Are monetary conditions too tight?

The Reserve Bank's latest quarterly survey of expectations popped up in my inbox the other day, and as usual I was at a loss to answer the question 'What is your perception of monetary conditions'.

It's the 'conditions' bit that throws me. The question is intended "to capture respondents' broad perceptions of current monetary policy settings and their expectations of the future stance of policy in one quarter's time and one year out", which looks as if it is probing about the interest rate setting side of monetary policy.

But interest rates are only part of overall monetary conditions as experienced by firms and households: the other big factor is the exchange rate (and arguably there are others - the willingness of banks to lend, the ability of firms to raise capital through bond or equity issues). So I'm never too sure what (say) the CFO at a big company might be feeling overall about monetary conditions: is the crimping effect of low export profit margins when the exchange rate might be high more important than the availability of cheaper finance when interest rates might be low?

And so every now and then (last time was in February) I'm driven to power up the spreadsheet and recalculate the old Monetary Condition Index (the 'MCI'), which attempts to blend interest rates and exchange rates into an overall assessment of the tightness or looseness of monetary conditions. Here is is, using RBNZ monthly data up to June and last Friday's data (after the RBNZ's economic update) for July.

It looks as if we are experiencing overall monetary conditions that are modestly on the tight side of our long-term average: going by the MCI alone, you'd say that the RBNZ definitely ought to cut the Official Cash Rate at its next opportunity on August 11. You'd want overall monetary conditions to be on the easier side, not the tighter side, when inflation is tracking below target.

"Going by the MCI alone" is a big qualification, though. For one thing, businesses don't seem to be feeling very squeezed by the exchange rate, as you can see in this chart from the ANZ's latest Business Micro Scope survey of small businesses. The exchange rate is listed there as a problem for a few, but it's well down their list of worries compared, in particular, to finding skilled employees (and compared to the burden of regulation, which is a topic for another day). And of course there's the potential impact of lower interest rates on floating rate mortgages and the housing market (aggravated by the fact that lower bond yields are feeding through to lower fixed rate mortgages as well).

So who knows - maybe the RBNZ will stay its hand on August 11. But if the be-all and end-all of monetary policy is overall monetary conditions conducive to getting inflation where it ought to be, the MCI logic says, cut the OCR.

Is our monetary policy stance right?

Having indulged in a little flight of fancy in my previous post about a stonking easing of monetary policy, it's time to get realistic again. So here's my latest occasional update to the actual stance of monetary policy - that old warhorse, the Monetary Conditions Index (the 'MCI'), which combines the level of interest rates and the level of the NZ$ into an overall measure (based on the RBNZ's monthly figures up to January, and current market levels for February).

Turns out, the flight of fancy may not have been so fanciful after all. Monetary policy, on this measure, is slightly on the tight side of average, and that doesn't seem to make a lot of sense at the moment: it's meant to be "accommodative" (as the RBNZ put it in the latest review of the Official Cash Rate). Unless as a central bank you're very confident in your call that everything's hunky-dory over a medium-term perspective, and that inflation will get back to around 2% on present monetary policy settings, you'd think the lesson from this graph is that policy should be starting to ease.

Which is also where the ANZ Bank has got to in their latest Market Focus, where they now think the RBNZ will cut the OCR by 0.5% this year (the publication isn't up on the ANZ website yet, but interest.co.nz have a commentary and a link to the publication itself). Interestingly, ANZ have their own 'financial conditions index', which is a different way of assessing the overall policy picture and which includes house prices, credit spreads and the NZ$: it's saying the same thing as the old MCI, namely that conditions have tightened recently. However you get there, the analysis is pointing towards the need for a lower OCR.

A modest proposal

The Reserve Bank has been taking some stick recently about not getting inflation up to 2% - you have your choice of posts on Michael Reddell's blog, for example - and yesterday Stuff's Vernon Small weighed in with 'Monetary policy is bust, so why are we still banking on it?'

So here's a modest proposal to get us back on track.

First, we cut the Official Cash Rate to 2%, the same level as the Australian policy rate. Nice big demonstration effect right there, with a 0.5% move instead of the usual 0.25%, plus it would be a genuine surprise (the futures market has only one 0.25% cut in the pipeline).

Second, we signal we'll match any future cuts in the Aussie rate (the futures market figures the RBA will cut by 0.25%, some forecasters think there are two cuts on the way).

Third, we do some quantitative easing (QE). The RBNZ buys enough government stock to drive down our current 10-year yield (3.04%) to the level of its Aussie equivalent (2.40%). It would help if Treasury cancelled its scheduled bond tenders and instead placed Treasury bills direct with the RB.

At that point, no sensible investors will pick New Zealand over Australia (the Aussies have a slightly better credit rating, so if the interest rates are the same, you'd pick them). Investors in New Zealand will clear off, and the currency will depreciate. It wouldn't hurt to give it a judicious nudge with some thin-market currency intervention.

If that doesn't get us nearer 2%, well maybe Vernon's right, and nothing ever will, but we'll never know unless we give it a go.

Course, the Auckland housing market will have turned incandescent, but you can't have everything, can you?

More seriously, I can't help feeling that it's theoretically possible, in the current collapsing-commodity, competitive-devaluation, out-QE-the-other-guy world, that there may be no feasible or desirable setting of local monetary policy that is consistent with 2% local inflation.

I've had a go in the past at trying to put this into some kind of formal framework (if you don't mind some simple graphs). My conclusion back then was that, if there was overseas monetary policy loosening (and a great deal more has happened since I wrote in 2013), and the RBNZ wanted looser policy but would prefer if it didn't exacerbate the housing market, then something had to give:

the Bank's got a bit of leeway: it doesn't have to keep inflation strictly at 2%. It's got a band of 1% to 3% to work with (on average aiming at a longer term average of 2%). Where the logic of things leads you to, though, is this: in current markets, the Bank will need to use this leeway, and let inflation undershoot 2% for some time.

It's possible that the sub-2% undershoot that we have indeed experienced isn't such a bad result, in the round. It could be the best we could realistically achieve in current world market conditions - or at least the best we could achieve short of having slavering buyers stampeding from auction to auction to snap up the last house under $3 million.

What drives the A$?

Exchange rate forecasting, as we all know, is usually a decidedly iffy proposition: the authors of this new Discussion Paper from the Reserve Bank of Australia point to "the well-documented difficulties in empirically explaining movements in exchange rates" and "the imprecise nature of exchange rate modelling, which is well established in the literature".

I'll just pause for a sec (before I get anyone into trouble) to point out that in any Discussion Paper, "Views expressed in this paper are those of the authors and not necessarily those of the Reserve Bank. Use of any results from this paper should clearly attribute the work to the authors and not to the Reserve Bank of Australia".

Right. Carrying on, and despite the well-known difficulties, they've done a pretty good job of modelling the behaviour of the (real) trade-weighted index (TWI) of the Aussie dollar. Here's how their model fits the data: if I'd managed that, I think I'd be retiring to the pub for a beer after a good day's work.

It's an error-correction model, where the TWI tries to move towards an equilibrium level determined in this model mostly by Australia's terms of trade, with a smaller supporting role for a real interest rate differential ("the real policy rate differential between Australia and G3 economies"). And it explains about half of the quarterly changes in the TWI over 1986-2014.

The authors were a bit exercised by those periods where the actual A$ TWI was well away from the modelled band - below, during the GFC, and above, more recently - and they've had a go at seeing whether various ways of modelling the impact of the recent Australian resource investment boom and of unconventional monetary policy overseas would explain those deviations. There were some suggestive hints, but no knock-out discoveries: "Taken as a whole, while the results from these augmented models support the notion that there have been some additional influences on the real exchange rate in recent years, they do not fully account for the behaviour of the exchange rate during the period". The existing model did more or less as well (and more simply) than potential alternatives.

Incidentally, if you're a student, or hence or otherwise would like to get up to speed with where the economics of exchange rates has got to in recent years, there's a very useful bibliography at the end of the paper.

You're probably wondering, is there a Kiwi dollar equivalent? And yes there is, give or take (the Aussie graph shows the modelled A$ TWI versus actual, the Kiwi graph shows an explanation of why the actual rate is away from its long-term average). Here's what it looks like, and I wrote it up in more detail here.

Takeaways? Two main ones. The story that the A$ and NZ$ are 'commodity backed' currencies is oversimplified, but not wrong. And exchange rate forecasting may be problematic, but I'd say not so problematic that you can't get something useful out of it.

Time for an interest rate cut?

"At 3.5 percent", said last week's Monetary Policy Statement, "the OCR" - the official cash rate - "is still providing support to demand".

Now, there's a sense in which this is true: a "neutral" rate, neither supportive nor contractionary, is reckoned to be around the 4.5% mark, so 3.5% is clearly on the stimulatory side.

But in terms of the overall tightness of monetary conditions, you can't look at the cash rate in isolation. It's the combination of interest rates and the exchange rate that makes life easier or harder for people and businesses. An OCR of 3.5% may be "providing support", but that doesn't mean a lot if the Kiwi dollar is so high that exporters are severely constrained. True, it would be better than 4.5% and a high Kiwi dollar, but that would be a rather moot consolation.

So here once again is my calculation of the overall tightness or otherwise of monetary conditions, as captured by the old Monetary Conditions Index, which mashes together the 90 day bank bill rate and the trade-weighted index of the Kiwi dollar into a single overall number.

The reality is that overall monetary policy conditions are tight. Tight, tight, tight. They're on a par with periods in the past when we were dealing with reasonably serious inflation pressures.

Not that there's a lot the Reserve Bank can do about it, as there's no feasible OCR that would bring monetary conditions back to neutral, let alone to the stimulatory side of neutral.

If you said that "neutral" is some kind of long-term average of the Monetary Conditions Index, then neutral would be about 500 (averaged over the whole history of the series since mid 1986) or about 350 (if you start in January 1991 after the initially brutal disinflationary period). The current MCI is around 1200: to get it to a neutral level around the mid 400s, you'd need a negative OCR at -4.0% or so.

Alternatively, if the OCR stays at 3.5%, you'd need the Kiwi $ to be roughly 14% lower for overall conditions to be neutral - say in the high 60s against the US$ rather than the current high 70s.

However, you look at it, though, you begin to come round (as I also did a wee while back) to the conclusion that, with the best intentions, and on the best decisions made in the light of the best info at the time, we've nonetheless ended up tighter than we ought to be. I've a great deal of sympathy for the view (as put by John McDermott, the RBNZ's Chief Economist, at last week's MPS press conference) that monetary policy making in real time is an evolving process of learning and adaptation as you go along. I'm beginning to think that the next step in the process ought to be a few steps backwards for the OCR.