Real interest gaps remain large

There has been a bit of coverage lately about the fact that New Zealand 10 year bond yields have dropped to around, or just slightly below, those in the United States.    Here is the chart, using monthly OECD data, of the gap between the two.

NZ less US

Since interest rates were liberalised here in the mid-80s, the only other time our 10 year rates have been lower than those in the United States was in late 1993 and very early 1994.  That phase didn’t last long.  Bear in mind that back then we were targeting an inflation rate centred on 1 per cent –  lower than the US, and lower than the Reserve Bank of New Zealand is charged with targeting now.

As the chart illustrates, the spreads moves around quite a bit, but the recent narrowing in the spread looks to be significant –  it is (roughly) a two standard deviation event.  Then again, so is the narrowing in the short-term interest rate spread.  Usually our short-term interest rates are well above those in the United States, but by later this year it is widely expected that their short-term interest rates will be higher than ours.   When that sort of reversal is expected to last for a while, it will be reflected in the bond yield spread as well.

NZ less US short

The Federal Reserve’s policymakers expect to raise the Fed funds rate to, and even at bit above neutral, in the next year or two (“longer-run” in the chart below is a proxy for FOMC members’ view of neutral), while there is nothing similar in our own Reserve Bank’s published projections.

Fed projections

I’ve made considerable play of the persistent gap between our real interest rates and those abroad.    Do these recent developments suggest that if there was a problem it is now just going away?

Well, the gap between our bond yields and those in some other advanced countries has also narrowed.    Even the gap between Australian bond yields and our own –  a gap which has been remarkably stable over 20 years –  is narrower than it was (although all else equal their higher inflation target should be expected to result in Australian yields typically exceeding our own).

But here is the gap between our 10 year bond yields and those in some other small inflation-targeting OECD countries.

nz less scandis

There doesn’t seem to be anything out of the ordinary going on there (and 10 year bond yields in Switzerland –  like those in Japan and Germany –  are a bit constrained by being almost zero already).

And here is the gap between New Zealand’s 10 year bond yields and the median of yields in all those countries the OECD has data for for the entire 25 year period.

nz less median

If one simply focuses on the last 15 years –  when our inflation target was increased to 2 per cent (midpoint) –  the current spread is not very different to the average for that period.

There simply isn’t much sign of the persistent gap between our real long-term interest rates and those in other advanced countries going away.

In fact, dig just a little deeper and even the story vis-a-vis the US is a bit less encouraging.  Both countries now have long-term inflation-indexed government bonds, the yields on which are a pretty good read on long-term real interest rates.  US government inflation-indexed 20 year bond yields are currently about 0.9 per cent (even with pretty wayward US fiscal policy).  The Reserve Bank reports that our 17 year indexed bond yesterday yielded 1.82 and our 22 year bond was yielding 2.0 per cent.    A full percentage point gap on a 20 year bond –  even if a bit less than it was – still adds up to an enormous difference over time.  Markets aren’t convinced New Zealand and US real interest rates are sustainably converging any time soon (and, to those who want to throw in claims that the US is bigger or central to the system or whatever, recall that US bond 10 year yields are currently among the highest in the OECD –  in other words, it is quite possible for small advanced countries to have lower interest rates, over long terms, than the US).

The other thing markets don’t appear convinced about is that the Reserve Bank will achieve the 2 per cent inflation target (set for it again this week).   One can proxy this by looking at the gap between inflation-indexed bond yields (real yields) and nominal bond yields.

Here is the US version, using constant-maturity yields for the real and nominal series.

us breakevens

For the last year or so, markets have again been behaving as if the Fed is likely to deliver inflation around 2 per cent over the next 10 years.

But here is the (cruder) New Zealand version.   I’ve just used data on the RB website –  their 10 year nominal government bond yield, and the yields on the two indexed bonds either side of 2028 –  one maturing in September 2025, and the other maturing in September 2030.  Right now, 10 years ahead is almost exactly halfway between those two maturity dates.

NZ breakevens

Halfway between those two lines, for the latest observation, is a touch under 1.3 per cent.    It is a long way from the target of 2 per cent, and the gap is showing no signs of closing.

There are two challenges it seems:

  • if the government is at all serious about beginning to lift productivity growth and close the productivity gaps, they need to think a lot harder –  and be willing to do something about –  the things in the policy framework that continue to deliver us much higher real interest rates than those in other advanced countries,
  • and the new Governor has some work to do if he is to convince people that he is really serious about delivering future inflation averaging around 2 per cent.  Since the government itself just renewed that target, it should concern them –  and their representatives on the Reserve Bank Board –  that the target doesn’t appear to be taken that seriously by people investing money who have a direct stake in the outcome.

5 thoughts on “Real interest gaps remain large

  1. Genuine question, Michael, as someone with a weak grasp of economics:

    Why is below-target inflation bad? I always thought the mantra with inflation was “the lower the better” when catastrophic examples such as Zimbabwe and 1930s Germany come to mind. What are the broader economic effects of inflation remaining at 1.3% as opposed to 2% or more?

    Also, what would you suggest as a way of reducing the gap between our real interest rates and bond yields, and those of our OECD cousins?

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    • The interest rate gap is not due to economic issues. It is mainly due to the monopoly power that the 4 major Australian banks have over its competition banks in NZ. The Australian banks have grown by acquiring pretty much all the largest NZ banks. NZ bank licensing requires that lending in NZ is backed by a significant percentage of NZ paid up capital and NZ local savings deposits. The main NZ banks therefore control most of the $170 billion in NZ local household savings which allows them to control most of the $175 billion in NZ house debt, $60 billion in farm debt, $60 billion in investment property debt and $150 billion in commercial debt.

      Competition banks that have recently entered the market do not have access to NZ local savings and therefore behave like embarrassing little banks. The great Bank of China in NZ is the Small NZ Bank Of China. The Giant ICBC Bank(International Bank of China) is a Little Dwarf NZ ICBC Bank. They bring knives to a gunfight.

      HSBC which is a British Bank is the only realistic competition offering usually below market interest rates to try and compete. But it is only the Immigrants that use HSBC for savings and therefore it is really only immigrants that are allowing interest rates to be kept a little lower than necessary. With a name like Hong Kong and Shanghai Bank most kiwis think that this is actually a Chinese Bank rather than a British Bank and would not put their savings there.

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  2. Robert

    The inflation target (here and in most advanced countries now) has been set centred on 2% because of a judgement that the economy works a little better with a small amount of inflation than it would with something more like absolute price stabililty. there is some small upward bias in the CPI, so even “true price stability” might be something like a 0.5% pa increase in the CPI. The main logic is that it is very difficult to get people to take nominal wage cuts – when bad stuff happens – but that small real wage cuts can be secured with unchanged nominal wages, and there is also the concern that too-low inflation means too-low nominal interest rates. Since interest rates can’t be cut below about -0.75% – where, eg the Swiss are now – that leaves insufficient room to cope with shocks eg new recessions.

    People can debate the merits of these arguments. Personally, I would probably prefer a lower target (but I’d also prefer govts to fix the problem of the floor on nominal interest rates. But the target is rightly something set by elected politicians – the RB’s job is just to operationally deliver – and they’ve set the target symmetrically, so even just from a governance/accountability perspective you want bureaucrats delivering what they were instructed to deliver.

    In terms of substance, the economic effects of the difference between 1.3% and 2% may be small, but part of that difference is the additional leverage when the next recession comes. A more determined strategy to deliver 2% would involve lower interest rates in the immediate future, but that would deliver a higher average future interest rate (higher inflation expectations), leaving more leeway when the next recession comes. Both in the US and NZ – and no doubt elsewhere – central banks often need to cut 500 bps in a recession. If they can’t even come close to that, the recession itself will be deeper – more people out of work for longer than is necessary – than otherwise.

    The biggest policy distortion here re our real interest rates is our immigration policy. In a country with a modest savings rate, running an immigration programme three times the size (per capita) of that in the US – which in turn is larger than the influx in most European/Asian advanced countries – puts persistent upward pressure on our real interest rates (and real exch rate) relative to other countries. Similar effects are at work in Australia – they have much higher savings rate, but also very capital intensive industries (mining etc) so the big increase in immigration in the last decade or so is having much the same qualitative effect as in NZ. My argument is that if we cut immigration (of non-citizens) to the per capita rate of the Bush/Clinton/Obama years in the US, we’d see materially lower real interest rates and a much lower real exch rate. Some of the mechanisms are laid out, and some objections are dealt with, in this speech.
    https://croakingcassandra.files.wordpress.com/2017/09/large-scale-non-citizen-immigration-to-new-zealand-is-making-us-poorer-mana-u3a-sept-2017.pdf

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    • There has been a wide gap between the OCR at 1.75% and actual interest rates at 5% for quite some time. Recently with the slowdown in the property market 1 year rates have dropped to around 4.2% with no change in the OCR. Immigration still sits at record levels of net gains of 70k for a number of years now. HSBC is the only competing bank that is able to offer up any lending rate competition with immigrant savings. Therefore immigrants have more a dampening impact on lending interest rates keeping it lower than the monopoly banks would prefer.

      Liked by 2 people

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