Interest rates

There was a quite odd paper released yesterday by the New Zealand Initiative –  the business-funded think tank, that has done quite a range of work on coronavirus-related policy issues –  on monetary policy, fiscal policy, interest rates, and asset prices.  I know some of my readers will agree with at least some of Bryce Wilkinson’s paper.  I disagree with it almost entirely, unlike the previous paper on some related macro issues the Initiative released under Bryce’s name (where my reaction was my along the lines of “yes, but…” or “perhaps, but that isn’t the whole story”.  On Bryce’s telling in this latest paper, central banks appear to be little more than wreckers and debauchers, driving the world inexorably towards its next (real) economic and financial crisis.

If I were fully well, I would devote a lengthy post (or two) to the paper.   Bryce is a smart guy and there is a range of material there that really should be carefully unpicked and scrutinised.  As it is, for today there will be just something brief.

Bryce seems to hold it against our Reserve Bank that it has cut the OCR to 0.25 per cent.  This is from pages 7 and 8

First, the sharp reductions in policy discount rates are an active response to hurtful economic shocks rather than a passive response to secular trends. Think of it as a response to signs of financial market stress – falling share prices, rising bond yields, a ‘dash for cash’ and market turnover drying up – causing step reductions in policy discount rates, with limited reversals for fear of triggering renewed signs of stress.

Second, policy discount rates still differ considerably around the world. They are the lowest by far amongst European and Scandinavian countries, Japan, the UK and the US. Outside that group, the Bank of International Settlements shows only Israel has a policy interest rate lower than New Zealand and Australia’s 0.25%. Of the 38 central banks in its dataset, half had policy discount rates in April of 1% or more.

and this footnote appears a page or so earlier

The Bank of International Settlements database shows that in April 2020 the policy rates of 29 of 38 central banks around the world were higher than for these four central banks. Israel, with a policy rate of 0.1%, was the only non-European central bank to be below New Zealand and Australia’s 0.25%. Almost one third of the central banks had policy rates of 2.5% or higher in April.

The first paragraph is mostly just out of step with the actual historical record.  Policy rates around the world have not been cut this year mostly because of financial market stresses –  which didn’t even really appear until mid-March –  but in response to rapidly deteriorating economic situations and emerging downside risks to inflation.

But what of those policy rates?  Here is the chart of nominal policy interest rates from the BIS.

policy rates BIS

(I capped the scale at 10 per cent –  Argentina actually has a policy rate of 38 per cent, but I guess Bryce won’t be commending their example to us.)

One can quibble about precisely which policy rate to use –  most reckonings for the ECB would probably use the deposit rate of -0.5 per cent, and although New Zealand and Australia are shown here as having the same rate in fact the effective rate in Australia is 15 basis points lower than it is here.   One could reasonably delete a couple of entries from the chart altogether –  Hong Kong and Denmark have long-term fixed exchange rates, and Croatia describes its monetary policy as keeping the exchange rate to the euro stable.  Korea cut by another 25 basis points last month.   But these are small institutional details: the main point is that pretty much the entire group of advanced economies have nominal interest rates of less than 1 per cent.  In almost all those cases, real interest rates –  which central banks do not control –  are negative.

On the other hand, Bryce is right to note that there are still countries with higher rates.  In fact, I could link to a longer list with many more countries with higher interest rates (Pakistan 8 per cent, Uzbekistan 15 per cent, Ukraine 6 per cent, Zambia 9.25 per cent).

But it is hard to see what is appealing about almost any of those countries’ macro management.    Quite a few have higher inflation targets (Turkey, for example, has a notional target of 5 per cent, and actual outcomes last year of almost 12 per cent).  Of all those higher interest rate countries,  only Iceland really counts as an advanced economy and it is the country in the chart with (by far) the largest cumulative fall in its policy interest rate since just prior to the 2008/09 recession (where, on the Wilkinson telling, the rot really began to set in).    There’s China of course, but (a) interest rates aren’t a key part of the transmission mechanism in the PRC, and (b) whether it is public or private credit one worried about, China took the great-debauch path more than most.

I don’t know all those countries to the right of the chart at all well, but I can’t think of a single one that I’d exchange for most of the countries on the left of the chart, New Zealand included, whether it was macro management or political stability (often somewhat connected) that I had in view.  In fact, even Japan and the US –  for all their faults and all their debt –  easily look a better (nominal) bet than any of those on the right of the chart.

And although one wouldn’t really know it from the New Zealand Initiative piece all the OECD countries with the lowest net government debt are also bunched towards the left hand end of the chart.

2019 govt net debt (% of GDP)  (OECD)
Finland -48.9
Luxembourg -47.6
Sweden -33.5
Estonia -24.2
Switzerland -12.4
Australia -11.5
New Zealand -2.8
Denmark -2.5
Czech Republic 8.8
Latvia 9.9
Lithuania 12.4

Plus Norway of course, with huge net financial assets.   Any of them could readily borrow more –  much more –  with no central bank hand on the scale, but they (probably responsibly) chose not to.

Two final brief thoughts.

First, what I always find striking among the critics of central banks from the side Bryce comes from is how powerful they seem to think central banks are over very long-term real interest rates.  I think central banks have quite a degree of influence over economic activity over perhaps a 1-3 year horizon, but beyond that their only real influence is on inflation.  I’m pretty sure that would probably have been the view of a younger Wilkinson –  Muldoon might, as the story went, juice the economy in the short-run for electoral purposes, but before long all we’d be left with was higher inflation.  Thus, Bryce declares himself scandalised that in its LSAP programme the Reserve Bank bought long-term inflation-indexed bonds at negative real interest rates but (a) long-term real interest rates have been falling for decades (I always recall the funds manager who for years afterwards proudly boasted of having bought New Zealand inflation indexed bonds at a real yield of 6 per cent) and (b) market real yields for New Zealand indexed linked bonds first went negative in August last year, way before there was any talk of RB asset purchases.   There are deeper forces at work –  real savings and investment preferences –  which Wilkinson’s paper seems not to address at all.

Second, related to this Wilkinson appears to have a hankering for deflation.  I’m not unsympathetic –  although not wholly persuaded –  by the case that if there was rapid trend productivity growth it could be attractive to take the gains in a lower general price level rather than higher nominal wages.   But that bears no resemblance to the world in which we actually live today.    Productivity growth in the frontier economies has slowed materially – and on many reckonings was slowing even before 2008/09 –  and, of course, the New Zealand productivity record has been particularly dire.   And there tends not to be a huge demand for investment when firms don’t perceive substantial profitable –  often productivity-enhancing –  investment opportunities.   When investment demand is weak and savings preferences are relatively strong, real interest rates will be very low, perhaps even negative.  There is no iron-law of nature that says that the market-clearing price for using savings need be positive (in nominal or real terms).  That doesn’t saving unwise or imprudent at an individual level –  one of Wilkinson’s concerns –   but does suggest you can’t expect much, if any, of a low-risk return to such savings.  That is, of course, true of many prudent things we do in life (insurance most notably).

 

Expecting low inflation, and interest rates

The Reserve Bank Governor has been heard in recent months expressing concern about the possibility that inflation expectations –  what people think will happen, which in turn can influence how they act – will drift lower.   It might seem like a rather abstract concern, but there are real world consequences.  If everyone used to expect inflation would be 5 per cent and now expect it to be 2 per cent then, all else equal, nominal interest rates will have to be set 3 percentage points lower than previously just to get the same degree of monetary policy bite/stimulus.  All else equal, if inflation expectations –  the ones that genuine reflect behaviour –  are falling then real interest rates are rising.

Lower inflation expectations has been the trend in New Zealand for more than a decade now.  The Reserve Bank surveys households and perceptions of the current inflation rate and expectations of the future inflation rate are both quite a lot lower than they were prior to the last recession.  Term deposit rates are now perhaps 500 basis points lower than they were in 2007, but in real terms that reduction is perhaps no more than 300 to 350 basis points.  On the more-widely quoted survey the Bank does of somewhat-more-expert observers, medium-term inflation expectations are also about a full percentage point less than they were in 2007.   In those days we took as pretty normal inflation of around 2.5 per cent.  No one –  try some introspection on yourself –  thinks of that as a normal New Zealand inflation rate now.

Some of that reduction in inflation expectations hasn’t been unwelcome.   The Reserve Bank had tended to be rather too accommodating of inflation in in the top half of the target range (some mix of forecasting mistakes and a cast of mind that wasn’t too bothered) and the range itself had been pulled up a couple of times by governments.   Expectations –  of the sort that shape behaviour –  genuinely centred on the target midpoint, 2 per cent inflation, would be a “good thing”.  More recently, across the range of surveys, expectations look to have been drifting down again.   With nominal interest rates already so low, that isn’t a good thing.  For example, when one thinks of the extent of Reserve Bank OCR cuts this year, the moves look quite large : 75 basis points.

But here are the three retail interest rate series the Reserve Bank publishes, showing the changes since the end of last year (and December last year wasn’t some abnormal month, but roughly where rates had been all last year).

SME new overdraft rate                                   -37 basis points

New residential first mortgage rate              -59 basis points

Six month term deposit rate                           -47 basis points

Deduct say 15 or 20 points more for a decline in inflation expectations and you really aren’t looking at much of a decline in real short-term interest rates (facing firms and households) at all.   By contrast, a 20 year indexed government bond rate (ie a very long term real interest rate) –  set freely in the market –  has fallen by about 120 basis points.

What is striking about the Reserve Bank’s treatment of inflation expectations is that they hardly ever –  change the Governor, change the chief economist and still they choose to ignore it – refer to the market-based indicator of implied inflation expectations from the market for government bonds.     There are all sort of quibbles people can mount about the numbers, but the fact remains that it is the only market-based measure, reflecting actual choices and dollars, not just answers to a survey question.

Here are latest inflation breakevens for New Zealand: the gap between the 10 year nominal government bond rate and a 10 year real government bond rate (linearly interpolated from the yields on 2025 and 2030 inflation-indexed government bond rates).  The last observation is the chart is yesterday’s data.

breakevens 0ct 19

It is old news that the last time these “breakevens” or implied inflation expectations were last at 2 per cent almost six year ago.  Not since then have financial markets been trading as if they believe the Reserve Bank will do its job over the coming 10 years.  This measure of expectations fell away sharply over 2014 to mid 2016, when the Bank was messing things up –  tightening when no tightening was necessary and then being grudging in their cuts (as Wheeler became ever more defensive).  There was something of a rebound, but it hasn’t lasted and since the end of last year the breakevens have been dropping away again.  Right now, markets are trading as if the average inflation rate over the next ten years could be as low as 0.87 per cent.  The OCR cuts this year have not been enough to stabilise, let alone reverse, the series.

Some of the patterns are global.  Here is the comparable US series

US breakevens oct 19

But the levels are national.  If current US breakevens should be uncomfortable for the Fed, at around 1.5 per cent they should be nothing like as troubling as the 0.9 per cent we have in New Zealand.    And, for once, going into any serious downturn our central bank has less conventional monetary policy leeway than the Fed does.

Throw in the slope of the yield curve – this chart from a few weeks ago, in which each time this variable has been at current levels it has been followed by a recession –  and there is a pretty good case for the Reserve Bank doing more than it has done.

nz yield curve 2.png

Inflation expectations have already been falling.  Given how little conventional policy room most central banks have –  and the distinct limits of unconventional policies – if there were to be a recession (here and/or abroad), few people then would rationally expect monetary policy to do its usual work.  A rational response would be for inflation expectations to fall away quite a bit further, driving real interest rates up (all else equal) at a time when the capacity for further nominal interest rate cuts is all but gone (unless/until governments finally do something about the effective lower bound).  That really would be a bad outcome.

In putting together this post, my eye was drawn to the array of current nominal New Zealand interest rates –  for any term at all now less than 1 per cent.  Here are some comparisons across a range of dates (12 years ago was in the months prior to the last recession –  and for anyone interested 30 years ago all the rates were in double figures).

Conventional government bonds
90 day bill 1 year 2 year 5 year 10 year
22 years ago 7.63 7.33 6.75 6.61 6.59
20 years ago 5.00 5.55 6.14 6.78 7.06
12 years ago 8.75 7.04 6.98 6.70 6.28
10 years ago 2.77 4.15 4.91 5.56
Five years ago 3.68 3.50 3.98 4.06
Current 1.04 0.78 0.69 0.76 0.99

Perhaps what is easy to lose sight of is that the steepest fall in New Zealand long-term actual and expected interest rates wasn’t in the wake of the last recession, but in the last five years (when our political parties squabbled over an allegedly healthy economy).

Whatever the Governor claims, these extraordinarily low interest rates are not normal by any standard, recent or historical.  And yet, at very least, they are necessary and unavoidable, in response to all else –  public and private –  going on in national and international economies.

 

Monetary policy and the yield curve slope

A month or so ago there was a great flurry of media coverage when the US interest rate yield curve “inverted”.  In this case, long-term government security interest rates (10-year government bond yield) moved below short-term government security interest rates (three month Treasury bill yield).   This was the sort of chart that sparked all the interest.

US yield curve

The grey bars are US recessions, and each time the long rate has been less than the short-term rate a recession has followed.   This chart only goes back to 1982 but it works back to at least the end of the 1960s.    There haven’t been any recessions not foreshadowed by this indicator, and there haven’t been times when the yield curve inverted and a recession did not come along subsequently (sometimes 12-18 months later).   Who knows what will happen this time.  It is, after all, a small sample (seven recessions, seven inversions since the late 1960s), and there is nothing sacrosanct (or theoretically-grounded) in using a 10 year bond rate.  Use the US 20 or 30 year government bond yields and right now the curve wouldn’t even be (quite) inverted.

But there are good reasons why changes in the slope of the yield curve might offer some information.  A long-term bond rate isn’t (usually) controlled by the central bank or government and might have a fair amount of information about what normal or neutral interest rates are in the economy in question. By contrast, short-term rates are either set directly or very heavily influenced by the authorities.    When the short-term rate is unusually far away from the long-term rate one might expect things to be happening to the economy, whether by accident or design.

Back in the day, when we were trying to get inflation down in New Zealand (late 80s, early 90s), the slope of the yield curve was for several years, off and on, a fairly important indicator for the Reserve Bank.  At times we even set internal indicative ranges for the slope of the yield curve (at the time, the relationship between 90 day commercial bill yields and five year government bond yields), and for a while even rashly set a line in the sand of not allowing the short-term rate to fall below the long-term rate.      We used this indicator because neither we nor anyone else had any idea what a neutral rate (nominal or real) would prove to be for New Zealand, newly liberalised and then post-crash, money supply and credit indicators didn’t seem to have much content, and we didn’t want to take a view on the level of the exchange rate either.  But whatever the longer-term interest rate was, if we ensured that short-term rates stayed well above that long-term rate, we seemed likely to be heading in the right direction –  exerting downward pressure on inflation and, over time, lowering future short-term rates as well.

But what about the New Zealand yield curve slope now?     Here is the closest New Zealand approximation to the US chart above, using 90 day bank bill yields and the 10 year (nominal) government bond yield.  I’ve shown it the other way around – 90 days less 10 years –  because that is the way we did it here (partly because of the long period, until 2008/09, when short-term interest rates were normally higher than long-term ones, rather different to the US situation).

nz yield curve 1

I can’t easily mark NZ recessions on the chart, but there were recessions beginning in 1987, 1991, 1998, and 2009, and each of them was preceded by this measure of the yield curve slope being positive,  But, for example, the slope was positive for four years in the 00s before there was a recession.    Against this backdrop, there isn’t really much to say about where we are right now (just slightly positive).   And take out whatever credit risk margin there is a bank bill yield (20 basis points perhaps?) and the slope of the curve would be dead flat.

But what about a couple of other possibilities.  Unlike the 90 day bill rate, term deposit rates  and bank lending rates directly affect economic agents in the wider economy, and as I’ve shown previously the relationship between the 90 day bill rate and term deposit (and floating mortgage) rates has changed a lot since 2008/09. margins

In this chart (constrained by data availability to start in 1987), I’ve taken the six month term deposit rate (from the RB website) and subtracted the 10 year government bond yield).

nz yield curve 2.png

That starts looking a bit more interesting.  The level of this variable –  even after the recent Reserve Bank OCR cuts –  is close to a level which has always been followed by a recession.   (It is a small sample of course; even smaller than in the original US chart).

What about the relationship between the floating residential first mortgage interest rate and the 10 year bond rate?  Here is the chart.

nz yield curve 3

The only times this indicator has been higher than the current level –  even after the recent OCR cuts are factored in, as they are in the last observation on the chart – have been followed by pretty unwelcome economic events (the 1991 recession wasn’t strongly foreshadowed by either this indicator or the previous one).

It is a small sample, of course, and there are no foolproof advance indicators.   But if I were in the Reserve Bank’s shoes right now, I would take these charts as yet further warning indicators.

On which count, it is perhaps worth keeping a chart like this in mind.

NZ yield curve 4

We’ve had 75 basis points of OCR cuts this year but only about 45 basis points of cuts in the indicative term deposit rate (latest observations from interest.co.nz).  It is not as if these retail interest rates are at some irreducible floor –  retail deposit rates in countries with much lower policy rates are also much lower than those now in New Zealand.  It is a reminder that, against a backdrop of a very sharp fall in New Zealand long-term interest rates (real and nominal) –  even after the recent rebound the current 10 year rate is still more than 100 basis points lower than it was in December –  monetary policy adjustments have been lagging behind.   Long-term risk-free rates have fallen, say, 110 basis points (almost all real), and short-term rates facing actual firms and households are down perhaps 40-60 points (floating mortgage rates nearer 60).

The Reserve Bank cannot (especially after a decade of persistent forecast errors) have any great confidence in any particular view of neutral interest rates for New Zealand.  With inflation still persistently below target and (as the Governor and Assistant Governor have recently highlighted) falling survey measures of inflation expectations, there isn’t a compelling case for the Bank to have lagged so far behind the market, allowing short-term rates to rise further relative to long-term rates.   The Governor has appeared to suggest that the Bank will only seriously look again at further OCR cuts at the next Monetary Policy Statement in November.  I reckon there is a much stronger case than is perhaps generally recognised for a cut at the next OCR review next week.

 

 

Current interest rates really are unusual

Here is a chart of current 10 year (nominal) government bond yields for a selection of advanced economies

current 10 year.png

The median yield across those bonds/countries is about 0.4 per cent.  For two of the three largest economies, long-term yields are negative.  Only Greece –  which defaulted (or had its debt written down) only a few years ago and still has a huge load of debt – is yielding (just over) 2 per cent, closely followed by highly-indebted Italy, which could be the epicentre of the next euro-area crisis.

Of course, you can still find higher (nominal) yields in other countries –  on the table I drew these yields from, Brazil, Mexico and India were each around 7 per cent –  but for your typical advanced country, nominal interest rates are now very low.    One could show a similar chart for policy rates:  the US policy rate is around 2 per cent, but that is now materially higher than the policy rates applying in every other country on the chart.

For a long time there was a narrative –  perhaps especially relevant in New Zealand –  about lower interest rates being some sort of return to more normal levels.  Plenty of people can still remember the (brief) period in the late 1980s when term deposit rates were 18 per cent, and floating first mortgage rates were 20 per cent.    Those were high rates even in real (inflation-adjusted) terms: the Reserve Bank’s survey of expectations then (1987) had medium-term inflation expectations at around 8 per cent.

Even almost a decade later, when low inflation had become an entrenched feature, 90 day bank bill rates (the main rate policy focused on then) peaked at around 10 per cent in mid 1996.  And the newly-issued 20 year inflation indexed bonds peaked at 6.01 per cent (I recall an economist turned funds manager who regularly reminded me years afterwards of his prescience in buying at 6 per cent).

But 90 day bank bill rates are now a touch over 1 per cent, and a 21 year inflation-indexed bond was yielding 0.53 per cent (real) on Friday.

So, yes, interest rates were extraordinarily high for a fairly protracted period, and –  once inflation was firmly under control – needed to fall a long way.  But by any standards what we are seeing now is extraordinary, quite out of line with anything ever seen before, not just here but globally, not just in the last 50 or 100 years but in the last 4000.

A History of Interest Rates: 2000BC to the Present, by Sidney Homer (a partner at Salomon Brothers), was first published in 1963, and has been updated on various occasions since then (I have the 1977 edition in front of me). It is the standard reference work for anyone wanting information on interest rates from times past.  It is, of course, rather light on time series for the first 3700 years or so, and it is western-focused (Sumeria, Babylon, Egypt, Greece, Roman and on via the rest of Europe to the wider world).   But it is a wonderful resource.  And you probably get the picture of the ancient world with this table –  the individual numbers might be hard to read, but (a) none of them involves 1 per cent interest rates, and (b) none of them involves negative interest rates,

ancient

(This brief summary covers much of the same ground.)

All these are nominal interest rates.  But, mostly, the distinction between nominal and real rates was one that made no difference.  There were, at times, periods of inflation in the ancient world due to systematic currency debasement, and price levels rose and fell as economic conditions and commodity prices fluctuated, but the idea of a trend rise in the price level as something to be taken into account in assessing the general level of interest rates generally wasn’t a thing, in a world that didn’t use fiat money systems.   In England for example, where researchers have constructed a very long-term retail price index series, the general level of prices in 1500 was about the same as that in 1300.  In the 16th century –  lots of political disruption and New World silver –  English prices increased at an average of about 1 per cent per annum (“the great inflation” some may recall from studying Tudor history).

But what about the last few hundred years when economies and institutions begin to become more recognisably similar to our own?   I included this chart in a post the other day (as you’ll see, the people who put it together also drew on Homer)

500 yrs

How about some specific rates?

Here is the Bank of England’s “policy” rate –  key short-term rate is a better description for most of the period (more than 300 years).

BOE policy rate

And here is several hundred years of yields on UK government consols (perpetual bonds)

consols.png

And here –  from an old Goldman Sachs research paper I found wedged in my copy of Homer –  US short-term rates

US short-term rates

Harder to read, but just to make the point, a long-term chart of French yields

Fr bonds

The lowest horizontal gridline is 3 per cent.

And, in case you were wondering about New Zealand, here is a chart from one of my earliest posts, comparing consol yields (see above) with those on NSW and New Zealand government debt for 20 years or so around the turn of the 20th century (through much of this period, the Australian economy was deeply depressed, following a severe financial crisis)

NZ bonds historical

UK nominal yields briefly dipped below 2.5 per cent (and systematic inflation was so much not a thing that UK prices were a touch lower in 1914 than they had been in 1800). In an ex ante sense, nominal yields were real yields.

And in case you were wondering what non-government borrowers were paying, the New Zealand data on average interest rates on new mortgages starts in 1913: borrowers on average were paying 5.75 per cent (again, in a climate of no systematically-expected inflation).  That may not seem so much higher than the 5.19 per cent the ANZ is offering today but (a) New Zealand rates are still quite high by global standards (UK tracker mortgages are under 3 per cent, and (b) the Reserve Bank keeps assuring us that inflation expectations here are around 2 per cent, not the zero that would have prevailed 100 years ago.

As a final chart for now, here is another one from the old Goldman Sachs research note

GS short rates

In this chart, the authors aggregated data on 20 countries.  Through all the ups and downs of the 19th century and the first half of the 20th century –  when expected inflation mostly wasn’t a thing –  nominal interest rates across this wide range of countries averaged well above what we experience in almost every advanced country now.

Systematic inflation started to become more a feature after World War Two, but even then it took quite a while for people to become accustomed to the new reality.  And in the United States, for example, as late as 1965 the price level wasn’t even quite double that of 1925 –  the sharp falls in the price level in the early 1930s were still then a fresher memory than (say) the high inflation of late 1970s/early 1980s New Zealand is now.     Here, Homer reports average New Zealand long-term bond yields of 3.74 per cent for the 1930s, 3.18 per cent for the 1940s, and 4.13 per cent for the 1950s (1.1 per cent this morning).

Partly as a result of financial repression (regulation etc) and partly because of a new, hard to comprehend, era, we went through periods when real interest rates were zero or negative in the period of high inflation –  but, of course, nominal interest rates were always then quite high.

I’d thought all this was pretty well understood: not so much the causes, but the facts that nominal interest rates and expected real interest rates across the advanced world (now including New Zealand, even though our forward are still among the highest  in the advanced world) are now extraordinarily low by any historical standard –  going back not just hundreds, but thousands of years.   Term mortgages rates in Switzerland, for example, are now under 1 per cent –  and rates which have been low for years are, if anything, moving lower.  And all of this when most advanced economies now have something reasonably close to full employment (NAIRU concept) and have exhausted most of their spare capacity.

It is an extraordinary development, and one for which central banks deserve very little of the credit or blame: real interest rates are real phenomena, about the willing supply of savings and the willing demand for (real) investment at any given interest rate.  Across an increasingly wide range of countries more new savings (household, business, government) is available at any ‘normal’ interest rate than the willingness to invest at that ‘normal’ interest rate, and so actual rate settle materially lower.  I don’t have a satisfactory integrated story for what is going on.  Sure, there are cyclical factors at play –  which together with “trade wars” –  get the day to day headlines.  But the noise around those simply masks the deeper underlying puzzle, about something that is going on in so many economies (it isn’t just that we all get given “the world rate”).  No doubt demography is part of the story, perhaps declining productivity opportunities, perhaps change in the nature of business capital (needing less real resources, and less physical investment, and there must be other bits to the story.  I find it very difficult to believe that where we are now can be the permanent new state of affairs –  5000 years of history, reflecting human institutions and human nature (including compensation for delaying consumption) looks as though it should count for something.  But can we rule out this state of affairs lasting for another 20 or 30 years?  I can’t see why not (especially when no one has a fully convincing story of quite what is going on).

Thus central banks have to operate on the basis of the world as they find it, not as they might (a) like it to be, or (b) think it must be in the longer-run.  There is the old line in markets that the market can stay wrong longer than you can remain solvent, and a variant has to apply to central banks.  For much of the last decade, central banks kept organising their thinking and actions around those old ‘normal’ interest rates and that, in part, contributed to the sluggish recovery in many places and the weak inflation we now experience (relative to official targets).  They need now to recognise that where we are now isn’t just some sort of return to normal from the pre-inflation era, but that we are in uncharted territory.

My impression is that most central banks are still no more than halfway there.  Most seem to recognise that something extraordinary is going on, even if there is a distinct lack of energy evident in (a) getting to the bottom of the story, and (b) shaping responses to prepare for the next serious economic downturn.

Late last week I had thought that the Reserve Bank of New Zealand had got the picture.  Whatever one made of the specific 50 basis point cut –  my view remains that 1 per cent was the right place to get to, but that doing it in one leap, without any obvious circumstances demanding urgency or any preparation of the ground, only created a lot of unnecessary angst –  I was struck by the way the Governor talked repeatedly at the press conference of having to adjust to living in a very low interest rate world.  As I noted in a post on Thursday, that was very welcome.

And so, when I saw what comes next, I could hardly believe it.   I’d still like to discover that the Governor was misreported, because his reported comments seem so extraordinarily wrong and unexpectedly complacent.   Over the weekend, I came across an account of the Governor’s appearance on Thursday before Parliament’s Finance and Expenditure Committee to talk about the Monetary Policy Statement and the interest rate decision. I can’t quote the record directly, but the account was from a source that I normally count on as highly reliable (many others rely on these accounts).  The Governor was reported as suggesting although neutral interest rates had dropped to a very low level, that MPs should be not too concerned as we are now simply back to the levels seen prior to the decades of high inflation in the 1970s and 1980s.

I almost fell off my chair when I read that, and I still struggle to believe that the Governor really said what he is reported to have said. I’m not the Governor’s biggest fan –  and he has never displayed any great interest in history –  but surely, surely, he knows better than that? He, and/or his advisers, must know better than that, must know about the sorts of numbers and charts that (for example) I’ve shown earlier in this post.

I get the desire not to scare the horses in the short-term (though it might have been wise to have thought of that before surprising everyone with a 50 basis point cut not supported by his own forecasts), and I agree with him that an OCR of 1 per cent does not mean that conventional monetary policy is yet disabled: there is a way to go yet.    But what we are seeing, globally and increasingly in New Zealand, is nothing at all like –  in interest rate terms – what the world (or New Zealand) experienced prior to the 20th century’s great inflation.  Real interest rates are astonishing low –  and are expected to remain so in an increasing number of countries for an astonishing long period –  and interest rates and credit play a more pervasive role in our societies and economies than was common in centuries past.    We all should be very uneasy about quite what is going on, and in questions around how/whether it eventually ends.

And central banks –  including our own –  should be preparing for the next serious recession with rather more options than those they had to fall back on last time when nominal short-term interest rates then reached their limits.  Those limits are almost entirely the creation of governments and central banks.  They could, and should, be removed,and could be substantially alleviated quite quickly if central banks and governments had the will to confront the extraordinary position we are now in –  late in a sluggish upswing that has run for almost a decade.

 

Interest rates

Interest rates are in focus this week as we look to the Monetary Policy Committee (minus anyone who might ever do macro or monetary policy research) OCR decision, and accompanying Monetary Policy Statement on Wednesday.    No one seems to doubt that the Reserve Bank will cut the OCR this week  (on the radio this morning I heard one of the historically most hawkish of the market economists being interviewed – who only a year ago was articulating the case for a higher OCR – and sounding quite relaxed about two more OCR cuts this year), so the real focus will be on the messages the MPC tries to send about what they might do in future if (unlikely event, as ever) things unfold as they expect.   And perhaps on which risks and issues they choose to emphasise.  I wonder if they will acknowledge that their relatively upbeat GDP forecasts earlier in the year relied on a strong acceleration in KiwiBuild –  of which there is little or no sign.

As week succeeds week, interest rates have generally been moving lower. But it is easy to lose sight of just how large the change has been.  I mostly use the Reserve Bank’s tables, and latest spreadsheet covers the period –  only 19 months –  since the start of 2018.    At the start of last year, the New Zealand 10 year government bond rate was 2.77 per cent.  Today, it is about 1.31 per cent.    That fall was almost as large as what we observed in New Zealand over the course of 2008.

10 year interest rate swaps have also fallen very sharply, with yields down 150-160 basis points over the period.

And it isn’t that inflation expectations have been collapsing.  Here are the yields on the three longest maturity New Zealand government inflation indexed bonds.

2030 maturity 2035 maturity 2040 maturity
3-Jan-18 1.53 1.76 2.03
2-Aug-19 0.40 0.61 0.78

Over the course of 2008 the then only (8 years remaining) indexed bond dropped only about 40 basis points in yield.

With two (or more) maturity dates, one can back out an implied future short-term rate at some point in the future.  Thus, for example, the Reserve Bank publishes rates for 10 year and 15 year interest rate swaps, which enables one to back out a implied five year rate in 10 years’ time (ie the period between the 10 and 15 year maturities).  At the start of last year, that implied forward rate was 3.89 per cent.  On Thursday (the last date for which the Bank has published numbers), it was 2.42 per cent (and the 10 year swap looks to have fallen another 15 points since then, most of which is likely to be reflected in the implied forward rate).    Something no higher than 2.3 per cent –  allowing for term premia perhaps something nearer 2 per cent – now looks like the best market guess at the long-term future OCR, when all the short-term cyclical factors are stripped away (no one forecasts cyclical factors 10 years plus ahead).

Incidentally, while those New Zealand yields are low by our standards, and have fallen a very long way over the last 18 months or so, they still look quite high by international standards.   Without a Bloomberg terminal (or something comparable) swaps data can be hard to find, but as far as I could tell 5 year forward rates 10 years ahead are still higher than those in Australia, the US (even though they currently have a higher policy rate), the euro area, Japan, Switzerland, Sweden or Norway.     That has been the New Zealand story for decades – our yields are typically higher than those in other advanced countries, for reasons not including commensurately faster productivity growth.  Low as our rates are now, and are expected to be, those gaps to other countries haven’t closed, and aren’t expected to.

We can do the same implied forward exercise using the indexed bonds on issue.    With a 21 year bond and a 16 year bond, we can back an implied 5 year rate in 16 years time: on Friday that would have been about 1.33 per cent down from 2.9 per cent at the start of last year.   That is a huge fall for an implied rate so far in the future.

With the 11 year maturity and the 21 year maturity, we can back out an implied 10 year rate in 11 years time.   That rate is 1.2 per cent.  The roughly comparable rate in the United States (implied 10 year rate in 10 years time) on Friday was 0.66 per cent.  Long-term real interest rates have fallen a long way in New Zealand, but are still well above those in the United States (and the US is a relatively yielding market internationally).

There was interesting, quite stimulating, article in the Financial Times last week on interest rates, headed “Profoundly low interest rates are here to stay“.   I wasn’t fully persuaded by all the author’s arguments (perhaps partly because he didn’t dig deeply into the question of why interest rates are so low in so many countries), but he ended with a couple of very useful points that are often lost sight of. First

this is not some perverse plot by Fed chair Jay Powell and ECB president Mario Draghi [or Adrian Orr for that matter]  to make life miserable for the world’s savers. The long-run real interest rate balances the desire to save and demand to invest. Central banks are its servants not its masters.

There are structural issues at play that are not adequately understood, perhaps around savings preferences, perhaps around demography, perhaps around productivity potential, perhaps aroud the optimal capital intensity of future production structures, perhaps…..(each of which have different implications).

I’m still sceptical of the idea that rates will remain low for ever: history would appear to be against that proposition

500 yrs

But the FT author’s final point is exactly right, and one too few central banks –  and probably market participants as well –  have heeded enough

it is time to stop waiting for rates to recover and face the world as we find it.

Including the fact that on current technologies, short-term official interest rates cannot be taken much lower in most advanced countries, and can’t even be lowered much in historically high interest rate countries such as New Zealand.

Interest rates: US and New Zealand

There is a bit of a story afoot that, somehow, the days of low interest rates are almost over.  There was even an editorial to that effect in the Herald yesterday, which seemed to hanker for higher interest rates here (without, for example, linking that preference to any good things –  much faster productivity growth –  that might make rather higher interest rates a welcome complement to greater economic success).

The idea that interest rates will soon be rising has been something of a constant (across much of the world) this decade.  Like the stopped clock, that line will no doubt eventually be proved correct.  But so far this decade, it seems to have been right (about policy rates) mostly when either:

  • there is some sort of crisis, in which domestic authorities are fighting a lower exchange rate (eg Turkey and Argentina), or
  • temporarily, when over-enthusiastic central banks misjudge inflationary pressures (eg New Zealand (twice) and a couple of other countries (eg Sweden and the ECB), or
  • on the back of massive, unsustainable, late-cycle fiscal stimulus (the US at present).

The Federal Reserve has now raised its short-term interest rate target quite considerably.  Then again, the US 10 year bond rate –  3.16 per cent as I type – is barely above the levels it reached at the end of 2013, five years ago.   And here is a chart that decomposes a 10 year yield into two parts, and using a 5 year yield, calculates the implied second half of that 10 year bond: a five year implied rate in five years time.

US 5x5

That rate has edged up a little recently, but is still a long way below where it was five years ago.   Markets recognise that short rates have risen, but seem to have no greater confidence that they are going to stay very high for very long.

What about New Zealand?  Here is much the same chart for New Zealand, drawn from the data on the Reserve Bank website.

NZ 5x5

No sign of any rebound at all.    The series isn’t at its (2016) low but –  as has been the case all decade –  each peak is lower than the one before.  Five years ago when the markets and the Reserve Bank were convinced the OCR was going up a long way, this implied forward rate was in excess of 5 per cent.  Yesterday it was 3.27 per cent.

Both charts so far have been of nominal interest rates?  What about real, inflation-indexed yields?   The New Zealand government now has a variety of maturities on issue, and this is how the yields have performed since the start of 2014.

IIBs oct 18

There is some volatility in the series, but the trend is pretty clearly downwards, even if one focuses just on the last 18 months or so.   With the passage of time each specific maturity has a shorter remaining time to run (in 2014 the 2025 maturity was an 11 year bond, and now it is just under a 7 year bond), but even adjusting for that the trend is still downwards.

Here is a chart showing the implied five year forward real rates from those indexed bond maturities.

implied forwards NZ IIBs

The continued downward trend evident in the previous chart isn’t so clear in this one.  But there is no sign of any trend rise in real long-term New Zealand yields at all.   And if we take the very longest of these series –  the grey line, which represents and implied five year real rate roughly 20 years from now (and which thus shouldn’t be much influenced by very short-term expectations of the OCR or the state of the economy) the implied forward yield has dropped by around a full percentage point in little more than a year.  Those are big moves for a very long-term security.

What about the US?  Here is the yield on a US government 20 year inflation-indexed bond, calculated as a constant maturity (ie always 20 years ahead, not fixed maturity dates as in my first NZ indexed bond chart above).

constant maturity 20 year iib

And here is the implied yield on a 10 year US indexed bond 10 years ahead (using the 10 and 20 year constant maturity series).

US 10 year implied

There is some sign of these very long-term implied US yields rising.  But even they aren’t setting new highs, or even surprising local highs of just the last few years.  Even with all that new government debt being taken on now, and projected into the future.

Perhaps the end of low interest rates really is nigh.  But there isn’t much sign of it in market prices at present –  none at all in New Zealand where, if anything, long-term and implied forward rates have just been keeping on falling.

Personally, my hunch is that yields (nominal and real) over the next decade could average lower –  not higher-  than those at present.   Mostly because when the next serious recession comes –  and there are plenty of things which could cause or compound it –  most advanced countries (and many emerging ones now) will have little capability, and perhaps even little willingness for some time, to do what it might take to get economies back on a firmer footing.   Look at how long it took last time round, even though going into that serious recession almost all countries had much more policy capacity –  and perhaps even political cohesion – at their disposal.

Later this morning, we’ll have the CPI data which may, at the margin, colour expectations about the near-term outlook.  But whatever those details, they want materially alter the picture of medium-term vulnerability, here and abroad.

 

Real interest rates

It is a while since I’ve done a real interest rate post, so here goes.

You’ll see stories from time to time about how low the New Zealand government’s borrowing costs are.

But it is still worth reminding ourselves of New Zealand’s long track record of having among the very highest average real interest rates in the advanced world.   Here, for example, are New Zealand, Australia, and the G7 countries for the last five years (the period chosen a bit arbitrarily, but a different set of dates wouldn’t substantially alter the relative picture).  I’ve just used average bond yields and average CPI inflation, from the OECD databases, but using (say) core inflation also wouldn’t materially alter the picture.

bond yields

Among these countries, we have one crisis-ridden hugely indebted euro-area country (Italy), one country with new substantial political and economic uncertainty –  and quite a lot of debt (the UK), one with extremely high levels of public debt (Japan), and one with recklessly large fiscal deficits and rising debt (the US).  And our real long-term government bond rates have been higher than all of them.

If we look at the situation today, the picture isn’t a lot different.  Italy has gone shooting past us, which should be no consolation to anyone (crisis pressures re-emerging there).  The gap between New Zealand and US real interest rates has narrowed quite a bit, as one might expect from the sequence of Fed interest rate increases in turn driven partly by unsustainable late-cycle fiscal expansion, but a 10 year US government inflation indexed bond was trading this week at 1.04 per cent, and a 10 year NZ government inflation indexed bond is trading at about 1.25 per cent.   Even that gap is substantially larger for 20 year indexed bonds.

As a reminder, our interest rates don’t average higher than those abroad because of:

  • superior productivity growth rates (we’ve had almost none in recent years),
  • macroeconomic instability (we have low stable inflation and low stable public debt),
  • public sector credit risk (see above –  and of the countries in the chart only Australia has comparably strong public finances),
  • weak banking systems (the Australian banks and their NZ subs have some of better bank credit ratings in the world),
  • risk around high levels of external indebtedness (not only is much of the external indebtedness on bank balance sheets –  see above –  but the New Zealand exchange rate has been persistently strong, not a feature you expect to see when risk concerns are to the fore).

Oh, and of the small OECD countries with floating exchange rates, over the last five years only Iceland (recently emerged from serious systemic crisis) and Hungary (IMF bailout programme as recently as 2008) had higher real interest rates than New Zealand.

At the heart of any explanation for this persistent real interest rate gap –  which has been there, on average, for decades –  must relate to factors influencing pressure on resources in New Zealand.   At some hypothetical world interest rate, there is  some mix of more demand for investment (housing, business, government) and a small supply of savings (households, business, government) than in most other OECD countries.    That incipient excess demand on resources is absorbed by having a higher domestic interest rate than in most other countries, and a higher real exchange rate.    That mix of adjustment will then squeeze out some of the incipient excess demand.  Global evidence suggests that overall savings rates aren’t very sensitive to changes in expected real returns.  Governments tend not to be very responsive to price signals, and people have to live somewhere (so although residential investment is highly cyclical, in the end everyone gets a roof over their head).  Much of the adjustment pressure is felt around genuinely discretionary, and market sensitive, investment spending: business investment, and especially that in sectors exposed to international competition.   It is the stylised story of New Zealand: moderate savings rates (overall), quite high rates of government and residential investment, modest rates of business investment, and a tradables sector which has managed little per capita growth for decades, and where international trade shares of GDP are stagnant or falling even a period when world trade blossomed.

And that is where my immigration policy story fits in.   Savings and investment pressures are aggregates of all sorts of forces and preferences, and so one can never say that a single factor “explains” the whole picture.  But if one is looking for areas where government policy – a non-market or exogenous influence –  plays a part, then New Zealand immigration policy over decades seems likely to be a significant part of the story.  Lots more people means lots more demand for investment just to maintain existing capital/output ratios.   New people need houses, and schools and roads and so on.  If this were a country where domestic savings (flow rates) were abundant –  and domestic savings are different from foreign savings because the act of saving domestically takes some pressure off domestic resources (incomes generated here not spent here) – it wouldn’t be a particular issue.  But that isn’t so in New Zealand.  Government policy choices may have influenced those outcomes to some extent –  I certainly favour a different tax treatment of savings –  but my reading of the international evidence leaves me sceptical that reforms in that area would make very much difference to desired savings rates (if only because income and substitution efforts tend to offset).

Instead, conscious and deliberate government policy drives up ex ante investment demand (at the world interest rate), and in the process tends to drive out the sort of investment that might have enabled those of already here to achieve better material standards of living.

(In a very small sample, it is perhaps worth noting that there are four OECD countries where policy is set to favour high rates of immigration.  They are New Zealand, Australia, Canada and Israel.  It should at least prompt a moment’s reflection among the immigration champions, that not one of those countries has been a stellar OECD productivity performer –  Australia and Canada have done better than New Zealand and Israel, but are nowhere near the OECD frontier, despite the abundance of fixed natural resources those two countries have.)

Inflation bonds and breakevens

I spent a large chunk of Friday interviewing funds managers.  In the course of our conversations, talk turned to the yields on government inflation-indexed bonds (a sensible asset for funds offering indexed pensions) relative to the yields on conventional government bonds.  There are a lot more inflation-indexed government bonds on issue now than there used to be, and I was encouraged to learn that, as a result, bid-ask spreads are also tighter.

The gap between nominal and indexed bond yields is what is known as the “breakeven” inflation rate –  the actual inflation rate that, over the life of the respective bonds, would generate the same return whether one was holding indexed or nominal bonds.   It can be seen as a proxy for market inflation expectations.

As regular readers know, one of my favourite charts is this one, showing the gap between those yields in New Zealand for the last few years.

IIB breakevens June 18

10 years from now is June 2028, so something nearer the average of the two series is at present a reasonable fix on a 10 year inflation breakeven for New Zealand.  But whichever series you use, the numbers have been consistently well below 2 per cent for several years now.  By contrast, at the start of the chart, it looks as though 10 year inflation breakevens were around 2 per cent (10 years ahead then was 2024, so the blue line was the more relevant comparator).

You might expect that a chart like this one would bother the Reserve Bank (paid to keep inflation around 2 per cent).  Instead, they simply ignore it.   Their statements repeatedly claim that inflation expectations are securely anchored at 2 per cent, relying on surveys of a handful of economists.  They simply ignore the indications from market prices.

It isn’t as if what we see in New Zealand is normal.   Here is the chart of US 10 year breakevens for the same period.

US breakevens jun 18

At something a little above 2 per cent, US breakevens are around the US inflation target (expressed in terms of the private consumption deflator, rather than the CPI-  which the bonds are indexed to).

What about other countries?  Courtesy of Fisher Funds, here are a couple of charts.  First the 10 year breakevens for the last year or so.

global breakevens

“DE” here is Germany.  As Fisher noted to us, it seemed a little anomalous that New Zealand 10 year breakevens are lower than those in Germany (although the German economy is one of the stronger in Europe, and they have no domestic monetary policy).

And here are the 20 year breakevens

20 year breakevens

BEI 2035 and BEI 2040 are New Zealand.   I’ve always tended to discount the UK numbers, because of the different tax treatment of indexed bonds there, but both the US and Australian breakevens look a lot closer to the respective inflation targets (2.5 per cent in the case of Australia) than is the case here.

One of the fund managers we talked to on Friday made a throwaway comment about people simply looking at the last headline CPI number.    Maybe, but annual headline CPI inflation in New Zealand for the last six years has averaged 1.0 per cent.   The Reserve Bank’s favoured core measure has averaged 1.4 per cent over the same period.  And the Reserve Bank has never reached the limits of conventional monetary policy (the OCR hasn’t gone lower than 1.75 per cent) – inflation could have been higher had they chosen differently.  It might not be irrational for investors to treat the track record of the last several years as a reasonable pointer to the period ahead.  After all, the last six years has been a period with a strong terms of trade, and sustained (albeit moderate) growth.    Even if, as all the fund managers we talked to suggested, we are now in a “late cycle” phase when inflation might be expected to pick up, “late cycle” phases tend to come just before the end of the cycle.  There will be downturns in the next 10 or 20 years.

What of other possible explanations for these now persistently narrow New Zealand inflation breakevens?  In years gone by there was almost no liquidity in the indexed-bond market (for a long time there was but a single indexed bond).  All else equal, that might mean investors demanding a higher yield to hold the indexed bond (relative to a conventional bond), narrowing the observed breakevens relative to “true” market expectations of future inflation.

But if it was true once, it must be a less important story now.  There are four indexed bonds on issue, each with principal of several billion dollars.  As I noted earlier, if bid-ask spreads are still wider than those (a) on nominal bonds, and (b) on indexed bonds in say the US, they are tighter than they used to be.  It isn’t an attractive instrument for high frequency trading, but these are multi-month, even multi-year, trends we are looking at.

The other possible story I heard a while ago was the suggestion that the government had glutted the market by issuing too many indexed bonds.    It had an air of plausibility about it.  It isn’t as if there are many natural holders of these instruments –  there are no indexed bond mutual funds in New Zealand, they don’t count as a separate asset class in many mandates, and so on.  Then again, in a low yield (and yield hungry) global environment, these instruments offer a pretty juicy yield (the government has a AAA or AA+ credit rating, and its 2040 indexed bonds are offering just over 2 per cent real –  there isn’t much around to match that combination).  Here is the 10 year indexed bond yield chart (again from Fishers –  ignore the UK again).

real 10 year yields

Over the last few years, this is the proportion of New Zealand government bond sales that have been in the form of indexed bonds.

indexed bond share

About 24 per cent of New Zealand government bonds on issue are currently inflation-indexed.

I’m not sure how that compares generally with other countries, but in the UK –  long a keen issuer of inflation indexed government bonds – the share is also about a quarter.  The British also appear to be winding back their issuance –  to 21 per cent of new sales this year.  According to a  FT story from earlier this year

Robert Stheeman, chief executive of the UK’s Debt Management Office, said that “no other country regularly issues a quarter of its debt in inflation-linked bonds”, which “gives us pause for thought”. In contrast Italy — the continent’s largest issuer of inflation-linked bonds — raises just 13 per cent of its debt in this way, according to figures from the DMO.

It may well have been prudent then for our own government to have wound back its issuance plans for index-linked bonds.  But that news has now been out since the Budget last month, and there is still no sign that 10 year breakevens are more than about 1.5 per  cent –  still well short of the 2 per cent inflation target, that was recently reaffirmed by the new government.

There is an OCR review announcement later this week.  We don’t get much analysis in a one page press release, but as the Governor mulls his decision, and his communications, and looks towards the next full Monetary Policy Statement, it might be worth him inviting his staff to (a) produce, and (b) publish any analysis they have, as to why we should not take these indications from market prices as a sign that inflation expectations are not really anywhere close to the 2 per cent the Bank regularly claims.  Perhaps there is a good compelling alternative story. If so, it would be nice of them to tell us.  But given the actual track record of inflation, it would be a bit surprising if breakevens persistently below 2 per cent were not telling us something about market expectations (right or wrong) of inflation.

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.

700 years of real interest rates

When I mentioned to my wife this morning that I’d been reading a fascinating post about 700 years of real interest rate data her response was that that was the single most nerdy thing I’d said in the 20 years we’ve known each other (and that there had been quite a lot of competition).   Personally, I probably give higher “nerd” marks to the day she actually asked for an explanation of how interest rate swaps worked.

The post in question was on the Bank of England’s staff blog Bank Underground, written by a visiting Harvard historian, and drawing on a staff working paper the same author has written on  bond bull markets and subsequent reversals.    It looks interesting, although I haven’t yet read it.

Here is the nominal bond rate series Schmelzing constructed back to 1311.

very long term nom int rates

And with a bit more effort, and no doubt some heroic assumptions at times, it leads to this real rate series.

very long-term real rates.png

Loosely speaking, on this measure, the trend decline has been underway for 450 years or so.   It rather puts the 1980s (high real global rates) in some sort of context.

In the blog post the series is described this way

We trace the use of the dominant risk-free [emphasis added] asset over time, starting with sovereign rates in the Italian city states in the 14th and 15th centuries, later switching to long-term rates in Spain, followed by the Province of Holland, since 1703 the UK, subsequently Germany, and finally the US.

In the working paper itself, “risk-free” (rather more correctly) appears in quote marks.  In fact, what he has done is construct a series of government bonds rates from the markets that were the leading financial centres of their days.     That might be a sensible base to work from in comparing returns on different assets –  perhaps constructing historical CAPM estimates –  but if US and West German government debt has been largely considered free of default risk in the last few decades, that certainly wasn’t true of many of the issuers in earlier centuries.  Spain accounts for a fair chunk of the series –  most of the 16th century  – but a recent academic book (very readable) bears the title Lending to the borrower from hell: Debt, taxes, and default in the age of Philip II.  Philip defaulted four times ‘yet he never lost access to capital markets and could borrow again within a year or two of each default’.  Risk was, and presumably is, priced.  Philip was hardly the only sovereign borrower to default.  Or –  which should matter more to the pricing of risk –  to pose a risk of default.

In just the last 100 years, Germany (by hyperinflation), the United Kingdom (on its war loans) and the United States (abrograting the gold convertibility clauses in bonds) have all in effect defaulted – the three most recent countries in the chart.  Perhaps one thing that is different about the last 30 or 40 years is the default has become beyond the conception of lenders.  Perhaps prolonged periods of peace –  or minor conflicts – help produce that sort of confidence, well-founded or not.

I’m not suggesting that real interest rates haven’t fallen.  They clearly have. But very very long-term levels comparisons of the sort in the charts above might well be concealing as much as they are revealing.    They certainly don’t capture –  say –  a centuries-long decline in productivity growth (productivity growth really only picked up from the 19th century) or changing demographics (again, rapid population growth was mostly a 19th and 20th century thing).  And interest rates meant something quite different in an economy where (for example) house mortgages weren’t pervasive –  or even enforceable – than they do today.

As for New Zealand, at the turn of the 20th century our government long-term bonds (30 years) were yielding about 3.5 per cent, in an era when there was no expected inflation.  Yesterday, according to the Reserve Bank, the longest maturity government bond (an inflation-indexed one) was yielding a real return of 2.13 per cent per annum.    Real governments yields have certainly fallen over that 100+ year period, but at the turn of the 20th century New Zealand was one of the most indebted countries on the planet  whereas these days we bask in the warm glow of some of the stronger government accounts anywhere.  Adjusted for changes in credit risk it is a bit surprising how small the compression in real New Zealand yields has been.