Many people criticized the RBNZ ex-governor Graeme Wheeler for not bringing the CPI inflation “up” to hit the
target. In other words reducing the OCR. Some went further to call for a negative OCR!
Two things influence moving the CPI inflation
to meet the target, policy and luck. By luck I mean the randomness of the shocks.
Shocks are very difficult to identify ex-ante. I don’t know Graeme Wheeler, but
examining the data indicate that perhaps he was mostly unlucky.
The main job of the central bankers is to analyze the data, as they arrive, and try to identify the nature and the permanency of the shocks in order to make forward looking policies to offset their effects, which is a very difficult job. Failing to identify the shocks gives rise to ‘gut feelings’ and backward looking policies. Clearly luck plays a big role.
The main job of the central bankers is to analyze the data, as they arrive, and try to identify the nature and the permanency of the shocks in order to make forward looking policies to offset their effects, which is a very difficult job. Failing to identify the shocks gives rise to ‘gut feelings’ and backward looking policies. Clearly luck plays a big role.
Soon after signing the first Policy
Target Agreement (PTA) in 1990, inflation came down to hit the target much
sooner that it was anticipated by anyone (back then the RBNZ experimented with
instruments other than the setting the Official Cash Rate - OCR). One arguments could be that the inflation expectations adjusted
downward quickly. Perhaps it was believed that the RBNZ was committed to
achieving the job.[1]
Once inflation expectations were anchored and the RBNZ held inflation around
the target successfully it gained reputation.[2] These are valid arguments. Don Brash was a credible inflation fighter. He was
fortunate too. No significant shocks occurred until 1997.[3]
Even Milton Friedman told him that he is a fortunate man.
Regardless of its reputation and
known commitment to keeping the CPI inflation on target, the RBNZ messed up a
big deal in 1997, the Asian Financial Crisis. Of course no one saw the shock
coming; the RBNZ reacted to it; and made a costly policy error (around 3
billion dollars of losses in GDP initially if I recall correctly, but I could
be wrong). The year 1997 was both bad luck and bad policy.
In 1999 the RBNZ began setting the
short-term interest rate (OCR) as a policy instrument. The next big shock was the 2007-2008 Global Financial Crisis (GFC). Monetary policy,
which uses the interest rate (price) rather than money (quantity) has different
dynamics. Quantitative Easing as a policy response in the US, the EU and elsewhere did not generate inflation. A successful anchoring of inflation expectations removes the positive
correlation between CPI inflation and the growth rate of money. I illustrated that
in an RBNZ discussion paper (Money in the Era of Inflation Targeting, 2001).[4]
Simply modeled, the CPI is a weighted
average of the domestic and foreign prices. Let the d Log CPI = a d Log P + (1-a) (d Log P*+d Log S),
where (d) is the annual difference, P is the GDP implicit price deflator, P* is the US CPI, S is the exchange
rate and (a) is a weight.[5]
The RBNZ has no control over the exchange rate. Macroeconomic fundamentals
cannot forecast the exchange rate because its fluctuations are dominated by randomness rather.[6]
Therefore, any governor would find it difficult to push the CPI inflation up/down
during times of extraordinary appreciation/depreciation of the currency.
Let’s look at the data. Unfortunately I do not have real-time data as Athanasios Orphanides taught us to do, but I do not think the exchange rate is subject to revisions anyways (price might be revised).
Figure (1) plots the actual d Log CPI (inflation) on
the vertical axis and d Log P + (d Log P*+d Log S) rates of change on the horizontal axis. The weight could be estimated, but it does not
matter in this case.
The association between the CPI
inflation, and the domestic and foreign prices is evident in the data until the
end of 2009, then a clean break in the correlation occurred and remained until
the end of the ex-Governor’s tenure.
I separate the variables to shed
more light on the components.
Figure (2) plot the CPI inflation
and NZ price of foreign exchange rate depreciation (P*+S). The picture is
similar to figure (1). There is a break in the correlation in 2009.
Figure (3) plots the CPI inflation and P, the domestic price inflation. There is a spike in domestic price inflation in 2014.
Figure (4) plots the CPI inflation rate and the US CPI inflation rate, and they seem to be correlated except for the period of the Great Recession in the US.
So it is the exchange rate!
Given these large, unpredictable, and persistent foreign exchange rate shocks, I imagine that it was very hard to hit the CPI inflation target during that period even if the OCR was set to zero or even negative.
Given these large, unpredictable, and persistent foreign exchange rate shocks, I imagine that it was very hard to hit the CPI inflation target during that period even if the OCR was set to zero or even negative.
CPI inflation reached 1.9 in
September and fell to 1.6 percent in December 2017 and these fluctuations are
associated with highly unpredictable random changes in the exchange rate.
Some may argue that Graeme
Wheeler could have done something about domestic price shocks, but I find it difficult
to believe that he or anyone else could do anything about the exchange rate
appreciation, which makes it very difficult to inflate and hit the CPI target. He (and the RBNZ) was more unlucky than anything else.
[1] There is a
large literature on commitment.
[2] There is a
large literature on reputation.
[3] Senior
colleagues at the RBNZ told me that they (the RB) were targeting lower
inflation a long time before the signing of the PTA in 1990.
[5] The variables
are logs. I use the resorcinol of the exchange rate posted on the RBNZ webpage.
[6] The variance
of the exchange rate depreciation rate is several folds larger than the
variance of macroeconomic fundamentals.
