Citi’s William Buiter On Central Bank Forward Guidance

Here is a long note from Citi’s William Buiter on central bank forward guidance. It is a good overview of how forward guidance can be “cheap talk” and in order for markets to take central banks seriously, contingent changes to monetary policy (like inflation or unemployment at certain thresholds) are the only serious option.

The best approach to signaling longer-term policy intentions in an operational manner typically has three components.

First, commit to the regular publication and updating of longer-term forecasts of the target variables, of any additional nominal or real thresholds, knockouts or triggers that define the central bank’s reaction function for each of its instruments, and of the instruments themselves.

Second, reach an agreement that at most one member of the monetary policy making committee, presumably its chair, speaks or writes publicly about the likely future paths of the policy instruments – rates, QE, or whatever. The other members can of course still discourse in public about the principles of monetary policy and the history of central banking.

Third, give the central bank skin in the game by requiring it to issue or purchase material amounts of financial instruments on which it will lose money if interest rates depart from the forward guidance-consistent levels – financial hostage instruments. If possible, link the pay of the monetary policy makers at least in part to the performance of these instruments.

Hat tip to FT Alphaville who wrote about this yesterday.

It is interesting that despite Buiter thinking that policy rate changes by committee is a good idea, he still thinks that only one person – the chair or governor should be communicating this stuff.

The US Federal Reserve has a whole lot of people making public comments – all of the regional governors for example – and I’m not sure that’s optimal.

Different Federal Reserve Banks have different ways of looking at the world, and if market participants can cherry pick forward guidance from who they like on the Board of Governors that’s problematic.

With respect to the hostage instruments he talks about, I don’t think that’s appropriate. The people best equipped to deal with these sorts of strategies are on trading desks, not on the capped salaries of the public sector.

It would be far too much to expect there to not be significant losses on the learning curve of those sorts of policies, in the vein of massive foreign exchange market intervention losses that have occurred in the past when countries tried to defend fixed exchange rates and went broke.

I think New Zealand is doing OCR changes the right way – the buck stops with the Governor and he is also the person who fronts the press conferences. It’s a shame they’re anointing themselves as arbiters of what loans are good and what loans are bad though.


Is The Reserve Bank On A Mission To Lose Its Independence?

The role of a central bank is to implement monetary policy. The role of a central bank is not to act as an arbiter of what credit allocation decisions are good and what credit allocation decisions are bad.

Matt Nolan has a very good overview of the issues around the level of discretion the Reserve Bank is claiming mandate for with respect to macro-prudential policy.

I’d point out that on top of the level of discretion the Reserve Bank is engaging in, the Basel III framework which includes provision for unexpected losses, is just as discretionary and distortionary when it comes to capital allocation decisions in the economy.

The idea that a bunch of officials can forecast market tops better than private industry is hilarious. If they could they’d be hired by hedge funds in the US straight out of graduate school and would never set foot in a central bank because the opportunity cost in terms of wealth accumulation would be too high.

Even though I’m still just an economics student, I follow the literature and blogosphere closely. I know that since the global financial crisis, a lot of the stuff the Reserve Bank talks about in its bulletins has been dealt to by private actors.

How so? Banks are only going to give large mortgages to large earners in stable careers. If you run a business or are self-employed, you are subject to credit rationing because banks have been burned so often. Although Rob Hosking is correct in saying that LVR restrictions will save some people from themselves, the unintended consequences of discretionary policy are where the real welfare losses lie.

At the heart of the housing affordability issue is that in 2008 a lot of banks prematurely pulled the plug on residential development funding that was plugging the supply and demand deficit in Auckland and other places around the country.

New Zealand is a poor country – someone on wages is unlikely to be able to save up enough capital to take a risk on a speculative property development so banks need to match up developers with loans. It’s risky – but it’s a societal benefit because without this activity, there would be no downwards pressure on house prices.

In the most cynical of analyses, I think the RBNZ could be pre-empting the possibility of a Labour / Greens / NZ First coalition government ripping up the already expanded memorandum of understanding and throwing in a whole lot of additional policy objectives for the RBNZ to achieve.

Are they on a mission to lose their independence? It sure seems that way. I’m not convinced that there is enough discussion about the trade-offs involved in making arbitrary decisions on what sort of lending is good and what sort of lending is bad.

In terms of efficiency, risk should be managed by those closest to the coalface. I think there has been a bit too much hysteria over the finance sector and not enough examination of how substantial changes in how they do business in light of their regulatory changes makes the Reserve Bank’s new clothes an awkward fit.

6 Charts You Need To See From The Latest Reserve Bank Bulletin

The Reserve Bank Bulletin is always an interesting read. The June issue delivers with “The last financial cycle and the case for macroprudential intervention” by Chris Hunt.

I like Reserve Bank publications for the awesome charts they produce. In this piece they try and apply the policies they’re suggesting to the 2001 – 2008 boom.


Look at the massive reduction in private sector credit growth to business – how much of that is due to finance company failures and risk aversion on the part of bankers? It also seems like agricultural credit growth ground to a halt as we saw over-extended farmers like the Crafars have their loans called in.



OK – so if you are on a floating rate mortgage, that you can only afford when interest rates are low, what happens to your debt servicing ability when interest rates rise? Bueller? Bueller?


Finance companies competed aggressively in the property development sector, lending on more marginal and riskier housing projects which ultimately sowed the seeds of failures within the sector from 2006.

OK. So with massive population growth and supply side restrictions on housing, who shall fund the supply-side response? What constitutes a “marginal and riskier housing project” when New Zealand is not building enough houses each year even to keep up with population growth and reduced family formation?



There are some big questions that don’t appear here – how do we compensate society if our macro-prudential intervention chokes an economic recovery before it even gets started? Do we include the costs of subdivisions not built or higher rents paid for apartments when marginal apartment building projects can’t get approved because of higher capital requirements in the financial sector?



There is a trade-off between lending and meeting Basel III requirements. There hasn’t been nearly enough discussion of how Basel III by itself could kill any credit financed recovery (household risk preferences won’t pay for it!).



OK so here the author is highlighting the gap between actual capital ratio and what any counter-cyclical buffer would have been to put a dampener on credit growth starting late 2005 – if the RBNZ had possessed such powers.

  1. Where would financial institutions raise additional capital from if their regulating central bank has just taken action to force them to raise additional capital or substantially reduce their loan book?
  2. Where would non-bank deposit takers be in this situation? How can the Reserve Bank stay ahead of alternative credit providers?

If there is one thing we can be grateful for when it comes to the Reserve Bank, it’s that you can read their bulletins regularly and develop a pretty good idea of where monetary policy and prudential regulation are headed.

They are transparent – so when I see criticism of “shadowy central bankers” it’s clear that someone hasn’t spent time on the recently redesigned Reserve Bank website.

All of this stuff affects you and your finances – particularly if you have a mortgage – so there’s no excuse not to read through this stuff when it’s available for free.

What You Ought To Know About Financial Stability And House Prices

The Reserve Bank of New Zealand has a financial stability mandate. If you go over to their recently redesigned website you’ll find a plethora of information about their oversight of banks, insurers and non-bank deposit takers (that’s finance companies and the like).

But what you ought to know about financial stability is that there is only so much that the Reserve Bank can do. Just because there is regulation and frameworks that have a goal of financial stability, does not mean that there actually is financial stability.

I believe that many people have no idea about what financial stability is, and how policies to achieve that sort of objective interact with their banking relationships and insurance relationships. Reading the latest Financial Stability Report would go right over the heads of many people that sort of information is produced to protect.

The other day I shared with you my thoughts on Basel III and how that has an impact on capital allocation in the economy. The higher capital and liquidity requirements mean there is a bias towards secured mortgage lending over business lending for example.

But here in New Zealand, the Reserve Bank is making judgments that I consider to be outside its purview. Here is a selection of quotes from that report’s introduction that concern me:

  1. New Zealand’s elevated exchange rate is also continuing to hinder a rebalancing of domestic activity towards the tradables sector, which would assist in reducing external vulnerabilities.

  2. Despite the higher capital buffers, rising house prices are creating risks for the New Zealand financial system, by increasing both the probability and potential impact on bank balance sheets of a significant house price adjustment. The greater willingness of banks to approve high loan-to-value ratio (LVR) mortgages has further increased the potential adverse impact of a fall in house prices.

  3. This [limits on high LVR lending] will strengthen the capacity of the banking system to weather a housing downturn, and should also lead the banks to review the riskiness of the loans they are currently writing.

  4. The Reserve Bank’s aim would be to apply the restrictions at times when high-LVR lending was judged to be posing a significant risk to financial system stability.

These are just some quotes that jumped out at me and set off alarm bells in my head. You should be concerned that the Reserve Bank thinks it can identify when price increases are in response to supply side contraints as opposed to “naughty” types of demand like speculation and residential property investment 😉

Why should you be concerned? Because there is no evidence that any central bank in the world has ever successfully identified the peak of a market cycle and adjusted its policy in such a way that a “crisis” was averted.

We need to think about what sort of buyer ends up in a high loan-to-value mortgage. Then we need to think about the reasons why house prices are so high relative to incomes. Then we need to read the NZ Initiative’s report on how all of the little rules and regulations around housing have halved the average number of houses built in this country to half of what needs to be built just to cover population growth.

We also need to think about changes in the rate of family formation and how that affects the number of houses and apartments that must be built. Deferred marriage and children means way more apartments are currently needed than are currently available. It also means that many couples are less able to save for a house because supply side restrictions jack up their rent and their income growth is not what they thought it would be when they left university or trades training.

All of these things matter when it comes to the price of houses – yet although I’m sure RBNZ officials are aware of them, they do not seem to realise how premature action on property lending could cut off the desperately needed supply side response before it even begins.

When BNZ Chief Economist Tony Alexander wrote a big wishlist of policy that could fix housing, I could not help but think about the most obvious reason there has been a slow supply side response to higher demand for housing in Auckland – his bank and other big banks pulled the plug on umpteen numbers of property developers and small time investors because of the GFC and the need to reduce risk.

The Reserve Bank does not want to acknowledge the role that the financial system plays in allocating capital. Mum & dad investors (the notional investor, as finance company judgments called them) are unlikely to invest in property developments. The only way for houses to be built in an industry that depends on credit is when the banks lend to builders and developers. That is not happening nearly as much as it should.

There are a lot of skilled people in construction sitting on the sidelines because the people that employ them can’t obtain funding even though there are clear supply side issues. It is a capital allocation failure that pursuit of financial stability at all costs will only make worse.

In fact, the concept of the “counter cyclical buffer” that would require banks to reduce lending and raise more capital if the RBNZ judges the economy to be in a “boom” does not come with any discussion of price rises as a price signal for more supply attached.

That should terrify you. There are hundreds of thousands more people in Auckland than anyone predicted over the past few decades. There is obviously a massive increase in demand from domestic migration to Auckland before taking overseas migration into account – Auckland is where most of the jobs are.

I am skeptical of the idea that more rules and regulations around financial stability will do anything to actually attain financial stability. Financial stability is a nebulous policy objective that runs the risk of thwarting any recovery in the economy. The near absence of funding for supply side responses to increased demand for housing is a function of risk reduction at the banks.

The collapse of many finance companies didn’t help things either. No matter what you think about them, and property developers, riddle me this – if finance companies had not provided billions of funding to developers that the banks didn’t want to touch, how much higher would house prices be now?

In the case of Auckland apartments, if all of those oft-disparaged “shoebox” apartments hadn’t been funded, can you imagine how much worse the housing situation in Auckland would be?

If you think the Reserve Bank is possessed of some special knowledge that enables it to call a “bubble” in the pursuit of financial stability, I have some finance company bonds with negligible risk premium to sell to you.

Why Time Consistent Monetary Policy Matters

The other week I explained why Bernard Hickey is wrong about the likelihood of the Greens, NZ First and Labour changing the Reserve Bank’s mandate and reducing central bank independence.

One of the reasons why central bank independence is important is because it affects inflation expectations. When inflation is expected to be higher, the nominal interest rate will increase to account for inflation lowering the real value of money lent to the government.

What this means for the New Zealand government’s finances is that the cost of servicing debt will rise. This means that in exchange for chasing after kooky policy goals like full employment and lowering the exchange rate, there is an increase in the risk premium on New Zealand government debt.

Time consistency of policy is an economic concept that in order for the government and Reserve Bank to be taken seriously, they have to commit to a policy in advance and not suddenly change their tune.

The Reserve Bank currently does this through their regular statements that accompany Official Cash Rate decisions and a plethora of working papers, articles and market updates throughout the year that give a clear indication of what the Reserve Bank thinks on topical monetary policy issues.

If the troublesome troika get their hands on rewriting the Reserve Bank Act after 2014, a substantial rise in the risk premium payable ultimately by taxpayers through lower government spending and higher taxes, is inevitable.

The independence of the Reserve Bank and provisions of the Public Finance Amendment Act mean that the New Zealand government can borrow to finance deficit spending but nowhere near to the extent that many other countries can.

In effect, there is a built in dilution effect that means kooky ideas cannot run their true course. A Greens/Labour/NZ First coalition would not be taken seriously by market participants. When that scenario becomes likely as John Key’s popularity subsides, forward interest rates and exchange rates will reflect that.

Any step towards reducing the Reserve Bank’s independence runs the risk of far higher debt servicing costs for the government. This means less money for things New Zealanders care about like welfare and hospitals, and a widening revenue gap needing to be plugged by higher taxes.

Bernard Hickey Is Wrong About Market Reaction

In the Herald over the weekend, Bernard Hickey argued that because Labour, NZ First and the Greens have realised the importance of monetary policy and its relationship to key macroeconomic variables, they will undermine how the Reserve Bank conducts monetary policy.

The problem with our system is that we think that all opinions are equal. The intellectual deficits present in Labour, NZ First and the Greens have been truly exposed with their calls for kooky ideas that are completely unjustified and have been proven in the real world to cause terrible side effects. Arguing for exchange rate intervention is an example of the stupidity we could expect if politicians had more influence on how monetary policy operates.

I am pleased that Graeme Wheeler has made it clear what job goals as Reserve Bank governor is – using inflation targeting as the monetary policy tool of the day and eschewing calls to intervene in the exchange rate and monetise government debt. Complaining that the Reserve Bank doesn’t make decisions by committee is childish in the extreme. Almost every other central bank in the world is worse than the RBNZ. They are extremely credible and a central reason for that is their strict adherence to their statutory mandate in the Reserve Bank Act.

There is no doubt that monetary policy is linked to our housing bubble in the 2000’s and a resurgent housing market. But to adjust monetary policy now by adding slippery targets on unemployment numbers, what the exchange rate should be and how much house prices should be defeats the entire purpose of having a reasonably independent central bank. Gareth Morgan’s comments that they should all be fired for incompetence are so far off the mark it’s not even funny.

With respect to housing, while increased M3 has enabled banks to lend more on housing, that’s them simply responding to incentives. There is an enormous demand for housing loans, there are severe supply restrictions on housing and loan-to-value ratios are not regulated so poor people who have no business buying a house easily qualify for 95% mortgages.

Did we not learn anything from the sub-prime debacle in the United States? One of the key drivers behind lax regulation around new mortgage lending was the “housing affordability” and “owning a home makes you a real American” nonsense. Just because many people can’t afford to buy a house doesn’t mean that the OCR should be lowered to stimulate more investment in housing. A lot of that extra credit will sit on bank balance sheets for their own risk-free carry trades.

If the markets really were spooked about the possibility of Graeme Wheeler having the Policy Targets Agreement rewritten by a troika of populist politicians, they would be pricing that risk in now. The 3 year bond rate would have spiked some time after October 26 and the drama-filled select committee meeting. Using the data at we see that since the 26 October speech by Graeme Wheeler the change in bond rates has been negligible. And here’s a nicer chart from Westpac that fits out time frame just nicely:

The risk premium for New Zealand debt has barely changed either. So what gives? If there was any likelihood of economic kooks coming to power, that risk premium would have shot up. So would the price of NZ government debt CDS swaps. If expectations were that the exchange rate would be lower then that would be reflected in the March 2014 NZD/USD futures. They’ve barely dropped a cent over the past month.

Non-residents own about $28 billion of the $72 billion of government debt on issue. If what Bernard Hickey is saying was credible – the risk of lower yields in future – why was there no rapid capital flight? We have extremely free movement of capital these days and if overseas institutions wanted to they could drop billions of dollars in NZ government debt in an afternoon.

The truth is that if market participants were thinking like Bernard Hickey, there are about 4-5 different things they would have done to lower the risk of any changes in monetary policy impacting on the capital they have invested in New Zealand.

Bernard’s column is sadly unique in that no one actually thinks Labour, NZ First and the Greens will get anywhere near destroying the independence of the Reserve Bank. In not arguing that the policy changes Labour, NZ First and Greens are proposing fall into the category of kooky economics, he is ignoring the reality that quantitative easing reinforces inequality, makes housing affordability even worse and lowers real money balances.

If the market starts pricing in the possibility of kook monetary policy being implemented, I’ll revise my opinion. Needless to say I’ll be watching the yield curve and forward exchange rate numbers with interest.