On Thursday Reserve Bank governor Graeme Wheeler will pronounce on the economy’s track and where interest rates should or might go and when. He is likely not to cut the official cash rate (OCR) but the slope of any future rise has been getting less steep by the quarter and the start date more distant.
The monkish bank economists will mine Wheeler’s sermon for clues for their traders’ exchange and interest rate bets. This they do in arcane rituals known as general equilibrium models (which assume you and I are always rational).
Down in the pews unions and manufacturers will berate Wheeler if he doesn’t cut the OCR, which the “markets” are betting 68% he will by year-end. (The Australian Reserve Bank, hovering over an economy weaker than ours, last week defied predictions of an OCR cut. Its governor doubted a cut would have much effect.)
A big part of Wheeler’s problem as he prepares his tablet of stone (or tissue paper) is that inflation has not been behaving as the models decree.
National output (GDP) has been cruising on two big “shocks”, dairy (now off) and the Christchurch rebuild (easing off next year). Auckland house prices have gone to heaven (23 per cent in February above the 2007 bubble-peak even when adjusted for general price inflation), forcing Wheeler into more bank-lending fiddling. Unemployment is low, on a high participation rate and strong job growth. Capacity is constrained.
The models’ logic accordingly suggests inflation will rise. A lower OCR would stoke the Auckland house market and could lower the exchange rate more and/or faster, further upping inflation and requiring sharper, and so damaging, OCR action later.
But leaving the OCR unchanged and/or charting future rises (OCR changes affect the real economy after around 12-18 months) would keep the exchange rate up and slow production and income, perhaps unnecessarily, which would slow inflation still more.
Wheeler’s devilish conundrum of low inflation despite buoyancy comes partly because our economy is very open. Prices here are greatly influenced by the low to zero inflation in our main trading partners and by the exchange rate, which has defied gravity until recently. The oil price fall, likely to reverse this year, also added a one-off inflation cut.
The spectre for mainstream rich-country economists is deflation: some version of the 1930s Depression’s vicious cycle of falling prices, consumers waiting for them to fall further, thus causing sales and investment to fall and with them jobs, incomes and prices. Central banks, which in the 1980s-90s focused on lowering inflation, now have targets for lifting it.
If this sounds upside down to you in the pews making ends meet in the real world and thinking low or falling prices are a good thing, it also does to some rich-world economists.
They attribute low inflation at least partly to big production cost cuts of many goods and services as a result of geo-economic rebalancing and rapid technological advances over the past two decades, coupled with changing lifestyles. There is a loose parallel in the second half of the nineteenth century when transport costs fell and mechanisation cut manufacturing costs.
Andrew Sentance, a former member of the Bank of England’s monetary policy committee which sets its equivalent of the OCR, wrote in the Financial Times of February 27: “Price stability could mean what it says on the tin — somewhere close to zero, perhaps as close as possible”. Instead, central banks, including Wheeler’s, are still targeting 2 per cent.
Sentance said “maintaining financial and price stability in well-performing economies” — like New Zealand’s, he could have added — “requires a gradual rise in interest rates.” His is not a lone voice.
Sentance says politicians expect central banks to do — and central banks are doing — too much of the maintenance of economic and financial stability which governments used to do. These “new masters of the economic universe” have cut official rates to or very close to zero (Sweden’s is below zero), printed rivers of money and rescued banks.
Bank rescues pose a deeper issue: the role of debt.
A new McKinsey and Co report finds that since 2007 the global debt-to-GDP ratio has risen 17 percentage points, around half in developing and half in developed countries. China’s overall debt has quadrupled (though its government has enough reserves to cushion a crash, at the cost of an economic slowdown).
In the rich world, apart from four “core crisis countries”, households’ debt-to-income ratios have risen from their already high 2007 level, McKinsey worries. It says governments, households and firms need to deleverage.
In addition, banks, notably United States ones, have been reviving some of the bad habits that led to the 2008 crisis.
The logic is another crisis and then periodic crises until credit and debt practices — and regulations — change more than they have so far since 2008.
But right now John Key has other worries.