A major finding of research of international interest rate behaviour I did at the Bank of England was that recent experience excessively influences people's expectations about the future.
In terms of the case for fixing debt, the experience over the last decade has been that shorter-term fixed rates have resulted in cheaper interest costs than medium-term and long-term fixed rates.
There have been good local and global reasons for this. However, ideas based on recent and in this case not so recent experience, often end up failing. In the context of having been pretty much the only economists who forewarned of the large increase in interest rates between 2004 and 2007 I see quite strong parallels between the unfolding OCR cuts and the cuts delivered in 2003 that were followed by 13 OCR hikes between 2004 and 2007.
I'm not suggesting interest rates will increase over the next several years as much as occurred after the misguided OCR cuts in 2003. But the parallels are strong enough for borrowers to start thinking seriously about them and the implications for fixed debt.
Implications of recent experience overly shaping expectations about the future
In the mid-1980s I spent 19 months on secondment from the Reserve Bank at the Bank of England in London - the UK central bank - researching interest rate behaviour for six major countries. The research focused on the behaviour of long-term relative to short-term interest rates. The result was a couple of research papers; the findings from the first one I nervously presented at an international economics conference at Oxford University.
One of the major findings from the research was that the experience of the last several years has an excessive influence on expectations about what will happen in the future. This can be shown in the context of the NZ interest rate cycle last decade that I see as having considerable relevance now.
Immediately before the large increase in interest rates between 2003 and 2008, long-term rates were not much above short-term rates. This is shown in the first chart below for 5-year versus 1-year fixed mortgage interest rates and in the second chart for swap rates that are relevant to corporate borrowers; highlighted by the two red arrows.
Long-term interest rates are largely driven by the market's expectations about what short-term rates will do in the future, that can be impacted by overseas factors, while short-term rates are market-led but are largely linked to the OCR. What this highlights is that just before the start of the huge increase in interest rates last decade the market didn't expect there to be much if any future upside in the short-term rates and, by implication, the OCR. The market's expectations about what would happen to the OCR were hugely off the mark.
It was the same story when it came to the economic forecasters. In March 2004 after the first OCR hike in January 2004 the Reserve Bank predicted little future upside in the benchmark short-term interest rate and twelve forecasters surveyed by NZIER on average predicted no upside over the next two March years (green and blues lines, respectively, next chart). The most hawkish of the 12 forecasters predicted that the 90-day bank bill yield would average 6% by the 2005/06 March year when it ended up averaging 7.3% (red line, 2nd chart).
Just like the market, the economic forecasters had no idea that a huge increase in interest rates would occur over the next several years. This was partly due to low quality analysis by the economists but to a large extent it was a by-product of the experience of relatively low interest rates by the standard of the day over the previous several years.
There are parallels with the OCR cuts in 2003 that should be ringing warning bells
As covered in the June Economic Roadmap report (see the special offer on the cover page), there are significant parallels between the experience last decade and what is likely to unfold over the next several years. The obvious one is that the low level of interest rates not just over the last several years but over the last decade will be heavily influencing the market and economic forecasters' expectations about the future. And now as was the case then the economic forecasters are justifying expectations of little future upside in interest rates using dubious inflation forecasts.
This is most notable in terms of the wage inflation forecasts. The first chart below shows the Reserve Bank's March 2004 forecasts for the unemployment rate and one measure of labour cost inflation that were used to justify predicting little future upside in interest rates. Assuming away the wage inflation threat didn't stop it from occurring nor did it end up standing in the way of a huge, market-led increase in interest rates.
The Reserve Bank is back at it in terms of trying to assume away the current wage inflation threat. For a number of years wage inflation hasn't increased much despite the Reserve Bank predicting upside but the labour market is now tight enough for it to be the other way around. Now increasing the wage inflation threat are a range of government policies, the Living Wage Movement and decisions by the Employment Relations Authority (as detailed in the June Economic Roadmap report).
The next chart tells the recent story about the Reserve Bank being back to assuming away a wage inflation threat at the very time it should be starting to focus on it and lean against it.
Following the introduction of full employment as a target of monetary policy in addition to the effective 2% target for CPI inflation the Reserve Bank started to include more detailed analysis of labour market prospects in the Monetary Policy Statements. This included forecasts for private sector average hourly earnings inflation shown in the next chart.
In August 2018 the RB predicted an imminent, large fall in hourly earnings inflation that didn't occur (the gold line). In February 2019 it predicted a smaller imminent fall that didn't occur while it continued to predict a downward path (green line). Most recently it predicts a huge fall in hourly earnings inflation next year followed by a partial rebound (blue line).
In my assessment these forecasts, like the RB's March 2004 labour market forecasts, are tainted by wishful thinking and seem to take no account of the range of government policies that will boost wage inflation and the prospect that the OCR cuts along with fiscal stimulus will boost GDP growth to the extent the labour market ends up tighter next year than it is now.
This article is re-posted here with permission. The original is here. Rodney Dickens also says: " In light of the importance of this issue that is covered in detail in the latest Economic Roadmap report I am offering the latest report to business and other major borrowers on a complimentary basis."