PAUL MCBETH: Is the Reserve Bank dancing with its own reflection?

Paul McBeth is the editor of The Bottom Line and Curious News, and previously worked at BusinessDesk for 15 years.

Central banks are meant to be boring and predictable.

The levers they pull in adjusting interest rates take an age to work their way through the complex monetary systems we’ve built up over millennia and every word uttered by a central banker is pored over by an army of analysts hoping for a little bit of edge in what’s meant to be a level playing field.

The problem there is that central bankers try to keep market participants in the loop with breadcrumbs leading the way, only to find that the market pricing they rely on is largely reflecting back their own guidance.

It’s what Federal Reserve chair Kevin Warsh described last month as the thorny hall-of-mirrors problem where those distortions potentially blind both central banks and market participants to new developments and make them more prone to making a mistake.

And as is typically the way, those who bear the most pain from those kinds of errors are more likely to be the folk faced with a bigger grocery bill as inflation runs away or who struggle to find a job when an engineered recession pushes people on to the dole queue.

Take a look at yourself and then make that change

That’s one of the reasons why he’s so keen to move away from the forward guidance introduced in 2012 when the dot plot of where governors reckon the federal funds rate will be was added to increase transparency at the Fed.

He wants markets to spend more time making their own minds up on the trajectory of economic growth, jobs and inflation, and less time trying to second guess what the Fed will do next.

Which isn’t to say that the central banks and financial markets should operate in isolation. Rather, Warsh is more keen on markets understanding how the central bank makes its decisions, rather than just the bare number on its own.

Salt Funds Management economist Bevan Graham described it as a framework-not-forecast approach, where there’s a recognition that making decisions in real-time involves judgement, especially when the nature of the economy is changing.

Of course, the speech itself at the central bankers’ annual symposium at Jackson Hole in Wyoming was literally taken as a hawkish read on where the Fed’s next move was going to be, with bond traders dialling up their bets for a September hike as Warsh talked up the focus on inflation.

Pavlov’s dogs obviously need a little more training.

Could it be really me pretending that they’re not alone?

But Warsh’s speech did bring to mind the relationship between bond market pricing and the Reserve Bank of New Zealand’s decision to hike the official cash rate a quarter-point to 2.75% last week.

Swaps markets have been pricing fairly aggressive rate hikes by the Reserve Bank for some time, as bond traders convinced themselves that last year’s cuts would swiftly be withdrawn – and that perhaps the last few reductions weren’t quite necessary.

The two-year swap rate – which is what two-year mortgages are largely priced from – has climbed about 80 basis points so far this year, closing at 3.73% on Friday. That swap rate has been pretty good at sniffing out trouble, having previously started to nudge higher ahead of the central bank’s previous tightening cycles.

As it turned out, the oil shock from the conflict between the US and Iran threw an unforeseeable spanner in the works, driving up fuel prices and threatening to stamp out the nascent signs of an economic recovery that’s felt more in heartland New Zealand than on the high streets of Auckland and Wellington.

And while Wednesday’s rate hike was widely expected, it certainly wasn’t universally embraced.

And no message could have been any clearer

Kiwibank chief economist Jarrod Kerr and Simplicity’s Shamubeel Eaqub have been outspoken opponents of the Reserve Bank’s hikes given the shaky state of the economy and the fact that much of the current bout of price rises was supply driven and not overly influenced by a lever affecting the demand side.

Inflation expectations appear to be well-anchored, even if the Reserve Bank’s quarterly survey tends to find respondents looking through the rearview mirror at how the consumers price index printed as opposed to where it actually goes.

So, has the Reserve Bank wandered into its own hall of mirrors?

When BusinessDesk’s Rebecca Howard put that to governor Anna Breman and her offsiders at the media conference, the governor went into the tried-and-true central bank hedge that the forecast track isn’t preset and is more a way for decisions to be held accountable.

The bank’s chief economist Paul Conway went further, pointing to the booming export sector and major structural changes taking place in the economy, at the same time as the oil price shock – all of which need flexibility for the current strategy of gradually withdrawing the monetary juice stimulating the economy.

Who am I to be blind, pretending not to see their needs?

It might very well have been easier for the governor to have directed people to the breakout box in the September monetary policy statement outlining how the Reserve Bank should respond to an oil supply shock under the terms of its remit.

After all, the medium-term target for inflation comes with an instruction to look through short-term spikes like said oil shock, and to avoid unnecessary instability.

The central bank helpfully spelled out the consequences had it tried to bludgeon inflation back into its range with a short, sharp hike in the official cash rate to 4.5%, with an even higher rate of unemployment and a steeper decline in the output gap between the economy’s actual and potential growth.

And the July and September increases wouldn’t have come so quickly had the Middle East conflict not broken out, with the second-round effects of more expensive petrol playing on decisionmakers’ minds – even if central bankers around the world are still waiting for them to emerge.

Still, the guardrails and assurances haven’t completely ruled out the suspicion that a financial market dog will always chase its tail, and market pricing is among the many factors the monetary policy committee takes into account.

After all, they wouldn’t direct us to the fact that markets were pricing in still more increases for the OCR by the end of the year if it didn’t matter.

As it stands, bond traders are picking the cash rate to be around the 3% level by the end of the year, down from the 3.5% rate priced in around the May MPS. And that’s with the forecast track of the benchmark rate remaining largely unchanged from the latest forecast.

Depending on how markets react to whatever flavour of coalition government New Zealand serves up in November, Christmas might very well be a time for reflection by the Reserve Bank.

Image from Curious News.