rate channels may have become stronger
since 2008 while the interest rate channel has become weaker – see BIS (2016).
This channel impinges differently on the economy, with much of its impact
focused on the tradable sector – often the most dynamic part of an economy. As
well, unwanted movements in exchange rates create inter-country tensions.
Figure 18: exchange rate channel is stronger
BIS (2016) Ch 4
These issues are often thought about in terms of the Mundell/Fleming ‘Impossible
Trinity’. With a floating exchange rate, small open economies can set their interest
rates independently, with the exchange rate departing temporarily from its longer-
32
term equilibrium in order to create an expectation of future exchange-rate change.
This expectation equilibrates the interest differential (the Dornbusch mechanism).
Capital flows are seen largely as passive funders of the current account position,
itself a reflection of the domestic saving/investment balance.
The post-2008 world has been rather different. Just about all advanced economies
(and many emerging market economies) pushed interest rates down to historically
low levels, willing to accept lower exchange rates as part of the effort to help
economic activity. With activity so weak, inflation was not a concern. The lowinterest-rate first-movers (often also QE countries) usually gained a worthwhile
boost to activity from depreciation, but just about every country was pushing
interest rates down dramatically hoping for the benefit to activity from
depreciation. Not every country, however, could benefit from depreciation.
Global interest rates moved largely in lock step, with researchers seeing this as
‘spill-over’ of the movements in the major countries rather than similar responses
by policy-makers in all these countries responding to weak domestic activity.
Resolving this distinction is not important to this narrative. Analysts are now
seeing the domestic long-term rate as being closely linked to the global rate
(Hördahl et al, 2016). The important point is that there was a ‘race to the bottom’
in interest rates driven partly by the state of the domestic economy but also by
unwillingness to accept loss of international competitiveness through appreciation.
This presented a challenge for those countries (e.g. Australia and New Zealand)
where activity was running at an acceptable pace. How far were they prepared to
see other countries bidding away demand in a demand-deficient world? Exchange
rate appreciation was unwelcome (especially with inflation below target, so the
cost-containing effect of a stronger exchange rate was unambiguously
unwelcome).
Australia and New Zealand just accepted the appreciation, painful though it was.
Switzerland, Sweden, Denmark, Japan and probably Europe responded more
33
actively using negative interest rates largely in response to these exchange rate
pressures, either to gain advantage or avoid disadvantage 22.
Exchange rates moved further than the Dornbusch mechanism implied. Capital
flows were not endogenous inflows attracted by the need to fund the current
account deficit (the counterpart of the saving/investment balance). Instead, they
were responses by foreign capital seeking yield due to policy actions taken in the
investor’s home market. These volatile flows were largely exogenous to the
recipient countries and were dominated by events (especially policy events) in the
large crisis-affected economies responding to risk-on/risk-off changes in foreign
investor sentiment 23. These flows present special challenges for small open
economies. The usual Mundell/Fleming answer – let the exchange rate equilibrate
the ex-ante flows – resulted in an often large unwelcome appreciation of the
exchange rate.
The experience of those countries that have tried to combat this over-appreciation
with intervention provides little comfort. Switzerland, faced by a clear case of
capital inflows pushing the exchange rate far beyond long-term sensible levels,
eventually gave up its attempt to hold a fixed rate. Lower interest rates may have
been an acceptable response given spare capacity in Switzerland, Sweden and
Japan, but in all cases the lower rate has been unhelpful for restraining asset-price
inflation.
Asset-price pressures interacted unhelpfully with capital flows and the exchange
rate. Incentives for more capital flow were created, which offered more funding
opportunities to bid up asset prices further. An added vulnerability occurs when
domestic borrowers make use of this foreign funding in the process creating
22
There were accusations of ‘currency wars’ and ‘beggar thy neighbour’ policies, mainly by
emerging economies directed at advanced economies. For their part G7 countries (mostly
complicit in these exchange rate weakening activities) asserted that changes in exchange rate
coming about as part of monetary policy implementation were not ‘currency wars’, and the
emerging economies should be grateful that the advanced economies were using monetary policy
vigorously to boost global demand.
23
See Rey (2013).
34
currency mismatches, especially inappropriate if used to purchase non-tradable
assets such as housing.
These problems would be still more intractable if interest differentials are not
simply cyclical (desynchronised business cycles). If Europe and Japan are at a
super-mature stage of very low growth and the US is exhibiting aspects of longerterm secular stagnation (as suggested by Larry Summers), then interest
differentials with growing economies such as New Zealand (with a higher natural
rate) will persist. This will be accompanied by global capital portfolios searching
for better investment opportunities, widening the current account deficit and
strengthening the exchange rate, reducing the incentive in the tradable sector,
which traditionally has had the highest productivity growth. If the carry-trade can
only be equilibrated by a volatile exchange rate (successive gradual appreciation
followed by sharp fall 24), this will do further harm to incentives in the tradables
sector.
This would argue for using a combination of lower interest rates and macroprudential measures. But if macro-prudential measures are used routinely, the
traditional measures (loan/valuation ratios and loan/income ratios) tend to drive the
borrowing demand outside the banking system into non-banks or, less desirable
still, into foreign-exchange borrowing (easier now through global financial
integration). A more attractive form of macro-prudential instrument might take the
form of fiscal policy – raising transaction taxes on mortgage contracts, which has
been successful in raising revenue in Singapore and Hong Kong25. Its impact on
housing prices is hard to discern, but it must help the budget.
Lesson 6: As global financial markets become more seamlessly integrated,
small countries will find it harder to maintain monetary policy appropriate
for their domestic economy. The exchange rate implications of monetary
policy become more important.
24
25
i.e. different from the smooth Dornbusch process.
And more recently in Canada.
35
II. Unconventional Monetary Policy
(a) QE
Conventionally and routinely, central banks carry out frequent (often daily) market
operations, buying and selling assets from their balance sheet to adjust centralbank money (base money) to meet the needs of the public for currency and the
banks’ demand for reserves. In normal times, base money is demand-determined.
Central banks also traditionally stand ready to provide liquidity if the banking
system needs it (particularly in times of crisis), purchasing bank assets in exchange
for base money.
Beginning in 2007, central banks did a variety of these conventional stabilityoriented ‘balance sheet operations’ (Juselius, 2015) to provide liquidity to banks at
a time when the banking system needed extra base money due to heightened
counterparty risk.
As well, there were less traditional operations:
• Some central banks bought non-bank assets in markets that had become
dysfunctional due to a heightened perception of credit risk.
• Some central banks offered various forms of lending to banks in order to
encourage them to expand credit.
• Almost uniquely26, the post 2008 period also saw the four largest central
banks and Sweden carry out what has come to be thought of as the core
version of QE - the purchase of government securities in exchange for base
money, that is the usual daily money operation but with the objective of
creating excess base money and flattening the yield curve. While other
balance sheet operations can be seen as aimed at shoring-up the financial
system, these core QE operations were seen as part of monetary policy.
Thus under the broad rubric of QE central banks had three different effects: market
calming, forward guidance and portfolio balance. These various balance sheet
operations (including quite conventional ones to provide liquidity to banks in need)
26
Although of course the Bank of Japan had carried out QE 2001-06 (Ito, 2014).
36
were largely confounded in the immediate post-crisis period. But to understand
what worked and what might usefully be used again as a policy instrument, it
would be useful to try to keep the various schemes with their different objectives
separated as much as possible 27.
Even before QE1 in the US, the Fed had carried out balance sheet operations that
doubled its balance sheet. These operations were conventional in the sense that
they provided liquidity to a banking system that had become straitened and
provided foreign exchange swaps to foreign central banks so that they could, in
turn, relieve foreign currency illiquidity in their domestic markets. These
operations were in the normal tradition of central bank activity, although not an
everyday occurrence and substantial in size.
The initial US Fed balance sheet transactions (which came to be called QE1)
mainly involved the purchases of private-sector 28 mortgage-backed securities
(MBS) with the aim of unfreezing the commercial market for these assets, where
transactions had dried up due to uncertainty around the risk quality of this class of
financial assets. This was termed ‘credit easing’ at the time, explicitly aimed at
dysfunctional markets (Bernanke 2009). While the assets bought were not strictly
bank assets, they were MBS assets generated by banks’ off-balance sheet
operations. These operations were not really unconventional in principle, although
the volume and duration of the operations made them very unusual. These
operations came to be called QE1 (and shared with QE2 and QE3 the characteristic
that substantial excess base money was created). These operations are widely
acknowledged to have met the goal of re-liquefying these markets successfully and
were scaled back when normal liquidity returned29.
27
See Ito (2014) and Cicchetti (2009): ‘But in the financial crisis of 2007–2008, the Federal
Reserve was the only official body that could act quickly and powerfully enough to make a
difference. Given the very real and immediate dangers posed by the financial crisis that began in
August 2007, it is difficult to fault the Federal Reserve for its creative and aggressive responses.’
28
Although an increasing proportion were guaranteed by GSEs – Fannie May and Freddie Mac.
29
See ITO (2014) and Cicchetti (2009). They were not entirely discontinued, and the later MBS
purchases might be seen as an attempt to encourage the banks to increase intermediation (and
support the recovery) via the MBS market.
37
There were similar operations elsewhere. The ECB purchased covered bonds (i.e.
asset-backed bank bonds) lent directly to banks to fund credit expansion and
bought corporate bonds. The ECB also made available US dollar swaps to provide
US dollar liquidity, in cooperation with the US Fed. Most of these operations could
be seen as following the traditional role of a central bank faced by a banking crisis
– to provide liquidity to the banking system 30. The Bank of England (BoE) offered
the Term Funding Scheme to provide cheap funding credit expansion and
purchased corporate bonds. In general these operations were also judged to be
effective where they acted to unfreeze dysfunctional markets and provide liquidity
to banks in need of it - although it is less clear that the measures to encourage
banks to create more credit had much impact. Both the US Fed and the BoJ also
bought and sold government bonds of differing maturities in order to flatten the
yield curve. Again, this was not unique (see the Fed’s ‘operation twist’ in 1961 31),
but nor was it routine.
As well as these operations, the four largest central banks 32 (the Fed, the BoE, the
ECB and the BoJ) carried out more unusual and extensive operations which have
come to be seen as typical or core QE. This core variety of QE involved buying
government securities in exchange for base money (i.e. just like normal daily
monetary operations).The principal objective probably differed between the
various central banks. The US Fed seemed to be mostly interested in flattening the
yield curve, while many at the BoE initially thought the main effect would be the
creation of additional money in the form of bank deposits.
30
Where the ECB bought government bonds, it generally sterilised the impact on base money, so
it did not resemble what has come to be seen as conventional QE.
31
http://www.federalreserve.gov/faqs/money_15070.htm
32
And the Swedish Riksbank.
38
Figure 19: Central bank assets
Borio and Zabai (2016).
Views differ on the nature and efficacy of these operations. Some, brought up in
the Milton Friedman tradition where extra base money fuels inflation, just
misunderstood how monetary policy works. The extra base money didn't push up
39
inflation. It just ended up in the balance sheets of the commercial banks, in the
form of reserves at the central bank, without setting off successive rounds of credit
creation. It did, however, have other effects. The purchase of bonds raised their
price, flattening the yield curve. The general objective was to influence private
sector portfolio behaviour, encouraging investors to shift towards more risky
higher yield instruments. QE also changed banks’ balance sheets, raising the
volume of bank deposits on the liabilities side and bank reserves on the asset side.
In some cases, these excess reserves might have encouraged banks to make more
loans. What the depositors did was less obvious. They may have bought other
assets (the portfolio rebalance channel) but they might also have extinguished their
deposits by paying back debt (consistent with the slow growth in credit)
Quantifying all this is hard, because at the same time conventional monetary policy
had pushed the short end of the yield curve close to zero and as financial markets
came to realise that the policy rate would be ‘low for long’. This had the
conventional effect in lowering longer bond yields, hard to distinguish from the
effect of QE. The extra reserves in banks’ balance sheets do not seem to have had
much effect in promoting credit growth, probably because bankable borrowers
were busy restructuring their balance sheets in response to the excesses of the pre2007 period.
Haldane’s picture of the immediate impact of QE operations suggest that it was not
very big (especially if QE1 is counted as a ‘dysfunctional market’ operation rather
than core QE). Gagnon (2016) interprets the QE impact much more positively. He
quotes Engen, Laubach and Reifschneider (2015) as arguing that overall QE
reduced unemployment by 1.25% by 2015 and added 0.5% to the inflation rate
(although their calculation includes not just the impact of QE on the term premium,
but the forward guidance effect). Borio and Zabai (2016) agree that QE lowered
bond rates (perhaps by 100 basis points) but are more sceptical that this had much
effect on the economy through the usual credit channels.
40
Figure 20: Impact of QE
Haldane (2015).
The main positive impact may have been on confidence and expectations of future
policy action – assuring financial markets that the central bank cared and would be
acting to keep interest rates down over an extended period. Whatever the actual
medium-term effect, financial markets waited with bated breath for each hint about
changes in QE, so there must have been something at stake for them. Asset-price
effects (especially on share-markets and the exchange rate) were probably more
powerful in some cases (the Japanese share-market rose 60% and the yen exchange
rate depreciated 20% around the time of Prime Minster Abe’s election to office).
The depreciation of the exchange rate raised uncomfortable issues of ‘beggar-thyneighbour’ - boosting demand through a lower exchange rate at the expense of
trading partners whose exchange rate underwent the counterpart appreciation. In
some economies the impact on housing asset prices in the midst of weak economic
activity created a policy dilemma for central banks. Was an interest rate setting
appropriate for weak economic activity too permissive for inflating asset prices?
Of course conventional policies (lowering the short rate) raise the same
ambiguities, but QE shifted the whole yield curve and operated in markets which
seem readier to respond through asset prices, including the exchange rate.
One near universal conclusion is that QE is a poorly calibrated instrument, whose
efficacy depends heavily on the particular circumstances of the time (in the jargon,
‘state-contingent’). When it was tried in Japan in the early 2000s it had little effect,
41
but with Shinzo Abe as Prime Minister, markets interpreted its policy-implications
differently, so that it had the desired effect of raising inflation expectations,
boosting share prices and depreciating the yen in 2013.
There is another more subtle issue. Central banks have been conscious that in
setting the short-term rate they are bringing their influence to bear on financial
markets, which in principle should be allowed to find their own equilibrium and
determine ‘market prices’. Setting the short end of the yield curve can be excused
because this is the nature of monetary policy – to shift the short end to bring
forward or discourage expenditure. In any case, if the central bank did not provide
stability at the short end, the daily exigencies of demand and supply for base
money might make the short rate very unstable, to no advantage in terms of
sending useful signals for intermediation, investment and saving. But to the extent
that QE has shifted the long end of the yield curve away from the market setting
(which would have in any case reflected the market’s view about where short-term
rates would be over the relevant duration), some might see this as excessive
interference in market outcomes.
As for the addition of large volumes of excess reserves into bank balance sheets,
this distorts markets by setting both the quantity and price of an important asset.
While policy-makers in those countries which implemented QE have unanimously
judged QE to be beneficial, an objective assessment might see it as an uncertain
state-contingent policy instrument which distorts bank balance sheets 33. It is too
early to give definitive judgments on its effect because the longer-term impact has
yet to be seen. When the flattening effect on the yield curve is unwound this will
33
Haldane (2015) summarises the case against routine use of QE this way:
‘First, QE’s effectiveness as a monetary instrument seems likely to be highly state-contingent,
and hence uncertain, at least relative to interest rates. This uncertainty is not just the result of the
more limited evidence base on QE than on interest rates. Rather, it is an intrinsic feature of the
transmission mechanism of QE. … Second, executing QE on a larger-scale or putting it on a
more permanent footing would risk blurring the boundary, however subtly, between monetary
and fiscal policy. … Third, one of the channels through which QE operates is the exchange rate.
Conventional interest rate policy works through the exchange rate channel too. But because QE
acts directly on stocks of assets held by the private sector, the potential for asset market –
including foreign exchange market – spillovers is prospectively greater.’
42
administer capital-losses to bond-holders, including the QE central banks, still
facing the task of unwinding their balance-sheet holdings at some stage. Some QE
enthusiasts have argued for it to become a normal part of a central bank’s tool-kit
(Gagnon, 2016) and Fed Chair Janet Yellen agrees (Yellen, 2016). Bernanke
initially expected QE to be unwound, but is now having second thoughts – see
Bernanke (2016a).
(b) Extended forward guidance
The inflation targeting framework has always embodied a strong element of
forward guidance, in the sense that it sets out fairly specifically how the central
bank will react to unfolding circumstances. The policy reaction function may not
be formalised, but it is clear (including which instrument will be used). Some
central banks (e.g. New Zealand, Sweden and the US Fed) go further, providing a
forecast of where the policy-rate or short-term rate seems likely to be into the
future34. All these central banks make clear (New Zealand more successfully than
Sweden 35) that this is no more than an indication of where rates will be if
circumstances turn out as predicted. There is no sense of commitment or constraint
on future policy actions.
In the post-2008 episode, extended forward guidance was taken further, in two
variants. First, some central banks which did not ordinarily provide any specific
forecasts of future policy settings began to provide guidance about the future path
of the policy rate, usually in the form of undertakings not to raise the policy-rate
for a specific time in order to guide financial markets expectations about ‘low for
long’. This differed from the New Zealand and Swedish forecasts (or the US Fed
‘dots chart’), which are very specifically contingent forecasts rather than
undertakings to keep interest rates at a certain level. The second guidance involved
specifying additional parameters for future action – goals or indices which had to
be achieved before policy would change. The clearest example was the 2012 US
Fed guidance that policy would not be tightened until unemployment fell to 6.5%.
This is an ad hoc modification to inflation targeting - one more hurdle that had to
34
See Charbonneau and Rennison (2015).
35
See Goodfriend and King (2016).
43
be met before policy was tightened. This was easier to achieve in the US without
undermining the policy framework as unemployment has long been an element in
the Fed’s mandate (although without a specific target). But the UK’s experience
illustrates how this kind of forward guidance can undermine the clarity of a simple
inflation target. Not only did it introduce another element into the policy
framework, but events (the unexpectedly rapid fall in unemployment) quickly
overtook the guidance, leaving financial markets uncertain (or even misled) as to
what actions to Bank of England would take when this additional hurdle was
crossed36.
The US Fed’s forward guidance was certainly effective in helping to flatten the
yield curve (although its specific impact was hard to separate from other policy
actions taken at the same time, especially QE). Its effectiveness was specific to the
circumstances of the time - markets had been slow to recognise that policy would
be ‘low for long’ and at times other signals from the Fed were suggesting a faster
tightening than actually occurred. Thus the forward guidance could substantially
change market expectations in a helpful way, bringing the market to a clearer
understanding of the Fed’s true intentions.
The critical constraint is the need for time consistency. If the forward guidance
takes the form of policymakers promising to do something (for example, keep
interest rates low for a specific time), they have to do it or lose credibility. Where
financial markets have misunderstood the policy intention, forward guidance can
usefully put markets back on track without danger to policymakers’ credibility. But
where policymakers attempt to use forward guidance to suggest a future outcome
that is different from their own best forecast of events, they risk loss of credibility.
Where they provide additional guidance outside the usual framework (add an
unemployment indicator to a simple inflation-targeting framework) they weaken
the framework. If, in addition, they depart from their commitment on policy
actions (or inactions), loss of credibility seems likely.
The limits of forward guidance are now better understood and policy-makers are
likely to use it more cautiously (Filardo and Hofmann, 2014). Experience with
36
In this, there is a reminder of McMillan’s famous explanation of what will determine future
policy: ‘Events, dear boy, events.’
44
specific forecasts about future policy rates differs substantially. New Zealand has
managed to provide such forecasts without constraining the central bank’s latitude
to change its mind (e.g. as it did in 2014). The Swedish central bank, on the other
hand, is judged to have focused excessively on its forward forecasts and why this
differed from market-based forward indicators of policy (Goodfriend and King,
2016), with some board members voicing their concerns about the implicit
constraints on the ability of policy to react to unfolding events and confusing the
message to the market.
Figure 21: Revisions to projections
Filardo and Hofmann (2014).
(c) Negative interest rates and the zero lower band
Central banks almost everywhere implemented very low settings of policy rates
following the 2008 crisis, which triggered a vigorous academic debate on whether
the long-discussed ‘zero lower bound’ was a constraint on monetary policy and if
so, how to get around the problem. Much of this debate centred on whether
negative rates would cause bank depositors to shift to cash, which led to ingenious
proposals to overcome this constraint by eliminating cash from the range of
available assets or charging a negative interest rate on cash-holding. Much of this
debate missed the key point. Substantially negative deposit rates would encourage
45
investors to shift into a range of assets which offered a positive rate, not just into
cash. If the banks offered only negative-interest deposits, the public would
economise on their bank-based transaction balances (helped here by advances in
payments technology). The bank balance sheets would shrink as depositors paid
back loans. The main downside of the (perhaps dramatically smaller) balances held
with deposit-taking institutions would be the constraint this placed on their
intermediation function, particularly important for small and medium enterprises
and households unable to issue their own bonds.
Figure 22: Negative policy rates
Ball et al (2016).
Can the authorities force the banks to pass substantially negative rates on to
borrowers? If there are other reasonably liquid assets offering investors a positive
return, banks can’t attract or retain the funds needed for intermediation, so can’t
sustain a loan portfolio at a negative interest rate. In these circumstances, the
central bank would lose its influence over the short end of the market-determined
yield curve (presiding over a largely irrelevant asset - banks’ reserves held at the
central bank) and bank intermediation would shrink. Interest rates on other assets
would be set by supply and demand in financial markets. The only way the central
bank could make the banks lend at negative rates would be to provide them with
negative-cost funding tied to on-lending.
46
In Section I, we looked at the circumstances which have made many bond-rates
negative in real terms, and quite a few ($13 trillion at last count) negative in
nominal terms also. First, the neutral rate has almost certainly fallen. Second, there
has been a shortage of riskless assets in the post-2008 world. There are fewer AAA
issuers, while investors have an enhanced desire to hold such assets, countries are
holding very large foreign exchange reserves (mainly in the form of riskless
foreign bonds) and financial institutions are required to hold riskless assets for
prudential reasons 37. Huge QE operations have reduced the supply of riskless
assets. Governments, for their part, have other constraints (the universal debt
phobia) that have prevented them from making use of the opportunity (and the
price incentive) to issue more riskless debt. With the general level of interest rates
low, those investors who favour riskless assets (or who have to hold such assets)
are ready to pay a small premium to hold riskless debt. Moreover, bonds have
actually been a good investment (thanks to capital gains) during this period of
falling yields. Thus the negative rates on bonds can best be explained in terms of
idiosyncratic and temporary demand/supply in financial markets.
Second, where central banks have set modestly-negative policy rates 38, the main
motivation seems to be concerns about appreciating currencies (often associated
with capital inflows). The clearest case is Switzerland 39, but Sweden, Denmark,
Japan and probably Europe also fall into this category. Central banks are reluctant
to articulate this issue too explicitly as it opens them to accusations of ‘beggar-thyneighbour’ tactics.
37
38
39
See Caballero and Farhi (2014).
See Jackson (2015).
‘Switzerland has not experienced a liquidity trap in the strict Keynesian sense. In particular,
bank lending is not impaired and the Swiss National Bank’s (SNB) monetary policy is not
focused on stimulating lending growth. Instead, the Swiss economy is faced with an overvalued
exchange rate, which weighs down on price inflation. Since early 2015, the SNB’s monetary
policy has been based on two elements: a negative interest rate on sight deposit balances that
reduces the attractiveness of Swiss franc-denominated investments, and the SNB’s willingness to
intervene in foreign exchange markets as necessary.’ Andréa Maechler, Swiss National Bank in
Ball et al (2016).
47
The wider implications of these tentative explorations of negative-interest territory
have been limited. Even if governments can borrow almost costlessly, there are
few opportunities for non-government borrowers to obtain funds at negative (or
even zero) rates. For their part, banks have generally not passed the negative rates
on to depositors. This has squeezed bank profits where bank reserves are
remunerated at negative rates, but this impact has been ameliorated where central
banks apply the negative rate only to bank reserves at the margin (see BoJ
practice).
These examples of negative policy rates demonstrate that the policy-rate can
become mildly negative without depositors shifting en mass to currency. The zero
lower bound does not mark some hard-edged technical boundary for monetary
policy. Certainly, as rates go into negative territory some additional issues open up,
mainly relating to the banks’ valuable intermediation function. And there are tight
limits on just how far central banks could retain their influence on short-term rates
if they attempted to achieve substantially negative rates in a world where assets
offering positive returns were available.
The deeper issue, however, is the one raised by Samuelson: why would it make
economic sense for policy-makers to create an environment where borrowers are
able to fund projects at negative cost? Under what curious circumstances would the
true time-value of funding be negative? Negative interest rates bring these
questions into high profile, but the questions apply also to the much more common
cases of very low positive nominal rates and negative real rates. As policy interest
rates are pushed down towards zero, the question has to be asked whether this is a
sensible signal to be sending to investors and savers.
In short, negative interest rates are a relatively minor aberration in a world where
near-zero rates are common. Both negative and near-zero rates signal a deeper
problem in the economy: perhaps structural stagnation, weak investment
incentives, excessive intermediation margins and global saving/investment
imbalance. While negative rates might have some minor and temporary policy role
to discourage excessive capital inflow, substantially negative interest rates would
not be a sensible sustained policy.
48
(d) Helicopter money
No country has so far undertaken the policy usually described as ‘helicopter
money’, but there has been extensive discussion and endorsement by high-profile
proponents such as Adair Turner (Turner, 2015). The essence of this suggestion is
that stimulatory expenditure should be undertaken, funded by the central bank
issuing base money. No central bank has a mandate to do this: central bank
operations (including QE) exchange one asset (say, base money) for another (say, a
government bond held by the public). Thus helicopter money has to be seen as
fiscal policy, where the government expenditure is funded by the central bank
rather than by issuing bonds to the public.
In an economy with underutilized capacity, government expenditure will be much
more powerful than, say, QE, where the central bank exchanges one asset for
another, leaving the public’s purchasing power unchanged. A helicopter drop, like
fiscal expenditure, puts additional purchasing power on the hands of the public
(like the Australian ‘cash splash’ of 2009: see Leigh (2012)).
While this policy appears to be attractive and there seems no technical reason
preventing this, it is certainly not a “free-lunch’ (see Grenville (2013)). As with
QE, the central bank’s action in issuing excess base money results in the
commercial banking system holding more base money (in the form of deposits at
the central bank) than banks desire under normal circumstances. If, as is common
practice, banks are paid a market rate on these deposits, this should be seen the cost
of funding the additional expenditure. This funding cost would be little different
from the cost of issuing government bonds. If no interest is paid on reserves (or is
paid on only part of the reserves, or reserves are remunerated at a below-market
rate), this represents a tax on the banking system, which distorts intermediation.
Nor does helicopter money fund expenditure without raising official debt: bank
reserves held at the central bank are an obligation of the official sector.
For proponents who understand this issue, the rationale for helicopter money
seems to be some version of Ricardian Equivalence: that any benefit from the extra
expenditure will be nullified if it is funded by the issue of government debt. But, as
we have noted, the amount of total debt (including the central bank’s debt to the
banks for their deposit holding) will be identical. The expenditure has to be funded
49
and if the credit-rating agencies or the public see any difference, it could only be
because they misunderstand the issue.
In any case the strength (or even relevance) of Ricardian Equivalence is in serious
question, non-permanent expenditure of this type is effective, especially in an
economy with spare productive capacity. Any Ricardian offset seems likely to be
trivial.
That said, there is a more important reason for increasing the conventional deficit
rather than undertaking helicopter drops. A key element of the institutional
infrastructure surrounding central bank operations and independence is that
governments should not be able to demand that the central bank fund budget
spending. History has enough cases where central bank funding of a budget deficit
was the first step in descent into economic chaos. Fuzzing this time-honoured
principle through QE seems dangerous enough: for a government to blatantly
contradict the principle through directly funding the deficit from the central bank
makes no sense. There has been a powerful case for the crisis-affected economies
to be less concerned with austerity and budget consolidation, but in most cases the
ongoing deficits could have been easily funded at very low cost by issuing bonds
into a market that was eager to buy riskless assets.
Lesson 7: None of the UMPs tried so far is a satisfactory answer to the
challenges to monetary policy which emerged after 2008.
50
III.
Is any of this relevant to New Zealand?
New Zealand had no symptoms of financial crisis but did experience a recession in
2009. Global events impinged, as usual, through the exchange rate, import prices
and the now-familiar global influence on domestic long-term bond rates 40. What
was less familiar (and perhaps harder to explain) was that New Zealand (like
Australia) also experienced the same subdued inflation 41 which was common to
advanced economies (and many emerging economies) in this period. As the
economy recovered at a moderate pace after 2009, inflation began a sustained
downward trajectory (putting aside the GST blip). McDermott (2015) explains this
in terms of weak tradable prices, held down by low global inflation, commodity
prices and the exchange rate. He also provides evidence of the flattening of the
Phillips curve42, with inflation slow to respond to the below-potential output in the
2009 recession and, in the other direction, to the well-paced recovery.
40
See Lewis and Rosoborough (2013), Hördahl, Soburn and Turner (2016).
41
See Kergozou and Ranchhod (2013).
42
The graphic evidence would be consistent with a shifting natural rate of unemployment, as
well as a flattening.
51
Figure 23: New Zealand Phillips Curve
Figure 24: Inflation
New Zealand Treasury Monthly Economic Indicators Chart pack
52
Policy interest rates closely followed global rates down at the end of 2008/early
2009, to a level which was historically very low in nominal and real terms. Thus
New Zealand, with few of the crisis-economies’ financial-sector headwinds, took
interest rates to levels which might have been expected to be quite expansionary.
Inflation, initially around the centre of the target band, was on a downward
trajectory. Monetary policy, consistently below Taylor Rule calculations (Kendall
and Ng, 2013), was less expansionary than expected. The RBNZ’s two-year-ahead
forecasts of both inflation and output were both biased upwards in this period 43 44.
Can we take this as a measure that the RBNZ was surprised that the monetary
policy setting was not more powerful in keeping inflation in the centre of the target
band?
Thus New Zealand may have experienced some of the same anomalies apparent in
the crisis-affected economies - very low policy rates seemingly unable to achieve
inflation targets. This created ongoing pressure to ‘increase the dosage’ – continue
to lower the policy rate. To this was added the usual market and public pressures
for lower interest rates. Third, as a small open economy there were unwelcome
upward exchange-rate pressures that encouraged a lowering of the policy rate. This
three-fold pressure may have resulted in the policy rate approaching zero faster
than the authorities might have preferred.
The cross-current here was that the central bank, uncomfortable that the low policy
rate was encouraging asset-price inflation (particularly in Auckland housing) and
that the rate was in any case unusually low, was looking for opportunities to get the
policy rate back to more normal levels, hence the rises in 2010 and 2014 45. These
good intentions, however, ending up with current rates as low as in 2009, perhaps
because of the all-too-familiar concerns about the exchange rate.
43
See Lees (2016) and Table 1 in McDermott (2016).
44
Or perhaps there were circumstances (e.g. pressure on asset prices, or difficulties in assessing
the impact of the Christchurch earthquake) that made the RBNZ content to underachieve on
inflation provided the recovery was satisfactory.
45
Just as the Fed Board dot-chart plots, always anticipating an imminent rise, reflect unease
among members that rates were unusually low.
53
Unlike policy settings in the crisis-affected economies, the policy rate is still some
distance from zero. It may be useful to ‘think the unthinkable’ about
unconventional monetary policy, but if these are policies that central banks
characteristically undertake only when they hit the zero lower bound, the caveat is
that New Zealand is not there. In the face of these unusual pressures, how has the
inflation-targeting framework performed?
(a) Inflation Targeting
Inflation targeting is still alive in the crisis-affected economies, but its essential
simplicity and clarity has been compromised by implementing unconventional
policies. The essence of inflation targeting is that the public (including the
financial markets) know how the central bank will react (and with what
instrument). Once unconventional policies are added, this clarity becomes ad hoc
and financial markets spend their time trying to second-guess policy actions,
including when and how these additional measures would be unwound46. Forward
guidance (to the extent that it says something other than confirming that the
inflation targeting framework will be followed) adds another random element.
Inflation targeting (in its evolved ‘flexible’ form) remains an effective politicaleconomy answer to the key problem of monetary policy: it provides ‘constrained
discretion’ to address time inconsistency (politicians will want to slide up the
short-run Phillips curve). Inflation targeting represents a sensible balance between
ensuring democratic oversight via a well-specified decision framework on the one
hand, and overly-constraining the central bank’s room for policy maneuver on the
other. A simple sole target of inflation has the powerful advantage of anchoring
inflation expectations. The inflation targeting framework has served New Zealand
well and there is no case for tinkering or adding unconventional monetary policy.
The RBNZ believes that the neutral rate has fallen 150bp or so during this cycle
and is now about 2.5% 47. Given the uncertainties in measurement, there is room for
46
47
The 2013 ‘taper tantrum’ is one manifestation of what can go wrong.
See McDermott (2013) and Richardson and Williams (2015). This is as large as the usual
estimates of the fall in the neutral rate in the USA.
54
scepticism about the extent (or the permanence) of the fall 48. In any case, it still
leaves room for the real policy rate to be set 450bp below the neutral rate (if
inflation is on target) before the zero lower bound is reached. If large (or extended)
departures of the policy rate from the neutral rate lead to distortions in asset prices
and investment decisions, this 450bp (or minus 250bp in real terms) might be
considered enough latitude for policy. To raise the inflation target in order to get
more room for variation in the policy stance is not justified in New Zealand’s
circumstances 49. A prior action would be to try to establish why the neutral rate has
fallen and see if any of these causes could be addressed: structural stagnation
arguments are not part of the New Zealand debate. 50 The case for policy-patience
seems strong 51.
Figure 25: The real neutral rate
With the interest rate instrument apparently less effective and inflation below the
centre of the target, it might be consistent with the inflation targeting framework to
continue to lower the policy rate (‘increase the dose’), along the lines of
48
49
Profits don’t suggest a sustained substantial fall.
See Williams (2016).
50
See Richardson and Williams (2015).
51
Some estimating methods lower the neutral rate iteratively when the model shows output
responding less than expected to a policy setting lower than the neutral rate. It is possible that the
right interpretation is that the real economy response is slower than the model envisages (e.g.
because of ‘headwinds’ or contractionary fiscal policy), rather than that the neutral rate has fallen
substantially. The correct policy response in this case is patience.
55
Orphanides and Williams (2002) suggestion that a ‘difference’ version of the
Taylor Rule would recognise that uncertainty that surrounds the neutral rate.
‘Would it help?’ is the right question for policy makers, rather than automatically
lowering interest rates every time the CPI comes in below expectations.
Three minor tweaks might be considered:
• It may be possible to refocus the financial market’s attention on the twoyear-out forecast of inflation rather than the latest reading. Or focus more on
the core rate or even on non-tradables inflation.
• It might also be worthwhile to emphasise that provided the policy rate is
below the neutral rate, it provides ongoing accommodation (unlike a
constant fiscal deficit, which after the initial impact provides no further
stimulus).
• The inflation-targeting framework has evolved since the original New
Zealand model, finding a place for some measure of real output (such as the
output gap). If, as a measure of the success of inflation targeting, inflation
expectations are very firmly anchored and hence inflation is a less sensitive
indicator of the macro-balance, the role of real-output measures in the policy
process might usefully be given more prominence. Although in practice this
will just highlight the uncertainty that surrounds these output measures in
real-time.
The inflation targeting framework has no place for reducing interest rates to help
keep the exchange rate down, even though ‘tit-for-tat’ might seem a good enough
excuse when other countries are doing it. Alternatives are suggested in the next
section.
It’s hard to see what more could be done in terms of forward guidance (the RBNZ
already gives a caveat-surrounded forecast of where the 90-day interest rates might
be over the next two years) without constraining the room for policy response to
unfolding events. The crucial distinction here is between forward guidance that
overrides the inflation targeting framework (e.g. promises to keep interest rates
unchanged for a period of time), and guidance which simply provides official
56
forecasts of what the implementation of that framework implies, which might help
the market understand the banks decision process better52.
Figure 26: Interest-rate projections
What about substituting a different target? When the inflation targeting framework
was being developed, consideration was given to using other inflation-related
single-targets, with the most common alternative suggestion to inflation being
nominal GDP. At the time, inflation targets were being promoted without including
any real variables such as the output gap. Within this narrow framework, nominal
GDP had the substantial advantage of including output in the decision process, so
it might have given a more appropriate guidance in the case of supply-side shocks
(McKibbin, 2015). Since then, with flexible inflation targeting well accepted
(including consideration of output and the effect of supply-side shocks), this
52
See McDermott (2016).
57
advantage is no longer so compelling 53. The arguments against nominal GDP,
however, still remain relevant. By combining the real variable (GDP) with the
nominal (inflation), the same weight is given to each. If terms-of-trade shocks are
prevalent (of particular relevance to New Zealand), there is a danger that a policyresponse guided by nominal income will result in excessive movements in the
exchange rate. Perhaps most importantly, the direct linkage with inflation
expectations would be lost. Williams (2009) has noted that the inflation targeting
framework has now been given a thorough stress-test in the face of big
commodity-price movements and has come through well, specifically because
inflation expectations remained well anchored. Thus the most powerful argument
against modification of the target is the well-proven success of the existing
framework 54.
What then should RBNZ do in the totally hypothetical possibility that its policy
rate is approaching zero and inflation is still not heading for the centre of the
target?
The tentative judgement made here is that core QE (i.e. balance sheet operations
with monetary policy objectives) was not particularly effective in achieving the
inflation target and was of very uncertain impact (state contingent), not adding
enough to the effectiveness of monetary policy to justify the loss of the essential
simplicity of inflation targeting (and the powerful effect this simplicity has in
anchoring inflation expectations) and the whittling away of central bank
independence 55. QE’s well-established effect of flattening the yield curve may in
any case be less relevant in New Zealand, where most borrowing is at a floating
rate. A fuller judgment of QE can be made when the measures are unwound, as this
53
For a comparison of decision rules, see deBrouwer and O'Regan (1997).
Recent advocacy for nominal targets by The Economist (editorial 27 August 2016) sees the
larger size of the target as providing central banks with more flexibility when confronted by the
zero lower bound, but this confuses the target and the instrument: the zero lower bound would
still provide the same constraint on shifting the instrument (the interest rate), even if the target
were changed to nominal income.
54
55
Orphanides (2013) discusses the danger that the wider array of instruments may overburden
central banks putting unrealistic pressures on them and creating expectations which can’t be
achieved. This would, of course, reduce central bank credibility.
58
is likely to have its own adverse impact (with the likely rise in bond yields a focus
of particular concern).
One important proviso: the crisis period demonstrated how important are measures
to ensure adequate bank liquidity in crisis times, and how effective central bank
measures can be into unfreezing dysfunctional markets, even when this means the
central bank is buying non-bank securities.
What should the RBNZ say if the policy rate gets to zero? They should confirm
that monetary policy is acting powerfully to support the economy and to get
inflation back to target, but if additional support is required for a faster return
to macro-balance, it will have to come from fiscal policy.
(b) External factors
Perhaps the main area where the overseas experience opens room for creative
innovation in New Zealand policy-making is in the external linkages: capital flows
and the exchange rate56. New Zealand has long been on the receiving end of
substantial carry-trade foreign capital inflows which introduce volatility into the
exchange rate (and perhaps result in a chronically appreciated exchange rate)57.
Since 2008 there has been a ‘race for the bottom’ in global interest-rate setting,
partly based on domestic factors in individual countries, but also motivated by the
56
The Central Bank of Iceland governor put the case for policy response this way: ‘If the
exchange rate channel were relatively well behaved - i.e., if it provided smooth adjustment based
on fundamentals and uncovered interest rate parity broadly held over relevant horizons - then the
answer might be no. The problem is, however, that experience has shown that uncovered interest
parity does not hold except perhaps over long horizons. Interest rate differentials give rise to
widespread carry trading, which is by nature a bet against UIP. Exchange rates therefore diverge
from fundamentals for protracted periods, followed by sharp corrections. So the exchange rate
often seems to be as much a source of shocks and instability as a tool for adjustment and
stabilisation.’ Guðmundsson (2015).
57
In 2014 the RBNZ governor (Wheeler, 2014) described the strong New Zealand dollar as
‘unjustified and unsustainable’. Observing the length of the peak-trough movements and their
size, there seems to be an attractive return to be made for anyone brave enough to play these
exchange rate cycles (largely driven by commodity prices). See Wheeler’s Table 1. These
opportunities may explain the popularity of the carry trade.
59
advantage of a depreciated exchange rate (or the burden of an appreciated
exchange rate) in a demand-deficient world. The only sure way of avoiding such
appreciation is to have an interest rate the same as the weak overseas economies,
which will often be inappropriately low for the New Zealand economy.
Figure 27: Real effective exchange rate
Given the fickle nature of the carry-trade, an argument could be made that New
Zealand would be better off with less of this inflow. Without going as far as active
discouragement, the authorities could ensure that there are no particular advantages
or concessions (especially in tax) that currently encourage such flows. Those who
make profit from the carry-trade should pay New Zealand tax.
This might begin to address a perennial issue in New Zealand: why has the
tradable sector lagged behind the overall growth of GDP? This discussion is often
linked with the disappointment of low productivity growth. There is no suggestion
here that the exchange rate should be artificially held down, but some public policy
60
discussion in both Australia and New Zealand carries the outdated legacy of the
pre-float world, where the greatest economic fear was that there wouldn’t be
enough foreigners ready-and-willing to cover the current account deficit. Whatever
special inducements might have been offered in the pre-float era, such measures
are not necessary (or desirable) now.
Figure 28: Tradable and non-tradable production
New Zealand Treasury Monthly Economic Indicators Chart pack
(c) Financial stability
Lesson 1 – ‘don’t have a financial crisis’ – might sound flippant but it is easy to
argue that the challenges experienced with monetary policy since 2008 were a
direct result of the financial crisis.
New Zealand has already quite extensive experience with macro-prudential
measures 58 to address the problem that an appropriate policy setting for CPI
inflation may be too low to constrain asset-price inflation and constrain a financial
cycle. The authorities are aware of the dangers of what used to be called
58
See Dunstan (2014).
61
‘disintermediation’ - transferring the demand for credit to non-banks and the
special dangers of funding investment in domestic assets from foreign borrowing.
The only possible additional foreign lessons here are from those countries which
have used fiscal policy actively as a macro policy instrument (e.g. transaction taxes
on housing)59. It is not clear how effective these have been in restraining asset
prices, but even if they do little to constrain asset prices, the revenue-collection
seems attractive 60.
Whether coordinating monetary policy with policies to counter the financial cycle
(as suggested by the BIS (2016) is the next step in the policy progression remains
to be argued out further 61. Certainly each branch of policy needs to take account of
the other (e.g. any impact of prudential policies on inflation needs to be taken into
account in setting monetary policy). That said, if financial-cycle indicators (credit
growth, leverage, defaults and non-performing loans) are used in policy
determination, there would seem advantage in keeping these separate (as indicators
for the setting of macro-prudential instruments) rather than incorporating them into
the more complex ‘inflation-plus’ targeting framework that the BIS seems to have
in mind.
59
Canada has just joined the group, with its 15% tax on foreigners buying Vancouver residences.
At least to those who don’t have the abhorrence of transaction taxes held by many economists!
61
For some relevant discussion in the context of the pre-2008 period, see Chetwin, and Reddell
(2012).
60
62
IV. Conclusion
The 2007-8 financial crisis was a watershed for monetary policy in the crisisaffected countries. The old instruments and framework were inadequate for the
task demanded of them – supporting a recovery weighed down by financial
headwinds and fiscal consolidation (austerity). Monetary policy was ‘the only
game in town’, even though by tradition it is ‘pushing on a string’ in this
accommodative mode, or is at least more effective in contraction than in
expansion. The US Fed led the other crisis-affected countries in expanding
monetary policy in innovative and adventurous ways, whose full impact cannot yet
be judged definitively, with more bumps likely ahead as these measures are
unwound.
New Zealand, isolated from this as much as any small open economy can be in a
globalised world, was able to maintain ‘business as usual’ for monetary policy.
The inflation-targeting framework still seems valid for the future, with no case for
changing the target or adding extra policy instruments. Are there other lessons?
• First, financial crises are very costly and leave permanent scars through
hysteresis and low productivity. Slow recoveries from deep recessions are
not ‘V-shaped’. Financial stability, traditionally a poor cousin of monetary
policy, needs to be kept centre-stage.
• Second, the fall in the natural rate has attracted the attention of central banks
because it might constrain the latitude of movement of the policy instrument
(i.e. how quickly will policy run into the zero lower bound). Any fall which
has taken place in New Zealand is insufficient to raise these issues, but even
a modest fall in the natural rate, if permanent, would have important
implications for other policy areas (e.g. pensions and retirement policy in
general).
• Third, like all small open economies in an increasingly integrated financial
world, New Zealand policy is constrained by a version of the
Mundell/Fleming ‘impossible trinity’. This is not the textbook version,
where small movements of the exchange rate are enough to provide
monetary independence, offsetting different interest rates. The more volatile
international capital flows are not driven mainly by interest differentials, but
63
by ‘risk-on/risk-off’ sentiment in global capital markets. These issues would
be serious enough if New Zealand cycles correspond roughly with the global
cycle (as at present). Desynchronised cycles might present sharper
challenges. More serious still, if New Zealand’s natural rate is consistently
higher than the global natural rate (e.g. because it is a more dynamic
economy), the exchange rate is not only likely to be more volatile, it may on
average be higher, with adverse impact on the tradables sector. There has
been a substantial (although not unanimous) shift in academic and policy
opinion about the part which capital flow management might play in
addressing these issues. This debate should become part of the New Zealand
policy discussion.
64
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