The Reserve Bank error that slowed economic growth
By Richard Harman (author)
The Reserve Bank yesterday released a study which said it got its interest rate settings wrong in 2014.
In December 2015, then-Finance Minister Bill English blamed Reserve Bank Governor Graeme Wheeler’s decision to raise the official cash rate in 2014 for 2015’s sluggish economic growth.
Over the course of 2014, the Bank raised the Official Cash rate from 2.5 to 3.5% and then by the end of 2015 dropped it back to 2.5%.
Last month Wheeler told The Herald that in 2014 the whole world was caught by the oil price crash.
"At that time we had the economy growing strongly, the international economy was looking good at that point, and our projections suggested that we would be moving to a positive output gap."
In other words, it looked as though the New Zealand economy was about to hit the upper limit of its growth capacity.
But central to the Bank’s actions that year were its inflation forecasts which were based the output gap referred to by Wheeler along with surveys of businesses seeking their expectations of what inflation might do.
The Bank was required to keep inflation within a 0 -3% band which it does by raising or lowering the Official Cash Rate thus (theoretically) stimulating or dampening economic activity.
The author of the paper, Chris McDonald, focuses on “non-tradable” inflation; that is the prices of goods and services which cannot be traded internationally such as council rates, electricity charges or housing costs and a host of others.
Non-tradable inflation makes up 56% of the consumers’ price index.
And McDonald finds that the traditional method used by the Bank, the output gap and survey method, suggested inflation was on the rise through 2014.
But in fact from 2014 non-tradables inflation was weaker than the survey and estimates of capacity pressure suggested.
When the Bank increased the OCR in early 2014, non-tradables inflation had been expected to rise from 3 percent to above 3.5 percent by early 2015. Instead, it declined to around 2.5 percent.
Thus the decision to raise interest rates that year was based on a faulty forecast.
It had a profound impact.
The New Zealand dollar shot up against the $US and $AU reaching 95 cents against the Australian by the end of the year with suggestions it might reach parity.
Growth had hurtled along at 3.3% during 2014 but slumped to 2.5% in 2015 --- it was that slump that English blamed the Bank for.
McDonald tested a different method of forecasting inflation.
He looked at whether using past inflation would produce a more accurate prediction of future inflation.
The paper says “measures of past inflation likely capture several things that affect price setting.
“For example, low CPI inflation means smaller increases in the cost of living, which may lead to less pressure on nominal wages.
“Surveys of inflation expectations should also capture this effect.
“Measures of past inflation may also identify changes in the structure of the economy and their impacts on inflation.”
And the study concludes: “The results show that forecasts constructed using measures of past inflation have been more accurate than using survey measures of inflation expectations, including the 2-year ahead survey measure previously used by the Bank. Instead forecasts constructed using measures of past inflation would have been significantly more accurate than the Bank's MPS forecasts since 2009, and only slightly worse than these forecasts before the global financial crisis (GFC).”
And he offers a revealing insight into the Bank’s current thinking on inflation.
He says that since ate 2015, the Bank has assumed that past inflation has affected domestic price-setting behaviour more than previously.
“As a result, monetary policy has needed to be more stimulatory than would otherwise be the case.
This price-setting behaviour is assumed to persist, and is consistent with subdued non-tradables inflation and low nominal wage inflation in 2017.”
In other words, if the bank hadn’t adopted the new method at the end of 2015 it would have run the risk of repeating the 2014 mistake all over again, of holding interest rates too high and choking the economy.