Matthew Goodson: What's the emergency, RBNZ?

Reserve Bank Governor Adrian Orr. Photo / File

COMMENT:

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 per cent 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 per cent CPI inflation at all costs.

This piece will show that the 2 per cent 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 per cent." 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 per cent, 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 per cent affects growth. No kidding.

So, NZ rolled out the RBNZ Act in 1989 with central bank independence and a tough 0-2 per cent 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 per cent target for almost all the pre-GFC period. Accordingly, it was moved to 0-3 per cent in 1996; to 1-3 per cent in 2002; a focus on the 2 per cent mid-point was added in 2012; and a dual focus on employment was added in 2018. Does all this tinkering give confidence that 2 per cent 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 per cent would produce better or worse outcomes for trend growth than trend inflation of 1.5 per cent."

So, even with inflation currently running between these 1.5 per cent and 2.0 per cent 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 per cent rather than 1.5 per cent.

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 per cent and +2 per cent. Contrary to the RBNZ's 2 per cent 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 per cent, they will set their prices and wages accordingly and we will have a self-fulfilling 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 per cent, the central bank can talk all it likes but it will not credibly be believed that it can deliver an inflation outcome of 2 per cent. 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 per cent 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 per cent, wages have risen by 78 per cent but medical services have gone up by +195 per cent, electricity +194 per cent and secondary education +203 per cent. Conversely, audio-visual and computing has fallen -89 per cent, games -16 per cent, cars -14 per cent and clothing/footwear -10 per cent. 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 per cent and has been low for years, while domestic non-tradeable inflation is +2.8 per cent 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 per cent is the right target. It could easily be 1.0 per cent or 1.5 per cent 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.

- Matthew Goodson is the managing director of Salt Funds Management.