As Doctor Frankenfurter prepared to step up the reactor power input three more points and bring life to the Rocky Horror in the classic Rocky Horror Picture Show, he welcomed the assembled “unconventional conventionists” who would witness his triumph.
Unconventional monetary policy is a bit like Doctor Frankenfurter’s giant defibrillator experiment with the Rocky Horror. It could work, if the circumstances call for it. Preparing for those circumstances can make a lot of sense. But it probably should not be tried except as a last resort. And it seems a bit odd to assemble everyone for a throwing open of all the switches, including fiscal policy, when the projected output gap is positive over the medium-term forecast range.
We should probably begin with a few bits of conventional macroeconomics that are probably too little appreciated.
First, a cut in the Official Cash Rate should not necessarily be seen as ‘easy money’. It could instead be a reaction to monetary policy’s previously having been too tight. On the flip side, rising interest rates typically mean prior monetary policy was too loose.
What Milton Friedman said
Milton Friedman drew an analogy between monetary policy and a thermostat.
If monetary policy is working perfectly, it accommodates anticipated changes in economic activity to keep inflation around the midpoint of the target band. A very good thermostat might link to the MetService hourly weather forecast and start the furnace as the temperature outside begins to drop, so the indoor temperature never changes. A very good central bank will anticipate changes in the underlying Wicksellian natural rate of interest – the rate of interest consistent with price stability – and adjust so that monetary policy is not out of step.
If the thermostat is in the wrong part of the room and does not notice changes in temperature right away, you will see the furnace working very hard when the room gets cold. That does not mean that the thermostat’s policy has become accommodative and is now targeting a higher temperature, or (worse!) that the furnace makes the room cold. It just means that it is reacting to a past error.
For much of the past decade, the RBNZ has undershot the midpoint of its CPI target – with several quarters’ inflation figures below the lower bound of the target range. During the mid-2000s, the thermostat’s errors were all in the other direction, with inflation too-often running above the top of the target band.
Monetary weather signals
So last week’s substantial cut to the OCR is less a signal of easy money than it is a continued reaction to past errors and worries about the future outlook. The temperature is a titch below the thermostat’s preferred setting, and MetService warns there could be a cold snap on the way.
The Bank could and should have signaled more clearly that it was expecting a change in the weather, as the OCR decision came as a surprise to the market.
But there are a few other troubling bits to the forecast.
The Monetary Policy Statement anticipates growing capacity constraints. The output gap measures whether, on the whole, economic activity is higher or lower than should be expected. When the output gap is negative, potential GDP is higher than actual GDP. In that case, there are unemployed workers and equipment that could potentially be put to work without substantial inflationary pressure. When the output gap is positive, actual output is higher than potential output, and prices should rise. The MPS expects a positive output gap and consequent rising wage inflation; inflation is forecast to return to the middle of the target band.
So while the interest rate is at a historic low, there is as yet little cause for more accommodative fiscal policy or for unconventional monetary policy. It would take worse international conditions than anticipated before either of those could make sense. The Government should have important infrastructure projects planned, consented, and ready for the shovels, in case the output gap should turn negative.
But if conditions continue as expected, and the Government responds to the low interest rate conditions by taking on substantial amounts of debt to fund new infrastructure, the forecast capacity constraints would bite more severely. The output gap would widen and prices would bid up. And, if the RBNZ were doing its job as thermostat to keep inflation at the 2 percent target, monetary policy would tighten in anticipation of those price increases.
Asking the Government to take on a more activist fiscal role under current conditions could be a multidimensional chess move to help the Bank eventually push interest rates back up, or it could be just a bit odd.
And we can also perhaps worry a bit about just what the Bank might intend should conditions prove worse than expected and more unconventional policy be called for.
Fire up the helicopters?
While the official cash rate can turn negative, it cannot go far into negative territory. Further monetary accommodation then requires the Bank to find other ways of getting cash into the economy.
Buying assets and government bonds is one way of doing that; handing out hundred-dollar notes to everyone – so-called helicopter money – is another.
If the Bank were to follow the US Federal Reserve’s example in buying up assets to get more cash into the economy (quantitative easing), it would have to have some way of deciding what to purchase. The Bank is currently exploring ways of developing mortgage-backed securities, in anticipation of perhaps wishing to purchase some come a rainy day.
But it would be rather nice were the Bank to provide a bit more guidance about just what it might do should the world become a bit more unconventional. In his interview with Bernard Hickey, Governor Adrian Orr noted the Bank’s advantage in being able to deploy capital a lot more quickly than traditional fiscal policy.
When restricted to the more conventional of unconventional policies, like ‘helicopter money’ payments to everyone in the country, that is certainly an advantage. When it comes to asset purchases, it would be nice to have a better idea of the sorts of things the Bank might contemplate.
The current remit for the Monetary Policy Committee begins with a preamble noting the Government’s Economic Objective of improving wellbeing and living standards and of moving towards a low carbon economy with a diversified export base.
During conventional times, where medium-term price stability contributes to any reasonable goal the Government might have, that preamble has little effect.
But if the Bank were deciding among assets to purchase, or investments to make, to get fresh cash into the economy through unconventional means, it might be tempted to read a bit more into that preamble and direct its asset-purchasing behaviour accordingly. This would be a substantial and potentially costly error, distorting investment and, worse, politicising an independent central bank. Where the Bank’s consultation document suggests Ministerial consent for RBNZ asset purchases other than government debt, concern about loss of political independence is not assuaged.
Tell us what's in and out
It is, I hope, unreasonable to think that the Bank might be so-tempted. But where the Bank is taking a more expansionary reading of its remit around climate change, for example, and where the Bank has been a bit happier of late to surprise markets, a few statements noting just what is ruled out in unconventional policy would be welcome.
Preparing for unconventional monetary policy can make sense, even if it is far from the Bank’s current expected path. But we are nowhere near the point at which throwing open the switches on fiscal policy is desirable.
Doing so during these more conventional times should have the Bank instead move to counteract the effects – at least if the output gap were expected to further widen. And clear signals that the Bank has no intentions of waking certain rocky horrors would put a few minds at ease.