Canada, Australia, and New Zealand; does the Zero Lower Bound matter?

I want to compare the economies of Canada, Australia, and New Zealand over the last couple of years. I know I will get things wrong, and leave important things out. That's what comments are for. Especially comments from Australia and New Zealand.

Why these three countries? Apart from any historical, cultural, and political similarities, all three are small open economies with an inflation targeting central bank. But there's one big difference between Canada and the other two.

The Bank of Canada hit the notorious "Zero Lower Bound" on nominal interest rates (or felt it had). That's supposed to matter. A central bank that hits that constraint cannot loosen monetary policy enough to offset a decline in aggregate demand. The Reserve Banks of Australia and New Zealand didn't even come close to the lower bound. So seeing how the otherwise similar Australia and New Zealand did compared to Canada should tell us if the ZLB matters. Australia seems to have done better than Canada, which fits the theory. But New Zealand seems to have done worse.

Inflation targets. Canada and New Zealand target 2% CPI inflation. Australia targets 2.5% CPI inflation.

Interest Rates. All three countries' central banks use the same interest rate mechanism to implement inflation targeting. But there is a very big difference between the actual numbers.

Compared to Canada, New Zealand has always had very high interest rates during the years of inflation targeting. In the first half of 2008, the overnight rate target was 8.25%. The RBNZ began cutting in July 2008, to a low of 2.50% in April 2009, where it has stayed since. This is one important difference, because the RBNZ could cut a massive 5.75% and yet never got anywhere even close to any Zero Lower Bound or liquidity trap.

Australia has also had much higher interest rates than Canada during the years of inflation targeting. In Summer 2008 the overnight rate target was 7.25%. The RBA began cutting in September 2008, to a low of 3.00% by April 2009, then began raising again in October 2009. Again, despite cutting 4.25%, the RBA never got anywhere even close to any Zero Lower Bound or liquidity trap.

Canada had an overnight rate target of 3% in Summer 2008. The BoC began cutting in October 2008, to a low of 0.25% in April 2009, where it has stayed since. A mere 2.75% cut brought the BoC to what it considered to be the lower bound.

New Zealanders and Australians have long puzzled over why their interest rates are so much higher than other countries' like Canada. I have read a little bit about this, but don't remember any really satisfactory explanation. But whatever the reason, their higher interest rates going in gave their central banks much more room to cut when aggregate demand fell.

But we have to be careful here. In absolute terms, RBNZ cut the most, at 5.75 percentage points, followed by RBA, at 4,25 percentage points, followed by BoC, at 2.75 percentage points. Yet in relative terms, BoC cut the most at 92%, followed by RBNZ at 70%, followed by RBA at 59%. It's not obvious what's the best way to compare the three countries.

Inflation. All three countries had CPI inflation above target in Summer 2008. Australia and New Zealand peaked around 5% inflation, while Canada peaked around 3.5% inflation. All three saw big declines in inflation, but Canada saw inflation dip the most below target, into temporarily negative values for Summer 2009. All three now have inflation close to target.

Unemployment. All three countries saw unemployment rates increase. Australia saw the smallest absolute increase, from 4.2% in Summer 2008 to a high of 5.8% in Summer 2009. Canada saw a larger increase over the same period, from around 6.0% to a high around 8.5%. New Zealand fared worst, with the unemployment rate doubling, albeit from abnormally low levels, and with no decline yet.

GDP. (Update, I forgot this one!). Australia only had one quarter of declining real GDP (and so escaped that stupid "technical recession" definition). New Zealand's GDP did much worse than Australia's, and about as bad as the US. Canada did better than the US.

Banks and Finance. None of the three countries saw any major financial institution in major trouble? Right, readers?

House prices. Canada saw house prices fall by around 8%, then recover fully. New Zealand saw a slightly larger decline, and house prices have stopped falling but have yet to recover. Australian house prices barely fell at all, and then continued to rise (pdf).

Conclusion. I don't have one really. After all, it's only a sample of three. But if the zero lower bound were such a problem I would have expected both Australia and New Zealand to have done much better than Canada. Only Australia did. And before you say that there were other shocks to aggregate demand, and that they were different for the three countries, remember this: a central bank that is not at the zero lower bound is supposed to offset any such shocks to keep inflation on target.

Comments

[Stephen Gordon]

One thing I thought might matter was exchange rate movements. The appreciating CAD helped keep down inflation, so Canadian interest rates were lower than they would have been otherwise.

But the Australian and NZ dollars also appreciated against the USD (and therefore the yuan) over this time, so maybe there's no story to tell here, either.

[Kosta]

A great post, some valuable insights should be generated by comparing these three economies. Given that all three economies are small and open, I think it is important to consider the large economies which each of Canada, Australia and New Zealand are most connected.

Canada's economy, as we all know, is heavily integrated into the U.S. economy, with a downturn south of the border generating significant headwinds north of the border. The severity of the Canadian downturn in 2009 was in part mediated by the collapse of economic activity in the U.S. (especially for the export-oriented manufacturing sector).

It seems to me that Australia's economy is strongly tied to China, with the latter country being the destination of much of Australia's exports (particularly commodities). As China's has had very robust growth for the past 10 years, I would expect that much of this economic activity and demand has spilled over into Australia This might help explain why Australian interest rates and inflation were higher than other OECD countries pre-financial crisis. Also, post-financial crisis, China initiated a very large stimulus program, which again undoubtedly spilled over into Australia, potentially helping the Land Down Under avoid a technical recession.

I think it would be hard to compare the economic performances of Canada and Australia without also considering how both the U.S. and China are also performing.

I'm not sure where New Zealand fits into this story, although they might provide a nice counterfactual to Australia.

[The Balf]

With regard to China and the U.S. as trading partners, I'll take the latter any day. Despite being arrogant, politically paralyzed, bankrupt and delusional, the U.S. is an open society with a transparent democracy. China can change courses at the drop of a hat. It is a militarily-menacing, totalitarian state with no regard for its own citizens, let alone the rest of us. Tread carefully, Australia!

[Nick Rowe]

New Zealand's exchange rate seems to have behaved like Canada's except with a bigger fluctuation. http://www.rbnz.govt.nz/keygraphs/Fig8.html

About the same with Australia: http://www.rba.gov.au/chart-pack/financial-indicators.pdf

Kosta: Thanks! Yes, the China vs US as trading partners for Australia vs Canada (NZ's biggest trading partners are Australia and the US, I think), must matter. But if it only matters via its effect on aggregate demand, monetary policy should be able to offset it. In particular, if New Zealand had a bigger drop in net export demand, why didn't/couldn't it just loosen monetary policy more?

[bob]

My guess is that both Canada and Australia got a big boost from the rebound in commodity prices, while New Zealand (I think) has a lot less natural resources and is an importer of oil.

I'd explain the difference between Australia and Canada as being mainly due to exposure to the US consumer/housing market vs. exposure to the Chinese stimulus/building boom via fungible commodities. While both economies have large commodity components that helped with the rebound, Canada was more dependent on US demand for other things like auto exports so we took a bigger hit.

[bob]

"if New Zealand had a bigger drop in net export demand, why didn't/couldn't it just loosen monetary policy more?"

Terms of trade maybe? I think this is one of Stephen's favorite areas so maybe he can chime in:
http://www.stats.govt.nz/browse_for_stats/economic_indicators/prices_indexes/overseastradeindexesprices_hotpdec09qtr.aspx

It looks like their import prices went way up during the crisis, so maybe they were worried about cost push inflation and that's why they didn't lower interest rates too much

[Kien Choong]

Hi Nick. Have you considered fiscal policy to explain why Australia did better than NZ? I understand NZ's conservative government did not try to stimulate demand, at least not to the same extent as Australia.

I also have the impression that Australia's stimulus package was well timed. It was rolled out quickly at a time when the stimulus mattered most.

I often wondered what the likes of Krugman and Delong would think about Australia's stimulus, given that their argument in favour of fiscal stimulus is conditional on the interest rate having reached zero bound. Maybe the Australian stimulus package was so quickly rolled out and so well timed that it was able to make a difference regardless of how tight monetary policy was. In particular, it shored up confidence in the private sector at a critical time.

Kien

[Declan]

Although Canada reached the zero bound, I'm not sure we 'hit it' in the sense that we needed to have negative interest rates, but couldn't. It seems that zero rates did their job in resurrecting the housing market. If we'd dropped rates to zero and the housing market kept falling (like in the U.S.) then I'd say we had hit the zero bound.

[Min]

Nick Rowe: "But we have to be careful here. In absolute terms, RBNZ cut the most, at 5.75 percentage points, followed by RBA, at 4,25 percentage points, followed by BoC, at 2.75 percentage points. Yet in relative terms, BoC cut the most at 92%, followed by RBNZ at 70%, followed by RBA at 59%. It's not obvious what's the best way to compare the three countries."

This seems to be getting ahead of yourself. If your main question is whether the zero bound matters, these seem to be distractions.

"All three countries saw unemployment rates increase. Australia saw the smallest absolute increase, from 4.2% in Summer 2008 to a high of 5.8% in Summer 2009. Canada saw a larger increase over the same period, from around 6.0% to a high around 8.5%. New Zealand fared worst, with the unemployment rate doubling, albeit from abnormally low levels, and with no decline yet."

This is the kind of thing that journalists do that drives me crazy. Please give the numbers for New Zealand, and don't mix factual reporting with editorializing. Grrrrr!

[Andy Harless]

I think it's a little early to be trying to draw any conclusions, for a couple of reasons.

1. At least Canada and NZ still seem to have significant output gaps right now, so I'm far from confident that inflation will remain close to target. If, for example, it goes below target again in both countries for a substantial period of time, then one will be able attribute NZ's experience to a policy error that prevented it from taking advantage of its interest rate leeway. And moreover, it may then successfully rectify that error and leave Canada at a disadvantage.

2. Canada is being affected by the US fiscal stimulus, whose impact will peak this year. If (as a very large minority of economists expect) the US subsequently goes into a second dip and the impact spills over the border, Canada will also likely find itself at a disadvantage for having reached the zero bound.

Even if none of this happens, I'll be rather skeptical of arguments that the zero lower bound didn't matter for Canada. Being happy about Canada's experience with the zero bound is rather like being happy with getting a just passing score on a professional exam: "This is great. I didn't waste a single minute on unnecessary studying." It's great for someone who never expects to take a similar exam in the future. But for someone who does, I would advise studying harder next time.

[scott sumner]

Nick, I have to agree with those who point out that there isn't enough information here. Obviously the zero bound didn't matter for Australian and New Zealand, but on the other hand they were impacted by something the US was not impacted by--and exogenous shock of a worldwide recession. So unemployment might rise even with optimal monetary policy. In that sense, of course, Canada is more like Australia than the US. So the only real question here is whether the BOC wanted to do more easing, but felt unable to because of the zero bound. What do they say? At the Fed you had Janet Yellen saying "we should want to do more." Did BOC officials spout any similar nonsense?

Kien's comment is very interesting. I haven't heard Krugman's views on optimal monetary policy in small countries. The zero bound isn't a factor, as they can always depreciate their currencies without limit. Does Krugman say fiscal stimulus never makes sense in small countries? Or can it be optimal if there are international (real) AD shocks impacting the small country?

[Stephen Gordon]

So the only real question here is whether the BOC wanted to do more easing, but felt unable to because of the zero bound. What do they say?

They prepared the ground for quantitative easing (some new legislation had to be passed first), but in the end, they decided not to implement it. Interest-rate-sensitive sectors (notably housing) responded to the low interest rates. I think that the way to put it is that the Bank grazed the zero bound, but didn't actually hit it.

[Nicholas Gruen]

It's sensible to draw attention to the various contrasts, but beyond that I'm not sure what one can get out of it. Australia was one of the most aggressive in using fiscal policy and it is benefiting from China's strength. As for the idea that monetary policy can substitute for fiscal policy if you're not at the zero bound, that might be true in the medium term, but not in the short term. Australia was able to dump a fiscal expansion of 1% of GDP into its economy within a couple of months of deciding to act - in (from memory) Oct 2008. Cheques were in the mail by December giving us a great Christmas - unlike just about everyone else.

[Angelo Melino]

The Bank of Canada hit the lower bound on the target interest rate in April 2009 and announced a framework for what they could do further. Although they avoided quantitative and credit easing, they did exploit one of the options outlined in that framework: they made the conditional commitment to keep the overnight interest rate fixed at 25 bps until the end of 2010Q2, and extended the maturity of their term PRA to reinforce that commitment. I think the conditional commitment (along with our well-functioning financial system) played a large role in stimulating housing and accelerated the recovery. But it would not have been made if the Bank hadn't hit the lower bound.

[Stephen Gordon]

After the dust has settled, it'd be interesting to see if someone can come up with a counterfactual that measures how effective that commitment was. Perhaps expressed in terms of the number of basis points it would have taken to get the same effect if were were away from the lower bound. How many extra points did the Bank get for that promise?

[Nick Rowe]

Was the ZLB a binding constraint on the BoC? (Did it want to go lower, if it could have done?). Eyeballing the data, it looks like the BoC on average changes the overnight rate target about every second Fixed Announcement Date. So there's a 50% chance it won't change the target. It is unprecedented for the Bank to keep the target fixed for so long. The chances of it keeping the target fixed for 8 FAAs in a row would be about 0.5^8. So just on statistical grounds, it looks like a binding constraint. (My argument here is sort of like the argument that a spike of wage settlements at 0% is evidence for downward nominal rigidity).

Min: I couldn't find data on the NZ unemployment rate (I didn't look very hard) but did find that handy graph I linked to. Looks like it went from around 4% to around 8% currently.

Nicholas Gruen: What you say about Australian fiscal policy might be the key. Temporary tax cuts and transfer increases aren't supposed to have a big fiscal multiplier effect. But maybe the Australian experience suggests they might. And they are (or can be) very quickly implemented. "Shovel ready" vs "cheque's in the mail"? What was NZ fiscal policy?

[Min]

Dear Nick,

Thanks for the info about New Zealand. :)

[Harry Tuttle]

One reason why Australia's interest rate reductions worked so well is that almost all mortgages are at variable rates. The RBA's interest rate reductions boosted household income by 4.5%. This is a powerful transmision channel for monetary policy that most other central banks don't have. The RBA gets far more "bang" for its policy moves, meaning that it was unlikely to get anywhere near zirp.

The government's strategy of sending out cheques handed A$8 billion directly to households. Real household income increased by 9% in the year to the December quarter. This helped offset the 8.5% decline in household net worth as a result of the crisis.

http://www.rba.gov.au/publications/smp/2009/may/html/dom-eco-cond.html

[Nick Rowe]

Harry: given Australia's population of about 22 million, and Canada's about 33 million (50% bigger), and treating the two dollars as equivalent, that A$8 billion would be about equivalent to about C$12 billion in Canada. Big, and very fast. I suspect, given the money supply regime, it was also, de facto, largely money-financed spending.

[Paul Friesen]

Interesting discussion.

Kosta said almost everything I wanted to say. I think that who your trading partners are and what it is you export are the most important determinants for how a small open economy will do in a crisis like this.

China was definitely a better partner to have here. Their stimulus package was about 15% of GDP vs about 2% for most other countries, and they got it out very fast, back in November 2008. Canada and the U.S. were still arguing about the existence of a crisis for a few more months.

I'm not a fan of dictatorship, but you do have to admire a little bit a decision-making process that can do that!

Booming Chinese demand also seems to me to explain why high interest rates were required in previous years to keep down inflation in Australia and New Zealand.

[Adam P]

Morning Nick,

seems to me that Melino's comment hit the nail on the head. The BoC hit the zero bound and reacted in exactly the the theoretically correct way (correct according to NK models).

Now, suppose we compare that to Britain (another relatively small open economy). The BoE engaged in a pretty aggressive QE package but ignored the prescription of the NK models and Britain is doing worse than Canada by A LOT.

If you had wanted to you could easily have made this post about how Canada's relative performance is a huge piece of evidence in favour of the canonical NK models and AGAINST the moneterist view. But you won't say that because you're a big believer in the quantity view...

[Nick Rowe]

Paul: But if booming Chinese demand explains NZ's high interest rates pre-crisis, why didn't it also lift NZ out of the crisis? And, by the interest rate parity condition, forex market traders must also have been expecting the Australian and NZ dollars to be depreciating annually against the Canadian dollar by an amount equal to the interest rate differential. I'm not sure that's plausible. It's not what's been happening, on average.

Afternoon Adam! (Or, do you put your clocks forward next week?)

Maybe. Did longer term bond rates fall more in Canada than in the UK? (Would that work as a test of your hypothesis?) I'm not sure about the answers to those questions.

Also, the UK had major problems at major financial institutions, Canada, Australia, and New Zealand didn't (I think, though no commenter has confirmed this yet.) And I think these UK problems appeared before Canada announced the "keeping interest rates low" strategy, and the UK announced QE.

By the way, I'm not sure that Canada's policy was textbook NK. The BoC made only a *conditional* commitment to keep interest rates low *until they needed to raise them*. The textbook policy says it should promise to keep interest rates *too low for too long*.

[Paul Friesen]

Good question about New Zealand. I don't have what I would consider a good answer, but maybe part of an answer.

New Zealand is extremely agricultural, and dairy products are a major export. I don't know how much the tainted milk scandal in China might have affected that. I do remember that a New Zealand company was part owner of the Chinese company that figured prominently. Perhaps Chinese demand was more of a factor before the crisis than after it, but I don't have figures to back that up.

Australia is more dependent on mining, and one thing that China did early in the crisis was to build up its stockpiles of certain metals, taking advantage of the low prices. There were even suggestions that it was trying to diversify its holdings away from U.S. treasuries by doing that, although someone calculated that the amounts were not large enough to make much of a difference there. Still, I expect that the spending would have been a significant boost for Australia.

I am not suggesting that policy differences of the sort others are talking about are insignificant, either.

[Matthew]

Regarding NZ and dairy exports, the EU and US boosted export subsidies at the low point of the slump in prices.

NZ unemployment went from about 3.5% to 7.3%

Also one other thing about NZ is it was already in a domestic recession before the financial crisis started.

[reason]

Harry Tuttle has a good point. The monetary policy transmission in Australia is very broad based and direct.