Some reflections on the world of
central banking: Excerpts from the speech of the Governor of the Reserve Bank of New Zealand, to the
Institute of Finance Professionals NZ, Auckland, 14 October 2015. (Emphasis is that of this blog author)
The global economy
appears to be growing at around 3 percent - slower than its average over the
past three decades and the weakest growth since 2009. This weakness comes
despite several supportive factors including: the unprecedented monetary
stimulus; the positive effect of low commodity prices on spending power; and
cheaper and more sophisticated information technology. For example:
- the world has never seen cheaper
financing. Policy rates are close to zero in advanced economies that
collectively generate 2/3rds of world output, and quantitative easing by
major central banks in advanced economies has totaled around USD7 trillion
in recent years.1
- due
mainly to the weakening in Chinese demand (but also to strong supply in
many markets), prices of a wide range of commodities have been falling
since early-2014.2 While this slows growth in the
developing world (which is the main global source of commodities) falling
commodity prices are generally positive for growth in developed countries.
- the
decline in the cost of information technology over the past three decades
possibly represents the largest continuous set of factor cost reductions
the world has experienced. Not only is the marginal cost of storing,
processing and transmitting information essentially zero, the creative
destruction of information technology has generated new products and
consumer markets, and enabled further efficiencies to be squeezed out of
global supply chains.
Despite these
factors, and the ease with which capital can flow across borders, economic
growth rates even in the advanced commodity importing countries remain below
potential growth rates eight years after the onset of the Global Financial
Crisis (GFC).
The inflation picture
(also), is complicated. In the vast majority of the 30 or so economies (mainly
advanced economies) whose central banks pursue inflation targeting, headline
and underlying inflation have averaged below specified goals over the past few
years. There are several reasons for
this: levels of excess capacity in factor and product markets remain high in
many economies; wage outcomes have been subdued, even in countries with low
unemployment; surveys show that inflation expectations have declined; commodity
prices have fallen substantially over the past 18 months; and the internet and
other technologies may be changing the tradables content of traditional
non-tradable goods and services.
...the greatest concern
at this point lies around the growth outlook for China. Over the past 35 years,
China has been the world's most successful economy, increasing its share of
world output from below 3 percent to 15 percent currently. Although China's
economy is just over 60 percent of that of the United States (at current
exchange rates) it has a much greater impact on commodity markets and global
trade volumes. China is now the number 1
or 2 trading partner for over 100 countries and its imports of non-oil
commodities are around 2 ½ times higher than those of the US.
...China's construction and manufacturing sectors continue
to be a concern, particularly as much of the investment has been financed
through extensive borrowing, much of it in the rapidly expanding shadow banking
sector. China's debt burden has increased at an unprecedented rate - from 130
percent of GDP in 2008 to around 200 percent currently. But financial markets
have also been unsettled by other factors, including the types of policy measures
introduced as the Shanghai index began declining, the magnitude of recent
capital outflows, and the questions raised by the decision to allow the RMB to
depreciate by 3.5% over two days in August.
Although the Chinese
Authorities have indicated they want a stable RMB, private capital outflows
continue to be large. Any substantial depreciation in the RMB would have
serious implications for the world economy: it would risk triggering exchange
rate adjustment among competitor economies - particularly in Asia, and would
spread deflationary forces across the globe.
...there are significant puzzles around the (US) labour market
and investment climate. Why, for example, has recent US labour productivity
growth been so slow, and what explains the substantial wage moderation and
weakness in business investment at this stage of recovery? On the policy side,
there is uncertainty as to when and how fast the process of raising interest
rates might take place, and its possible impact on international growth and
asset prices - especially at a time when the Bank of Japan and European Central
Bank are considering expanding their quantitative easing programs.
It's a world of complex linkages, of instantaneous
information, massive daily cross-border portfolio flows, unprecedented monetary
accommodation and, in some instances, sharp swings in market liquidity and
asset prices.
It's also a world in
which high expectations have been placed on central banks to use all of the
scope within their mandate to stimulate growth in demand and counter the risk
of inflation remaining below desired goals for extended periods. In seeking to
do so, central bankers have often had to work without the support of fiscal
policy, or the structural adjustment reforms needed to raise potential output
growth.
Flexible
inflation targeting has been successful over the last 25 years in reducing
inflation to low and stable levels - the best contribution monetary policy can
make to an economy's long-run growth.
Monetary policy is,
however, relatively powerless to influence the decisions that determine
long-run economic performance and distributional outcomes. For example, over
the long run, monetary policy can do little to generate higher spending by
households and firms. Even in the shorter term, monetary policy's influence may
be low in an environment where debt levels are high and where there is
considerable uncertainty about economic prospects.
Monetary policy can influence risk-taking in asset markets,
but this does not necessarily translate into risk taking in long term real
assets - requiring the investment and entrepreneurial decisions that underpin
productivity growth and hence long-run improvements in living standards.
Similarly, the
Reserve Bank is unable to influence long term real interest rates. These are
affected by a range of factors, including global savings and investment flows,
risk premia and expectations for economic growth and inflation. Monetary policy
can only influence short term interest rates and, over the medium term, actual
and expected rates of inflation.
Monetary policy
generally affects inflation outcomes with a 12 to 18 month lag, reflecting the
pace at which changes in interest rates and the exchange rate typically spread
to risk-taking and spending in the economy. This means that central banks are
constantly trying to interpret the outlook for inflationary pressures, growth
and financial stability 12 - 18 months ahead.7
Financial markets, which respond almost instantly to policy
signals and expectations about risk and returns across the world, operate with
a more immediate focus. Moreover, the magnitude of their transaction flows can
swamp the balance sheet strength of any central bank.
Mechanistic approaches to setting monetary policy don't
work, and since monetary policy affects inflation with a 12-18 month lag, by
the time one is certain as to the correct policy adjustment, it may already be
too late to be effective.
At a technical level, setting monetary policy involves
estimating output levels and forecasting how they might evolve relative to the
level of potential output. This "output gap", together with inflation
expectations, are seen as the main drivers of inflation pressure in the
economy. A major challenge is that potential
output, the output gap and the level of neutral interest rates are not
observable; all have to be estimated through economic modelling.
