Here is a link
to a brief that I wrote for the Housing Industry Association. Below is an
extended version.
New Zealand’s
apparent willingness to accept higher inflation than the US could come in handy
in the next downturn.
Terminology time! An inflation ‘hawk’ is a person who is
more worried about inflation getting too high. An inflation ‘dove’ is someone
more worried about inflation getting too low.
The US and New Zealand demonstrate both these positions
quite well.
The US is increasing interest rates while inflation barely
touches their target of 2%. Understandable – they slashed interest rates so
dramatically in the GFC and have remained so low for so long that they’re no
doubt eager to bring them back up, lest they spur some unintended imbalances,
like an over-inflated stock market or housing bubble. Still though, hawkish.
In NZ however, recent economic data is pointing to strength
– stronger economic growth, decade-low unemployment now at just 3.9%, and
employment and inflation expected to overshoot their targets on a sustained
basis. Inflation is still currently in the middle of their 1-3% target, but
given this strong data, you’d think they’d upgrade their intentions for future
interest rates rises. On the contrary, they’re being quite dovish about it.
They’re intent on keeping interest rates where they are until mid-2020 (the
same intention they had before this new stronger data came out).
As Westpac’s Dominick Stephens said:
“RBNZ
recognises that inflation pressures have built. The inflation forecast was
lifted, upside risks to inflation were emphasised more heavily, and rising
inflation was discussed up front in the document. Intriguingly, the forecast
was for inflation to rise above [their target] 2% in the medium term. [But]
RBNZ has declined to alter its [cash rate] forecast … They’re choosing
higher inflation rather than a higher [cash rate]”.
There has been commentary for several years, including from
Nobel Prize-winning economist Paul Krugman, that advanced economy central banks
may have set their inflation targets too low – the US and UK at 2%, the EU under
2%, Australia 2-3%, NZ 1-3%. Again, understandable. They were set in the 1990s,
with the high inflation of the 1970s and 80s still fresh in policymakers’
minds. So they were extra keen to keep inflation under control, and believed a
1-3% buffer above zero would be enough to prevent self-fulfilling deflation
during any downturn (which can actually be just as bad and just as hard to fix
as high inflation – if not more so).
The GFC however, demonstrated that inflation can indeed,
still get too close to zero – and lower. Current inflation buffers have not
negated the dreaded ‘liquidity trap’, where central banks have already dropped
interest rates to zero but, because of inadequate inflation, real
interest rates (the gap between interest rates and inflation) are still not low
enough, making monetary policy impotent to help recover the economy.
Consequently, many advanced economies undershot their inflation targets for
most of the last decade. It turns out, even getting close to deflation –
let alone actually achieving it – can be hard to reverse.
If however, inflation targets were increased to, say, 3-5%,
that would provide a bigger buffer, without inflation getting out of control.
Another way to look at it is that the risks of central bank policy are asymmetric:
the costs of allowing inflation to venture a little too high right now are far
smaller than the risks of increasing interest rates too fast and driving the
economy back into a liquidity trap or worse, a deflationary spiral.
Perhaps this is what NZ’s central bank is thinking – an
upwards reset of their 1-3% target so they have more inflationary ammunition in
the next downturn.
Take the following hypothetical example of what NZ
and the US could be facing soon.
The US is raising interest rates rapidly to keep their
inflation rate no higher than 2%. NZ however, is raising their interest rates
more slowly, willing to accept higher inflation of, say, 4%. This means that
the real interest rate remains much lower in NZ, actually below zero and
declining for most of this period – much more stimulatory for the economy.
Therefore, in almost two years, inflation is much higher in NZ and interest
rates much lower; and in the US, inflation is much lower and interest rates
much higher.
Then in two years, where I have assumed a significant global
downturn, both the US and NZ drop their interest rates back down to zero. It
would appear the US is in a better position – they were able to drop rates a
full 5%, NZ only 2.25%. NZ however, had a much higher inflation rate beforehand
that only falls to 2%, whereas the US’s 2% inflation rate falls back to 0%.
Which means upon the downturn, NZ’s real interest rate becomes -2% and the US’s
just 0%.
This would leave the US dealing with a ‘liquidity trap’
situation. Whereas in NZ, investment would still be preferable to holding cash,
so ongoing investment in NZ would act to stabilise the economy during the
downturn. In the US, the prospect of deflation would create a disincentive to
invest[1]
and the lack of investment would be an additional headwind exacerbating the
downturn.
So even though the US can drop interest rates more
dramatically upon the downturn, NZ is able to achieve a lower real
interest rate (even though it barely decreased in the last month) and
therefore, undertake stronger stimulus – because they allowed their inflation
rate to rise further beforehand, rather than rushing to increase interest
rates.
While these numbers are somewhat arbitrary, it does
illustrate that it’s not the size of the interest rate cut you have up your
sleeve. It’s the stimulatory effect of your interest rate position after the
cut has been made – the real interest rate. 0% interest rates with 2%
inflation is more stimulatory than 0% interest rates with 0% inflation.
Furthermore, in the former case of 2% inflation, people are also less worried
about self-fulfilling deflation[2].
The implications if Australia’s Reserve Bank similarly chose
to run the economy hotter for longer are clear for the housing industry. Lower
interest rates for longer will support mortgage holders and investors alike,
thereby supporting one of Australia’s most significant industries, even in the
face of the current housing downturn.
I know all of this sounds like a bit hypothetical and
abstract. But remember, psychology is very important in economics. The
perception of being too close to deflationary territory can, all by itself,
cause an economy to fall into deflationary territory. And the housing industry,
through the mortgage market, can be the hardest hit in such an event. That’s
why an arbitrary buffer sufficiently above 0% inflation is so important.
Because perception very much becomes reality.
[1] Not
just business investment in things like property, buildings, equipment,
machinery and staff, but also household investment in property, appliances, furniture,
vehicles, etc. Even government, upon the deflationary expectation that things
will be cheaper (or at least not much more expensive) in the future, may be tempted
to put off major infrastructure investments.
[2] And
as for the unintended consequences of prolonged low interest rates, like
financial instability – interest rates are not a good tool for reigning in
asset markets, especially if they are running in the opposite direction to the
real economy (as was the case in Australia until recently with booming housing
markets). This is more a job of macro-prudential regulation and oversight, by
the central bank and/or other regulators (like APRA and ASIC in Australia). Interest
rates should be the tool used to manage the real – not financial – economy.
