Category Archives: Interest Rates

New Zealand’s Neutral Rate of Interest

A speech delivered last July by John McDermott (Assistant Governor and Head of Economics at the RBNZ) talked about the neutral rate of interest. Central Banks have often used the term ‘the neutral rate’ which refers to a rate of interest that neither stimulates the economy nor restrains economic growth. This rate is often defined as the rate which is consistent with full employment, trend growth, and stable prices – an economy where neither expansionary nor contractionary measures need to be implemented.

The neutral interest rate is the rate of interest where desired savings equal desired investment, and can be thought of as the level of the OCR that is neither contractionary nor expansionary for the economy.

OCR > Neutral Rate = Contractionary and slowing down the economy
OCR < Neutral Rate = Expansionary and speeding up the economy

The RBNZ’s last published estimate of the neutral OCR was in June 2017 at 3.5%, with a range of estimates around that between 2.6% to 4.6%. Like many other countries, the neutral cash rate in NZ is estimated to have been declining over many years.

Since the GFC neutral rates around the world have been falling which reflects the following:

  1.  Lower expectations about growth in the economy = reduces the return to investment
  2.  Relative to pre-GFC, a wider spread between the central bank rate and the interest rates faced by households and businesses (i.e. mortgages and business lending rates).
  3. An increase in global desired savings. For instance, demographic trends offshore have led to an increase in saving among the cohort of the population going through prime earning years (as they save for retirement). Likewise, increased income inequality is thought to increase desired savings, as top income earners typically have a lower marginal propensity to consume – MPC.
  4. Higher debt ratios in some countries (including NZ) make the economy more sensitive to interest rate increases than before.

Central Banks don’t have the independence to set the neutral rate as it is very much influenced by global forces. However they do have independence as to where they set their policy rate relative to the neutral rate.

Source: BNZ – Interest Rate Research – 14th June 2018

Looks like inflation might hit 2% in New Zealand

The ASB Bank produce a very good Economic Report and below are some of the points they make with regard to inflationary pressures – useful for NCEA Level 2 and 3 as well as CIE AS and A2 level. The CPI will be on the rise with higher global commodity prices (see graph below) as well as the weakening NZ dollar which in turn makes imports more expensive.

  • Commodity-price related influences are expected to directly contribute around 1 percentage point to annual CPI inflation over 2018. The direct impact is expected to wane.
  • The period of retail deflation looks like it might be coming to an end. The lower NZD and pending increases in wage costs could see this component add to inflation. The extent to which prices will firm will depend on retail margins.
  • Administered price increases will add roughly half a percentage point to annual inflation despite the impact of the free tertiary fees policy. Higher prices for tobacco and local authority rates seem to be a fact of life: one driven by health objectives, the other by perennial infrastructure demand and a lack of competitive pressure.
  • The labour market is likely to become more of a source of price increases. We note that higher wages need not impact on consumer prices if they are offset by a corresponding increase in labour productivity/trimming in producer margins.
  • Price increases from the housing group are expected to subside. It is no longer a sellers’ market for existing dwellings. The balance of power for building work looks to be increasingly shifting towards the customer and away from the provider. Rental dwelling inflation is expected to remain moderate.

Breakdown of CPI Weighting

Source: ASB Bank – Economic Note – Inflation Watch 26 July 2018

New Zealand’s Phillips Curve 1993-2017

Bill Phillips (a New Zealander) discovered a stable relationship between the rate of inflation (of wages, to be precise) and unemployment in Britain from the 1850’s to 1960’s. Higher inflation, it seemed, went with lower unemployment. To economists and policymakers this presented a tempting trade-off: lower unemployment could be bought at the price of a bit more inflation. The downward-sloping Phillips curve is apparent in the graph below which plots core inflation against headline unemployment for New Zealand.

There has been also an apparent shift inwards of this relationship where lower rates of unemployment have become possible for a given level of inflation, particularly relative to the 1990s. The simple plot in the graph does not take into account other factors such as changes in import prices, inflationary expectations and capacity constraints which also have the potential to shift the Phillips Curve. These are discussed further below:

1. The price of imports. As the price of imports increase whether it is raw materials or finished products, the price of local goods become more expensive which increase the general price level. Also if a country finds that its exchange rate depreciates the price of imports rises. Oil is a very inelastic import and with a barrel of oil below $30 in 2016 there was little pressure on the CPI. Where inflation has been higher is in those countries that have withdrawn price subsidies and also had sharply falling currencies – Argentina 24% and Egypt 32%.

2. Public Expectations. In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves. In Japan firms and employees have become conditioned to expect a lower rate of inflation. Prime minister Shinzo Abe has called for companies to raise wages by 3% to try and kick start inflation.

3. Capacity pressures. This refers to how much ‘slack’ there is in the economy or the ability to increase total output. If capacity pressures are tight that means an economy will find it difficult to increase output so there will be more pressure on prices as goods become more scarce. Unemployment is the most used gauge to measure the slack in the economy and as the economy approached full employment the scarcity of workers should push up the price pf labour – wages. With increasing costs for the firm it is usual for them to increase their prices for the consumer and therefore increasing the CPI. However many labour markets around the world (especially Japan and the USA) have been very tight but there is little sign of inflation. This assumes that the Phillips curve (trade-off between inflation and unemployment) has become less steep. Research by Olivier Blanchard found that a drop in the unemployment rate in the US has less than a third as much power to raise inflation as it did in the mid 1970’s.

This flatter Phillips curve suggests that the cost for central banks in higher inflation of delaying interest-rate rises is rather low.

Why negative interest rates are justified.

The Free Exchange column in The Economist referred to negative interest rates as neither unfair of unnatural. Irving Fischer used the metaphor of the world’s oldest ship’s biscuits from a voyage back in 1852. Known as hardtack these biscuits were renowned for their longer storage life and therefore making them an important source of nutrition for sailors.

Fischer wrote in ‘The Theory of Interest’ in 1930 an imaginary scenario where a group of sailors are shipwrecked and the only food they have to sustain them is hardtack. Fischer proposed the question ‘under what circumstances would sailors borrow and lend biscuits? For most people interest is the reward for saving and delayed satisfaction so negative interest rates would seem to be unjust. In the case of shipwrecked sailors if one of them is prepared to lend another a biscuit the lender would want more than one biscuit in return and the more hungry they are the higher the interest rate. However Fischer pointed out that the interest rate should be zero as if it were positive it would mean that the sailor would have to take more than one hardtack biscuit to repay the loan. However no sailor would accept these terms as he could instead eat one more piece from his own supply, thereby reducing his future consumption by one hardtack biscuit. And a sailor who had already depleted his supply would be in no position to repay borrowed biscuits. If for instance the sailors were washed ashore with perishable items the interest rate would be negative – Fischer concludes that the rate of interest for any commodity should be negative not positive.

Recently banks in Japan, Switzerland, Denmark and Sweden started charging customers for saving money which asks the question why should people pay to keep their money in banks when they had already earned it? But charging customers interest is a natural occurrence when you consider that savers preserve their purchasing power without any care required to prevent any resources eroding. In 1916 economist Silvio Gesell gave his treatise in favour of negative interest rates on money. His said that storing wealth required considerable effort and ingenuity especially commodities like meat, wheat, fruit etc which are perishable. Gesell said that our goods rot, decay, break and rust. Only if money depreciated at a similar pace would people be as anxious to spend it as suppliers were to sell their perishable commodities. To keep the economy going he wanted money to rot like potatoes and rust like iron.

The negative interest rate introduced by Japan accompanied by an inflation target three years before is in effect pursuing Gesell’s dream of a currency that rots and rusts, albeit by only 2% a year.

Source: The Economist – Free Exchange – 3rd February 2018

Ten years on and is the world economy still vulnerable to another crisis?

In 2007 the world economy was thrown into turmoil as the subprime housing crisis in the USA started a chain reaction around the world. Although developments dating back to the 1970s led to increased risk-taking as markets became less regulated. In total it is estimated that the loss to the global economy was US$15 trillion. But it could have been worse if it wasn’t for the lessons learned from the Great Depression of the 1930’s.

What did policymakers do better in 2008 compared to 1929?

Government’s in 2008 were a lot more active in pumping money into the circular flow and their budgets became a much bigger share of the economy, thanks partly to the rise of the modern social safety net. As a result government borrowing and spending on benefits did far more to stabilize the economy than they did during the Depression. Also policymakers stepped in to prevent the extraordinary collapse in prices and incomes experienced in the 1930’s. Although unpopular government’s bailed out banks and prevented panic like that in the Depression were there was a ‘run on the banks’ – about half the banks in the USA closed after 1929. This prevented an implosion of the global economy. But after the Depression government’s were forced into radical reforms to correct the economy which ultimately led to 50 years of economic stability. This wasn’t the case with the GFC in that the success of government policies meant that they avoided the radical reforms of the 1930’s – the disposing of the gold standard. So does this mean that the global economy is still vulnerable to the same variables that caused the problem in the first place?

Financial Reforms
To explain the root cause of the 2008 financial crisis George Soros uses an oil tanker as a metaphor. In the movie documentary “Inside Job” he basically said that markets are inherently unstable and there needs to be some sort of regulation along the way. The oil tanker has quite an vast frame and, in order to stop the movement of oil from making the tanker unstable, shipping manufacturers have designed them with approximately 8-12 compartments, depending on the size. This maintains the tanker’s stability in the water.

After the Depression the Glass Stegal Act was passed in 1933. This act separated investment and commercial banking activities. At the time, “improper banking activity”, was deemed the main culprit of the financial crash. According to that reasoning, commercial banks took on too much risk with depositors’ money. Therefore to use Soros’ metaphor, a compartment was put into the tanker to make it more stable.

However, in 1999 Gramm–Leach–Bliley Act effectively removed the separation that previously existed between investment banking which issued securities and commercial banks which accepted deposits. The deregulation also removed conflict of interest prohibitions between investment bankers serving as officers of commercial banks. Therefore, the tanker had a compartment/s removed which made it very unstable and it eventually capsized. Consequently the deregulation of financial markets has led to the end of compartmentalisation.

Post Depression Roosevelt restored growth and made up for what was lost during the depression years but post GFC there have been no major reforms of capital flows and the concentration of the financial sector’s weight in the global economy hasn’t changed. Also central banks have not tried to make-up the lost output and as a result the recovery has been weak. Monetary policy has had to remain very much expansionary and will take time before it returns to a neutral rate. This means when the next recession comes around monetary policy will become ineffective with little ammunition left as rates are so low. However, the main issue is that the fundamental problems that caused the GFC are still there.

Source: A lost decade – The Economist December 16th 2017

Eurozone growth faster than US but not in good shape for the long-term.

According to the OECD the rate of growth in the eurozone has surpassed that of the US, UK and Japan and has surprised many with its resilience. However is the EU in a position of strength to cope with the challenges of another recession? The Economist ‘Free Exchange’ looked into this issue and identified some shortcomings. The crisis in the EU was severe and the impact financially was was around €1.4trn as this would have been the amount of GDP lost since 2007, assuming that most economies grow at 2% per year.

The damage was compounded by the fact that the EU’s monetary policy which has 3 main weaknesses:

1. Within the EU the printing of money is centralised through the European Central Bank in Frankfurt. Therefore countries who wanted to print more money to bail themselves out and stimulate the economy could no longer do it. Furthermore as there is no central fiscal budget it meant that individual countries were responsible for their own fiscal solvency. So if they ran up big deficits the risk of default was great and made markets react negatively to any concerning news on a country’s fiscal prudence. In reacting to this scenario the ECB said, as a last resort, that it would step in and buy government bonds to help ailing economies. On this news bond yields dropped as the ECB has brought about some stability.

2. In 2014 the EU was still struggling but was constrained by its inflation mandate. When economies go through major economic downturns they loosen monetary and fiscal policy – cut interest rates and increase government spending respectively to make up for the lost private spending. Although the ECB cut interest rates to 0% and government increased spending there was the problem of its mandate. The ECB was curbed by the 2% inflation ceiling unlike the 2% target for most other countries and by the fact that its strongest economy, Germany, was paranoid about inflation – memories of the post-war hyperinflation years. Only with the threat of deflation did stimulatory asset purchases start to happen.

3. This is the mismatch between the scope of its economic institutions and its political ones. No European institution enjoys the democratic legitimacy of a national government. The crisis meant greater reform in the financial sector but also led to increased authority of unelected institutions like the ECB. The frustration has been that countries in the eurozone have suffered significant amounts of pain by unaccountable European politicians. Countries don’t want to lose their sovereignty but it seems that any further integration is a catalyst to its demise.

The return to improving growth levels has been brought about by increasing export volumes – with a weaker euro. With consumer spending and investment on the decline foreign consumers have been the saviour of the EU. However this is dependent on global growth which cannot last forever and the euro area needs to be prepared politically to get through the next recession.

Source: The Economist – Free Exchange – The second chance. 2nd December 2017

Zero sum game – Tax cuts v Higher interest rates.

The recent tax cuts in the US by the Trump administration are estimated to create above 4% growth each year according to Gary Cohn – Director of the National Economic Council. If the US does achieve this level of growth, tax reform is said to have little impact as long-term growth – studies have estimated that the tax bill will have an impact of between 0.4% – 0.9% on GDP.

Textbooks that cover supply-side policies tend to suggest that lower taxes on labour income should raise its supply whilst lower taxes on capital income should increase saving and investment which should then increase labour productivity and competitiveness in the market place. But there is the income and substitution effect to consider. With tax cuts people’s income increase therefore there is the chance that the substitution and income effects come into play.

Substitution effect – if wages are higher workers may forgo some of their leisure time and work longer hours. SS1 on the graph

Income effect – if wages are higher workers may reduce some of their working hours as the demand for leisure time goes up – SS2 on the graph

Most textbooks favour the substitution effect with tax cuts although research shows that neither labour-force participation nor hours worked move in response to tax changes. However reported labour income does rise in response to income tax cuts, thanks largely to less tax avoidance. Furthermore savings rates have changed little with tax cuts in fact they have decreased in the US over the past 40 years. Savings rates are important for investment purposes although the current administration believes that this shortfall will be filled by overseas investors.

Oligopolists to benefit

With the lack of competition in US industry – especially in the banking sector – it is the these companies (many whom are oligopolists) and their shareholders who will reap the benefits of tax cuts. Research has shown that a cut in corporate tax of 10% would raise long-run output output by 0.15%. National Income would raise less with much of the addition to GDP going overseas.

What about higher interest rates?

Although tax cuts (increase in demand) do help out especially when there is a lot of spare capacity in the economy this is hardly the case at the moment. The US has limited spare capacity and the Federal Reserve fearing inflation have been more contractionary in their actions by recently increased interest rates which cancels out the stimulatory tax cuts.

Tax cuts and inequality

Although the republican rhetoric has been that tax cuts will benefit all they haven’t mentioned the distributional consequences. The cuts will reduce the tax burden of the top 0.2% by an average of $278,000 by 2017. This is in contrast to the bottom 20% of earners will get an extra $10 dollar by 2017.

Where is global inflation?

The Economist had an article in its Finance and Economics section on the fact that after record low interest rates and extended quantitative easing global inflation seems stubbornly low – see graph. In order to explain this you need to consider the model that central banks use to explain inflation. There are three elements to this model:

1. The price of imports. As the price of imports increase whether it is raw materials or finished products, the price of local goods become more expensive which increase the general price level. Also if a country finds that its exchange rate depreciates the price of imports rises. Oil is a very inelastic import and with a barrel of oil below $30 in 2016 there was little pressure on the CPI. Where inflation has been higher is in those countries that have withdrawn price subsidies and also had sharply falling currencies – Argentina 24% and Egypt 32%.

2. Public Expectations. In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves. In Japan firms and employees have become conditioned to expect a lower rate of inflation. Prime minister Shinzo Abe has called for companies to raise wages by 3% to try and kick start inflation.

3. Capacity pressures. This refers to how much ‘slack’ there is in the economy or the ability to increase total output. If capacity pressures are tight that means an economy will find it difficult to increase output so there will be more pressure on prices as goods become more scarce. Unemployment is the most used gauge to measure the slack in the economy and as the economy approached full employment the scarcity of workers should push up the price pf labour – wages. With increasing costs for the firm it is usual for them to increase their prices for the consumer and therefore increasing the CPI. However many labour markets around the world (especially Japan and the USA) have been very tight but there is little sign of inflation. This assumes that the Phillips curve (trade-off between inflation and unemployment) has become less steep. Research by Olivier Blanchard found that a drop in the unemployment rate in the US has less than a third as much power to raise inflation as it did in the mid 1970’s.

This flatter Phillips curve suggests that the cost for central banks in higher inflation of delaying interest-rate rises is rather low. See graph below showing New Zealand’s Phillips Curve