Thursday, 11 May 2017

No change to interest rates? Really?

Today's Monetary Policy Statement wasn't quite what I expected.

I thought we'd get something along the lines of, "One quarter's CPI is neither here nor there, so we'll wait and see if the June one is also unexpectedly high, but if the March quarter outcome is repeated, we'll probably start raising the OCR a bit earlier than we've previously indicated". Instead we got exactly the same projected track for the OCR as we had in the February Statement - no increase until late 2019, and then only one 0.25% increase.

Can't see that happening, myself, and neither can the financial markets. Today's 90 day bank bill yield is just below 2%: the futures market has it at 2.77% by the end of 2018, which would be equivalent to three 0.25% increases next year. The futures market can be a flighty beast, and futures sentiment can change quickly, but having had the best of today to think about it, it's currently saying there it doesn't believe a word of "nothing till late 2019".

What explains the gap in viewpoints?

Three things, I'd reckon.

One is the possibility - I'd put it no stronger - that the Bank is institutionally scarred by its premature tightening in 2014. It wasn't, in my view, a strange thing to have done at the time, but as things panned out it had to be reversed (and then some). So it's possible that the Bank has decided, whatever mistakes it's going to make in the future, premature tightening isn't going to be one of them. The risk, though, is that it gets "behind the curve", as the jargon goes, chasing after inflation that's got away from it.

The second is that we're actually at an inflexion point in trend inflation - it's been unusually low, but is on the turn - and turning points are notoriously hard to pick in real time. I'm not surprised that "uncertainty" and its variants turned up 38 times in the Statement. So these are genuinely tricky times for the Reserve Bank, and irrespective of whether it is battle scarred or not, it might well want to wait for clearer signals.

For what it's worth, I think the inflation tide is definitely coming in. I like to look at non tradables inflation, ex the cost of new houses, as a rough and ready guide to domestically generated inflation pressures (the only ones the Bank can ultimately influence). As the graph shows (and I've included an alternative, non tradables ex housing and ex household utilities, as an extra perspective), domestic inflation is on the up.


The third is even trickier again: what if the economy isn't behaving the way it used to? As the Bank found on its latest visits to businesses, "wage pressure remains surprisingly limited". It's not clear whether the employers, or the Bank, were surprised - maybe both - but in these strong cyclical conditions, on past experience, people would be asking for pay rises and threatening to move on if they didn't get them.

But "on past experience", that's the thing. As the visits found (p26 of the Statement), "Contacts suggested this may in part reflect the negative impact of the GFC on employees’ expectations of wage growth and employers’ willingness to offer substantial wage increases". I have some sympathy for this view that the post-GFC world is (at least for now) structurally different to the pre-GFC one, though not quite enough to believe it has changed enough for the Bank to leave policy "accommodative for a considerable period". We'll see.

Two final thoughts. Businesses also reported that "it is difficult to find workers with the right skills", which may be partly cyclical (the one with the skills are already spoken for) but also, I suspect, reflects all not being entirely well with our education system and our 'active' labour market policies. And they said that they "also expected to increasingly look offshore for labour": I don't expect this will make a blind bit of difference to the current anti-immigration sentiment and its backers,  but it's a reminder that tightening up immigration in a boom labour market doesn't look like the smartest idea.

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