Dutch diseases, the dollar, and the MPS

Today's Monetary Policy Statement rightly notes that continued strength in the New Zealand dollar means there's less reason for increasing interest rates.* The Policy Targets Agreement requires that the RBNZ keep the inflation rate over the medium term between 1 and 3 percent. There seems to be no pressure on the CPI: iPredict forecasts through September quarter have it between 1 and 2 percent. At the same time, there's no prediction of interest rate hikes through the end of the year (though backing out cumulative probabilities from the sequence of quarterly "What will RBNZ do" forecasts isn't straightforward). I'd worried that the GST hike might have fed through into more wage settlements despite the offsetting income tax cut; that seems not much to have happened and forward-looking expectations are within bounds. Nice call RBNZ; I might just lose my bet with Matt.

The MPS has been interpreted as sending signals about the RBNZ's views on the appropriate level of the dollar; Alex Tarrant takes it as warning of interest rate cuts if the dollar stays high. And the MPS does wonder whether the recent appreciation is justified:

The New Zealand dollar has appreciated markedly since the publication of the December  Statement. This appreciation is difficult to reconcile with developments in New Zealand’s economic environment, having occurred at a time when export commodity prices have tracked sideways. Instead, the exchange rate appears to have been driven upward by a combination of an easing in global monetary policy and recovery in global risk appetite. 

The March projection assumes the New Zealand dollar TWI depreciates modestly over the next few years. Should this not occur, all else equal, the Bank would see less need to increase the OCR through this time. While helping contain inflation, the high value of the New Zealand dollar is detrimental to the tradable sector, undermines GDP growth, and inhibits rebalancing in the New Zealand economy.

But this doesn't translate into the RBNZ now targeting the exchange rate, even if Bernard Hickey wishes it were so. The high dollar automatically keeps the CPI down by pushing down the price of tradeable goods in the CPI basket. So if the dollar stays high, there's less need for RBNZ to do anything on interest rates. And if policy easing elsewhere is pushing up the New Zealand dollar, that might give reason for easing on our own part to avoid falling below the lower band of the PTA, if there's risk of falling below the lower bound. iPredict says 10% chance of inflation below 1% in either of the next two quarters, so it's not looking particularly likely. RBNZ, in my reading, is just reminding folks that its inflation target is bounded both from above and from below and using that to do a bit of jawboning on the dollar.

I'm less than convinced that a high dollar is such a bad thing. Even if dairy prices have been flat over the recent few quarters' dollar appreciation, it's hard to say whether that means that the dollar's current strength is unjustified or whether it means the weakness during the worldwide recession was a temporary thing. If the appreciation is due to "the increase in risk appetite, higher global commodity prices and further policy easing by major central banks", a decent chunk is just a return to the status quo ex ante, and perhaps only a temporary one with Greece looking more likely to have a messy default sooner or later and with reasonable concerns about malinvestments in China. But if the rest of the world is getting better, we're back to folks being willing to take on currency risk in exchange for relatively higher returns available in NZ.

Import-competing sectors face stronger competition when the dollar is high. But it's debatable whether some of those import-competing sectors should even here exist. Book retailing probably shouldn't survive here outside of a few niches in the long term when BookDepository can get books here from the UK, delivered, for a bit more than half of the current retail price. If the worry is that milk exports drive up the price of the dollar and hurt other manufacturing, that's not unlike the current situation in Canada where oil and commodity exports have strengthened the Canadian dollar. Stephen Gordon there is trenchant:

Firstly, the prospect of fewer Canadians making things for foreigners is to be welcomed: what matters for Canadian economic welfare is consumption by Canadians, not making things that will be consumed by non-Canadians.

The Dutch disease story also supposes that the employment losses in the export sector are not offset by employment gains in other sectors. This has clearly not been the case in Canada: the resource boom of 2002-2008 saw a steady reduction of unemployment rates to their lowest level since the Labour Force Survey started collecting data in 1976. Nor were these jobs systematically lower-paying: after stagnating during the 1990s, real median wages saw significant growth during the resource boom -- even in Ontario.

Real median wages here also increased substantially from 1998 to 2009 or so**, with nominal stagnation and some real decline during the recent period.

Commodity price driven dollar appreciation isn't as much a disease as a recommendation to shift resources to their more highly valued uses. We're shifting towards dairy manufacturing and away from other forms of manufacturing. I wouldn't call it a disease in need of treatment.

* Please take the strong caveat that I am not a macro economist. And, while I think I was right in criticizing the RBNZ back in 2005 for being too slack, they were very right and I was very wrong in early 2008 when I worried about their very rapid cuts in interest rates.

**This is a nominal series; CPI here for adjusting. Real median wages up about 18% over the decade.

RBNZ on seismic risk

Here's RBNZ Governor Alan Bollard on the Reserve Bank's activity during the Canterbury earthquake:

One of our most pressing concerns immediately following the earthquakes was the maintenance of payments systems. In the aftermath of events such as natural disasters, there is strong demand for food, water, petrol and other necessities. And with damage to power and telecommunications systems, access to cash is a key concern. Only two hours after the  February earthquake the Reserve Bank started receiving orders from banks for more cash for delivery to Christchurch. Ensuring cash was available required us to work closely with banks and Cash in Transit companies to meet the spike in demand. This task was complicated by damage to roads that meant travel, where possible in Christchurch, was taking about three times as long as normal.

The public also needed information about where cash was available. To ensure this, Bank staff used Google maps to provide a live feed of operational and accessible ATMs. Overall about $150 million of extra cash was sent to Christchurch in the week of the earthquake, representing about $350 per resident.  There was a big drop in electronic payments and increased demand for cash, initially in the form of $20 and $50 notes through the surviving ATM machines. We learned a lot about ATM configuration to ensure operability, and the internet was very useful to provide up to date information on ATM availability.

I saw a lot of non-functioning bank machines, but I didn't see any not working in places where the power was on and the phones were working. After the February quake, there wasn't really anything on my side of town on which money could be spent. But the precautionary motive for cash balance holding certainly has affected how much I keep on hand.

Bollard goes on to talk about balancing medium-term inflation risks coming from eventual Canterbury reconstruction against short term declines in economic activity. The costs in Wellington of a similar event would be far worse: more roading chokepoints through hills, dependence on the Cook Strait Cable, and an airport built on land that didn't exist prior to an earlier earthquake.

RBNZ is ready in case Wellington goes down:

But even though our building could be standing after an earthquake, there is a risk that damage to surrounding buildings could make the Wellington office  inaccessible. To ensure that the Bank's core functions can be maintained in such circumstances, an Auckland office has been set up that houses a dozen staff on a day-to-day basis. These staff are engaged in a number of business critical roles (including foreign reserves management, domestic liquidity, and payments and settlement systems) to ensure the economy of New Zealand would continue to function with some stability in the event of a major disaster. Furthermore,  provisions in the Reserve Bank Act provide for the delegation of key aspects of the Governor's role to the Auckland Office Manager, with appropriate safeguards.

They warn against over-reaction: guarding against downside risk imposes cost in states of the world where the risk doesn't obtain, and it's possible to overinsure against earthquake risk with building regulation. But they also warn about our potential isolation in the case of a big hit to Wellington. It's because of this latter risk that I've worried about EQC's being heavily invested in domestic government securities. Hopefully any future rebuilding of the fund will have more diversified asset holdings.

There will have to be a serious rethinking of EQC's role once the current disaster has played out; it will be interesting to see what changes RBNZ and Treasury recommend. The interplay between EQC and private insurers have been a complete mess. Whatever losses might obtain due to agency problems in a world where EQC simply covered the first $100k of property damage as assessed by the private insurer are likely less than the costs that we're currently seeing due to coordination failures between insurers and EQC.

Earthquakes and monetary policy

From today's Monetary Policy Statement, in which the RBNZ (as entirely expected, and as entirely reasonable) did not change the interest rate:

Repairs and rebuilding in Canterbury will have a substantial influence on the New Zealand economy.  Construction sector activity will be boosted for several years, creating resource shortages in the building industry and other parts of the economy more generally.

The eventual volume of repairs and rebuilding is highly uncertain. Since the March Statement, the Bank has based its projections on a working assumption of $15 billion of reconstruction in 2011 dollars. Recent assessments from the EQC and additional damage from aftershocks have highlighted upside risk to this working assumption. As a result the Bank has revised up its working assumption to $20 billion. The Bank will continue to update this assumption as more information becomes available.

While some properties have been repaired, so far only limited rebuilding has occurred. Continuing aftershocks have hindered planning and building, and made it very difficult to secure insurance for new buildings. It seems unlikely that construction sector activity will pick up as soon as was projected in the June Statement. The updated projections assume major aftershocks soon cease, allowing EQC contractors to step up repairs on moderately damaged properties from early next year. Furthermore, seismic stability would be expected to help free up the private insurance market. It is assumed that rebuilding of severely damaged properties gets under way from the middle of next year.

In terms of the influence on monetary policy, it is the pace of reconstruction and the resultant degree of pressure on resources, rather than the eventual magnitude of reconstruction, that will have the greatest influence on interest rate settings. It is unclear how rapid reconstruction will be.

Earthquakes do bring spending. But only with long and variable lags. Even leaving aside wealth and capital destruction, the unavoidable uncertainty induced by ongoing aftershocks imposes large costs. Nobody knows when they'll be able to rebuild. Add on top of the natural and unavoidable uncertainty the regulatory uncertainty induced by that Council's still deciding who will be allowed to rebuild where and subject to what building codes. Earthquakes just don't seem that great a Keynesian policy prescription.

There's a limit to the extent to which resource shortages in building will wind up generating resource shortages; at least some of the supply pressures in construction will likely be handled by importing workers from a flagging Australian construction sector. Wages will be bid up to the point at which Kiwi construction workers in Oz come back home.

I would like to revise one prior post where I had things partially wrong. I'd not been pleased that the Earthquake Commission's asset base consisted largely of New Zealand government securities and suggested foreign investments as preferable, or at least a portfolio the value of which ought to be higher after an earthquake: construction companies and the like. An earthquake large enough to require EQC's portfolio liquidation would, I'd thought, cause the Kiwi dollar to tank with an NZ credit downgrade. I'd missed that reinsurance inflows would push the dollar higher. So I'd retract the part where I suggested a strong foreign-bias in the EQC investment portfolio; reinsurance inflows for anything big are going to dwarf the currency effects of EQC portfolio liquidation. But it still seems a bad idea to have EQC having to sell off a couple billion dollars worth of NZ government securities at the same time as the government has to go to the debt markets to cover the parts of earthquake cost for which government has assumed responsibility.

RBNZ tracking

Is the RBNZ on track to keep inflation outcomes within its mandate over the medium term? All signs at iPredict point to yes. Inflation in September quarter is expected to be more than 4.5% and less than 5%, but the GST hike hits year on year CPI changes until September quarter. After that, we find:

• December quarter inflation expected to be more than 2% but not more than 3% (though there's still a 40% chance of the latter)
• March quarter inflation expected to be more than 2% but not more than 3% (and a 34% chance of the latter)
• And, all this despite that the RBNZ is forecast to leave rates alone this go-round and also to leave them alone in October. There's better than even odds of no change in December, but not by a lot; if we add in the chances of a hike in October (which could make a December hike less likely), we're probably looking at even odds of an increase by December. No change is the most likely outcome in each period, but the cumulative chances of no change get smaller. Perhaps more interesting would be a set of contracts on the level of the OCR at each period rather than whether the RBNZ moves.

So inflation hawks might want to head over and make some money if they think the figures are wrong. I'm not going to second guess both RBNZ and iPredict traders on this one.

iPredict also has trading on unemployment and GDP growth. It wouldn't take much to put the figures together for Sumnerean NGDP targeting. Scott Sumner wished that the government would invest a few million dollars in creating markets and subsidizing trading on NGDP futures contracts. I suspect that iPredict runs on a budget just a bit thinner than that. But I'd also expect that RBNZ would need contracts running farther into the future for them to be useful for targeting.

Weasel whacking

Inflation outcomes for this past quarter, while high overall, aren't that crazy once we account for the changes in GST, a few expected seasonal price effects on fruit and vegetables, and the ETS. So argued Matt over at TVHE. I'd commented there that I'm happier trusting to RBNZ's discretion this quarter. Back in 2005, I was (rightly, I think) incensed about the Bank's seeming to ignore its inflation mandate while seeing just how fast they could push the economy. Late 2007 and early 2008, I worried (very very wrongly, in hindsight), that RBNZ was again ignoring its mandate. Inflation outcomes were beyond threshold and were projected to be beyond threshold for rather some time; you had to average over a large number of quarters to get outcomes below 3% on average. But the folks at RBNZ had a closer eye than I had on what was going on in the international credit markets and saw some of the mess that was to come; tightening up then would have been a rather bad idea.

RBNZ will have to tighten, and hopefully before inflation gets embedded into wage expectations. 2005 left me in 2008 with the impression that RBNZ was happy to take any excuse to avoid its mandate; 2008 reminded me that their eye on the data is a hell of a lot better than mine. And so I'm happier to take RBNZ inaction as suggesting bad things on the horizon than that they're ignoring their mandate; I trust them more now than I did then. I have worried that ETS increases could get embedded into wage expectations; I expect that RBNZ is keeping an eye on things.

For a rather nice parable on the other side, here's Andrew Coleman hoisted from the comments over at TVHE. I, for one, wish he'd start his own blog rather than let gems like this languish over in comments sections:

Once upon a time there was a land where beautiful songbirds lived. The people in the land loved their songbirds, and tried to ensure the population kept increasing. Their efforts were undermined, however, by a population of weasels that would stalk and prematurely kill the birds.

The people put their heads together and decided to create a Department for Weasel Control, thinking that if they could minimize the death toll on the bird population the population would grow. The move was not uniformly popular, however, for efforts to kill weasels sometimes temporarily lowered the birth rate of the songbirds. Moreover, it was not clear exactly how the Department would work. In the end, it was decided that the Department would be left to its own devices, subject to being accountable for ensuring the general level of the weasel population was stable. A department head would be hired – popularly known as the chief weasel whacker – and left to get on with it.

The move was controversial. Some people said that the weasel population didn’t really matter if the song bird population was growing. Others didn’t like the reduction in the songbird population that occurred when a full-scale weasel eradication programme was in full swing. Others were enthusiastic, but warned that someone with a paranoid hatred of weasels should be hired as chief weasel whacker to ensure the department did its job well.

One day a new chief weasel whacker was hired, someone with a background in songbird appreciation. From the start he argued that it was both unfair and unnecessary to require him to make sure the weasel population was stable, all that was needed was a requirement that it didn’t grow too fast, maybe not faster than 3 percent in the medium term. The real objective was the increase in the population of songbirds, and the eradication of weasels was just a means to an end. In any case, the weasel population fluctuated naturally, and it was silly to hold him responsible for factors outside his control. Not all people were convinced, but he was good with songbirds.

At first, things weren’t too bad. The songbird population initially increased quickly, after the weasel control programme was eased. Not everyone was happy, as the population of weasels wasn’t stable at all but increasing at nearly three percent a year, but the songbird population increased at a steady pace. Then a major shock occurred, when a weasel disease crossed to songbirds and killed a few. The Chief Weasel Whacker put on hold efforts to control weasels until the songbird birthrate started to increase. Weasel control was neglected for several years

Soon debate broke out up and down the land. Should people be worried that the chief weasel whacker didn’t seem to go around whacking weasels? Or should they just monitor to songbird population? Did it matter that the weasel population had been growing at nearly 3 percent for several years? And what about the original intention of keeping the weasel population stable? It had increased by nearly 20 percent, and never shown any indication of falling. Matters came to head when one year the weasel growth rate couldn’t be counted on the fingers of one hand. The loony weasel haters emerged from the undergrowth making outrageous and funny claims about a world that would be overrun by the Great Weasel who would go around stealing human babies. Fans of the Chief Weasel Whacker denigrated the loons, but others could help but wonder if the original founders had it right after all. Perhaps if you let the weasels increase by a maximum of 3 percent a year, soon they would increase by 3 percent nearly every year. Maybe hiring someone with a paranoid hatred of weasels would have been clever. And maybe there might be a better way of controlling the weasel population than simply trying to whack them after they were born. Perhaps it would be useful to understand weasel physiology and psychology and see if their breeding patterns could be controlled……

Unfortunately I don’t know how the story ends but apparently it might be time to hire a new Chief Weasel Whacker soon, so the story is sure to be interesting.

I'll never be able to listen to this one the same way again...