A speech delivered last July by John McDermott (Assistant Governor and Head of Economics at the RBNZ) talked about the neutral rate of interest. Central Banks have often used the term ‘the neutral rate’ which refers to a rate of interest that neither stimulates the economy nor restrains economic growth. This rate is often defined as the rate which is consistent with full employment, trend growth, and stable prices – an economy where neither expansionary nor contractionary measures need to be implemented.
The neutral interest rate is the rate of interest where desired savings equal desired investment, and can be thought of as the level of the OCR that is neither contractionary nor expansionary for the economy.
OCR > Neutral Rate = Contractionary and slowing down the economy
OCR < Neutral Rate = Expansionary and speeding up the economy
The RBNZ’s last published estimate of the neutral OCR was in June 2017 at 3.5%, with a range of estimates around that between 2.6% to 4.6%. Like many other countries, the neutral cash rate in NZ is estimated to have been declining over many years.
Since the GFC neutral rates around the world have been falling which reflects the following:
- Lower expectations about growth in the economy = reduces the return to investment
- Relative to pre-GFC, a wider spread between the central bank rate and the interest rates faced by households and businesses (i.e. mortgages and business lending rates).
- An increase in global desired savings. For instance, demographic trends offshore have led to an increase in saving among the cohort of the population going through prime earning years (as they save for retirement). Likewise, increased income inequality is thought to increase desired savings, as top income earners typically have a lower marginal propensity to consume – MPC.
- Higher debt ratios in some countries (including NZ) make the economy more sensitive to interest rate increases than before.
Central Banks don’t have the independence to set the neutral rate as it is very much influenced by global forces. However they do have independence as to where they set their policy rate relative to the neutral rate.
Source: BNZ – Interest Rate Research – 14th June 2018
Nassim Taleb of “Black Swan” fame has a new book out entitled “Skin in the Game”. Below is an interview with John Solman of PBS ‘Making Sense’. In this he argues:
- a financial system works only if the people who are running it have a stake in the outcome.
- a society should be built around risk and reward – if you make good decisions you do well but if something goes wrong you are penalised.
- Currently profit is privatised and loss is socialised, where the taxpayer only has a downside and will never have the benefit of what’s going on.
- The financial system is at risk if people can make money transferring risk to others and aren’t penalised. Dangerous, unfair and immoral
- The Federal Reserve tried to cure debt with debt, transferring debt from one to the other, from the private to the public.
- The system loaded — laden with debt and with pseudo experts will collapse eventually.
From the Reserve Bank of New Zealand – useful for Monetary Policy.
The Reserve Bank uses the Official Cash Rate (OCR) in two ways to influence the short-term interest rates your bank offers you.
Here is a video from PBS News with Paul Solman – he looks into cryptocurrencies and tries to explain what they are and how to buy them. Also is bitcoin a bubble?
Professor, author and hedge fund manager Vikram Mansharamani states:
You do need some more stability in the value of it before it gets truly adopted as a currency, not as an instrument of speculation. Today it’s de facto an instrument of speculation or a means through which to fund illicit activities off the grid. Bitcoins and sort of other cryptocurrencies live outside of the traditional banking network. And in fact are intended to do so by design.
In 2007 the world economy was thrown into turmoil as the subprime housing crisis in the USA started a chain reaction around the world. Although developments dating back to the 1970s led to increased risk-taking as markets became less regulated. In total it is estimated that the loss to the global economy was US$15 trillion. But it could have been worse if it wasn’t for the lessons learned from the Great Depression of the 1930’s.
What did policymakers do better in 2008 compared to 1929?
Government’s in 2008 were a lot more active in pumping money into the circular flow and their budgets became a much bigger share of the economy, thanks partly to the rise of the modern social safety net. As a result government borrowing and spending on benefits did far more to stabilize the economy than they did during the Depression. Also policymakers stepped in to prevent the extraordinary collapse in prices and incomes experienced in the 1930’s. Although unpopular government’s bailed out banks and prevented panic like that in the Depression were there was a ‘run on the banks’ – about half the banks in the USA closed after 1929. This prevented an implosion of the global economy. But after the Depression government’s were forced into radical reforms to correct the economy which ultimately led to 50 years of economic stability. This wasn’t the case with the GFC in that the success of government policies meant that they avoided the radical reforms of the 1930’s – the disposing of the gold standard. So does this mean that the global economy is still vulnerable to the same variables that caused the problem in the first place?
To explain the root cause of the 2008 financial crisis George Soros uses an oil tanker as a metaphor. In the movie documentary “Inside Job” he basically said that markets are inherently unstable and there needs to be some sort of regulation along the way. The oil tanker has quite an vast frame and, in order to stop the movement of oil from making the tanker unstable, shipping manufacturers have designed them with approximately 8-12 compartments, depending on the size. This maintains the tanker’s stability in the water.
After the Depression the Glass Stegal Act was passed in 1933. This act separated investment and commercial banking activities. At the time, “improper banking activity”, was deemed the main culprit of the financial crash. According to that reasoning, commercial banks took on too much risk with depositors’ money. Therefore to use Soros’ metaphor, a compartment was put into the tanker to make it more stable.
However, in 1999 Gramm–Leach–Bliley Act effectively removed the separation that previously existed between investment banking which issued securities and commercial banks which accepted deposits. The deregulation also removed conflict of interest prohibitions between investment bankers serving as officers of commercial banks. Therefore, the tanker had a compartment/s removed which made it very unstable and it eventually capsized. Consequently the deregulation of financial markets has led to the end of compartmentalisation.
Post Depression Roosevelt restored growth and made up for what was lost during the depression years but post GFC there have been no major reforms of capital flows and the concentration of the financial sector’s weight in the global economy hasn’t changed. Also central banks have not tried to make-up the lost output and as a result the recovery has been weak. Monetary policy has had to remain very much expansionary and will take time before it returns to a neutral rate. This means when the next recession comes around monetary policy will become ineffective with little ammunition left as rates are so low. However, the main issue is that the fundamental problems that caused the GFC are still there.
Source: A lost decade – The Economist December 16th 2017
A Buttonwood piece in the Economist (30th September 2017) looked at how central banks can trigger the next financial crisis. Deutsche Bank have looked into long-term asset returns in developed markets and suggest that crises have become much more common. They define a crisis when a country suffered one of the following:
- a 15% annual decline in equities;
- a 10% fall in its currency or its government bonds;
- a default on its national debt; or
- a period of double-digit inflation.
Pre the Bretton Woods system of fixed exchange rates and a central bank’s limited ability to create credit, very few countries suffered a shock in a single year. But since 1980 there have been numerous financial crisis of some kind. Under the Bretton Woods system a country that expanded its money supply too quickly would encourage an increased demand for imports which would ultimately lead to a trade deficit and pressure on its exchange rate; the government would react by slamming on the monetary brakes. The result was that it was harder for financial bubbles to inflate.
But with a floating exchange rate a country has more flexibility to deal with economic crisis as they don not have to maintain a currency that is pegged to another. A weaker currency makes exports more competitive and imports more expensive. But it has also created a trend towards greater trade imbalances, which no longer constrain policymakers—the currency is often allowed to take the strain. See flow chart below.
As well as companies and consumers taking on debt, government debt has also been rising as a proportion of GDP since the mid-1970’s:
- Japan – a deficit every year since 1966
- France – a deficit every year since 1993
- Italy – only one year of surplus since 1950
This has resulted in significant credit expansion and collapse – by allowing consumers to borrow more money the cost of assets (esp. houses) is pushed higher. However when lenders lose confidence in borrowers ability to repay they stop lending and mortgage sales follow. This is then reflected in the credit rating of borrowers. In order to try and rectify the problem the central banks intervene and reduce interest rates or buy assets directly. This may bring the crisis to a temporary halt but results in more debt and higher asset prices.
Deutsche Bank suggest that could mean another financial crisis especially if there is the withdrawal of support from central banks who saved the global economy when the GFC started. Indicators suggest that this may be the case:
- US Fed – has pushed up interest rates and cut back on asset purchases
- ECB – likely to cut asset purchases next year
- Bank of England – has recently pushed up interest rates
However rates are still at a stimulatory level and developed economies have been growing for several years. According to Deutsche Bank any kind of return to “normal” asset prices from their high levels would constitute a crisis. This would then force central banks to once again lower interest rates again but they will not want to appear to be the ambulance at the bottom of the cliff every time this happens. Remember the bailouts of AIG and the investment banks. It seems that the investment banks are happy to privatize the reward but socialise the risk – when it all “turns to custard” they need to be bailed because they are too big to fail. The question that people are now asking is what is the vulnerable asset class? Mortgage-backed securities was the cause in 2008.
Below is another great video from PunkFT. Financial crises start with significant increases in asset prices followed by a severe correction and a collapse. But with more debt and more credit the market is unstable and although they have never been higher the yields have never been lower.
Thanks to more and more debt driving yet more and more credit, making everything more and more unstable. Today, for example, markets have never been higher. Yields have never been lower.
The early warning signs
These economic crises are easy to spot and they follow a familiar pattern. The warning signs are:
1. A bank grows very quickly and issues poor quality loans against nominal yields. It uses leverage to do this and fails to be aside reserves for possible future losses.
2. Normally the share price of these banks would plummet but in fact the opposite happens – the share price is driven up. As the bank takes more and more risk to generate more return, the market gets giddy, and they drive up the share price.
3. We don’t learn from our mistakes. The Global Financial Crisis suggests that the economy is following the contours of typical recession but that it is more severe. Subsequently forecasters who have tried to make resemblance to post-war US recessions are “barking up the wrong tree” and are of the belief that conventional tools like expansionary fiscal policy, quantitative easing and bailouts are way to go. The real problem is that the global economy is badly leveraged and there is no quick fix without a transfer of wealth from creditors to debtors. Ken Rogoff (co-author of ‘This Time is Different’) suggests that the ‘Second Great Contraction’ is a more realistic description of the current crisis in the global economy. The “First Great Contraction” was the Great Depression of 1929 but the contraction applies not only to output and employment, as in a normal recession, but to debt and credit, and the deleveraging that typically takes many years to complete.
If everybody else is doing it and getting rich, why, the CEO asked himself, shouldn’t I? The real cause of banking failures and systemic collapse lies with ethics at the top. And human nature tells us that bad ethics drive out good ethics.
Black Monday refers to Monday, October 19, 1987, when stock markets around the world crashed, shedding a huge value in a very short time. In New Zealand and Australia it is sometimes referred to Black Tuesday because of the different time zone. By the end of October stock markets around the world fell significantly:
- Canada – 22.5%
- USA – 22.68%
- UK – 26.45%
- Spain – 31%
- Australia – 41.8%
- Hong Kong – 45.5%
- New Zealand – 60%
Unlike other countries the effect of the crisis was compounded by the Reserve Bank of New Zealand’s inaction to lower interest rates and therefore reduce the value of the NZ dollar. This is in contrast to the USA, Germany and Japan whose banks loosened monetary policy to prevent a recession. Below is a video from the FT looking back at the events 30 years ago. Also a useful graph to put the crash in perspective – the two circled ares are the dot.com crash and the GFC.
An article in the Sydney Morning Herald last month looked the Reserve Bank of Australia (RBA) and the neutral interest rate. For almost a year the RBA has kept Australia’s official interest rate at 1.5% and uses this instrument to control the overnight cash rate to try to manage the economic activity of an economy. EG.
Expansionary = Lower interest rates = encourages borrowing and spending
Contractionary = Higher interest rates = slows the economy down with less spending
How do we know that 1.5% is either expansionary or contractionary? Central banks indicate what they believe is the neutral rate of interest – this is a rate which is defined as neither expansionary or contractionary. In Australia the neutral is estimated to have fallen from 5% to 3.5% since the GFC. RBA deputy governor, Dr Guy Debelle, explains that the neutral rate aligns the amount of nation’s saving with the amount of investment, but does so at a level consistent with full employment and stable inflation. In Australia this equates to 5% unemployment and 2-3% inflation.
The level of a country’s neutral interest rate will change with changes in the factors that influence saving and investment.
More saving will tend to lower interest rates
More investment will tend to increase interest rates
Debelle indicates that you can group these factors into 3 main categories:
1.The economy’s ‘potential’ growth rate – the fastest it can grow without impacting inflation.
2. The degree of ‘risk’ felt by households and firms. How confident do they feel about investing. Since the GFC people are more inclined to save.
3. International factors – with the free movement of capital worldwide global interest rates will influence domestic interest rates.
“We don’t have the independence to set the neutral rate, which is significantly influenced by global forces. But we do have independence as to where we set our policy rate relative to the neutral rate.” Dr Guy Debelle
Another very informative clip from the FT. Some of the salient points include:
- Since the global financial crisis the Bank of England, US Fed, Bank of Japan and European Central Bank have bought assets and printed US$12 trillion.
- Can interest rates return to what has been normal in the past – say 5% instead of close to 0%.
- US Fed plans to shrink its balance sheet later this year – monthly reduction US$6bn in its assets. But this is a very small amount when you consider that the Fed holds US$4.5 trillion
- But this is not happening elsewhere. Bank of Japan and European Central Bank are still printing money and buying assets. With Brexit the Bank of England faces huge uncertainties regarding their balance sheets.
- Interest rates will remain low partly due to: ageing population, low productivity growth and a savings glut. This has reduced the attractiveness of capital spending.