John McDermott: Looking at the stars
Speech by Dr John McDermott, Assistant Governor and Head of Economics of the Reserve
Bank of New Zealand, to HiFX, Auckland, 26 July 2017.
* * *
I would like to thank Jamie Culling for his help in the preparing this speech, along with assistance
from Sarah Drought and other Bank colleagues.
Introduction
Thank you for inviting me to speak with you today; it is a pleasure to be here. Today I'm going to
talk to you about the 'stars' I look at in the New Zealand economy. When looking at the stars, it is
not a desperate attempt to adopt astrology to aid my understanding of the economy. Rather, I am
looking at the trends in our economy. I will expand on this in a moment.
The Reserve Bank of New Zealand has operated a flexible inflation-targeting framework for nearly
1
30 years. Over time, the practice of inflation targeting has become more systematic and
transparent. Transparency improves the understanding of our goals and policy intentions, which
makes policy more effective and allows for more rational evaluations of the Bank's decisions.
Today's speech adds to this transparency by outlining how we think about the trends of the New
Zealand economy, and how knowing these trends helps us implement the flexible inflation
targeting framework.
Our inflation targeting framework focuses on keeping future annual CPI inflation outcomes
between 1 percent and 3 percent on average, over the medium term, with a focus on keeping
future average inflation near the 2 percent target midpoint. Key to this is the notion that there is an
equilibrium level at which the economy could operate that would be consistent with inflation
remaining stable at 2 percent. In practice, the economy faces a range of shocks (such as a rise
in the price of our exports, or an increase in net immigration) that push output away from its
equilibrium. This would not be such an issue if there were no frictions in the economy and prices
could adjust seamlessly - prices and wages would rise and fall across sectors, as required to
re-allocate resources efficiently and move output back to its equilibrium level.
But the world is not so simple. Many frictions exist in the economy, which prevent or slow the
2
adjustment in prices and output. For example, wages and prices are typically only reset
periodically, and labour is often not quickly transferable across sectors and locations. These
frictions create a role for monetary policy in stabilising the rate of inflation over the business
3
cycle, while also seeking to moderate the swings in output away from its equilibrium level. To do
this, the Bank influences interest rates across the economy, to stimulate or dampen output, and
move inflation back towards its target level. The Bank lowers the Official Cash Rate (OCR) when
inflation is weak, which encourages households and businesses to bring forward spending,
thereby stimulating output leading to higher inflation. Conversely, when inflation is too strong,
higher interest rates encourage savings and a delay in spending plans, which dampens output
growth leading to lower inflation. In addition, changes in interest rates may alter the exchange
rate and hence the relative price of domestic and foreign goods.
When we model the economy, the concept of a frictionless economy is represented, somewhat
imperfectly, by a collection of interrelated and unobservable trends of key macroeconomic
4
variables. These trends are the anchors around which we aim to stabilise the economy, and
thereby inflation over the medium-term. While the Bank cannot influence many of these trends,
estimating and understanding them is crucial for monetary policy to be set appropriately. As
such, we devote a significant amount of time and effort to it.
In our economic models, these unobserved trends are conventionally denoted with the
superscript 'star' (*). Three particularly important trends are: r* - the neutral interest rate;
Y*potential output; and e*- the equilibrium real exchange rate.
Another important unobservable variable is core inflation, or π*. Core inflation, along with future
expectations of it, is a key variable we can influence. Although we target headline inflation, there
are components of inflation we cannot control, such as commodity prices (e.g. oil), and changes
in central and local government charges (e.g. changes in GST). Core inflation is useful because
by filtering out temporary or unusual features, it provides a better guide to future medium-term
inflation.
The framework we use, assessing output relative to trend and the OCR relative to the neutral
5
interest rate, is an approach adopted by many of the flexible inflation-targeting central banks. As
such, numerous central bank publications refer either directly to one of the trends mentioned
6
above, or imply the concept of trends in their framework.
In a number of speeches and publications over the past few years we have explained our thinking
behind the important trends, or 'stars' if you like. This speech draws on recent work to provide an
update on how we think about the trends in the New Zealand economy.
r* - The Neutral Interest Rate
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First, we look at the neutral interest rate, r*. While there are a range of interest rates of different
maturities and different levels of risk, each with their own trend, the benchmark neutral rate we
8
estimate is the nominal neutral Official Cash Rate (OCR). The neutral interest rate is the rate of
interest where desired savings equal desired investment, and can be thought of as the level of
9 10
the OCR that is neither contractionary nor expansionary for the economy. , To put this
another way, an OCR above neutral provides a headwind for output and inflation, while an OCR
below neutral provides a boost to output and inflation.
Because the neutral OCR rate is unobservable, the Bank uses a range of models, surveys, and
financial market prices to help form our estimate of neutral. We also care about real interest
rates, and use a suite of models for inflation expectations (which also have a wide range of
11
measures) alongside our neutral interest rate.
Over time, the neutral interest rate has been slowly falling; a trend that has been seen in many
countries around the world. Economic theory tells us that changes in neutral real interest rates
reflect changes in real economic factors such as population growth, productivity growth,
12
preferences for savings, and world conditions. A combination of these factors appears to have
13
been contributing to the fall in neutral, both in New Zealand and abroad.
Currently, we estimate that the neutral interest rate has moved below 4 percent, with the median
of the indicator suite currently sitting around 3 1⁄2 percent (figure 1). Given the neutral rate is an
unobservable long-run variable; it is very difficult to estimate precisely. The estimates in the
models from our indicator suite currently range between 2.6 and 4.6 percent, highlighting the
significant uncertainty around our estimate. Overall, a neutral rate of around 3 1⁄2 percent implies
that monetary policy is stimulatory at present, given an OCR of 1.75 percent. Upcoming
projections will incorporate an assumption of a 3.5 percent neutral rate into our modelling
frameworks. We have been factoring in this on-going decline in the neutral interest rate for some
time, so the overall impact on the outlook for interest rates over our projection horizon from this
particular update will be modest.
Y* - Potential output
The neutral interest rate and the economy's potential output are interrelated, with both factors
sharing common drivers. Potential output, or Y*, is the level of output that is sustainable, and is a
14
useful conceptual tool in gauging aggregate output consistent with stable inflation. In our
framework, the difference between the actual level of output and the level of potential output - the
output gap (figure 2) - is a key influence on inflation.
In the short-run, frictions such as stickiness of nominal wages and other prices can prevent the
economy from achieving its potential output when it is hit by a shock. When an economy is
running ahead of its potential, a positive 'output gap' is said to exist, where pricing pressure
increases in order to ration demand on scarce resources (such as capital and labour), boosting
general inflation. The longer output is away from its potential, the greater the adjustments costs
incurred as output converges back to potential. Sustaining growth and minimising these
adjustment costs is highly desirable, given how much recessions hurt social and economic
15
outcomes.
Neither potential output nor the output gap can be directly observed. Ultimately, estimating
potential requires determining whether movements in observed output are temporary cyclical
movements, or permanent changes to the economy's structure. To estimate potential output, we
use a production function approach that combines the inputs of production - labour and capital
16
- along with total factor productivity.
We have a range of uncertainty with respect to the output gap; around ± 2 percent of potential
17
output. Given the challenges in estimating potential output in real time, we cross-check the
results from this approach against a number of other potential output estimates, including
18
estimates from time-series models, and fully-estimated structural models. Moreover, the
estimate for the output gap is checked against a range of measures, including indicators from
the labour market and business surveys. Given the important role that the potential output
estimate (and thereby the output gap) plays in influencing inflation pressure, these estimates
garner considerable discussion and scrutiny as part of the policy process, and are
judgementally-adjusted as necessary.
Potential output growth in New Zealand is currently estimated to be 2.9 percent per annum (figure
3). The current strength of potential output growth has been driven by growth in the labour supply
(especially strong net immigration flows) and the capital stock. There has been almost no
20
contribution from productivity growth in recent years. This is not unique to New Zealand, and is
a heavily-debated topic internationally. There are multiple ideas behind waning productivity
21
growth. Firstly, there could simply be less innovation now than in the past. Or, it may be the
22
case that we just have not utilised recent innovations yet. Alternatively, measurement errors
may be at play; for example, it is hard to measure efficiency gains from use of the internet or ICT
23
services.
24
e* - Equilibrium real exchange rate
Of all the prices within our economy, the real exchange rate is one that is not subject to short-run
rigidities. Indeed, the real exchange rate can and does move rapidly over time, as economic
developments such as a rise in the terms of trade (figure 4) - the ratio of our export prices to
import prices - are quickly reflected in its relative price. The fast-moving nature of the real
25
exchange rate means it plays an important role in absorbing shocks to our economy. But while
part of the movement in the real exchange rate over time reflects persistent fundamental
developments (such as structural improvements in the terms of trade or changes in relative
productivity), much of the movement in the real exchange rate reflects deviations away from its
medium-term equilibrium level, e*. This feature of the exchange rate to 'overshoot' or
'undershoot' its equilibrium stems from the fact that currencies can react to incoming news
instantly, while other prices (besides interest rates) are slower to adjust. These deviations may
result in mis-allocation of resources between tradable and non-tradable goods.
There are various definitions of the equilibrium real exchange rate, which tend to focus on the
26
drivers of the exchange rate over a given time horizon. The medium-term notion of equilibrium
tends to be based on the value of the real exchange rate that would be consistent with internal
balance (output at potential) and external balance (the current account sustainably financed).
One of the several models that the Bank uses is the macro-balance model, which assesses the
degree to which the exchange rate is currently too high or too low in order to stabilise the net
27
foreign liabilities (NFL) to GDP ratio at its current level. This model indicates that the current
level of the real exchange rate is consistent with NFL remaining at about 60 percent of GDP,
given the Bank's medium-term outlook for key economic variables (such as the terms of trade).
However, it yields no further reduction in NFL-GDP from its current level. A lower New Zealand
dollar would be needed to lower NFL-GDP and our external vulnerabilities further. Indeed, from a
growth point of view, a lower real exchange rate would help rebalance growth towards the
tradables sector, especially as not all traded industries are benefiting from the current high terms
28
of trade.
π* - Core inflation
As noted earlier, monetary policy typically has little influence on many underlying trends in the
economy. But it does influence inflation, and expectations about future inflation, even if we cannot
influence every price. A useful concept for a flexible inflation-targeting central bank is core
inflation, which abstracts from one-off or highly volatile price movements, like large changes in
the price of an individual product (e.g. oil). This is important because while idiosyncratic price
movements can materially affect headline CPI inflation, they may not reflect fundamental or
persistent sources of inflation pressure. Consequently, central banks often use core inflation as
29
an important measure of inflation over which it has some control. Specifically, core inflation
abstracts from noise and provides a clearer picture of how far inflation is from our objective
under the Policy Targets Agreement. Because inflation is affected by factors outside of the
Bank's control, and people's expectations need not coincide perfectly with the Bank's
mediumterm objective, we monitor a range of core inflation measures to gauge current inflation pressure.
The measures of core inflation we examine include, among others, model-based measures and
30
exclusion-based measures. The model- and exclusion-based measures reflect the current
central tendency of price movements, while other measures focus more directly on future
(beliefs about) inflation outcomes. Our sectoral factor model reflects, in part, both concepts of
31
core inflation.
The sectoral factor model is our preferred measure of core inflation because it best predicts
where headline inflation will converge to in the future once the transient noise dissipates, and is
32
smoother than our other (relatively) more volatile core inflation measures. Based on this
measure, core inflation is currently estimated to be 1.4 percent (figure 5), and has broadly
tracked sideways over the past year. So while inflation pressures have lifted from the lows seen
in early 2015, they still appear to be relatively moderate. Revisions to this measure occur from
time to time, but the sectoral factor model is only one measure in our suite of inflation indicators,
so changes to a single measure are unlikely to materially alter the overall assessment of inflation
pressures at any particular period.
Conclusion
To set monetary policy we need to know where the key macroeconomic factors (such as interest
rates, output, and the exchange rate) are tracking relative to their equilibrium levels, denoted by
our 'stars'. These stars are unobservable and complex to estimate, so we use a range of
techniques to help form our view of their values over time
Like the night sky, our stars keep moving. To respond to an evolving macroeconomic
environment and set monetary policy appropriately, we keep track of the changes in the
underlying state of the economy. Regularly explaining our view of the stars helps financial market
participants and others better understand our analytical framework and policy decisions.
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1
The Reserve Bank of New Zealand Act 1989 came into force on 1st February, 1990.
2
See Parker (2016) for a discussion of firms' price setting behaviour in New Zealand.
3
At its core, flexible inflation targeting highlights the objective of monetary policy - stable inflation - whilst also
permitting flexibility in the short-run trade-off between inflation control and economic stability.
4
The frictionless economy referred to here is broadly consistent with a New Keynesian perspective outlined in
Woodford (2003).
5
See Svensson (1999).
6
See, for example, RBA (2017); BoE (2017); FOMC (2017); Jarocinski & Lenza (2016).
7
In much academia and policy research, r* will denote the real neutral interest rate, which is the nominal neutral
interest rate minus expected inflation. Here, I am referring to nominal rates, assuming inflation expectations are
stable.
8
Richardson & Williams (2015) provide detail on estimation of the neutral interest rate.
9
For further detail on the definition of the neutral rate, see Chetwin & Wood (2013).
10
Savings in this context could be thought of as domestic or foreign savings, if referring to a closed or open
economy, respectively.
11
Lewis (2016) uses various surveyed measures of inflation expectations and yield curve modelling techniques to
develop a framework for monitoring inflation expectations.
12
For example, a sustained fall in productivity growth lowers the returns to investment, making it less desirable to
invest. If the desire to invest falls and the desire to save remains unchanged, a lower neutral rate will be
required to reconcile savings and investment plans. For further discussion of factors that can affect the neutral
rate, see Archibald & Hunter (2001), and Williams (2016).
13
For a discussion on the lower neutral rate, see Pescatori & Turunen (2015); return on investment, see
Summers (2014); the "global savings glut" hypothesis, see Bernanke (2005); demographics, see Barro &
Salai-Martin (2003).
14
This definition of potential output follows Okun (1963). Potential output here refers to the goods market. A related
concept in the labour market is the natural rate of unemployment (NAIRU). Like the other trend variables
presented here, it is unobservable and subject to uncertainty.
15
For example, Kato (2009) and Beckman et al. (2009) both discuss the effects of the Global Financial Crisis on
Asia and developing economies, respectively.
16
For details surrounding our estimations of potential output, see Lienert & Gillmore (2015).
17
Challenges arise on a number of fronts, including that potential output can vary substantially over time and that
data revisions to GDP in particular can result in substantial revisions to our estimates of potential output in
"realtime" versus ex-post.
18
For details on our estimation of the output gap, see Armstrong (2015).
For a discussion of labour market flows and dynamics, see Armstrong & Karagedikli (2017) or Armstrong,
Kamber, & Karagedikli (2016).
20
For discussion on New Zealand's productivity performance, see Steenkamp (2016) or Conway (2016).
Steenkamp produces aggregate TFP estimates for New Zealand, while Conway outlines why New Zealand has
struggled to lift productivity in recent decades.
21
For example, OECD (2016) shows that government R&D budgets are receding in many countries.
22
There is debate as to whether the slowdown in innovation is permanent, or whether it is temporary as
breakthroughs in Artificial Intelligence and robotics loom. See Gordon (2016), or Brynjolfsson, E., & McAfee, A.
(2014).
23
Particular internet-based services (e.g. Google searches or Wikipedia) are largely not reflected in GDP
measurements, as there is often no price attached to their use. See Box 1 in Adler, et al. (2017) for further
information.
24
The real exchange rate is the nominal exchange rate, measured on a trade-weighted basis, adjusted for the
relative prices between New Zealand and our trading partners. This captures the fact that New Zealand faces
many exchange rates, and a weighted measure of individual bilateral exchange rates is necessary to
summarise the country's exchange rate position.
25
For discussion on the role of the exchange rate as a shock absorber, see: Karagedikli, et al. (2013).
26
The drivers of New Zealand's exchange rate are examined in McDonald (2012).
27
Graham & Steenkamp (2012) outline the macroeconomic balance model.
28
For discussion on recent developments in New Zealand's NFL, see Bascand (2017).
29
For discussion surrounding drivers of core inflation in New Zealand, see Kirker (2010).
30
A number of core inflation measures are discussed in Ranchhod (2013).
31
"The sectoral factor model provides a measure of core inflation that distinguishes between price movements in
the two major sectors of the economy, and hence helps to identify where inflationary pressures are coming
from." (Price, 2013, pg. 2).
32
For further details on the econometric assessment of the sectoral factor model, among others, see Kamber &
Wong (2016).