Economist Rodney Dickens accuses the RBNZ policy makers being out of touch with "the coal face" and the consequence will be a painful retrenchment after an unnecessary boom

By Rodney Dickens*

This morning the Reserve Bank released a brief “economic update” that laid the groundwork for an OCR cut on 11 August.

In that context, the critical comment in the statement was: “At this stage it seems likely that further policy easing will be required to ensure that future average inflation settles near the middle of the target range.”

To me the “economic update” is no more than a propaganda exercise aimed at trying to talk the exchange rate down in line with Governor Wheeler’s long-standing crusade.

My last Raving highlighted that the OCR cuts since July 2015 have been followed by a higher not lower exchange rate and that the forex market is smarter than the Reserve Bank (use the following link to access that report – http://www.sra.co.nz/pdf/SmartForexJul16.pdf).

The Reserve Bank is, unfortunately, repeating past mistakes.

Lower interest rates in 1993 and 2003 were followed by an appreciating not depreciating exchange rate. But today’s statement by the Reserve Bank should ring more warning bells than just the risk excessive OCR cuts will drive the exchange rate higher not lower.

The “economic update” had a lopsided focus on a few issues and especially the exchange rate but didn’t mention once the most important issue of relevance to the medium-term inflation prospects Governor Wheeler is supposed to focus on most. It is no more than a misguided propaganda statement.

How can I tell that the “economic update” released by the Reserve Bank today is a misguided propaganda statement? It included no mention of the inflationary threat developing in the labour market as a result of overly stimulatory monetary policy. This follows in the footsteps of the June Monetary Policy Statement that severely lacked quality analysis of labour market prospects.

By contrast, one of the key findings of BNZ chief economist Tony Alexander’s latest quarterly survey of businesses was: “Across many sectors employers are finding it difficult to source skilled staff, especially construction and engineering.”

The Reserve Bank is out of touch with what is happening at the coal-face of the labour market, just as was the case in the early-to-mid-2000s.

Consequently, the odds are high that interest rate and exchange rate prospects are very different to what the Reserve Bank and bank economists are predicting, as was the case last decade. There is a real risk Governor Wheeler’s misguided monetary policy experiment, like Governor Bollard’s misguided go-for-growth experiment last decade, will result in boom-bust cycles for the economy and housing market.

The best means you have for protecting your business and investments from this misguided experiment is to sign up for our pay-to-view reports. I have a proven track record at advising clients what will happen when the Reserve Bank goes off on a misguided experiment.

What the Reserve Bank is overlooking and why it should ring warning bells

This Raving highlights the most important issue to medium-term inflation prospects that the RB is completely out of touch with and makes some general statements about the implications. There isn’t a labour cost inflation problem based on the historical data that plays too much of a part in the RB’s assessment of inflation prospects. However, insights from the coal-face, like those provided by Tony Alexander’s latest survey and from feedback I have from contacts around the country, highlight that a labour cost inflation problem is starting to develop as a result of an excessively low OCR driving excessively strong economic growth.

The consensus of the nine forecasters surveyed by NZIER in June was that GDP growth won’t improve much (green line, left chart). The RB is a bit more optimistic about near-term prospects but it is less positive thereafter (blue line, left chart). I have argued that the bank economists and RB forecasters have been putting too much weight on the fall in dairy farm incomes and fading Canterbury rebuilding and not enough on the major stimulus from: (1) super-low interest rates; (2) super-charged net migration; (3) the Housing Accords, especially in Auckland, that will provide more of a boost to residential building this year and beyond; and (3) the spreading of the housing boom further around the country that is reflected in the latest REINZ and QV numbers and will filter to residential building and consumer spending. Consistent with my view, the most useful leading indicator points to GDP growth rebounding (right chart).

Consistent with their forecasts for GDP, the RB and economic forecasters are predicting only moderate employment growth (green line and blue line, respectively, adjacent chart). By contrast, the ANZ survey of employment intentions points to growth improving back to around 3% (left chart below) while the job ads surveys have spiked recently (right chart below). The leading indicators are behaving as they should be given that GDP grew at a 3.3% annualised rate over the last two quarters (i.e. robust employment growth and a falling unemployment rate shouldn’t be a surprise to the RB and economic forecasters but have been). The evidence is swinging in favour of my view that employment growth will be stronger than the RB and forecasters in general have been predicting. However, it is becoming more than just a case of the labour market tightening as a result of GDP growth being boosted above the level consistent with Governor Wheeler’s 2% CPI inflation target. The labour market is heading into a disequilibrium situation that gives too much bargaining power to employees, just as occurred in the lead up to numerous OCR hikes last decade. Calls for more OCR cuts are hugely misplaced, but this won’t stop the governor from cutting more.

The unemployment rate has already fallen to a level that is likely to boost productivity-adjusted labour cost inflation above 2% (left chart below). The NZIER survey of labour shortages that leads growth in total gross incomes by three quarters is telling the same story (right chart). The two charts below are consistent with the evidence starting to emerge from the coal-face of the labour market. However, the RB is completely overlooking these insights and is instead intent on boosting economic growth further and driving the unemployment rate further into inflation territory just as Governor Bollard did over a decade ago.

The complete lack of reference to the emerging labour cost inflation problem by the RB today is nothing new. In March 2004, after Governor Bollard delivering the first of 13 OCR hikes, the RB was predicting that the unemployment rate would increase and that labour cost inflation would fall on the verge of the opposite happening (left chart below). And in March 2004 the RB was predicting no further upside in interest rates when instead Governor Bollard ended up delivering 13 OCR hikes that drove the 90-day bank bill yield and mortgage rates up dramatically (right chart below).

The historical experience is straight forward: let the unemployment rate fall too far and it will spark a labour cost inflation problem, a wage-price spiral and mean economic growth is for a period quite resilient to OCR hikes. To solve the labour cost inflation problem a major slowdown in economic growth will be required (i.e. slowing growth well below 2% so that it boosts the unemployment rate back up to the rate consistent with keeping inflation low on average over the medium-term, which is around 5.5%). However, the RB is no good at engineering slowdowns in economic growth (i.e. “soft landings”) because of the rear-view mirror approach it uses to assess inflation prospects and make OCR decisions. Two years from now the RB will see the labour cost inflation problem in the rear-view mirror and is likely to tighten monetary policy beyond the extent needed to fix the problem, resulting in a recession and falling house prices.

While on the topic of house prices and the potential risk of falling house prices to the financial system, the lending restrictions planned for 1 September and the income-related restrictions planned for next year will act partly like OCR hikes, but not enough to solve the developing labour cost inflation problem.

I am dubious of the RB’s rationale for introducing lending restrictions, but more are coming. Part of my criticism of the lending restrictions in general and the latest restrictions in particular is that they are largely only needed because interest rates are too low. On the one hand the RB is fuelling a housing boom with an excessively low OCR. Excessively low interest rates are a threat to financial market stability because of the inevitable interest rate hikes that will follow and the resulting boom-bust housing cycle (i.e. a repeat of the monetary policy misadventure conducted by Governor Bollard last decade that contributed to numerous finance company failures as pointed out in past Ravings). On the other hand the RB is trying to arbitrarily target investors because this is supposed to be needed to protect the financial sector from a boom-bust housing cycle. The RB plans to keep one foot firmly planted on the accelerator and at the same time will be pulling hard on the handbrake.

My second criticism is that people will in time find ways around the restrictions as was the case with the range of lending restrictions the Muldoon Government introduced in the late-1970s and early-1980s. This means the restrictions will ultimately be a waste of time but will impose costs on the groups trying to get around them while they will result in some unexpected and undesirable outcomes. As people find ways to supplement funding for house purchasing/investing it will shift the risk the RB has helped fuel with excessively low interest rates from the banking sector to non-bank lenders (e.g. as a result of the Muldoon restrictions, 40% of total mortgage lending ended up being conducted via lawyers’ trust accounts before the restrictions were abandoned).

In my assessment the Reserve Bank’s desire to control the housing market with lending restrictions is much like the ongoing and misguided attempts by the governor to talk the exchange rate down that have backfired and are likely to continue to do so (i.e. flawed and likely to result in perverse outcomes). Add to this the willingness of the RB to put out an “economic update” that completely overlooks the most important issue to medium-term inflation prospects and warning bells should be ringing loudly.

Things will turn out very differently from what the RB and most of the bank economists are predicting and if you aren’t aware of the potential implications of the latest misguided monetary policy experiment you are likely to be in for some unexpected and potentially unpleasant surprises.


*Rodney Dickens is the managing director and chief research officer of Strategic Risk Analysis Limited.