Easy to underestimate how far things may go

I was at a meeting earlier this week at which a funds manager from one of the leading firms in the New Zealand market was giving us a presentation on our money, their performance etc etc.  We had a light agenda and the presentation was basically over and I like to probe funds managers to see how they think about things.  So I asked him about the possibility of New Zealand getting to negative interest rates, deliberately phrased in  a fairly vague way (rather than, say, “what is the probability in the next 12 months?”).  You’ll recall that the OCR at present is 1 per cent.

Anyway, the funds manager’s response was that it was “highly unlikely”, going on to note that although a “couple of people” had been talking up the possibility that had been a while ago.  The implication was that those people had been, most likely, proved wrong.

I found it a really surprising answer.  Maybe many clients (at least on our fairly modest scale) don’t like talk about uncertainty, contingency etc and want to hear more definitive views from their funds manager.  If so, they are ill-advised.  The world isn’t like that.     And it isn’t 1990 when negative interest rates anywhere in the world might have seemed all-but inconceivable.

Closer to now and to home, even the Governor of the Reserve Bank has been quite open about the possibility of negative rates.

If someone asks me my question –  and they do from time to time –  my answer is along these lines: in many respects it would be surprising if we didn’t get to a negative OCR at some point in the next few years, just because the starting point is one per cent and we know so little about the future.  I often go on to add that after nine years since the last recession the chances of some fairly significant downturn at some point in the next few years must be quite high (statistically, the probability of a significant downturn in any particular year is never that low).

Fan charts are one of the techniques people use to illustrate the plausible ranges of uncertainty around macroeconomic (and similar) forecasts.  Here is an example, applied to the US, from an RBA Discussion Paper published a couple of years ago.

fan charts 1.png

Focus on the bottom-right chart.  Over a three-year ahead horizon, only 70 per cent of historical forecasting errors for the Fed funds target rate would be captured in a range five percentage points wide.

Our OCR system has only been running for 20 years, but I had a look at the historical record to see how much the OCR moved over a three year horizon. (One could do the exercise looking at outcomes vs RB forecasts, but that would be more time-consuming.)  The (absolute value) median change in the OCR over a three year horizon was 1.25 per cent.  Take a longer run of data and look at changes over three years in the 90 day bill rate since financial markets were liberalised here and the median change was 1.8 per cent.

Those are medians, so encompassing only 50 per cent of the changes.  From a starting OCR of 1 per cent, a reasonable description of the range of possibilities –  knowing precisely nothing about the macro outlook –  simply based on historical variability would be along the lines of a 50 per cent chance that the OCR three years hence would be in a range of -0.25 to 2.25 per cent, with a 25 per cent chance each that the OCR would be lower or higher than that the options encompassed by that range.     Simply based on historical variability, there might be something like a 30 per cent chance that the OCR would go negative, from this starting point, in the next few years.

Another way of looking at the issue is to look at how large the falls in short-term interest rates have been when the economy turned down.

For the pre-OCR period we had these examples:

1987 to 1989:   about 600 basis points

1991-1992:   about 700 basis points

1997-1998:   about 450 basis points

And since the OCR was adopted

2001:    175 basis points (not measured as a New Zealand recession)

2008-09:    575 basis points

Recessions in New Zealand look to have been associated with 500 (or more) basis points of cuts in short-term interest rates.

That isn’t particularly unusual: I was reading last night a recent speech by one of Fed Board of Governors who noted, in a quite matter-of-fact way, that the Fed has typically needed about 4.5-5 percentage points of policy leeway in recessionary periods in the last 50 years.

(Under current laws and technologies) the OCR can’t be cut by 500 basis points, but cut by 125 basis points from here and we would already be negative.

Of course, it might be reasonable to ask what is the appropriate starting point. The last time the OCR was raised was back in late 2014, and the OCR is already 250 points lower than it was then.   Since those OCR increases were never really warranted by the data (with hindsight –  and some with foresight – never really needed to meet the inflation target), perhaps 3.5 per cent isn’t really a sensible starting point.

But this year’s 75 basis points of OCR cuts have been in response to actual/forecast data on weakening economies and inflation pressures. If so, perhaps 1.75 per cent might be a reasonable starting point for comparison.  And if a recession hits in the next few years, historical experience suggests that (the equivalent) of 500 basis points of easing will be required.  Again, we can’t cut 500 basis points from 1.75 per cent, but we don’t need anything like that –  less than half in fact –  to get negative.

What are the chances of a recession in the next three years?   Well, no one can tell you with any great confidence.  But if we look at (a) the array of risks, locally but especially internationally, (b) the passage of time since the last recessions, and (c) the very limited conventional macro firepower authorities have at their disposal (and are known by markets to have at their disposal) it would be a brave forecaster –  or funds manager – who didn’t have such a possibility in their reasonable range of outcomes over the next few years.   One could add into that mix the fact that in most advanced economies inflation starts below target (quite different from, say, the New Zealand starting point in 2008).   With the best will (wishfulness?) in the world, I’d have thought a significant downturn, requiring a lot more macro policy support, had to be more than “highly unlikely”.

The Reserve Bank surveys professional expectations/forecasts of the OCR, but only a year ahead, and it only asks for point estimates, not (say) a band within which the forecaster would be fairly confident.  The latest survey has a range – for September next year –  of point estimates of 0.0 per cent to 1.25 per cent.  Even if the more pessimistic of the respondents might have pulled back their point estimates a bit, they aren’t responses suggesting negative rates in the next few years are “highly unlikely”.

I’m not sure whether anyone sells options on, say, bank bill futures in New Zealand.  If so, it would be interesting to know what the prices of those instruments are saying about the range of plausible outcomes for the next few years.

I suspect our fund manager was really just giving (a) his point estimate, and (b) implicitly at least, something about the next 12 months or so.  But the general point is independent of his specific comment: when the OCR is already 1 per cent and the economy is still relatively near a NAIRU (not deep in a downturn already), little or nothing from historical experience should give anyone grounds for confidently predicting that New Zealand will avoid a negative OCR at some point in the next few years.   Constantly thinking the OCR is as low as it will go has been a pretty consistent mistake of observers of New Zealand for 10 years now.

9 thoughts on “Easy to underestimate how far things may go

  1. ASX 90 day New Zealand Bank Bill futures and options

    ASX’s New Zealand 90 day bank bill futures and options are the leading short term interest rate derivatives products in the New Zealand market. As New Zealand’s most actively traded derivatives product the New Zealand 90 day bank bill futures contract is used by market participants and commentators as the key indicator for New Zealand interest rates.

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    • Westpac has just raised their 2 year rates to 3.55%. We are far out from negative interest rates. Referring to 1% OCR is just a non event.

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      • If you are talking about retail lending rates, yes. But the discussion – and the post – was about short-term wholesale rates. Fact remains: OCR is 1% and history suggests a non-trivial (prob quite material) risk of a negative OCR in the next few years. It is the wholesale rates where the effective lower bound would be expected to bite.

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  2. Hi Michael, I think you are right about fund managers liking to leave an impression that they have a core view about what may happen over the next 12 months or longer. I havent read it yet, but see that Robert Shiller has a new book “Narrative Economics”, which from what I understand describes a behavioural tendency for people to try to understand the world and its uncertainties by creating a narrative. This is equally applied to the past and speculation about the future. Conceptually, I can see that people can do this. There are obvious and serious pitfalls from this, notably a tendency to oversimplify and ignore inconvenient complicating evidence.
    This brings me to your idea of a fan of possible outcomes (where people struggle to accept that rates can be negative). I agree it is a good way to force people to contemplate a range of outcomes, and particularly those that we havent seen. Using the “narrative” approach, there are scenarios that could mean rates become negative in NZ.
    However , recent data in NZ has been suggesting a pickup in activity. This is not really the case offshore. Housing, the terms of trade, business confidence, more fiscal spending, retail sales are all stronger. It also seems that banks are willing to increase lending in the mortgage market. The bank capital regime, along with prescribed capital requirements across different lending sectors is motivating banks to tilt towards mortgage lending and we see quite competitive mortgage rates, despite the recent rise in swap rates.
    So, a scenario (or narrative) I can imagine for the next 6-12 months is that the pickup in the housing market continues, taking house prices to new record levels and household debt higher too. There’s a possibility we get a fresh housing bubble. Its also possible that inflation, especially non-tradables picks up further, leading the RB to eventually and reluctantly signal higher rates.
    It time, this could lead to a harder fall in housing, easier monetary policy and those negative rates. Of course this scenario ignores all the other things going on, but is a risk that concerns me at present.

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    • Interesting scenario. My alternative would be that a pickup in the housing market doesn’t spill over any more broadly, and weakness in China (in particular) just proves relentless at a global level (where there are few/no pockets of other real strength).

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      • I think you got it backwards. The pickup in the housing market is a refection of a increasing confidence in the NZ economy generally. I looked at the White Island costing charge at $375 a tourist with 41 on that awful day is $15,375 a day. Someone mentioned $129 million tourist spendup annually into the the backpockets of retailers, motels, Air BnB rentals and restaurants etc in that small community.

        The spending of $15 billion per year by 4 million tourists and 60,000 full time equivalent international students surprisingly underestimated in terms of the effect on the exchange rate and its positive effect on the confidence in the NZ economy.

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  3. Always surprises me how few people reference the very simple framework Janet Yellen put forward in that Jackson Hole speech some years ago. And how she pretty much laid out that QE will be the norm in the US, and a lot of countries, during the next downturn if there is no meaningful rise in r* – something other arms of policy remain reticent to take any meaningful action on.

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    • Lael Brainerd’s speech a couple of week’s ago was quite clear that hitting the ELB is going to be the norm. What concerns me is the tone that things around the margin in mon pol – forward guidance, capping long-term rates – will be enough of a compensation for not being able to cut the short rate further. That seems unlikely.

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