A Must Read for Central bankers and Forex / bond dealers -Learned Observations from Graeme Wheeler

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.