Saturday, August 17, 2019

The RBNZ's OCR Cut

Business NZ criticized the RBNZ for cutting the OCR by 50 basis point recently. It said that the current economic conditions do not warrant such a large cut.

The governor of the RBNZ issues a statement saying that the RB makes forward looking policy decisions, i.e., it is based on forecasts of domestic and global economic conditions, and not on current conditions.

Makes sense to me. Obviously, monetary policy affects the economy with "variable and long lags," i.e., it takes time for the OCR cut to work through.

That being said, there is an issue with the RBNZ OCR cut. It assumes that its forecast is reliable. No forecast is reliable. A forecast error could translate into a policy error. Policy errors are persistent. They are costly to undo. In this case, large policy move is riskier than small moves.

Economists usually argued for interest rate smoothing. A large shock, if indeed it is large, which requires a 50 basis points cut in OCR could have been smoothed out, 25 followed by 25.

Shocks are hard to identify ex-post let alone predict ex-ante.

But let's examine the RBNZ forecasts, which is posted in the MPS, chapter 4, pp. 26 - 35.

They do not indicate, to me at least, that there are problems that warrant a 50 basis point, surprise, cut in OCR!

Begin from the bottom page, forecasts up to 2020 show that, tradeables inflation is low - near zero; CPI inflation returning to the target; non-tradebales inflation is forecast to "dip" slightly. It looks like it increasing before dipping. This is basically house price inflation, asset price inflation. With lower OCR, house price inflation should increase!

Wage inflation is expected to increase!

The output gap is positive but they have a small decline in 2019!

These forecasts do not indicate a need for this large cut in OCR.

Employment does not look like falling. They say it is near maximum.

Unemployment increases very little over the forecasting horizon. These forecasts do not seem to warrant a 50 basis points cut in interest rate either.

Business investments up over the forecasting horizon, but the forecast is revised downward relative to last MPS forecast.

Fiscal stimulus supports a lift in GDP growth. Government consumption is up over the forecasting period and higher than that made in May MPS.

Households consumption is higher than the previous forecast, albeit weak, they said, 2 percent growth on average perhaps!

Residential investments do not indicate weakness, rather strong. House price inflation is up.

Overall, real GDP is projected to be "subdued" .

Net immigration remains elevated but is expected to decline.

Demand for New Zealand’s exports is slowing.

Import price expected to be lower.

Net immigration remains elevated but is expected to decline

They say that global conditions have continued to weaken, but I wonder how good is the RB forecast of global conditions.
I do not see anything alarming in these projections really. Therefore, the 50 basis point cut remains controversial.


Friday, June 28, 2019

Price Stability and Inflation in New Zealand

Many people ask why prices increase year after year while the Reserve Bank says the inflation rate is low. I have heard economists who cast doubt about the merit of inflation targeting citing rising prices as a reason!

I bet that if we conduct a survey we would be surprised to know that most people think the same way.

A layman’s explanation first

This is just an example using arbitrary numbers. Table (1) has four columns. Column 1 has four years, 1 to 4. There is a price level in the second column and the percentage change of the price level, i.e. the inflation rate in the last column.

Table 1

So in this example the price increased every year from 100 to 102 to 104... The inflation rate, however, remained stable, 2 percent every year. This is what an inflation-targeting central bank desires to achieve. 

Inflation-targeting central banks treat bygones as bygones. Essentially, the central bank ignores the effects of the various shocks that increase the price level and focuses on maintaining the inflation rate target period by period. The price level is not the concern of the inflation-targeting central bank.Under inflation targeting, the price level will drift up forever. That is why prices keep increasing every year and the inflation rate does not.

The sketch below describes it in a different way. A shock at period 1 increases the price from p0 to p1. The price stays there, but the inflation rate, which is the slope (i.e. the change in the price over time), remained unchanged.

Academic talk - not for the average reader 

We could go further and use academic language for those who are interested. I tested the data for NZ as everyone in this field does routinely. The price level measured by the CPI has a unit root; inflation does not.

Figure (2) 

Thus, the forecast of the price level is meaningless because the forecast error variance grows to infinity as the forecast horizon increases. The mean, variance...of the price level are all functions of time.These are the results of targeting the inflation rate. The RB could target the price level if they want to. I have shown that (with Eric Hansen) in 1995 in an RB conference. No takers. Many scholars have written about price level targeting. Still No takers.

As long as the public demand for money (the stock of money, e.g., M1)keeps increasing, which is the case in NZ, the price level will  increase in proportion because people spend the money (could be spent on assets and housing too and increase asset prices). Money and prices are highly correlated. Inflation and money growth, however, are not correlated at all because the RBNZ rendered inflation stationary, but not money.I studied this issue in 2001 when I was in the RB and I don't think anything has changed since. 

If the CPI inflation is under control then What kind of inflation do we have? 

Average annual money growth over the past since 1989 is about 7 percent. Lending to housing plus personal lending average growth rate over the period from Dec 1990 is 9.6 percent. People spend the money. They buy things, but they also buy assets and housing. The CPI inflation does not measure that. Hence, inflation is absent. 

We have much higher housing price inflation than CPI inflation. Figure (3) plots the two inflation rates. Over the same period from Dec 1990 to Dec 2018, the average CPI inflation was 2 percent while housing price inflation, HPI, was 6.2 percent! 

Figure (3)

Thursday, June 13, 2019

Low interest rate and the next recession

Recently, more people wonder how the central banks would deal with the next recession given that the interest rate is too low.

Central bankers, and many economists, believe that the short-term nominal interest rate is the main or only policy instrument. However, this may not be entirely true. Central banks could use the money supply, by they never did.

Not many central bankers care about money anymore when setting up policy. Certainly, money does not even play a role in their models. I remember Stanley Fischer giving a lecture in Wellington about 20 years ago on the Russian monetary policy after the collapse of the USSR. I wrote in my notes that he said that the central bank brought down inflation by "controlling money and credit."

People may worry about recessions, but they are impossible to predict. Shocks are random. The propagation mechanism of these shocks - the data generating process - is unknown. Even identifying the shocks ex-post is very hard.

The question though is, what happens to real GDP growth (or the output gap) if the short-term nominal interest rate is literally zero? (In fact Milton Friedman argued that the short-term nominal interest rate should be set to zero such that the marginal cost of producing money is equal to the price.)

Consider this simple counterfactual.

In an open-economy - Keynesian - IS curve (i.e., the good market schedule), real GDP growth could depend on its own past (persistence), real interest rate, real exchange rate, and foreign real GDP growth. To carry out the counterfactual, replace the real interest rate with the negative of expected inflation (lag inflation for simplicity) if the nominal interest rate is zero (the Fisher equation). One could choose / estimate the coefficients and calibrate this IS equation with a random normal errors. One could even use a more elaborate Dynamic Stochastic General Equilibrium model to do this counterfactual experiment. Here is one simple counterfactual for New Zealand under such scenario.

The counterfactual suggests that:

-  Real GDP growth could have been higher the actual on average, 4.1 percent compared to 2.6 percent.

-  Real GDP growth could have been less volatile than actual. The variance is 3.1 compared to 4.5

-  The peaks could have been higher and the troughs could have been lower.

-  No recessions detected in the counterfactual.

Friday, May 24, 2019

Genes, and early childhood interventions

A long time ago I wrote several technical notes about early childhood intervention to the deputy and the secretary of labour when there was still "a Department of Labour" . I am almost certain they did not read any of these notes. James Heckman, Nobel Laureate, econometricain at Chicago wrote extensively on this subject and showed the efficacy of early childhood intervention. Intervention would save the country a lot, and reduce private and social cost over time. I argued that it is the right way to go for New Zealand.

I have been reading a very informative book, which I highly recommend because it has very well written interesting stories. The book is The Gene, An Intimate History, by Siddhartha Mukherjee who is an American cancer physician and researcher at Columbia University. My daughter, who is a University of Cambridge PhD in Chemistry and a Chief Editor at Nature Science in the UK, and I had an argument on the dinner table about the gene and gene-environment effects on student's ability (ability is an unobservable variable) so she recommended that I read this book.

Here is something from page 459, which reminded my of the notes that I wrote back then at the DoL.

He says, "In 2010, a team of researchers launched a research study, called the Strong African American Families Project, or SAAF, in an impoverished rural belt n Georgia. It is a startlingly bleak place overrun by delinquency, alcoholism, violence, mental illness, and drug use. Abandoned clapboard houses with broken windows dot the landscape; crime abounds; vacant parking lots are strewn with hypodermic needles. Half of the adults lack high school education, and nearly half the families have single mothers.

Six hundred African-American families were randomly assigned to two groups. In one group, the children and their parents received seven weeks of intensive education, counseling, emotional support, and structured social interventions focused on preventing alcoholism, binge behaviors, violence, impulsiveness, and drug use. In the control group, the families received minimal  interventions. Children in the intervention group and in the control group had the 5HTTLPR gene sequenced (It encodes a molecule that modulated signaling between certain neurons in the brain.It was found that it is associated with response of psychic stress. The gene comes in two forms or alleles - a long variant and a short variant. The short variant called 5HTTLPR/short and it is carried by about 40 percent of the population and seems to produce significantly lower levels of the protein. The short variant has been repeatedly associated with anxious behavior, depression, trauma, alcoholism, and high-risk behaviors. The link is not strong, butbit is broad: the shorter allele has been associated with increased suicidal risk among German alcoholics, increased depression in American college students, and higher rate of PTSD among deployed soldiers).

The first results of this randomized trail was predictable from prior studies: in the control group, children with short variant, i.e. the high risk form of the gene - were twice as likely to veer toward high-risk behaviors, including binge drinking, drug use, and sexual promiscuity as adolescences, confirming earlier studies that had suggested an increased risk within this genetic subgroup. The second result was more provocative: these very children were also the most likely to respond to the social interventions. In the intervention group , children with high-risk allele were most strongly and rapidly "normalized"  - i.e., the most drastically affected subjects were also the best respondents. In a parallel study, orphaned infants with the short variant of 5HTTLRP appeared more impulsive and socially disturbed than their long-variant counterparts at baseline - but were also the most likely to benefit from placement in a more nurturing foster-care environment."                 

Enjoy reading the book

Tuesday, April 30, 2019

Climate Change and the New Zealand Economy

Global warming is a fact. Figure (1) plots the average change in Global, Northern hemisphere and Southern hemisphere temperatures from 1880 to 2018 (reference). The temperature has been rising, more so in the Northern Hemisphere. 

Figure (1) 

The standard economic story is that global warming increases the cost of production of food and primary commodities, reduces their supplies, and as demand keeps rising, the price of commodities increases (excess demand).[1]

Figure (2) plots the ANZ bank, New Zealand’s commodity price index and the World commodity price index (it includes meat, skins and wool; dairy; horticulture, forestry, seafood and aluminium).

Note that both prices increasing as predicted, but the New Zealand commodity price is often lower than the world’s commodity prices.

Figure (2) 

Based on such information, The New Zealand Agricultural Greenhouse Gas Research Institute concludes, “Climate changes could further drive up international commodity prices. That in turn would benefit New Zealand farmers and agricultural exports.”

Figures (1) and (2) clearly imply that the New Zealand commodity price level (as measured by the commodity price index) is positively correlated with global average change in temperature (both rising). This is also true for the price of every commodity in the index (meat, dairy...etc.). However, the conclusion of the Institute is misguided because the demand for New Zealand’s commodities depends, not on the New Zealand commodity price alone, but on both, the New Zealand price and the world’s price.

How is that?

What matters for the demand on the New Zealand primary commodities is not the New Zaland commodity price per se, but rather the relative price that is the ratio of the New Zealand commodity price to the world’s price of the same commodities.

Figure (3) plots the data from Jan 1986 to Mar 2019. The correlation is negative.

Figure (3) 

In a global commodity market, a change in the nominal price of a NZ commodity exerts two effects on the quantity demanded of New Zealand primary commodities. First, it changes the relative price, which is a change in the terms at which a global buyer can exchange a NZ commodity for another non-NZ commodity (e.g., New Zealand’s dairy and the other countries dairy). The change in the relative price leads to a substitution effect. A lower relative price increases global demand for New Zealand’s commodities. Second, there is an income effect. A change in the nominal price of New Zealand’s commodity causes a change in real income of the buyers, or in the size of the basket of primary goods, a global buyer can buy. If global warming causes the price of a New Zealand commodity to fall, all other prices remained unchanged, the consumer’s real income rises because more of such good, or other goods, could be purchased.

Assuming that everything else remains unchanged, the patterns depicted in figure (2) remain as such under global warming, the higher the New Zealand’s productivity (in primary commodities sector) is, the lower our relative commodity prices, and the higher the global demand on our commodities.

Furthermore, although commodity prices are highly volatile, they still share significant cyclical fluctuations with nominal GDP. They are also positively correlated with expected inflation. I showed that changes in relative commodity prices fully explain the Kiwi dollar depreciation rate Razzak, 2018. Global warming is very relevant to economic policy; see Rudebusch 2019 (here).     

Global warming is clearly a danger and a game changer. The economic analyses I have seen so far are thin. Policymakers need a more general equilibrium analysis to understand the costs and the benefits. There must be some benefits, I do not know what they might be. I can imagine that truism might benefit from warmer temperature. Farmers might be able to produce new varieties that they could not produce before, hence opening new markets. 

[1] Google for example, How Climate Change Will Alter Our Food; How Climate Change May Affect Global Food Demand and Supply In the Long Run; and Roundtable II: Economic Growth and Climate Change: Long Run Implications for Commodity Prices and Trade.

Friday, April 5, 2019

Corruption and Economic Growth

On March 19, 2019, the well-known American political scientist, Stephen Walt, wrote in FP (here) “corruption is inherently inefficient.” He explained, “Instead of resources going where they are most needed, they get diverted into bribes, payoffs, kickbacks, and other shady arrangements. And when the wealthy and powerful use connections to get jobs or contracts (or to get their kids into college), that means that more deserving and talented people get excluded and less qualified people end up in positions of authority. The more common such practices become the more honest and law-abiding people will be tempted to follow suit just to keep up. And once corruption becomes endemic in a society, rooting it out becomes difficult if not impossible.”

Economic research on the relationship between corruption and economic growth is relatively thin. Exceptionally, Isaac Ehrlich and Francis T. Lui (1999) paper in the Journal of Political Economy (here) explains the relationship rigorously and in a way, economists understand. They use endogenous growth models.

They arrive at a variety of results. Here are a few interesting ones.

·         “Accumulation of some political capital, hence corruption, is thus shown to be an inevitable aspect of government intervention in the economy.”

·         “… A given level of government intervention will be more harmful to persistent growth prospects in human capital–poor countries than in human capital–rich ones. The former can afford fewer ‘‘errors’’ in government policies. This implication seems contrary to conventional theories of development, which typically recommend more involvement of government in less developed countries.”

I think that more government involvement in less developed countries is, perhaps, needed in the early stages of development (building infrastructures, schools, hospitals etc).

·         “Corruption and per capita income level are expected to be negatively correlated across different stages of economic development. The difference is that corruption depends on investment in political capital as a ticket for entry to the bureaucratic rank, unlike entry to many criminal activities, which requires little skill. Such an investment has repercussions on the incentive of productive agents to invest in human capital. The relationship between corruption and the economy is thus explained as an endogenous outcome of competition between growth-enhancing and socially unproductive investments and its reaction to exogenous factors, especially government intervention in private economic activity.”

·         “The relationship between government, corruption, and the economy’s growth is nonlinear. Government intervention in private economic activity hurts most in the poorest countries and those at a critical takeoff level. This may explain the prevalence of corruption in countries trapped in poverty.”

·         “Perhaps the most intriguing result of the analysis concerns the possibility that autocratic regimes, such as the command economies, could in principle achieve a rate of growth equal to or higher than decentralized democracies, albeit not a higher level of per capita income. These economies can be successful as long as an informed leadership is operating to maximize the long-term growth potential of productive agents and constrains bureaucratic corruption to a degree commensurate with this objective. This explains why economically successful autocratic regimes often resort to forceful anticorruption campaigns and why corruption often intensifies when the leadership loses its grip on power. At the same time, the analysis also anticipates the potential failure of autocratic regimes because of the leadership’s inability to focus on long term goals, its susceptibility to ideologically induced policy errors, and the general deadweight costs associated with protecting an autocratic regime by brute force.”

I wrote in the past about the positive relationship between corruption and government regulation (here).  

I use the Corruption Perception Index (here). To illustrate Walt’s point graphically I took the average of the percentage change for the period from 2012 to 2018 for ten most advanced European countries and the USA (USA, Austria, Belgium, Finland, France, Germany, Italy, the Netherlands, Spain, Sweden, and the UK).

The percentage change in the corruption perception index for 11 advanced countries for the years 2012-2013 compared with 2017-2018 has declined in three countries (the US, UK, and Germany), more in the US and the UK and less in Germany. Although Walt’s argument is valid, the available data for the US do not show such increase in corruption. Maybe new data for 2019 and more future data would show what Walt is describing.

The index has not changed significantly in Sweden and Belgium; and increased in the rest of the countries (Spain, Italy, the Netherlands, Finland, Austria, and France) with France exhibiting the most significant increase.

Figure (1) plots the data.

Figure (1) 

Then I computed the average productivity growth and the average Total Factor Productivity growth (TFP) – a measure of economic efficiency – from the EUKLEMS 2017 data set. Productivity is real value added per hour worked. EUKLEMS publishes a TFP index. The samples are slightly different across countries, but most data cover the period up to 2015. For all data, I use the measure of what EUKLEMS refers to as the “market” instead of “total economy” whereby the government and the services such as education, health, etc. are excluded. Check (here).

Figures 2 and 3 plot the correlations of the percentage changes in the corruption perception with productivity growth and TFP growth.

Figure (2)

Figure (3)

Surely, the correlation between corruption and productivity growth is negative across the advanced countries. Thus, rising corruption is associated with lower productivity.[1]

[1] Corruption is not the sole explanatory variable of low productivity. I have written on this before. There are measurement issues (e.g., Feldstein, 2017) and a population effect. Population data show significant decline in the growth rates of working age population, fertility rate, youth population, etc. in advanced countries. Thus, there are fewer people working on scientific research, which reduced global research output needed for economic growth. This trend is quite alarming in advanced economies. Robert Gordon (2016) argued that the days of high productivity in the US have gone for good. Fernald and Jones (2014) suggest that the U.S. future economic growth is likely to slow down because educational attainment and population are likely to slowdown in the future. They also argue that the shape of the idea production function introduces uncertainty into the future growth. They also suggest that the rise of China and India’s research growth, artificial intelligence, climate change, income inequality, and health care are among the variables that explain future productivity in the United States. Bloom et al. (2017) argue that evidence at the micro level US. data suggest that there has been an increase in global research efforts (i.e., the number of people in research) coupled with a sharp decline in research productivity. They say that it is getting harder to find a new idea.

Excessive regulations ==> more corruption ==> lower productivity growth 

Saturday, March 16, 2019

On the future supremacy of the US dollar

The “flight-to-safety” describes the tendency to hold a assets denominated in a robust currency. This has been true for the US dollar during the post-war period. Ilzetzki, Reinhart, and Rogoff (2018) studied the issue and found that the US dollar remains the preferred anchor and reference currency despite the introduction of the Euro and the rise of the Chinese currency.[1]

Recently, a number of an online journalistic articles argued that there have been some underlying political-economy sort of events that might undermine the dominance of the US dollar.

One of these events is the financial money-transfer system, e.g., SWIFT - the Society for Worldwide Interbank Financial Telecommunication. Clearly, this system is highly influenced, or even dominated, by the United States, is it not? The trouble might stem from the US decision, for whatever reason, maybe political, to cut off countries such as Russia or China, or Iran, etc. from that system. There has been a strong push against Russia and China in the US recently.

That led Russia and China to creating an alternative system.

Moreover, the EU decided, including the UK, to continue to trade with Iran in defiance of the US. The EU announced that it had created a new system, INSTEX - Instrument in Support of Trade Exchange - to bypass the international system, which is under the control of the US, in order to facilitate payments with Iran, and other countries that have bad relationships with the US. This must be an important development in the international monetary arrangement, and must have some implication for the US dollar domination, now and in the future.

There is no doubt that there is a rising tension between the US and the EU regarding the latter's economic ties with Iran, Russia, and China. Trump has a very different stance on globalization and international trade from previous governments. INSTEX could be used in case the US decided to punish the EU for importing gas from Russia, for example, could it not.

The market value of the US dollar, and a lot more currencies, are highly affected by trade, i.e. the price of a currency in terms of another (exchange rate) is a function of trade issues.

The tariff war on China may not be benign, or a bluff. It does affect the exchange rates among other things. It increased uncertainty. Uncertainty is not something one could insure against; it would distort prices and affect the volume of trade. What if no deal is reached and tariffs increased by 25 percent?

So the straightforward implication of the break of the US dollar dominated international monetary arrangement, which has been in place since 1945, may be at the end of the day only a declining global demand for the USD, thus, a depreciated currency.

A depreciation of the USD itself is not a major cause of a concern for economists.

Countries with fixed exchange rate such as China and Russia and most of the oil-producing rich countries hold a huge amount of US dollar debt and reserves. Although the interest rate paid on US debt is low, these countries would also lose a great deal if they undermine the US dollar, don’t they? In other words, dumping the US dollar is costly.

However, something else could jeopardize the supremacy of the US dollar.

Modern Monetary Theory, which is advocated by some Democrats in the U.S. today, proposes to use the Fed balance sheet to, permanently, finance social programs. The issuing of more debt would put upward pressure on interest rate. If the debt issuing is persistent or permanent, it might have some damaging effect to the US dollar.

In my paper with Moosa (here) “Monetary Policy, Corporate Profit, and House Prices,” we show, using US data, that there is a strong relationship between corporate profit and asset prices such as housing prices and stock prices. Monetary policy drives all these variables. The increase in interest rate and / or the reduction of the money stock reduce both corporate profits and asset prices (different magnitudes).

A permanent change to monetary policy along the lines suggested by the Modern Monetary Theory would induce a secular decline in corporate profits, and asset and share prices that could cause a permanent decline in the demand for US dollars and setup the way to ending its dominance at some future point.

That is a testable scenario.

[1] Ethan Ilzetzki, Carmen M. Reinhart, Kenneth S. Rogoff, February 2017, Exchange Arrangements Entering the 21st Century: Which Anchor Will Hold? NBER Woking Paper No. 23134.