Transcript: Oliver Hartwich and John McDermott discuss winding back the overhang of monetary stimulus

Dr Oliver Hartwich
Dr John McDermott
Podcast
4 July, 2022

In this week's podcast Dr Oliver Hartwich chats with Dr John McDermott, Executive Director of Motu and former Assistant Governor and Chief Economist at the Reserve Bank of New Zealand about monetary policy in New Zealand, the overhang of monetary stimulus from the last few years, and what will happen if we don't wind this back.

 

OLIVER HARTWICH

0:05

Hello and welcome to the New Zealand Initiative’s Podcast. My name is Oliver Hartwich and today we are joined by John McDermott. And John is the Executive Director of Motu. It’s a research organization, a consultancy here in Wellington. But perhaps more importantly for the conversation that we’re having today, he was also the chief economist at the RBNZ, and he was an Assistant governor at the RBNZ. And we want to talk about monetary policy in New Zealand. Welcome, John.

JOHN MCDERMOTT

0:30

It’s a pleasure. Thank you for having me.

OLIVER HARTWICH

0:32

It’s great to have you on our podcast. I’ve invited you after reading one of your columns in the NBR a couple of weeks ago where you talked about the overhang of all the monetary stimulus from the last couple of years, the quantitative easing that we’ve seen, and how difficult it is to wind this back and what would happen if we don’t wind it back. Can you explain to our listeners what’s happened?

JOHN MCDERMOTT

0:57

Well, I’ll try. Lots of things have happened. If you go back to 2020, there was a lot of pressure on the central bank. The financial system was gumming up because of the concerns around COVID, so they had to do something.

OLIVER HARTWICH

1:11

So, we are talking about March, April 2020.

JOHN MCDERMOTT

1:13

Yeah. And the first thing they’re looking at is the banking system itself was getting very nervous about what might happen. It was very uncertain. So, there’s a few policy responses. One is the traditional let’s cut interest rates, support demand. But in addition, they also wanted to do quantitative easing because they got interest rates very low. And the first stage of that was actually to buy government bonds.

OLIVER HARTWICH

1:37

And that was one of the announcements quite early on in the COVID crisis. And I mean, you were probably there at the time of the GFC that reminded many of observers of what happened in the GFC, right?

JOHN MCDERMOTT

1:50

Similar to other countries in the GFC. New Zealand didn’t have to do that at that time. It had a much more traditional monetary policy. Didn’t have to do QE

OLIVER HARTWICH

1:59

Because it also came from a much higher rate at the time. Correct, correct.

JOHN MCDERMOTT

2:05

And then you were looking at the scale of the bond purchasing program in New Zealand. It was very large relative to the size of our economy.

OLIVER HARTWICH

2:14

It was about $20,000 per head.

JOHN MCDERMOTT

2:16

Yeah, very large. And you think about the scale of it relative to the fact that the slowdown in New Zealand wasn’t as bad as other countries. The period of lockdown was much shorter and the public health problems were constrained, fortunately, but it was very uncertain. So maybe, maybe not, but it was very large.

OLIVER HARTWICH

2:39

At what time during 2020 did it become clear to you that actually the economic emergency is not quite as large as people thought it might be back in March?

JOHN MCDERMOTT

2:49

So, at the time, I was actually doing some work on COVID on what was happening, and I was actually on national radio at about day twelve of the lockdown, saying, this has now been effective. We’re going to get rid of COVID from our community. It’s going to work. There’ll be a bit of a tail. So, you can start thinking about from day twelve of the lockdown, the first stage of the emergency was over. And it was about, what, 28 days of lockdown? Or there about, I forget the exact number, but certainly once we were out of lockdown, the economy was rebounding very fast, and the financial system was no longer in panic.

OLIVER HARTWICH

3:30

That’s right. And there was also, of course, a lot of not just monetary stimulus, but fiscal stimulus as well.

JOHN MCDERMOTT

3:36

Yeah. And some of that was to protect vulnerable businesses, businesses who had been forced to lock down. So that was a regulated market failure for a public policy reason or for public health reason. And so, the government decided, what we’re going to support them. So fiscal policy, I think, unusually, was rapid. It was temporary and timely, and that fiscal policy lingers, and it carries on and you build up the debt. But there was no reason beyond the first month or a couple of months to continue with emergency monetary policy.

OLIVER HARTWICH

4:07

So basically, by May 2020, it became clear that apart from education, exports, and tourism, obviously the rest of the economy basically was unscathed.

JOHN MCDERMOTT

4:19

Correct. And things were coming back rapidly. Confidence was coming back. And you know those sectors you mentioned, there’s very little that monetary policy could do about that anyway. What was more amazing, though, is the central bank started to talk about negative interest rates.

OLIVER HARTWICH

4:36

They had talked about this in 2019 already, I remember.

JOHN MCDERMOTT

4:39

Which seemed unnecessary at that time. They started to have the banks, probably at great expense, get ready for this policy initiative. And it was difficult. And then the one thing additionally they did is start to introduce funding for lending. So, this wasn’t buying government bonds, this was allowing the banks to come to the central bank and borrow money. But that wasn’t in effect until December 2020, well after it was needed.

OLIVER HARTWICH

5:07

So, what has all of this done to New Zealand’s monetary base?

JOHN MCDERMOTT

5:10

So, the monetary base, typically before this, was very stable, quite steady, at about $15 billion. It’s now just a bit short of $60 billion.  So, we’re talking about a nearly four times increase.

OLIVER HARTWICH

5:27

What should happen then, when the emergency is over, is of course, that you would try to bring the monetary base back to where it should have been without the emergency. But that’s not what’s happening right now.

JOHN MCDERMOTT

5:39

No. And it’s quite astonishing. And despite the fact the central bank knows and accepts there’s an inflation problem because of this,

OLIVER HARTWICH

5:45

It’s quite visible now.

JOHN MCDERMOTT

5:46

And everybody’s feeling it, absolutely. And they’re raising interest rates, so you would expect the monetary base would be normalising, and it’s not. It’s actually still increasing and nobody’s talking about it. It’s quite astonishing.

OLIVER HARTWICH

6:01

How unusual is that actually, compared to other central banks around the world? Are they trying to reduce their monetary base or are they also still in this mode where they’re pumping in more liquidity into the markets?

JOHN MCDERMOTT

6:33

Yeah, great question. So now the central bank has said it has stopped buying bonds. So, you think it would have stopped increasing the monetary base. We’ll talk about why that’s not the case. You look at other countries that started to do similar things, maybe after the Reserve Bank of New Zealand, but already their monetary bases are in decline. Now they’ve got a long way to go, but they’ve actually turned a corner. What’s different here is our monetary base is still increasing.

OLIVER HARTWICH

6:38

And we’re talking especially about the Federal Reserve. So, the Federal Reserve actually, if you’re going through their monetary base statistics, you can see that after the GFC, they were already trying to bring that back, the monetary base. And of course, they had a massive jump in 2020 like everybody else. But now they are trying to bring this back down again. Probably because of America’s experience of the Faulk years. They don’t want to have that kind of rapid change again. But in New Zealand, and probably at the ECB as well, they are still in this territory where they’re increasing the monetary base for all sorts of political reasons. Would you agree with that?

JOHN MCDERMOTT

7:15

Now, so the Fed is slightly easier to understand. They’ve gone through a few phases. One is inflation has gone up, but it will be temporary. We don’t want to react so violently to disturb the real economy or the labor market. So, we’ll let it run a little bit. Then they’ve gone, oops sorry we’re wrong. I think they got to the point where there’s a recognition that that was a mistake. They’ve now focused on price stability, which will come into parts. One will be increasing interest rates and they’re already on the move. The other one is, as they stop their bond purchasing program, they’ll allow the monetary base to actually roll over. And they’ve already seen this, so that the Fed’s balance sheet is starting to shrink, and it will accelerate from here.

OLIVER HARTWICH

7:58

Quite a bit already from the peak.

JOHN MCDERMOTT

7:59

Yeah, and so that’s the right thing to do. ECB, very complicated. In the time we have I can’t explain all this because it’s a

OLIVER HARTWICH

8:07

Oh, I appreciate that.

JOHN MCDERMOTT

8:09

So, there’s many countries under a single system. Each of them have followed different fiscal paths, have different debt profiles. So, some of them are in really good shape, can sustain an interest rate increase, which is needed to control inflation across the Eurozone. Absolutely. But there are some other countries with very high debt profile, government debt profile, who are very vulnerable, and the market looks at that and says, you can’t sustain it and we’re going to bet against you. And so, they’re very high risk.

OLIVER HARTWICH

8:38

Okay, so if you’re looking by comparison, at the two largest central banks in the world, the Federal Reserve is already trying to get out of this. The ECB, for various political reasons, is unable to do it. But New Zealand should be able to do what the Americans do, and yet they are basically doing what the Europeans do.

JOHN MCDERMOTT

8:54

We should have been reversing that monetary base in late 2020. At the latest. And look, it wasn’t impossible. So other countries have done this. So, if you look at what Norway did, wonderful example of emergency lending. They increased the monetary base more than New Zealand, and they’re back to normal. So, they recognised that this was an emergency. You increase an emergency, the emergency is finished, and you go back to normal settings.

OLIVER HARTWICH

9:19

And what did it do to the Norwegian krone and to inflation in Norway?

JOHN MCDERMOTT

9:25

So again, they had a spike. So inflation was coming back to normal. It sort of jumped about four-ish, or a little bit higher, was coming back to three. They would have had a cured inflation problem. Unfortunately, they’re right next to now what is a war zone, and so higher energy prices have pushed it back up again.

OLIVER HARTWICH

9:47

On the other hand, of course, they’re big energy exporter, Norway. So, in a way, for in terms of trade, that would have been quite a positive in that sense.

JOHN MCDERMOTT

9:55

Yeah, but what I’m saying is, in terms of the inflation problem, they liquefied the system. They got a little bit of inflation, but they removed the inflation problem would have been down to three or 2% by now had it not been for other factors that came along just later.

OLIVER HARTWICH

10:10

Okay, so you said before COVID, we had a monetary base of about 15 billion.  In a normal year, that would have probably gone up by two, three, 4%, something like that. So, without COVID, we would still be at around 15 and a half, maybe 16 billion. Instead, we had 60. And that means we have to now shrink this back by more than 40 billion dollars. If we don’t do that, what is going to be the outcome?

JOHN MCDERMOTT

10:35

So, imagine a world, it’s hard to imagine, but imagine a world where you just keep it at near 60 billion. So, we don’t do anything. Well, your price level has to adjust to accommodate that. So, your price level has to move up by a factor of four. Now, assuming that doesn’t happen all at once, that would be kind of crazy. If you move inflation at 7% a year, your price level will double every decade. So, it would take two decades to adjust. So, you could still have 20 years of 7% inflation.

OLIVER HARTWICH

11:09

Right. Will it actually take 20 years of constant seven percent inflation? Or do you think that at some stage it becomes a spiral?

JOHN MCDERMOTT

11:19

All I was doing was the original. Of course, if you allow that to happen, you change everybody’s expectations if you don’t make the policy adjustment. Now, I really do think

OLIVER HARTWICH

11:33

And they’re making some adjustments aren’t they.

JOHN MCDERMOTT

11:35

Yes. Let’s just go back to the funding for lending program, because that was something I did highlight. This was something that was put in place where they made a commitment that it would last for two years. I don’t know why you would do that. Because it should be in place while there’s an emergency. That’s what should have been done. So, it’s still in place. Banks can borrow on three-year terms. The interest rate they are charged is the official cash rate. Now, if you look at

OLIVER HARTWICH

12:03

It’s, very convenient for the banks.

JOHN MCDERMOTT

12:06

It’s fantastic. Not just convenient, it’s fantastic because let’s have a think about if they went elsewhere to borrow three-year money, they’d have to pay the market rate, which is the reference rate, would be the three-year swap rate. At the time I was writing the column, it was like 200 basis points higher than the official cash rate. So, this is a subsidy to the banks.

OLIVER HARTWICH

12:28

This is roughly also what happened in the Eurozone, of course, with a longer-term refinancing operation. So basically, where the ECB says you can borrow as much as you like at a zero rate under the condition that you invested into Italian ten-year bonds.

JOHN MCDERMOTT

12:43

The right principle for emergency lending is to lend freely. Look, you don’t want your financial system to gum up, you really want to protect it.

OLIVER HARTWICH

12:51

But you do it at a penalty rate.

JOHN MCDERMOTT

12:52

You do it at a penalty rate. At the very least, you should have done it at a market rate. So right now, the banks have no incentive to back away from this. And this is why it’s difficult or now impossible to actually get rid of the monetary base.

OLIVER HARTWICH

13:08

That also happened, if I remember correctly, in 2020, against the backdrop of the government underwriting some of the bank’s lending.

JOHN MCDERMOTT

13:15

But again, the policy was put in place during an emergency. Again, to protect a run on the system. No problem with actually thinking about the central bank being a lender of last resort. That’s what it’s there for. But you do it while there’s an emergency, you lend freely, and you land at a rate that starts to encourage the banks, when things are normal, to stop using that emergency funding.

OLIVER HARTWICH

13:39

And now I would like to know from you why this was allowed to happen. I mean, the question I ask myself is, is any such policy possible, even with an independent Reserve Bank, without implicit political backing of the Minister of Finance?

JOHN MCDERMOTT

13:55

So, the first part of your question was why was this allowed to happen? It’s like that’s a major puzzle.  I have no idea. So, the government offered an indemnity. So, the Central Bank was relieved of all financial liability here. There’s pluses and minuses with that, one is good in an emergency for the Minister of Finance to stand behind Central Banks saying this is a tough time, they’re doing some tough policies, they have my backing. I kind of understand that. But the nature of that indemnity probably left for soft thinking.

OLIVER HARTWICH

14:32

The indemnity, by the way, by now would have cost us as taxpayers about $8 billion, according to Michael Riddell.

JOHN MCDERMOTT

14:39

$8 billion. That’s real money. That’s an opportunity cost that we’ve lost. So Central Bank has actually lost $8 billion.

OLIVER HARTWICH

14:47

Technically speaking, they would be insolvent if they didn’t have that indemnity. Right?

JOHN MCDERMOTT

14:52

Yeah. But on the flip side, whose gained in part, now the government is allowed to issue government bonds at a rate that’s kind of cheaper because of that. So, the overall loss to the crown is probably less than $8 billion. But at some point, why the central bank wants to hold onto those when it’s causing an inflation problem is kind of crazy.

OLIVER HARTWICH

15:12

Okay, but back to the question, how was this allowed to happen? There is the Monetary Policy Committee, of course. So, it’s no longer just a Reserve Bank governor making these decisions. They should have seen this coming. They should have seen in mid-2020 that they were probably over stimulating. They should have also seen the problems with the longer-term lending policy. And they didn’t, they didn’t do anything. It took them another year until they carefully started making noises about perhaps bringing this to a close

JOHN MCDERMOTT

15:43

And also, the sequencing. So, when you’re thinking about it, we’ve liquified the system, we’ve got very low interest rates, we’ve increased the monetary base, we no longer need it. What you would expect to have happened without an indemnity is the central bank doesn’t want to make a financial loss. So, what it would have done is thinking about well I’ve done these two things, I’ve got lowered interest rates and I’ve issued, I’ve issued all this cash into the system. When I hold these bonds, I’m going to lose money. So, I should have actually sold the bonds first then moved interest rates. That would have avoided the financial loss. It would have been the right thing to do in terms of inflation control.

OLIVER HARTWICH

16:21

Yes, and it would have made sense.

JOHN MCDERMOTT

16:25

It would have made sense. So somehow the analytic thinking was lost, and this was never discussed. So, the reason I can’t answer your question this was never discussed in a monetary policy statement. This was never discussed in a speech. We got some vague statements about a lending for funding program that we have to keep it in place because we promised to keep it in place.

OLIVER HARTWICH

16:45

Right. That doesn’t make any sense whatsoever.

JOHN MCDERMOTT

16:47

It’s circular thinking. No, and so that promise should have never been made. The promise should have been we’ll keep it in place as long as we need it which is as long as the emergency lasts.

OLIVER HARTWICH

16:56

Right. So, you’ve got the bank’s self-interest not to incur any losses on their programs okay. Even though indemnified. But at the very latest when the inflation expectations signal that there’s something happening in the market and people actually think that inflation is going to go up that would have been the last point actually where the bank should have actually reversed.

JOHN MCDERMOTT

17:18

Yeah, correct and again the sequencing would have been to fix your monetary base.

OLIVER HARTWICH

17:24

Don’t allow the expectations to spiral out of control.

JOHN MCDERMOTT

17:26

Yes, given that you’re starting to lose control there already the sequencing should have been let’s fix the monetary base, let’s get that back to normal. So, two things. Stop buying government bonds, they did that reasonably early, I would have done it earlier but still, sell some to the market. That produces your monetary base and actually puts interest rates up at the point where it affects business and consumer lending. So, it has the right effect. Stop the funding for lending program or at the very least, move the interest rate to a market rate, right and then after all that then you can start moving your policy rate

OLIVER HARTWICH

18:04

Okay, but where we are now all of this didn’t happen it is probably too late. Where does it leave the RBNZ today? How much credibility does it still have for price stability? Given the fact that it actually missed the boat on all of these different measures.

JOHN MCDERMOTT

18:21

And now it’s in a tough place, inflation is already out of control. Expectations have moved, they are moving interest rates aggressively to try and cure this problem. But that’s going to leave the country with a recession that we didn’t need to have.

OLIVER HARTWICH

18:36

Does it matter then, in the long term that the current leadership of the Reserve Bank and the Monetary Policy Committee probably lost credibility for price stability and therefore they will have to work twice as hard now to regain it? So, in that sense they would have to increase interest rates much more than a Reserve Bank with the right credibility would have to do.

JOHN MCDERMOTT

18:55

That’s what I was saying. Once inflation is running, you know, at 7% it’s really hard to bring it back. Already firms and businesses will be saying we have to compensate our employees. That’s going to cost us 7%. They give them a 7% pay rise but they go my cost of production has gone up, I now have to increase my prices and people are doing that. That’s already happening. To break that psychology, you have to alter economic conditions and so interest rates are going to be way, way higher than otherwise would have been the case.

OLIVER HARTWICH

19:24

So, is that your forecast? That we can expect the RBNZ now to increase interest rates massively over the next year or two?

JOHN MCDERMOTT

19:33

So, we’ll continue to increase interest rates. We will have a weaker economy. I think it’s still possible to cure inflation. We can still get on top of it in terms of moving interest rates, the Reserve Bank, he was probably one of the first people probably looking at it as being serious, but part of the game is they want a demonstration effect.

OLIVER HARTWICH

19:55

Yes, and actually, on that, can I just ask, I have seen quite a few pieces of commentary, especially in international newspapers, but also some commentary here in New Zealand, where commentators said, well, look at the Reserve Bank. They are doing a fantastic job because they’re now leading the way. They are showing the world how to fight inflation. And I find this ironic because they’re only fixing their own mistakes and now, they’re getting praised for that.

JOHN MCDERMOTT

20:21

Well, they’ve moved interest rates before the central banks. That’s all they’ve done. But they are laggards in the other space and they’re allowing the monetary base to increase when others are already fixing it. So, they’re not at the front of where they’re need to be.

OLIVER HARTWICH

20:36

Well, then let’s hope that they can regain some of that credibility for price stability. But thank you very much, John, for joining us today.

JOHN MCDERMOTT

20:51

My pleasure.

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