AUGUST 15, 2019
What’s the emergency? Unemployment is near multi-decade lows, CPI inflation is at its 20 year average and financial markets are booming. Forward indicators are softening but that reflects many factors other than interest rates. Yet the RBNZ has just slashed rates to 1.0% and may print money and move to negative interest rates. What on earth is going on? Does the chart of core inflation look like a crisis?
The success of central banks in flooding the world with liquidity and preventing a depression after the GFC seems to have emboldened them with a zeal to pursue 2% CPI inflation at all costs.
This piece will show that the 2% target is a made-up number with no clear academic basis. Worse, inflation is low for structural reasons that have nothing to do with monetary policy. The RBNZ will merely create more debt, greater income inequality and ever more over-valued financial markets that threaten future stability. The RBNZ Governor may come to regret his declaration of war on those who have the cheek to save.
According to a RBNZ paper by Brook et al (2002), the first mention of an inflation target came from Sir Roger Douglas in a TV interview in April 1988, when he made an off-the-cuff suggestion of, “around 0 or 0 to 1 percent.” According to the same source, “the original target was designed primarily to reduce inflation rather than derived from a careful evaluation of what might be the optimal average inflation outcome.”
Given the RBNZ’s zealous focus on 2%, we obviously expected to find this careful evaluation and subjected ourselves to thirty years of academic discourse on the RBNZ website. All we came up with was one general review piece which found that inflation above 3% affects growth. No kidding.
So, NZ rolled out the RBNZ Act in 1989 with central bank independence and a tough 0-2% inflation target that was essentially a made-up number. What mattered was convincing markets, companies and unions that we would not lurch back to our bad old inflationary ways. It cost us a nasty recession in the early 1990’s but it worked by breaking the old psyche.
The RBNZ struggled to meet the 0-2% target for almost all the pre-GFC period. Accordingly, it was moved to 0-3% in 1996; to 1-3% in 2002; a focus on the 2% mid-point was added in 2012; and a dual focus on employment was added in 2018. Does all this tinkering give confidence that 2% is actually the right target?
A speech by RBNZ Assistant Governor, Dr John McDermott in April 2018 did state that, “we had also found no clear evidence that trend inflation of 2 percent would produce better or worse outcomes for trend growth than trend inflation of 1.5 percent.”
So, even with inflation currently running between these 1.5% and 2.0% levels, the RBNZ is threatening us with all sorts of bizarre measures when by their own words there is no justification for targeting 2.0% rather than 1.5%.
A paper by US Federal Reserve economist, Anthony Diercks in 2017 looked at over 150 academic studies of the optimal inflation rate. The chart below is from anthonydiercks.com.
Putting aside outliers, the range is consistently between -4% and +2%. Contrary to the RBNZ’s 2% zeal, there is huge uncertainty. Those economists of a “monetarist” persuasion tend to have a zero or negative finding, while “new Keynesians” tend to have zero or positive targets.
The only clear findings from the pure academic research are that high inflation is bad and that deflation is only a problem when debt levels are extremely high.
A similar study by Sweden’s Riksbank in 2018 had a starting point of whether inflation targets should be increased but their conclusion was, “it is not possible to draw any firm conclusions on the appropriate level of the inflation target from academic research.”
The inflation models of central banks revolve on expectations. The idea is that if firms and workers expect inflation to be at least 2%, they will set their prices and wages accordingly and we will have a selffulfilling outcome. This worked brilliantly when central banks took on the scourge of high inflation in the 1980’s by credibly committing to low inflation levels. But it’s not working in reverse.
If everyone knows there are structural reasons for inflation being below 2%, the central bank can talk all it likes but it will not credibly be believed that it can deliver an inflation outcome of 2%. Inflation expectations are stuck.
Recent academic research finds that when prices are relatively stable, inflation expectations are oblivious to monetary policy announcements. The expectations model does not work. Renowned Harvard economist, Jeff Frankel cited this in a recent blog, “perhaps it is time for the Fed and other central banks rather than doubling down on their oft-missed 2% inflation target, to quietly stop pursuing it.” I think I’d back Jeff Frankel over Adrian Orr’s double-down.
Another issue is that the make-up of inflation has nothing to do with central bank policy. An article in “The Age” quoted Fidelity International research and looked at the Australian CPI since 2000. The overall CPI has risen by 57%, wages have risen by 78% but medical services have gone up by +195%, electricity +194% and secondary education +203%.
Conversely, audio-visual and computing has fallen -89%, games -16%, cars -14% and clothing/footwear -10%. Central banks have no impact on these sub-groups and it just so happens that the big deflationary categories have been larger in the last decade.
Structural deflationary factors such as an explosion in computing power and disruptive network effects have been major. We all know how easy it is these days to search for the cheapest price. Research from the Bank Of International Settlements shows large demographic effects. Societies with large groups of old people tend to have far lower inflation than those with large working age populations. NZ has become much older since the pre-GFC days as baby boomers retire.
BIS research has also shown how the integration of hundreds of millions of workers from China and Eastern Europe into the global economy has squashed unskilled wage inflation especially in sectors open to trade. Funnily enough, NZ’s tradeable sector inflation is +0.1% and has been low for years, while domestic non-tradeable inflation is +2.8% and has been high for years.
Even worse, the experience in Europe of implementing negative rates is that banks bleed deposits and this caps their lending as they must keep their targeted retail versus wholesale funding ratios. Negative rates cause a credit crunch not inflation. The banks are the current whipping-boy for the RBNZ but this is a serious issue.
Further, a zero cost of debt is prolonging the life of zombie companies and excess capacity. It also makes it very cheap to fund disruptive technologies that are deflationary by their nature. As just one example, catching Uber rather than a taxi has dramatically lowered my transport costs but this has been abetted by ultra-low interest rates creating a speculative share market bubble that is financing Uber’s vast losses for now.
To conclude, NZ’s inflation target started as a made-up number in a TV interview. It has been gradually lifted over time as structural drivers pre-GFC made it too hard to meet. The structural drivers have since flipped, making it tough to meet on the upside. There is a huge band of uncertainty from academic research as to what the target should be, with the only certainties being that high inflation is definitely bad and deflation might be bad. There is absolutely no certainty that 2% is the right target. It could easily be 1.0% or 1.5% and if that was the case, we would be lifting rates.
Despite all these caveats, the RBNZ is preparing to unleash an unprecedented monetary experiment on NZ. The result will be an expansion in financial and property market bubbles, a further lift in inequality as capital-owners are enriched and a sharp lift in debt levels which will make the eventual bust even greater. Time for a major re-think.
Managing Director, Salt Funds Management