Inflation and the smoking gun in the case of NZ’s central bank
Published in The Australian (Sydney), 8 November 2022
Hindsight is a wonderful thing. It is often only after time passes that one realises what one should have done differently. These are decisions one should not have made if one had known about later events.
However, hindsight can also provide a cheap excuse. That is when one blames one’s past mistakes on future events – even when there is no link between them.
The Reserve Bank of New Zealand (RBNZ) is currently engaged in this kind of history falsification. It conveniently shifts the blame to Vladimir Putin for New Zealand’s high inflation. No matter that the RBNZ mainly has itself to blame.
Last week, the RBNZ’s Governor Adrian Orr appeared before the New Zealand Parliament’s finance and expenditure committee. It was a regular appearance following the release of the Bank’s latest Financial Stability Report. Orr used the opportunity to defend his record.
“For us to have maintained inflation between the 1 to 3 percent target range, we would’ve had to predict the 2022 Russian invasion of Ukraine back in early 2020,” Orr said in his opening remarks. With that claim, he shifted the blame for New Zealand’s inflation record to external events, away from the RBNZ’s monetary policy. He maintained this position throughout his testimony.
It sounds plausible, at least superficially. New Zealand is experiencing high inflation, but much of the world is as well. Also true is that inflation accelerated after Putin’s Russia invaded Ukraine on 24 February. The war has affected food, fertiliser and energy prices, especially in Europe.
Still, it was a bit cute for the RBNZ Governor to wash his hands of any responsibility for domestic inflation. Too cute indeed.
For all its international implications, the Ukraine war affected the New Zealand economy less than it did Europe. Unlike many European countries, New Zealand is a major net exporter of food. Any food price increases would have bolstered New Zealand’s terms of trade, strengthened the Kiwi dollar and been a dampener for domestic inflation. Also, New Zealand’s electricity is largely powered by domestic renewables and thus insulated from the European energy crisis.
There are no good reasons to believe that Putin’s war caused New Zealand’s inflation. The data does not support such a link in any case.
Michael Reddell, previously an economist with the RBNZ and now one of New Zealand’s most-read economic bloggers, had none of Governor Orr’s excuses. He calculated what New Zealand’s consumer price inflation would have been if war-related items were excluded.
Even without food, household energy and petrol, Reddell found inflation at around 6 percent for September. Remarkably, this adjusted inflation rate was already at that level at the beginning of the Ukraine war.
So, if Putin cannot be blamed for New Zealand’s inflation, who is responsible for it?
Answering that question takes us right back to the RBNZ. It also requires a bit of monetary economics.
In the 1990s, US economist John B. Taylor studied monetary policy records to figure out how central banks target inflation. By devising a formula, he managed to replicate real central bank decisions.
Eventually, this formula became known as the Taylor Rule. It can be used for more than simply describing what central banks do. Using it can also help central banks decide what they should do.
A central bank trying to achieve an inflation target can thus use the Taylor Rule to figure out what official cash rate (OCR) would get it there.
In an ideal world, there should not be much of a gap between the OCR and the rate calculated under the Taylor Rule. The Taylor Rule is designed to achieve the same inflation target the central bank should achieve. So when there are large discrepancies between the Taylor Rule and the actual OCR, it means that the central bank is likely to get off track.
This makes calculations by Christoph Schumacher, an economics professor at Massey University, telling. Going through New Zealand’s monetary policy history, Schumacher calculated the Taylor Rule gap for the past two decades (see graph).
Difference between Taylor Rule rate and New Zealand’s official cash rate
(source: Professor Christoph Schumacher, Massey University)
Since the beginning of the century, the OCR was oscillating around the value prescribed by the Taylor Rule. For the first decade, the OCR was a bit lower than the Taylor Rule would have prescribed. For the 2010s, it tended to be just a bit too high.
In 2021, however, something remarkable happened. The difference between the two became large. By June 2021, the Taylor Rule suggested the cash rate should be above 2% when, in fact, it was still only 0.25%. Today, it should be close to 7% when the OCR only stands at 3.5%.
Schumacher’s findings indicate that the RBNZ was setting interest rates at a level far too low to achieve its inflation target. By the time the Ukraine war started, that gap had been positive for more than a year and stood at more than 3 percentage points back then.
As far as monetary policy is concerned, this is a smoking gun. Based on this evidence, the RBNZ’s policies were grossly misaligned. The RBNZ’s monetary policy was so far removed from where it should have been under the Taylor Rule, there was no chance the Bank could have achieved its inflation target.
Never in the past two decades has the RBNZ deviated so much from where it should have set its OCR. The difference is so enormous, it calls into question the RBNZ’s professional judgement.
Perhaps that is the real reason Governor Orr now tries to distract from his Bank’s disastrous policy decisions. By blaming Putin, he has found a convenient scapegoat – and it even sounds halfway plausible.
Once you go through his claims, however, Orr’s fairy tale falls apart. What remains is the story of a Reserve Bank that completely lost the plot and caused one of the most severe inflation outbreaks New Zealand has witnessed in recent decades.
Is this a record that warranted Governor Orr’s reappointment?
New Zealand’s Minister of Finance, Grant Robertson, obviously thought so. Just a week after Orr’s Russian fairy tales in Parliament, Robertson reappointed Orr for another five-year term.