Aaron Drew says ending inflation targeting would be throwing the baby out with the bathwater as monetary policy under an inflation targeting regime can be set with concern for asset prices, the exchange rate and other factors

By Aaron Drew*

Last week the RBNZ cut the OCR once again, to a new record low of 2% for the overnight cash rate.

In this, of course, they are not alone. The Reserve Bank of Australia also cut rates to a new record low of 1.5% at the beginning of the month, and many economists expect that rates in Australia and New Zealand will fall further still towards levels seen in the large advanced economies.

Zero and below here we come?

Will Rogers, an American cowboy, actor, comedian, author and newspaper columnist in the 1920s quipped: 

“It isn’t what we don’t know that gives us trouble, it’s what we know that ain’t so.”

Behind these extra ordinary moves is a core belief that central bankers hold around how their actions impact the economy and inflation.  The so-called monetary policy transmission mechanism. When the OCR is cut, the belief is that this will cause inflation to rise through two main transmission channels. The first ‘direct channel’ is that a rate cut causes the exchange rate to fall, which increases the price of imported goods and hence inflation. 

Last week we saw that this did not, in fact, occur.  Markets had been expecting a more emphatic easing path, and hence the exchange rate (an asset price that bakes in expectations of interest rates in New Zealand versus abroad) rose. This would be disappointing, but hardly surprising for RBNZ policy makers. The linkage between short-term rates changes and the exchange rate is tenuous, and the text-book response does not always occur.

The second, and usually more reliable and important ‘indirect channel’ is through boosting economic activity, including household and business spending, exports, and the fortunes of firms competing with imported products and services. One important part of this part of the transmission channel is via asset prices. A cut in interest rates, and the transmission of this to longer term rates, in theory should boost asset prices because it reduces the discount rate applied to their earning streams. In turn, this should lift household spending via a ‘wealth effect’, and potentially business investment because it increases the net asset value of the firm (relieving balance sheet constraints on borrowing). The overall lift in aggregate demand is expected, in time, to put upward pressure on inflation.

As a former central bank researcher and provider of economic modelling services to a number of central banks globally, I have some claim to suggest that this orthodox view is ingrained and very widespread in central banks. It is codified in their macroeconomic models, and a key part of the narrative that is used by policy makers to describe how monetary policy impacts the economy.

But the orthodox view is beginning to be challenged because inflation and household spending remains weak globally, despite record low rates. Recent OECD economic data, for example, shows household savings rates have in fact risen over recent years in countries such as Germany, Japan, Denmark, Switzerland and Sweden where interest rates are now zero or negative. They are now in some cases at their highest recorded levels since the OECD began collecting the data in 1995.[1]

Two key arguments are made as to why cutting rates may be making things worse rather than better. The first is essentially a confidence argument. Cutting rates to very low levels, and in the extreme case to negative levels, signals that things are very wrong with the economy. Households and firms react to this by pulling-back spending. For example, in the case of the Euro Area, Deutsche Bank’s Chief International Economist, Torsten Slok, argues that:

Normalizing rates would be seen as a positive signal by consumers and corporate investors. The longer the ECB persists with unconventional monetary policy, the greater the damage to the European project will be.

The second key argument is that cutting interest rates to very low depresses, rather than boosts, household spending because the negative impact it can have on savers and the retired outweighs positive impacts elsewhere.  In a recent speech, Yves Mersch, Member of the Executive Board of the ECB comments[2]:

…we need to be aware that there are distributional consequences of our actions – and these may well be particularly significant at times of exceptionally low interest rates…

When rates are extremely low it reduces the income streams from financial assets (such as bank term deposits, bond yields, and the dividends from equities). This means that people who are no longer working that rely on these income sources have less to live on and less to spend (unless they choose to “eat” their capital). At the global level, McKinsey estimates that housed net interest income in the US and Euro Area has declined by a staggering $630 billion as rates fell over 2007 to 2012.[3]  Clearly the cumulative impact is larger still now. We are seeing more and more people coming into our advisory practice because they are extremely upset over RBNZ actions and the fall in income they are receiving from bank term deposits.

For savers looking to build a retirement nest egg low rates mean that they have to save more and for longer to build a sustainable income stream, reducing the amount they can spend today. In addition, low rates have boosted asset prices globally, which reduces the return that can be expected from financial assets in the future. Asset consultancies, pension funds and financial advisers generally expect to see much lower future returns than what has occurred over recent years, and are warning that savings levels need to significantly increase in order to prepare for retirement despite the boost in asset prices. This message may be getting through.

For young savers looking to purchase their first home, low interest rates in New Zealand have arguably been nothing short of a disaster. The rates cuts we have seen have no-doubt significantly contributed towards increased house prices – surely this is the elephant in the room regarding the “housing crisis”. The RBNZ has reacted to the financial stability risks from over-valued housing by increasing required loan-to-value ratios. This means young savers have to save even more to build a deposit in an environment where the return from savings is also lower.  A double whammy impact on the amount of income they have left over to spend today.

The key question the above points beg is whether the transmission mechanism has weakened, or even changed sign, as we have entered a very low interest rate environment?  

From a central banks perspective this should be seen a classic “empirical issue”. Interest rates are a blunt tool for managing aggregate demand and inflation, and how interest rates impact different sectors of the economy can’t be fined-tuned. But ideally what any central bank should have is a clear understanding of the distributional impacts, and how this aggregates up to the overall impact on demand. Unfortunately scant empirical research appears to be available on this potentially crucial issue. For example, at a recent conference hosted by the Brookings Institute in the United States[4] on what we have learned from negative interest rates the distributional impacts were barely acknowledged, and how this could interplay with demographic profiles was not raised at all. 

Given the challenges of running monetary policy in today’s environment some economists and commentators have called for the end of inflation targeting, the dominant policy framework that monetary policy makers operate under today.  In my view, this is throwing the baby out with the bathwater. Monetary policy under an inflation targeting regime can be set with concern for asset prices, the exchange rate and other factors. This is explicitly the case in New Zealand with the current Policy Targets Agreement.  

Others have questioned the judgements that the RBNZ has applied over recent times. As discussed in an article September last year,[5] my view was that rates were already too low given the strength of the domestic economy and if rates were cut financial stability risks could rise given the likely intensification and spread of the housing bubble from Auckland to other parts of New Zealand. But I hasten to add that challenging judgement is an easy accusation to throw from the side lines. Policy has been cut because inflation has been unambiguously below target, and the balance of risks are never clear ex-ante.  It would have been, and remains, a very difficult task to balance financial stability risks against potential debt-deflation, external imbalance and global risks. 

The third alternative to the conundrum facing the RBNZ and other central banks today is to take more seriously concerns that the transmission mechanism could be working differently when rates are low. Or to paraphrase Will Rogers, it’s the things that we believe are true that ain’t so that create the real trouble.

Aaron Drew is an Associate of the NZIER and Chief Investment Officer of the Stewart Financial Group.  He has worked as an economist at the OECD and held senior positions at the New Zealand Superannuation Fund and RBNZ.