An interpretation of the OCR decision

01/02/2013 § 5 Comments

I’m finding this monetary discussion interesting and useful. Matt Nolan and Eric Crampton have added a lot to it. Since the Reserve Bank decided yesterday to leave the OCR unchanged at 2.5%, I thought I’d offer an interpretation.

The Bank is balancing several different concerns. Some factors point toward looser policy: inflation below the target band, weak labour market, ‘fiscal consolidation’, and a high exchange rate. Other factors point toward tightening: house price inflation in Auckland, expectations for the Christchurch rebuild, positive business sentiment. They’ve split the difference and kept the OCR unchanged. Bernard Hickey explained this very well on Breakfast this morning.

Is it a good decision? We’ll only know that later in the year. But here are some thoughts on it.

First, the RBNZ has been consistently optimistic about the economy over the last several quarters, predicting increases in the OCR that didn’t eventuate. As part of that, the Christchurch rebuild has consistently underperformed. That suggests that if the Bank is wrong, they are likely to be on the high side.

Secondly, other people clearly have a more pessimistic view. Eric pointed to the iPredict website and the predictions for the economy. He noted:

markets also are pegging pretty stagnant GDP growth rates and an unemployment rate unlikely to drop below 6% before September quarter 2013.

That’s consistent with the Bank’s own forecasts in December 2012 (pdf).

The Bank had essentially two choices, with their own costs and benefits:

Cost Benefit
OCR lower Possibility of overshooting Greater economic activity
OCR unchanged Higher unemployment Inflation below 2%

Looked at this way, the OCR decision means that the Bank has chosen the certainty of higher unemployment rather than face the possibility of missing its inflation target, a possibility that should be considered against a backdrop of misplaced optimism. If I were being churlish, I would suggest that Auckland’s failure to deal with its planning issues is resulting in tens of thousands of people being purposely kept out of work. But I won’t — it wouldn’t be politic.

About these ads

Tagged: , , , ,

§ 5 Responses to An interpretation of the OCR decision

  • nolan83 says:

    “First, the RBNZ has been consistently optimistic about the economy over the last several quarters, predicting increases in the OCR that didn’t eventuate. As part of that, the Christchurch rebuild has consistently underperformed. That suggests that if the Bank is wrong, they are likely to be on the high side.”

    Indeed, the Chch rebuild, and prior to that unforeseeable policy failure in Europe, has led to a situation where the ex-post outcomes were worse than the ex-ante forecasts.

    The key question is, at this point in time is the ex-ante forecast appropriate? I don’t think we can use a heuristic such as “they have been wrong in recent years” without thinking about this in more detail – after all, their forecasts were “too pessimistic” for many years prior to the crisis.

    Essentially I think you are saying that the RBNZ’s forecasts are systematically biased due to the conservative nature of central banking. This could be the case – but as the Bank always says, under its current set of forecasts they believe the risks are appropriately balanced. Given everyone else who has technical expertise in such things is forecasting the same sort of thing, they seem to have a point!

    • Bill says:

      There are two points I’d make.

      1. ‘Everyone else’ isn’t agreed — there is still pessimism about the economy, as seen by the iPredict markets and Donal’s December column. Given that everyone isn’t agreed, I think it is worth highlighting the range of opinions.

      2. Think of this in a Lancastrian framework: the Bank is making a binary decision (hold or cut) that represents a weighted sum of many factors. They’ve told us the factors in the press release, but not the weightings. I’m trying to derive the weightings from the observable data — the factors and the decision. My eyeball estimate is that they have heavily weighted concern about Auckland house prices and lightly weighted actually existing unemployment. This is my way of getting a handle on what drives the decision making and what factors the Bank cares about.

      • nolan83 says:

        My term “everyone else” was poorly defined by what I mean’t, my apologises. Everyone else in this context was everyone else who uses a forecasting model to derive what the appropriate stance of monetary policy – and from the Shadow Board everyone apart from Shamubeel, who has articulated why he believes the weight of risks is different, see this as the case. That was the everyone else I was getting at.

        It is fine for people to qualitatively disagree with the Bank, but unless we are going to come out and say “their forecasts are ex-ante biased” it isn’t particularly fair – as they do consistently forecast inflation in the band and unemployment/output gap measures closing (more on that later in the comment).

        Remember also that they only weight criterion based on their impact on “demand” (and the way that impacts on welfare such as consumption variability), and financial stability – they don’t go that further subjective step forward in valuing states … as that is the purpose of fiscal policy and the market place.

        We could flip the modeling criteria around and state that the release of a forecast is a narrative device to show both their belief in the trade-offs involved (which is based on empirical data and the application of theory). They then solve for the policy path given this – which is based on their view of the welfare function (solving to minimise variablility in consumption) for an equilibrium where inflation gradually moves to its target.

        Given this, we judge the appropriate of policy directly on their forecast – a flexible inflation targeting central bank that is looking to limit the welfare cost associated with demand shocks will aim to target a “forecast of inflation” and set their policy rate as a tool to do this. Remember, inflation isn’t really the primary “cost” involved here – it is a factor that signals whether the central bank is effectively managing the “demand” side of the macroeconomy given the belief in a series of factors that make short term shifts in “demand” in the macro sense costly.

        This is where people that support NGDP will come in and say that NGDP, not inflation, is a better representation of this. This is all well and good – but I have a preference for inflation targeting as the form of communication, and believe that central bank policy based on output gaps and flexible inflation targets is virtually equivalent to NGDP targeting in a functional sense (albeit FIT allows more discretion).

  • Bill says:

    Matt, you’re right — I don’t have a model or a staff of analysts, and it isn’t my area of expertise. I’m taking a risk putting some ideas out there that do not conform to what other people are saying.

    Mainly, I’m pointing out just one thing: The Bank said in the press release that inflation was below the target band, and that their policy preference is to guide the economy so that inflation moves ‘slowly back towards the 2 percent target midpoint’. They had an alternative, which was to point out that inflation is too low (‘we missed our target, sorry about that’), and that they have a mandate to target inflation in the 1%-3% band. In the interests of helping New Zealand businesses and employees, they would target the top half of the band.

    But they didn’t. That reveals a policy preference for targeting the bottom half of the target band over putting people back to work.

    • nolan83 says:

      “Matt, you’re right — I don’t have a model or a staff of analysts, and it isn’t my area of expertise. I’m taking a risk putting some ideas out there that do not conform to what other people are saying.”

      Indeed this is cool, that is what blogs are for. All I’m doing is trying to put what the bank is aiming to achieve, and the method it uses for doing do, in some perspective :)

      “But they didn’t. That reveals a policy preference for targeting the bottom half of the target band over putting people back to work.”

      I don’t believe they view the trade-off in quite as stark a way – and again, deviation in inflation aren’t what is costly in of itself … the justification of active monetary policy is through smoothing consumption, and ensuring that we don’t have unemployment that is solely due to “insufficient demand”.

      Their policy aim is to close the output gap, which would suggest they are doing everything that is possible to ensure that future unemployment isn’t due to underlying demand being too low – that is why they forecast inflation to go back to 2%, and unemployment to fall steeply, all within the next 18 months. This was their forecast based on the weight of probabilities – during the crisis they explicitly stated that they weighted negative outcomes more heavily than positive outcomes (compared to how they would have with strict probabilities).

      You seem to be saying that you are fine with their model, and their general methodology – but you believe they should weight downside risks more strongly to account for social concerns. But there are two issues here:

      1) Monetary policy works through expectations – if the central bank biases its policy towards downside risks, then overtime inflation will be above their target, and inflation will become unanchored. They will lose the ability to smooth economic activity AND inflation will be more variable. This is the traditional view that the short-run Phillips curve relationship breaks down if the central bank tries to use it (Lucas Critique came in here).
      2) You may say this is a special circumstance where more must be done – understandable. But in this case I still don’t understand why a central bank who is managing demand effectively must also become akin to an insurance agency (by treating risks around states of the world asymmetrically). This issue is one that needs to be seen as part of our “social contract” through fiscal policy – and is a key argument for the existence of automatic stabilisers in fiscal policy, and active countercyclical infrastructure spending.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

What’s this?

You are currently reading An interpretation of the OCR decision at Groping towards Bethlehem.

meta

Follow

Get every new post delivered to your Inbox.

Join 109 other followers

%d bloggers like this: