Budget 2020: Brian Fallow - Borrowing to reach the other side

COMMENT:

We heard some scary big numbers from Finance Minister Grant Robertson yesterday about deficits and debt levels.

In the current year and the next two fiscal years, operating deficits (before gains and losses) average around $28 billion, while net core Crown debt is expected to increase on average by around $32b a year.

The Treasury's forecast (i.e. best guess) is that net debt will hit $200b by June 2024, or 53.6 per cent of gross domestic product, $125b more than expected six months ago.

It expects its net bond issuance over the five years to 2023-24 to be $142b, the biggest chunk of which will be $49b in the coming 2020-21 year.

In the oft-quoted words of US Senator Everett Dirksen: "A billion here, a billion there, and pretty soon you're talking real money."

Worries people might have about what that means for them are probably not allayed, however, by Wednesday's assurance from the Reserve Bank that it stands ready to expand its quantitative easing (QE) programme, buying up to $60b of government bonds over the next 12 months with money newly created for the purpose.

By the end of April the Reserve Bank was holding $15.2b of government securities, up $10.4b on two months earlier.

It does not want to own any more than half of the bonds on issue at any stage, lest it completely dominate the secondary market.

When the Reserve Bank undertakes QE — buying government and local government bonds on the secondary market — its aim is to lower longer-term interest rates.

It assures private sector institutions like banks, which might participate in a government bond tender, that should they wish to sell the bonds, there is a buyer in the market with the deepest possible pockets and which is, moreover, intent on keeping bond yields low and therefore bond prices high.

And indeed, bond yields have fallen by about a full percentage point since the start of the year.

But inflation expectations have also dropped with a thud, so real yields have fallen much less.

And only a fraction of the decline in wholesale rates has flowed through to retail interest rates.

"Retail interest rates are also affected by banks' cost of funding, the demand for new lending, and by competition between banks. So far, we have not observed the pass-through of wholesale interest rate reductions to retail interest rates to the extent we might expect in normal times," the bank said on Wednesday. It expects to see more pass-through.

A charitable view of the stance of monetary policy at the moment is that it is defensive rather than stimulatory. It continues to expect fiscal policy to do the heavy lifting to deal with the Covid-19 recession, while it plays Robin to the Government's Batman.

The way QE works is that when the Reserve Bank buys a government bond, it credits the vendor's account with money it has not had to acquire from anywhere.

That new money will show up as an increase in settlement cash, which is the amount trading banks collectively have in their deposit accounts with the Reserve Bank at the end of a trading day after they have squared accounts with each other on behalf of their clients.

For many years settlement cash has moved around in a tight band between $7b and $8b, but since the middle of March it has climbed to the $28b-$30b range.

In the jargon, the Reserve Bank is increasing the monetary base (physical cash plus settlement cash) in the course of accommodating a large and rapid increase in debt issuance by the Government.

More informally, it is printing money so the Government's cheques don't bounce.

The thing is that the Reserve Bank pays interest on settlement cash, at the official cash rate. That liability offsets the assets, in the form of bonds, it has acquired.

Because the Reserve Bank is part of the core Crown, any payments between it and the Treasury over the road — coupon interest in one direction, dividends in the other — and any call on the indemnity for potential losses the bank has received from its owner are internal book-keeping matters within the core Crown accounts. They are not something we need worry about.

The effective interest rate the state is incurring here — to the extent bond buying by the central bank matches bond issuance by the Treasury — is the official cash rate.

And that is almost zero right now, 0.25 per cent. It may even go lower.

But even if the OCR remains low for years, we have to hope that eventually economic activity will recover to the point that the economy's spare resources — especially the unemployed — are put to work, firms can think about raising their prices and the risk to price stability is inflation, not deflation.

At that point the Reserve Bank will want to tighten, by raising the OCR and possibly by reducing its holdings of government bonds, although this has seldom happened in practice overseas.

That must be the bank's monetary policy committee's call to make, not the Government's.

How far the bank accommodates deficit spending by the Government has to be governed by its own dual mandate of price stability and supporting maximum sustainable employment. Governor Adrian Orr was emphatic on that point when appearing before Parliament's finance and expenditure select committee yesterday.

Reserve Bank Governor Adrian Orr. Photo / Mark Mitchell

In the meantime, though, from the point of view of a Government with a large deficit to finance, quantitative easing is, if not quite a free lunch, at least a very cheap one.

There is a happy overlap or alignment between what the bank wants to do for monetary policy reasons (buy bonds) and what the Government wants to do for fiscal reasons (sell bonds).

Down the track there will be an important debate about what to do about the legacy of public debt from this period.

Should taxes be raised, or public spending cut, including perhaps changing the entitlement parameters for New Zealand Superannuation?

The other option would be to rely on the fact that so long as the interest rate on the debt is less than the rate at which nominal GDP (i.e. real growth plus inflation) is increasing, the debt-to-GDP ratio will decline of its own mathematical accord. The question would be whether that is fast enough. All of these options have their own distributional consequences.

But that trilemma lies some way down the road. Right ahead the roadway has disappeared into a yawning chasm of a sinkhole and getting across it is the immediate priority.

What, then, about the inflationary risks of flooding the system with new base money?

There isn't a rigid mechanical link between increases in the monetary base and increases in broader measures of the money supply.

The experience of other countries, and the eurozone, which have carried out quantitative easing has not been runaway inflation. Far from it. Scaremongering about the hyperinflation of the Weimar Republic or Zimbabwe is empirically challenged, to put it mildly.

Right now the risk to price stability is deflation, not inflation.

A gruesome recession is not conducive to raising prices; quite the contrary. A net 9.5 per cent of firms in ANZ's latest monthly surveys say they expect to have lowered prices in three months' time. And the Reserve Bank's own quarterly survey of expectations last week recorded dramatic drops in inflation expectations.

All else being equal, that implies higher real interest rates, the opposite of what is required.

The Reserve Bank's baseline (most optimistic) scenario has annual consumers price index inflation at minus 0.4 per cent by March next year.