Economics and Banking – Page 447 – Digital Finance Analytics (DFA) Blog

BIS On Financial Regulation

Interesting panel remarks at the IMF conference “Rethinking macro policy III: progress or confusion?” by Jaime Caruana, General Manager, Bank for International Settlements in Washington DC. The comments were entitled “The international monetary and financial system:eliminating the blind spot”.

Introduction

Thank you for inviting me to discuss the international monetary and financial system (IMFS) at this engaging conference. The design of international arrangements suitable for the global economy is a long-standing issue in economics. The global financial crisis has put this issue back on the policy agenda. In my panel remarks, I would like to concentrate on an important blind spot in the system. The current IMFS consists of domestically focused policies in a world of global firms, currencies and capital flows – but are local rules adequate for a global game ? I shall argue that liquidity conditions often spill over across borders and can amplify domestic imbalances to the point of instability. In other words, the IMFS as we know it today not only does not constrain the build-up of financial imbalances, it also does not make it easy for national authorities to see these imbalances coming.

Certainly, some actions have been taken to address this weakness in the system: the regulatory agenda has made significant progress in strengthening the resilience of the financial system. But we also know that risks and leverage will morph and migrate, and that the regulatory response by itself will not be enough. Other policies also have an important role to play. In particular, I shall argue that, in order to address this blind spot, central banks should take international spillovers and feedbacks – or spillbacks, as some may call them – into account, not least out of enlightened self-interest.

Local rules in a global game

Let me briefly characterise the present-day IMFS, before describing the spillover channels. In contrast to the Bretton Woods system or the gold standard, the IMFS today no longer has a single commodity or currency as nominal anchor. I am not proposing to go back to these former systems; rather, I will argue in favour of better anchoring domestic policies by taking financial stability considerations into account, internalising the interactions among policy regimes, and strengthening international cooperation so that we can establish better rules of the game.
So what are the rules of the game today? If there are any rules to speak of, they are mainly local. Most central banks target domestic inflation and let their currencies float, or follow policies consistent with managed or fixed exchange rates in line with domestic policy goals. Most central banks interpret their mandate exclusively in domestic terms. Moreover, the search for a framework that can satisfactorily integrate the links between financial stability and monetary policy is still work in progress with some way to go. The development and adoption of such a framework represent one of the most significant and difficult challenges for the central bank community over the next few years.

When one looks at the international policy discussions, the main focus there is to contain balance of payments imbalances, with most attention paid to the current account (ie net flows) and not enough attention to gross flows and stocks – ie stocks of debt. This policy design does not help us see – much less constrain – the build-up of financial imbalances within and across countries. This, in my view, is a blind spot that is central to this debate. Global finance matters – and the game is undeniably global even if the rules that central banks play by are mostly local!

International spillover channels

Monetary regimes and financial conditions interact globally and reinforce each other. The strength and relevance of the spillovers and feedbacks tend to be underestimated. Let me briefly sketch four channels through which this happens. The first works through the conduct of monetary policy: easy monetary conditions in the major advanced economies spread to the rest of the world via policy reactions in the other economies (eg easing to resist currency appreciation and maintain competitiveness). This pattern goes beyond emerging market economies: many central banks have been keeping policy interest rates below those implied by traditional domestic benchmarks, as proxied by Taylor rules.

The second channel involves the international use of currencies: most notably, the domains of the US dollar and the euro extend so broadly beyond their respective domestic jurisdictions that US and euro area monetary policies immediately affect financial conditions in the rest of the world. The US dollar, followed by the euro, plays an outsize role in trade invoicing, foreign exchange turnover, official reserves and the denomination of bonds and loans. A key observation in this context is that US dollar credit to non-bank borrowers outside the United States has reached $9.2 trillion, and this stock expands on US monetary easing. In fact, under this monetary policy for the United States, US dollar credit has been expanding much faster abroad than at home (Graph 1, top right-hand panel).

Third, the integration of financial markets allows global common factors to move bond and equity prices. Uncertainty and risk aversion, as reflected in indicators such as the VIX index, affect asset markets and credit flows everywhere. In the new phase of global liquidity, where capital markets are gaining prominence and the search for yield is a driving force, risk premia and term premia in bond markets play an important role in the transmission of financial conditions across markets. This role has strengthened in the wake of central bank large-scale asset purchases. The Federal Reserve’s large-scale asset purchases compressed not only the US bond term premium, but also long-term yields in many other bond markets. More recently, the new programme of bond purchases in the euro area put downward pressure not only on European bond yields but apparently also on US bond yields, even amid expectations of US policy tightening.

A fourth channel works through the availability of external finance in general, regardless of currency: capital flows provide a source of funding that can amplify domestic credit booms and busts. The leverage and equity of global banks jointly drive gross cross-border lending, and domestic currency appreciation can accelerate those inflows as it strengthens the balance sheets of local firms that have financed local currency assets with US dollar borrowing. In the run-up to the global financial crisis, for instance, cross-border bank lending contributed to raising credit-to-GDP ratios in a number of economies.

Through these channels, monetary and financial regimes can interact with and reinforce each other, sometimes amplifying domestic imbalances to the point of instability. Global liquidity surges and collapses as a result. What I have just described is the spillovers and feedbacks – and the tendency to create a global easing bias – with monetary accommodation at the centre. But these channels can also work in the opposite direction, amplifying financial tightening when policy rates in the centre begin to rise, or even seem ready to rise – as suggested by the taper tantrum of 2013. Nevertheless, it is an open question whether the effect of the IMFS is symmetric in this regard, creating as much of a tightening bias as it does an easing bias. In both cases, it is important to try to eliminate the blind spot and keep an eye on the dynamics of global liquidity.

Policy implications: from the house to the neighbourhood

This leads to my second point, that central banks should take the international effects of their own actions into account in setting monetary policy. This takes more than just keeping one’s own house in order; it will also require contributing to keeping the neighbourhood in order. An important precondition in this regard is the need to continue the work of incorporating financial factors into macroeconomics. If policymakers can better manage the broader financial cycle, that would in itself already help constrain excesses and reduce spillovers from one country to another.

But policymakers should also give more weight to international interactions, including spillovers, feedbacks and collective action problems, with a view to keeping the neighbourhood in order. How to start broadening one’s view from house to neighbourhood? One useful step would be to reach a common diagnosis, a consensus in our understanding of how international spillovers and spillbacks work. The widely held view that the IMFS should focus on large current account imbalances, for instance, does not fully capture the multitude of spillover channels that are relevant in this regard.

An array of possibilities then presents itself in terms of the depth of international policy cooperation, ranging from extended local rules to new global rules of the game. To extend local rules, major central banks could internalise spillovers so as to contain the risk of financial imbalances building up to the point of blowing back on their domestic economies. Incorporating spillovers in monetary policy setting may improve performance over the medium term. This approach is thus fully consistent with enlightened self-interest. The need for policymakers to pay attention to global effects can be seen clearly in the major bond markets. Official reserve managers and major central banks hold large portions of outstanding government debt.

If investors treat bonds denominated in different currencies as close substitutes, central bank purchases that lower yields in one bond market also weigh on yields in other markets. For many years, changes in US bond yields have been thought to move yields abroad; in the last year, many observers have ascribed lower global bond yields to the ECB’s consideration of and implementation of large-scale bond purchases. Central banks ought to take account of these effects when setting monetary policy. However, even if countries do optimise their own domestic policies with full information, a global optimum cannot be reached when there are externalities and strategic complementarities as in today’s era of global liquidity. This means that we will also need more international cooperation. This could mean taking ad hoc joint action, or perhaps even developing new global rules of the game to help instil additional discipline in national policies. Given the pre-eminence of the key international currencies, the major central banks have a special responsibility to conduct policy in a way that supports global financial stability – a way that keeps the neighbourhood in order.

Importantly, the domestic focus of central bank mandates need not preclude progress in this direction. After all, national mandates in bank regulation and supervision have also permitted extensive international cooperation and the development of global principles and standards in this area.

Conclusion

To conclude, the current environment offers us a good opportunity to revisit the various issues regarding the IMFS. Addressing the blind spot in the system will require us to take a global view. We need to better anchor domestic policies by taking financial factors into account. We also need to understand and internalise the international spillovers and interactions of policies. This new approach will pose challenges. We have yet to develop an analytical framework that allows us to properly integrate financial factors – including international spillovers – into monetary policy. And there is work to be done to enhance international cooperation. All these elements together would help establish better global rules of the game.

The global financial crisis has demonstrated that international cooperation in crisis management can be effective. For instance, the establishment of international central bank swap lines can be seen as an example of enlightened self-interest. However, we must also recognise that there are limits to how far and how fast the global safety nets can be extended to mitigate future strains. This puts a premium on crisis prevention. Each country will need to do its part and contribute to making the global financial system more resilient – and I would add here that reinforcing the capacity of the IMF is one element in this regard. And taking international spillovers and financial stability issues into account in setting monetary policy is a useful step in this direction.

March Monthly Banking Stats Update

APRA published their monthly banking statistics for March. Overall housing lending was $1.336 trillion by the banks (the RBA number of $1.45 trillion includes the non banks). This was a rise of 0.59% in the month, with owner occupied loans lifting 0.46% and investment loans 0.84%. Investment loans accounted for 35.1% of all loans in the month. Looking at the individual bank data, there was little change, with CBA holding the largest share of owner occupied loans, and Westpac, investment loans. Macquarie continues its growth path.

Looking at the portfolio movements, ING and Suncorp both lost portfolio share, whilst Macquarie continues to expand at pace. Members Equity and Bendigo/Adelaide also grew well above the market average.

Looking at the annual growth rates, for owner occupied loans, Macquarie led the way (partly thanks to acquisition) and ANZ was the major with the largest growth.

On the investment lending side, where there is more interest in not exceeding the 10% “alert” level, we see that ANZ and Westpac were at 10%, whilst CBA and NAB were above the 10% mark. Macquarie and Members Equity continue to grow their investment lending book well above system. No doubt the regulators are having a quiet word! As APRA said, “strong growth in lending to property investors — portfolio growth materially above a threshold of 10 per cent will be an important risk indicator for APRA supervisors in considering the need for further action”

Talking about APRA, their supervisory lens also includes serviceability buffers – “loan affordability tests for new borrowers — in APRA’s view, these should incorporate an interest rate buffer of at least 2 per cent above the loan product rate, and a floor lending rate of at least 7 per cent, when assessing borrowers’ ability to service their loans. Good practice would be to maintain a buffer and floor rate comfortably above these levels”. So how come we do not get any reporting on this dimension? As discussed before, this should be addressed.

Deposits grew at 0.47%, so slower than lending, indicating that some banks are relying more on other funding avenues to support growth. Deposits rose by $8.6 billion to a total of 1.8 trillion. There was little relative movement amongst the major players in terms of share, though we do see deposit repricing in hand, with rates continuing to falling.

Individual movements are charted below for selected banks.

Finally, the credit card portfolio grew by $169 million in the month, and sits at $41,6 billion. Little change in the market shares reported this month.

Housing Lending Now Up $1.45 Trillion – RBA

The latest credit aggregates continues to show the same trends, with housing up again overall by 0.66%, but with investment lending still running at 0.9%, whilst owner occupied lending was 0.51% higher in the month. As a result, the share of investment loans rose again, to 34.46%, from 34.37% last month. So the housing investment skew continues. More food for thought against further interest rate cuts. Total housing lending is running at an annual growth rate of 7.3%, up from 5.9% this time last year.

Overall lending was 0.48% higher, with business lending growing just 0.19%, and personal credit 0.24%. Worryingly again we see a fall in the ratio of business lending to total credit, so once again, the banks are much happier meeting demand for house loans than helping business to borrow for productive purposes. We are not sure lower interest rates would stir business into action in the current environment, and with current lending policy and capital ratios in play. We think rates will stay on hold.

ABS Tweaks First Time Buyer Data Again

The ABS released updated data for housing finance for February 2015 today. As a result the number of first time buyers in the data changed a little. The chart below shows the variation on a monthly basis between the latest revisions, and the earlier figures. They warn that further changes should be expected. The net impact is a fall in the count of first time buyer loans written. The total number of loans recorded does not change.

From the December 2014 issue, the ABS changed its method of estimating loans to first home buyers by adjusting for under-reporting by some lenders that only report on those buyers receiving a first home owner grant. Data on first home buyers are collected by the Australian Prudential Regulation Authority (APRA) under the Financial Sector (Collection of Data) Act 2001. The ABS and APRA continue to work with lenders to ensure that loans to all first home buyers are identified in future, regardless of whether or not buyers receive a first home owner grant.

The model developed by the ABS for lenders who are under-reporting loans to first home buyers draws on the ratio of first home buyers to total loans for those lenders reporting correctly. The new estimation method will continue to be used in future releases. Monthly First Home Buyer Statistics are likely to be subject to future revision, as the modelled component is adjusted to reflect improved reporting by lenders.

The information paper Changes to the method of estimating loan commitments to first home buyers (cat. no. 5609.0.55.003), released on the ABS website on 4 February 2015, describes the new methodology and the extent of revisions to previously published estimates.

RBA on FSI and Quest For Yield

Glenn Stevens spoke at the Australian Financial Review Banking & Wealth Summit “Observations on the Financial System“. He included comments on the implications of the quest for yield on retirement incomes, financial services culture, and remarks on the FSI inquiry.

The Inquiry has eschewed wholesale changes in favour of more incremental ones. I do not intend to offer a point by point response to all the recommendations. Let me touch on just a few themes.

The first is enhancing the banking system’s resilience. There are a few issues here, the most contentious of which is whether banks’ capital ratios, which have already risen since the crisis, should be a little higher still. The Inquiry concluded that they should.

There has been a lot of debate about just where current capital ratios for Australian banks stand in the international rankings. The reason there is so much debate is because such comparisons are difficult to make. There seems little doubt, though, that most supervisory authorities (and for that matter most banks) around the world have, since the crisis, revised their thinking on how much capital is needed and none of those revisions has been downward. So wherever we stood at a point in time, just to hold that place requires more capital. And it’s likely to be demanded by the market. There’s generally not much doubt about which way the world is moving.

Of course, capital is not costless. If capital requirements become too onerous then the higher cost of borrowing could impinge on economic growth. But more capital brings the benefit of a more resilient system, one less prone to crisis and one more able to recover if a crisis does occur. Crises are infrequent, but very expensive. So there is a cost-benefit calculation to be done, or a trade-off to be struck – higher-cost intermediation, perhaps slightly reduced average economic growth in normal times, in return for the reduced probability, and impact, of deep downturns associated with financial crises. The Inquiry, weighing the costs and benefits, concluded that the benefits of moving further in the direction of resilience outweigh the rather small estimated costs.

The second set of issues surround ‘too-big-to-fail’ institutions and their resolution. The Inquiry is to be commended for grappling with this. These issues are complex and even after substantial regulatory reform at the global level, there is still key work in progress. The stated aim of all that work is to get to a situation where, with the right tools and preparation, it would be possible to resolve a failing bank (or non-bank) of systemic importance, without disrupting the provision of its critical functions and without balance sheet support from the public sector. This is explicitly for globally systemic entities, but the Inquiry has, sensibly enough, seen the parallel issue for domestically systemic ones as worthy of discussion.

Ending ‘too-big-to-fail’ is an ambitious and demanding objective. To achieve it, not only must systemic institutions hold higher equity capital buffers, but more tools to absorb losses are needed in the event the equity is depleted. Typically envisaged is a ‘bail-in’ of some kind, in which a wider group of creditors would effectively become equity holders, and who would share in the losses sustained by a failing entity. For this to work, there needs to be a market for the relevant securities that is genuinely independent of the deposit-taking sector – we can’t have banks hold one another’s bail-in debt. In a resolution, a host of operational complexities would also have to be sorted out. A resolution needs the support of foreign regulators if it is to be recognised across borders. It needs temporary stays on derivatives contracts so that counterparties don’t scramble for collateral at the onset of resolution. And it needs to be structured and governed well enough to withstand potential legal challenges and sustain market confidence.

A proposal for ‘total loss-absorbing capacity’, or TLAC, was announced at the G20 Summit in Brisbane last year. Consultations and impact assessments are under way, and an international standard on loss-absorbing capacity will be agreed by the G20 Summit in Antalya later this year; guidance on core policies to support cross-border recognition of resolution actions should be finalised shortly after.

It is fair to say that in its main submission to the Inquiry, the Reserve Bank counselled caution as far as ‘bail-in’ and so on is concerned. We would still do so. The Inquiry also favours a cautious approach. Again, though, the world seems to be moving in this general direction. It isn’t really going to be credible or prudent for Australia, with some large institutions that everyone can see are locally systemic, not to keep working on improvements to resolution arrangements.

The third set of recommendations from the Inquiry I want to touch on are those related to the payments system. The Inquiry generally supported the steps the Payments System Board (PSB) has taken since its creation after Wallis, but raised a few areas where the Board could consider consulting on possible further steps. As it happens, these dovetail well with issues that the PSB has been considering for some time. The Reserve Bank has since announced a review of card payments regulation and released an Issues Paper in early March. Among other things, it contemplates the potential for changes to the regulation of card surcharges and interchange fees.

Surcharging tends to be a ‘hot button’ issue with consumers and generated a large number of (largely identical) submissions to the Financial System Inquiry. But virtually all of the public’s concern is directed at a couple of industries where surcharges appear to be well in excess of acceptance costs, at least for some transactions. The Bank considers that its decision to allow surcharging of card payments in 2002 has been a valuable reform. It allows merchants to signal to consumers that there are differences in the cost of payment methods used at the checkout. By helping to hold down the cost of payments to merchants, the right to surcharge can help to hold down the prices of goods and services more generally.

The Bank made some incremental changes to the regulation of surcharging in 2013, but to date these have had a relatively limited effect on the cases of surcharging that most concern consumers. Our current review will consider ways we can retain the considerable benefits of allowing merchants to surcharge, while addressing concerns about excessive surcharges. One element of this might be, as the Financial System Inquiry suggests, to prevent surcharges for some payment methods, such as debit cards, if they were sufficiently low cost. This would mean that in most cases consumers would have better access to a payment method that is not surcharged, even when transacting online. Other options being considered are ways to make the permissible surcharge clearer, whether through establishing a fixed maximum or by establishing a more readily observable measure of acceptance costs.

The capping of card interchange fees is also now a longstanding policy and, we think, a beneficial one. Nonetheless, it is important to ensure that it continues to meet its objectives. Caps were put in place in 2003 based on concerns that interchange fees in mature payment systems can distort payment choices and, perversely, be driven higher by competition between payment schemes. As suggested by the Inquiry, the Bank’s review will consider whether the levels of the current caps remain appropriate. We know, for example, that lower caps have now been set in some other jurisdictions.

But there are other elements of the current regime that also warrant consideration. For instance, while average interchange fees meet the regulated caps, the dispersion of interchange rates around the average has increased significantly over time. The practical effect of this is that there can be a difference of up to 180 basis points in the cost of the same card presented at different merchants. This problem is aggravated by the fact that merchants often have no way of determining which are the high-cost cards.

Although the wide range of interchange fees is not unique to Australia, we would want to ensure so far as possible that the regulatory framework does not contribute to this trend or to declining transparency of individual card costs to merchants. The Bank’s review will consider a range of options, including ‘hard’ caps on interchange fees and hybrid solutions, along with setting more frequent compliance points for caps. Options for improving the ability of merchants to respond to differing card costs will also be considered.

While considering interchange fees, it is also appropriate to consider the circumstances of card systems that directly compete with the interchange-regulated schemes. This means, in particular, bank-issued cards that do not technically carry an interchange fee, but nonetheless are supported by payments to the issuer funded by merchant fees.

More broadly, all the elements I have mentioned – interchange fees, transparency and surcharging – are interrelated, which means that there are potentially multiple paths to achieving similar outcomes. I encourage those with an interest to engage with the Bank in the review process in the period ahead.

Turning away from the Financial System Inquiry to other matters, let me mention two.

I said at the beginning that the ‘search for yield’ continues. There is a line of discussion that tackles this issue from a cyclical point of view, thinking about how the balance sheet measures taken by the major central banks are affecting markets, the extent and nature of cross-border spillovers, what happens when the US Federal Reserve starts to tighten policy at some point and so on. I’ve spoken about such things elsewhere and have nothing to add today.

There is another conversation, however, that tends to take place at a lower volume, but which definitely needs to be had. That conversation is about what all this means for the retirement income system over the longer run. The key question is: how will an adequate flow of income be generated for the retired community in the future, in a world in which long-term nominal returns on low-risk assets are so low? This is a global question. Just about everywhere in the world the price of buying a given annual flow of future income has gone up a lot. Those seeking to make that purchase now – that is, those on the brink of leaving the workforce – are in a much worse position than those who made it a decade ago. They have to accept a lot more risk to generate the expected flow of future income they want.

The problem must be acute in Europe, where sovereign yields in some countries are negative for significant durations. But it is also potentially a non-trivial issue in our own country. In a conference about wealth, this might be a worthy topic of discussion.

And the final issue is misconduct. This has loomed larger for longer in many jurisdictions than we would have thought likely a few years ago. Investigations and prosecutions for alleged past misconduct are ongoing. It seems our own country has not been entirely immune from some of this. Without in any way wanting to pass judgement on any particular case, root causes seem to include distorted incentives coupled with an erosion of a culture that placed great store on acting in a trustworthy way.

Finance depends on trust. In fact, in the end, it can depend on little else. Where trust has been damaged, repair has to be made. Both industry and the official community are working hard to try to clarify expected standards of behaviour. Various codes of practice are being developed, calculation methodologies are being refined, and so on.[¹] In some cases regulation is being contemplated. Initiatives like the Banking and Finance Oath also can make a very worthwhile contribution, if enough people are prepared to sign up and exhibit the promised behaviour.

In the end, though, you can’t legislate for culture or character. Culture has to be nurtured, which is not a costless exercise. Character has to be developed and exemplified in behaviour. For all of us in the financial services and official sectors, this is a never-ending task.

Getting To Grips With Loan To Income

We think that the ratio of loan outstanding to income (LTI) is a good indicator to assess the health of a mortgage loan portfolio, especially when incomes are not rising fast. In Australia, there is no official data on LTIs, from either the statistical or supervisory bodies, or from individual lenders. We think this needs to change. Internationally, there is more focus on the importance of LTI analysis, and LTI is regarded by many as the best lens to assess potential risks in the portfolio. We highlighted the New Zealand analysis recently.

We recently analysed data from our household surveys and presented some of the data in an earlier post, comparing LTI with LVR. Today we look further at the relationship between LTI and income, again using the DFA household data. We find significant variations. The data takes the current loan balance, and current income data (not that which may have existed when the loan was written initially). Not all banks appear to update their customer income data regularly, so many will not know the true state of play. When incomes are rising fast, as happened in the early 2000’s, this was probably not a issue, but now with income growth slowing, and loans larger, this is much more important.

The first chart shows the income scale on the left, and the LTI on the right, and we look at the loan size across the page. We see that LTI’s tend to be lower and more consistent up to about $300k, but as the loan size rises above this, the loan to income ratio varies significantly. Some borrowers with large loans have an LTI on 15-20. These larger loans will be assessed by lenders on other factors, including assets and other investments held.

Now, lets shift the lens to the various mortgage providers. I have disguised the individual lenders in this chart, but this shows the average LTI of all mortgages outstanding, and average household income by provider. The highest portfolio has an LTI of above 6, the lowest, half as high. It is fair to assume therefore that banks use different underwriting criteria to grant loans. All else being equal, higher LTI is higher risk.

So now lets look at interest only loans versus normal repayment loans. This is important because interest only loans make up more of the portfolio, We see that the LTI is somewhat higher on an interest only loan, though these loans on average tend to align with slightly higher income.

We also find that normal repayment loans, compared with a line of credit or offset loan, have a lower LTI, and income.

We find that households whose education level reached university have higher incomes, and a higher LTI compared with households who left after education at school level.

Looking at the DFA segments, we find that those trading up, and first time buyers have the highest LTI, but there is a significant difference in average incomes between the two. We do not capture LTI data for Want To Buys, Property Inactive households or Investors. We also see that those who own property, with no plans to change, have a lower average income than those aspiring to enter the market.

We have sorted the data by our core segments, and see that the Exclusive Professional segment has the highest income and the highest LTI. But note how the Young Affluent have an average LTI of around 6, yet their income is significantly lower. Those stressed households generally have significantly lower LTI’s so we can see that underwriting criteria does vary by segment, and the lowest LTI resides amongst Wealth Seniors.

Another lens is the DFA geographic bands. Here we find that households in the inner suburbs have the highest LTI, around 6, whilst both income and LTI drift lower as we migrate into the more remote regional areas.

Finally, up to now we have used national averages, but it is worth highlighting that average incomes and LTI do vary across the states. NSW has the highest LTI, around 5, whilst NT sits around 2. Average household income is highest in the ACT, but NSW and WA also have higher levels of average income, compared with some of the other states.

We think there is important work to be done to apply risk lenses across LTI bands, and we believe we need reporting on this important aspect. Without it, we are flying blind.

Pay Day Hot Spots

DFA has been using its household survey to analyse the $1.5bn+ Pay Day lending market. ASIC of course has been highlighting poor compliance within the industry, and also recently showed the range of purposes pay day borrowers might borrow for. Cash flow emergencies was the highest.

Pay day loans, or small loans, as they are properly called, are unsecured loans of up to $2,000 that must be repaid between 16 days and 1 year. Such loans are usually repaid from a bank account direct debit, or a direct deduction from pay. Since the recent changes to consumer regulation, loans of $2,000 or less to be repaid in 15 days or less have been banned.

These days many providers use on line channels to reach prospective borrowers, together with tv and radio ads. Ads for two payday lenders, MoneyPlus and MoneyMe, have recently been running on Network Ten and its youth-focused multichannels Eleven and ONE, during programs including The Simpsons, Futurama and Bob’s Burgers. The MoneyPlus website, which promises fast cash for “immediate needs” within 30 minutes, among them lists “bills — electricity, gas bill or speeding, parking fines”.

There are more than 100 providers of Pay Day loans operating in Australia. They are under an obligation to ensure the loan is made responsibly, and they will ask for sight of bank account statements and other documents. For recipients who receive 50% or more of their income from Centrelink, small loan repayments must not exceed 20%.

Fees are high, though there are some limits, and providers are only able to charge, a one-off establishment fee of 20% of the amount loaned, a monthly account keeping fee of 4% of the amount loaned, government fees or charges, default fees or charges and enforecment expenses. Credit providers are not allowed to charge interest on the loan.

Those these rules do not apply to loans offered by Authorised Deposit-taking Institutions (ADIs) such as banks, building societies and credit unions, or to continuing credit contracts such as credit cards. You can read more here.

Using data from our surveys, we heat mapped relative the distribution by post code. Here is the data for the Sydney region. We see there are some areas with more than 8 times the number of households compared with others, with significant concentrations in western Sydney. This includes suburbs such as Casula, Chipping Norton, Hammondville, Liverpool, Lurnea, Moorebank, Mount Pritchard and Warwick Farm.

Nationally, Toowoomba in QLD (4350) had the highest penetration of pay day loans.

Finally, looking at the average age, most pay day borrowers are in their 30’s and 40’s, though some are older, as shown in the mapping below. We also find a high correlation between age, internet use and pay day lending.

UK Lending Update

The Bank of England just released their lending trends data for first quarter 2015. Included in the report is some relevant data on investment or buy-to-let loans. BTL mortgages accounted for 15% of the total outstanding value of UK-resident mortgages as at end-2014 Q4. The rate of possession of buy-to-let properties was almost twice as high as for owner-occupied ones.

Overall, the rate of growth in some measures of the stock of lending to UK businesses picked up in the three months to February. Net capital market issuance was positive in this period. Mortgage approvals by all UK-resident mortgage lenders for house purchase rose slightly in the three months to February compared to the previous period. The stock of secured lending to households increased, but the pace of growth has slowed since 2014 H1. The annual growth rate in the stock of consumer credit was little changed in recent months.

Pricing on lending to small and medium-sized enterprises was little changed in the three months to February. Respondents to the Bank of England’s 2015 Q1 Credit Conditions Survey reported that spreads on new lending to large businesses fell significantly. The Bank’s series of quoted interest rates on fixed-rate mortgages decreased in 2015 Q1 compared to the previous quarter. Quoted rates on some personal loans continued to fall.

Contacts of the Bank’s network of Agents noted that credit availability had eased further, including for most small and medium-sized companies. Respondents to the Bank of England’s Credit Conditions Survey expected demand for bank lending to increase significantly from small businesses, increase from medium-sized businesses and be unchanged from large businesses in 2015 Q2. Lenders in the survey reported that the availability of secured credit to households was broadly unchanged and that
demand for secured lending fell significantly in the three months to early March 2015.

Secured lending to individuals. The number of mortgage approvals by all UK-resident mortgage lenders for house purchase increased slightly in the three months to February compared to the previous period. Approvals for remortgaging also rose slightly. The stock of secured lending to individuals increased, but the pace of growth has slowed since 2014 H1. The monthly net mortgage flow was little changed in recent months.

Overall, gross secured lending was higher in 2014 than in recent years. Within this, the share of gross lending for buy-to-let purposes increased. BTL lending represented 13% of total gross mortgage lending in 2014, with gross advances having recovered from its post-crisis trough though still below its 2007 peak. BTL mortgages accounted for 15% of the total outstanding value of UK-resident mortgages as at end-2014 Q4. A buy-to-let mortgage is a mortgage secured against a residential property that will not be occupied by the owner of that property or a relative, but will instead be occupied on the basis of a rental agreement. In 1996 the Association of Residential Letting Agents, the trade body of estate agents dealing with rental properties, along with four lenders set up its first BTL initiative to encourage private individuals to invest in rental property. This market grew steadily and the share of BTL lending in total gross mortgage lending increased until mid-2008, according to data from the Council of Mortgage Lenders (CML).

After the onset of the financial crisis, gross buy-to-let lending fell more sharply than total mortgage lending. Reflecting discussions with the major UK lenders, the July 2011 Trends in Lending publication noted one reason for this decline in 2008–09 was that the availability of this lending was said to have tightened as some specialist lenders exited this market. Another reason was that wholesale funding markets — often used to fund BTL lending — became impaired.

Gross lending for BTL purposes has grown since 2010, reflecting both supply and demand factors, and was £27.4 billion in 2014. Over the past five years the share of total BTL lending in overall mortgage lending has picked up to 15% in 2014 Q4, higher than in the pre-crisis period, according to data from the CML. Data based on the Bank of England and Financial Conduct Authority’s Mortgage Lenders and Administrators Return (MLAR), derived from a different reporting population and definitions of residency, also show that gross BTL lending grew faster than overall gross mortgage lending in recent years. Contacts of the Bank’s network of Agents noted that the rental market had continued to grow strongly in recent months, supporting continued steady growth in buy-to-let activity.

Gross buy-to-let advances for remortgaging have also increased in recent years. Its share of the total grew from 32% in 2002 to 52% in 2014, with the share of gross advances for house purchase at 45%. The share of the number of BTL mortgages for house purchase in the total number of house purchases has increased from its trough in 2010 to 13% in 2014 though remains below its 2008 peak, according to data from the CML. A significant proportion of advertised BTL mortgage products in the four years after the financial crisis were at loan to value (LTV) ratios below 75%. The number of advertised BTL mortgage products at LTV ratios of 75% and above has increased since mid-2013, but most are below 80% LTV ratio.

Data on quoted rates for fixed-rate BTL mortgages from Moneyfacts Group indicate that they have fallen since the onset of the financial crisis. This follows the same broad pattern as the aggregate measures of quoted rates on fixed-rate mortgages published by the Bank of England. Spreads over reference rates initially widened on fixed-rate BTL products, as mortgage rates fell by less than swap rates. Since 2013, spreads on these products narrowed as relevant reference rates increased. In recent months, spreads ticked up as fixed BTL rates fell by less than these swap rates. Floating BTL mortgage rates have also decreased since the onset of the financial crisis. The decrease was similar to that for rates on fixed BTL products since 2013. With Bank Rate unchanged, spreads over Bank Rate for floating-rate BTL mortgages have narrowed in recent years. Looking ahead, lenders in the Bank of England’s Credit Conditions Survey expected a reduction in spreads on BTL lending in 2015 Q2. Indicative BTL rates by LTV ratio ranges have also decreased over the years. Rates for LTV ratios below 75% have fallen sharply over the past twelve months.

BTL mortgages as a proportion of the total number of outstanding mortgages more than three months in arrears rose sharply at the start of 2009, around the same time as the overall mortgage arrears rate. The BTL arrears rate fell back and has been lower than that for all mortgages in recent years. In some contrast, the possessions rate on BTL mortgages peaked much later than that for owner-occupied mortgages and while it has fallen recently, still remains higher than that for owner-occupiers. But the CML noted that some of the differences in the path of arrears and possession rates seen when comparing the BTL sector with the wider market reflects the use of receivers of rent in the BTL sector. Other things being equal, the use of receivership may have mitigated some increase in reported BTL arrears and possession rates and delayed the increase in reported BTL possessions.

The rate of possession of buy-to-let properties was almost twice as high as for owner-occupied ones, even though the rate of underlying arrears on buy-to-let lending remained lower in 2014, according to data from the CML. They commented that this was because lenders offer extended forbearance to owner-occupiers to help them get through periods of financial difficulty without losing their home.

Inflation – A New Zealand Perspective

A timely and interesting speech today from the Reserve Bank of New Zealand by John McDermott, Assistant Governor & Chief Economist, “The Dragon Slain?” on the subject of inflation, why its low, and the limits of monetary policy on managing it. Like Australia, there is a significant imbalance between non-tradables and tradables and from an international perspective its a global phenomenon, with inflation in 16 out of 18 countries examined below target.

Introduction

It is a pleasure for me to be here today to address the Chamber. As some of you may be aware, today is St George’s Day, the saint famous for slaying a dragon. The subject of my speech is inflation, which has in the past been likened to a dragon ravaging society. With annual inflation in the March quarter at 0.1 percent, is this another slain dragon? I do not believe so; the dragon is merely sleeping.

Inflation is currently low, and is mostly due to negative tradables inflation caused by the slow global economic recovery, the high exchange rate, and the recent sharp falls in oil prices (figure 1). There is little monetary policy can to do influence inflation outturns in the near term. Our strategy for returning inflation to the midpoint of the target range is to maintain stimulatory monetary policy to help generate output growth in excess of potential growth for an extended period.[1] This strength in aggregate demand relative to supply will help generate the inflation required to reach the midpoint objective.

Figure 1: Annual CPI headline, tradables and non-tradables inflation

Source: Statistics New Zealand.

With the benefit of hindsight, the low inflation outturn can be explained. Tradables inflation has been negative for the past three years as a result of: the slow global recovery; weak or declining prices of capital goods manufactured products and commodities; and the strength of our exchange rate. In the three years to March 2015 the cost of new cars fell 9 percent, major household appliances 9 percent, computing equipment by 32 percent; televisions and other audio-visual equipment prices fell by 36 percent.

More recently, a sharp decline in the oil price has driven tradables inflation down even further. The fall in petrol prices alone reduced the headline inflation rate in the March quarter by 0.8 percentage points. In the face of falling oil prices, the Bank’s focus is on the medium-term trend in inflation since this is the horizon at which monetary policy can best affect inflation. The Bank is unable to offset large relative price shocks and any attempt to do so by sharply reducing interest rates would result in an unnecessary boom then slowdown in activity. Unnecessary volatility in output and interest rates that our Policy Targets Agreement directs us to avoid.

In my remarks today, I am not going to focus on the inflation numbers we received earlier this week. We will consider those, along with all the other indicators of capacity and inflationary pressures, next week in our April OCR meeting. Instead, I will offer some perspective on low inflation in New Zealand over the past couple of years. In particular, I will outline the framework we use to think about inflationary pressures in New Zealand, then consider how the global economy is affecting New Zealand inflation. I then discuss some factors that might be contributing to somewhat weaker-than-expected domestic inflationary pressures.

Inflation and its causes

At the horizon relevant for monetary policy, inflation is typically thought of as being influenced by two main factors: capacity pressure and inflation expectations. The changing balance between aggregate demand and aggregate supply over the business cycle causes inflation to rise and fall. While the long run path of output is determined by the supply side of the economy – labour supply, investment and technology[2] – over the business cycle output can be above this ‘potential’ level (a positive output gap) or below it (a negative output gap) for several years. Periods of strong demand see inflation rise, while downswings see inflation fall. The other main influence on inflation is expectations of future inflation, which people build into price and wage setting.

Economists often summarise the implications for inflation of the output gap and inflation expectations in a ‘Phillips curve’. This relationship indicates that over periods of several years inflation tends to be higher when demand is stronger; and that over the cycle and in the long run inflation will be higher when inflation expectations are higher.

The Reserve Bank pursues its inflation target by setting the Official Cash Rate (OCR). Higher interest rates tend to lower inflation over the following 18 to 24 months by slowing the growth in aggregate demand, and reducing the output gap. In the short term, movements in interest rates can also cause the exchange rate to move, affecting the New Zealand dollar prices of imports. The long lag involved from changes to the OCR having their full effect on inflation requires the Reserve Bank to react to expected future inflationary pressure rather than past outturns.[3]

International factors

The sharp decline in global oil prices over the past year has had a large impact on headline inflation. The Dubai price for crude oil is now 44 percent below its June 2014 peak. This lower oil price affects domestic prices through several channels.[4] It directly affects the price of petrol paid by consumers; petrol prices are 15 percent lower than a year ago, reducing headline CPI inflation by 0.8 percentage points. If petrol prices remain unchanged over the coming year, this reduction will unwind, boosting annual inflation by 0.8 percentage points.

Falling oil prices indirectly affect consumer prices by reducing the production costs of other businesses. How much, depends on the share of oil and petrol in total costs, businesses’ expectations of how permanent the fall will be, and how businesses change their prices in relation to changes in costs. Our research on price-setting behaviour suggests that New Zealand businesses are more likely to pass on to customers an increase in costs than a decrease.[5]

The significance of this sharp decline in oil prices for inflation depends on whether the fall is caused by factors specific to the oil market, or is symptomatic of a more general fall in global economic activity. The Bank’s view is that this drop in oil prices is caused by a mix of factors, but primarily increased supply.

When declining oil prices reflect factors specific to the oil sector, it should be viewed as a relative price shift, rather than generalised inflation. It is a positive supply shock for New Zealand: it lowers inflation and boosts output. Since monetary policy operates with a lag, it cannot react to the immediate impact of oil prices on inflation. Any such response would affect output and inflation after the initial impact on petrol prices has left the annual inflation rate. The Policy Targets Agreement directs the Reserve Bank to avoid unnecessary volatility in output and interest rates and instead focus on medium-term inflationary pressure.

Inflation is low globally (figure 2), and below target in 16 out of 18 inflation targeting countries.[6] The low inflation reflects falling oil prices and the prolonged period of excess capacity in most advanced economies. But even accounting for oil and weak capacity pressures, inflation is weak in our trading partners, and lower than policymakers had forecast.[7] Weak inflation and continued excess capacity have resulted in extraordinarily supportive monetary policy across the world.

Figure 2: World inflation 2008 Q3 and 2014 Q4

Source: IMF, ILO, Eurostat, Haver Analytics, Thomson Reuters Datastream and various national sources.

Global inflation affects inflation in New Zealand via two main channels.[8] Low inflation in our trading partner economies results in small international price increases for New Zealand’s imports. Extremely low, and in some cases negative, interest rates overseas have been a factor causing an appreciation of the New Zealand dollar, which further depresses import prices when expressed in New Zealand dollar terms.

The pass-through of global inflation to New Zealand import prices seems to be taking place in a normal way (figure 3). Similarly, tradable CPI inflation appears consistent with the movements in import prices. Nonetheless, the combination of surprisingly weak inflation overseas and our high exchange rate are the principal reasons why we have had downside surprises to headline inflation.

Figure 3: Trading partner export prices and New Zealand import prices (US dollar terms)[9]

Source: Haver Analytics, Statistics New Zealand and RBNZ estimates.

While the weakness in tradables inflation is explainable given international factors, non-tradables inflation has also been weaker than expected. In part the weakness in non-tradables may be influenced by international factors, since around a tenth of non-tradable prices are accounted for by imports.[10] Indeed, looking more closely at non-tradables, the sectors that are relatively more open to international competition exhibit lower inflation at present.[11]

Domestic inflationary pressures

While non-tradables account for a small part of the overall weakness in headline inflation, the dynamics of non-tradables inflation is central to our strategy of returning inflation to the target midpoint. In this context I will discuss our estimates of spare capacity in the economy, how that spare capacity affects price and wage-setting behaviour, and the inflation expectations of wage and price setters. None of these areas are directly observable, and require estimation by economic models based on available indicators.

Spare capacity in New Zealand

Estimates of the output gap are difficult to carry out in real time, and can be heavily revised. To mitigate this uncertainty, we corroborate our estimates of the output gap from our main model with a range of other indicators of capacity pressures. These measures suggest that the output gap was negative for much of the past couple of years, explaining why non-tradables inflation has been weak. The indicators point to the current output gap being positive, at around half a percent of potential output (figure 4). Monetary policy is currently supportive, which should help to drive the output gap higher in coming quarters and generate the additional inflation to return to the target midpoint.

Figure 4: Output gap and indicator suite (percent of potential output)

Source: RBNZ estimates.

The weakest indicators, though, are consistent with a negative output gap, and hence lower inflationary pressure. The weakest one at present is based on the unemployment rate, which could be influenced by immigration and structural changes in participation. Net immigration is running at historically high levels, and has two offsetting effects on inflationary pressure. Immigrants require housing and new capital equipment to work, increasing aggregate demand. At the same time, immigrants may increase the labour force, increasing supply in the economy and reducing wage inflation. These offsetting forces make it hard to calibrate the net effect of migrants on the output gap in the short run.[12]

Labour force participation in New Zealand is currently at record levels, due to the upward trend in participation of female workers and higher participation among older cohorts. Should that high rate of participation prove permanent it would imply a greater level of potential output than we currently estimate, a smaller positive output gap and lower non-tradable inflation.

The impact of capacity pressure on inflation

All of the various indicators of capacity pressures have one thing in common. Each indicator shows a gradual tightening of capacity pressure over the past couple of years, which should be consistent with gradually increasing inflationary pressures and higher inflation outcomes. The subdued nature of the actual increase in domestic inflationary pressure raises the question of whether the output gap is having a smaller influence on actual inflation than it has in the past. In other words, has the slope of the Phillips curve become flatter?

Consider a stylised version of the New Zealand Phillips curve, mapping the outturns for inflation and a simple output gap measure – the deviation of unemployment from trend (figure 5).[13] During the 1970s, there were large movements in inflation without much corresponding movement in the unemployment gap. In part this may be a function of labour hoarding by businesses as the general shortage of labour made them reluctant to lay off workers even faced with large swings in output.

Figure 5: New Zealand Phillips curves

Source: Statistics New Zealand, RBNZ estimates.

During the 1980s, there is a clear negative relationship, with higher unemployment gaps associated with lower outcomes for inflation. Since the introduction of inflation targeting in 1990, the curve is markedly flatter – large movements in the unemployment gap have not resulted in corresponding changes in inflation. The flattening of the Phillips curve is witnessed in many countries. Nonetheless, experience since the global financial crisis has led many policymakers to question whether it has flattened further in recent years.[14] During the depths of the global financial crisis, non-tradables inflation remained stubbornly high, in New Zealand and elsewhere, despite large negative output gaps.

This anchoring of inflation at low levels represents a success for the monetary policy framework, as shocks hitting New Zealand do not result in big changes to general price inflation. But it also poses a challenge. With a flat Phillips curve it becomes more difficult for the Reserve Bank to influence inflation by affecting the demand for resources and the size of the output gap. The current flatter Phillips curve could mean that the positive output gap is exerting less inflationary pressure than we currently believe, slowing our eventual return to target midpoint.

Has pricing behaviour changed?

Survey measures of inflation expectations have fallen in recent quarters. The decline in expectations is consistent with the decline in actual inflation over the period. In the decade to 2012, CPI inflation averaged 2.6 percent and was in the upper half of the Reserve Bank’s target range. The current Policy Targets Agreement (signed in 2012) put greater focus on achieving the midpoint of the target range, so some decline in inflation expectations should be expected. Lower inflation expectations have been observed across the globe.[15]

What matters for inflation is not the average response to a particular survey of expectations, but how general inflation expectations held by businesses and households translate into price-setting behaviour and wage bargaining. Research on price-setting by New Zealand businesses suggest that many only take into account current inflation when setting prices, and very few businesses are purely forward looking.[16] Preliminary work on wage setting in New Zealand also points to the importance of past inflation outturns.[17]

The evolution of inflation expectations over coming quarters merits vigilance. If price and wage setting is very backward looking, the temporarily low headline inflation from falling petrol prices could become more widely entrenched.[18] There is certainly a growing discussion of low inflation captured in the media (figure 6). Recent research has pointed to possible asymmetries in behaviour, with inflation expectations becoming more backward looking in periods of low inflation, and reacting more to downside inflation surprises than upside ones.[19] A certain degree of movement in expectations is to be expected, particularly for short-term measures, but the more firmly anchored expectations are, the smaller the overall inflation impact.[20]

Figure 6: Media articles in New Zealand citing ‘low inflation’

Source: Fuseworks, Statistics New Zealand.

Longer-term survey measures of inflation expectations are currently consistent with the midpoint of our target (figure 7). Estimates from a range of economic models are somewhat lower and have declined recently. A market-based measure using the return on an inflation-indexed bond has also fallen sharply over the past year.[21] The level of these other measures are consistent with inflation expectations at or just below the target midpoint of 2 percent, but all highlight the downward direction over the past year (table 1).[22]

Figure 7: Long-term inflation expectations

Source: Aon, Statistics New Zealand, RBNZ/UMR.

Table 1: Summary of inflation expectation measures

Current estimate Range for current estimate Direction of change in last year Consistent with midpoint

Survey measures* 2.1 1.8 – 2.2 ↓

Model-based measures 1.4 1 – 1.5 ↓

Market based measure 1.5 1.5 ↓

*Excluding surveys of less than 1-year ahead

The outlook for monetary policy

I have talked today about the causes of recent low inflation in New Zealand. The outlook for inflation is also subdued, and suggests that monetary policy should remain stimulatory for a prolonged period. This cycle is unusual in that CPI inflation is staying very low, requiring interest rates to also remain low. The timing of future adjustments in interest rates will depend on the evolution of inflationary pressures in both the traded and non-traded sectors. We continue to monitor and carefully assess the emerging flow of economic data.

The impact of some factors influencing headline inflation will prove temporary. Past declines in oil prices will reduce headline inflation substantially in 2015, but absent any further falls this negative contribution will drop out of the annual inflation rate by the start of next year.

Looking ahead, we will ensure that monetary policy is stimulatory to support output growth above potential. Increasingly, this positive output gap will help lift non-tradables inflation, returning headline inflation gradually to the target midpoint. Real GDP growth has been above potential growth for a number of years and is currently underpinned by high net immigration, strong construction activity and robust household spending. Employment growth is strong and the unemployment rate is low and projected to fall.

At present, the Bank is not considering any increase in interest rates. Before considering any tightening in monetary policy we would need to be confident that increased capacity utilisation and labour market tightness was generating, or about to generate, a substantial increase in inflation.

Evidence of weakening demand and domestic inflationary pressures would prompt us to consider lowering interest rates. There are some areas of uncertainty surrounding the outlook for capacity pressures, including the lingering effects of the recent drought in parts of the country, fiscal consolidation, lower dairy incomes and the impact of the high exchange rate on some export and import substitution industries. Beyond these factors, we are also assessing the outlook for tradables inflation that is being dampened by global conditions and the high exchange rate. The fact that the exchange rate has appreciated while our key export prices, such as dairy, have been falling, is unwelcome.

We remain vigilant in watching wage bargaining and price-setting outcomes. Should these settle at levels lower than our target range for inflation, it would be appropriate to ease policy.

Concluding comments

Inflation has been low in New Zealand for a number of years. At present, the outlook requires a period of supportive monetary policy. Our approach, as a flexible inflation targeter, is to support ongoing sustainable growth in New Zealand that should help raise costs and prices in order to achieve our inflation target. We will not react to temporary deviations from target, as this will only generate unnecessary volatility in activity.

[1] In setting monetary policy, we have to consider whether we have calibrated the degree of monetary stimulus correctly. In our framework we measure the degree of monetary policy stimulus by the gap between actual interest rates and the so-called neutral interest rate. Our current estimate is for a neutral 90-day rate of 4.5 percent. We lowered our estimate of the neutral rate following the global financial crisis to reflect the higher debt levels of households and higher financing costs pushing up the spread between the 90-day rate and the interest rate on household mortgages. See McDermott, J (2013), ‘Shifting gear: why have neutral interest rates fallen’, Assistant Governor, RBNZ. Speech to New Zealand Institute of Chartered Accountants CFO and Financial Controllers Special Interest Group in Auckland, 2 October; and Chetwin, W and A Wood (2013), ‘Neutral interest rates in the post-crisis world’, RBNZ Analytical Note, No. 2013/07.

[2] For a detailed description of our modelling framework for potential output, see: McDermott, J (2014), ‘Realising our potential: potential output and the monetary policy framework’, Assistant Governor, RBNZ. Speech to the Wellington Chamber of Commerce, 9 July and Lienert, A and D Gillmore (2015), ‘The Reserve Bank’s method of estimating “potential output’, RBNZ Analytical Note, 2015/01.

[3] This is a broad, high-level summary of our framework. In carrying out a monetary policy review we take into consideration a wide range of factors, which I do not have time to detail today. In these remarks I am focusing on the key issues around the dynamics of inflation.

[4] See Chapter 6 of the March 2015 Monetary Policy Statement for a fuller description of the impact of oil prices on consumer prices.

[5] Parker, M (2014c), ‘Price-setting behaviour in New Zealand ’, RBNZ Discussion Paper, No. 2014/04.

[6] Carney, M (2015), ‘Writing the path back to target’, Governor, Bank of England. Speech at the University of Sheffield Advanced Manufacturing Research Centre, 12 March.

[7] E.g. Bank of Canada (2014), ‘Box 2: Assessing the impact of excess supply on inflation’, Monetary Policy Report, April. Carney, M (2015) ibid., Haldane, A (2015), ‘Drag and drop’, Chief Economist, Bank of England. Speech at the Bizclub lunch, Rutland, 19 March. Sveriges Riksbank (2014), ‘Why is inflation low?’, Monetary Policy Report, July.

[8] For a more detailed description of how the international situation passes through to New Zealand consumer prices, see Parker, M (2014a), ‘Exchange-rate movements and consumer prices: some perspectives’, RBNZ Bulletin, 77 (1, March): 31-41.

[9] The series for China has a shorter history, but adding it does not qualitatively affect the path for trading partner export prices.

[10] Parker, M (2014b), ‘How much of what New Zealanders consume is imported? Estimates from input-output tables’, RBNZ Analytical Note, No. 2014/05.

[11] See Galt, M (2015), ‘How do international factors affect non-tradable inflation? Exploratory analysis using disaggregated trans-Tasman data’, RBNZ Analytical Note. Forthcoming. Nonetheless, even accounting for global inflation factors, inflation in New Zealand appears weak, see Richardson, A (2015), ‘The pass-through of global economic conditions to New Zealand inflation’, RBNZ Analytical Note. No. 2015/03.

[12] Our own research suggests that different types of immigrants to New Zealand have differing implications for overall inflationary pressure. See McDonald, C (2013), ‘Migration and the housing market’, RBNZ Analytical Note, No. 2013/10.

[13] The unemployment gap is calculated at the percentage point deviation of the actual unemployment rate from a trend calculated using a stiff Hodrick-Prescott filter (lambda = 50000). A positive unemployment gap represents slack in the labour marker, so would be equivalent to a negative output gap.

[14] See Yellen, J (2014) ‘Labor market dynamics and monetary policy’, Chair, Board of Governors of the Federal Reserve System. Speech given at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole. Haldane, A (2015), op.cit. The IMF estimates that the slope of the global price Phillips curve has fallen from around 1 in the 1970s to 0.1-0.2 most recently. See IMF (2013), ‘The dog that didn’t bark: Has inflation been muzzled or was it just sleeping?’, World Economic

Outlook, April 2013.

[15] For example, see Nechio, F (2015), ‘Have long-term inflation expectations declined?’, Federal Reserve Bank of San Francisco Economic Letter, No. 2015-11; Haldane, A (2015) op cit.; Miccoli, M and S Neri (2015) ‘Inflation surprises and inflation expectations in the euro area’, Banca d’Italia Occasional Papers, No. 265.

[16] Parker, M (2014c), op. cit.

[17] Armstrong, J and M Parker (2015) ‘How wages are set: evidence from a large survey of firms’, Reserve Bank of New Zealand. Forthcoming.

[18] Our research suggests that when supply shocks are permanent in nature, monetary policy will need to focus more on inflation outturns and less on the output gap than is the case when supply shocks are temporary. The intuition behind this result is that with supply shocks having permanent effects, inflation expectations will eventually become unanchored unless the central bank acts to keep inflation stationary around target. See Yao, F (2014), ‘Stabilising Taylor rules when the supply shock has a unit root’, Journal of Macroeconomics. Forthcoming.

[19] Ehrmann, M (2014), ‘Targeting inflation from below – how do inflation expectations behave?’, Bank of Canada Working Paper, No. 2014-52. The impact of downside surprises in inflation outturns on expectations has been observed recently in the euro area, see Miccoli, M and S Neri (2015) op. cit.

[20] Wong, B (2014), ‘Inflation expectations and how it explains the inflationary impact of oil price shocks: evidence from the Michigan survey’, CAMA Working Paper, No. 45/2014. demonstrates these facts for the United States following oil price shocks using the Michigan survey of household inflation expectations.

[21] Limited liquidity in this bond, and the lack of a long history suggests caution should be taken over the reliability of this measure, but the direction of change is indicative of lower inflation expectations.

[22] Lewis, M (2015), ‘Measuring inflation expectations’, RBNZ Analytical Note. Forthcoming.

Core CPI Right In RBA Target Range

The Consumer Price Index (CPI) rose 0.2 per cent in the March quarter 2015, following a rise of 0.2 per cent in the December quarter 2014, according to data released by the Australian Bureau of Statistics (ABS) today. The CPI rose 1.3 per cent through the year to the March quarter 2015, following a rise of 1.7 per cent through the year to the December quarter 2014. The reading is flattered by a significant fall in fuel.

The underlying rate was 2.4%, right within the RBA target range, a little higher than expected, and as such it will more than likely tip the RBA in “hold” territory next month, when coupled with better than expected previous employment data, and hot Sydney property. Moreover, little evidence that a further cut would change the picture much (other than reducing savers ability to spend).

The most significant price rises this quarter were in domestic holiday travel and accommodation (+3.5 per cent), tertiary education (+5.7 per cent) and medical and hospital services (+2.2 per cent), These rises were partially offset by falls in automotive fuel (—12.2 per cent) and fruit (—8.0 per cent). The decrease in fuel was registered in all fuel types with the quarterly fall the largest since December 2008 and over the twelve months to March 2015, automotive fuel has decreased by 22.5 per cent. This is the largest yearly fall in the history of the series, beginning in September 1973.

	Current estimate	Range for current estimate	Direction of change in last year	Consistent with midpoint
Survey measures*	2.1	1.8 – 2.2	↓
Model-based measures	1.4	1 – 1.5	↓
Market based measure	1.5	1.5	↓
*Excluding surveys of less than 1-year ahead