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Reserve Bank of Australia – Neutral Rate

August 20, 2017 Leave a comment

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.

Aus - Neutral rate

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

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QE unwind? Yeah right

August 18, 2017 Leave a comment

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.

Does the US Fed Chair need a PhD?

July 22, 2017 Leave a comment

How important is it to have an economics background to run the Federal Reserve? The FT’s US economics editor Sam Fleming talks to several leading economists on whether being versed in the theory is a basic requirement for a Fed chair.

Current US Fed Chair Janet Yellen could be heading into the final six months of her first term at Fed Chair. If Donald Trump does not give her a second term it may usher in new thinking from the US Government. There is no requirement for Donald Trump to appoint someone who is from the academic world of economics. They mention the success of Paul Volcker as Fed Chair who didn’t have a PhD in Economics but had a Masters Degree and also experience in  banking (Chase) and commercial sector. From the left you have – Janet Yellen, Paul Volcker, Alan Greenspan and Ben Bernanke.

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DW Documentary – “The Money Deluge”

July 11, 2017 Leave a comment

Below is a recent documentary from Deutsche Welle (DW – Germany’s international broadcaster) on the impact of exploding real estate prices, zero interest rate (see graph below) and a rising stock market. The higher income groups are benefiting greatly from these conditions but how does it effect middle income earners especially those in retirement. The DW documentary addresses these issues and explains how money deals have become detached from the real economy. Worth a look.

For years, the world’s central banks have been pursuing a policy of cheap money. The first and foremost is the ECB (European Central Bank), which buys bad stocks and bonds to save banks, tries to fuel economic growth and props up states that are in debt. But what relieves state budgets to the tune of hundreds of billions annoys savers: interest rates are close to zero.

The fiscal policies of the central banks are causing an uncontrolled global deluge of money. Experts are warning of new bubbles. In real estate, for example: it’s not just in German cities that prices are shooting up. In London, a one-bed apartment can easily cost more than a million Euro. More and more money is moving away from the real economy and into the speculative field. Highly complex financial bets are taking place in the global casino – gambling without checks and balances. The winners are set from the start: in Germany and around the world, the rich just get richer. Professor Max Otte says: “This flood of money has caused a dangerous redistribution.

ECB Rates.png

Those who have, get more.” But with low interest rates, any money in savings accounts just melts away. Those with debts can be happy. But big companies that want to swallow up others are also happy: they can borrow cheap money for their acquisitions. Coupled with the liberalization of the financial markets, money deals have become detached from the real economy. But it’s not just the banks that need a constant source of new, cheap money today. So do states. They need it to keep a grip on their mountains of debt. It’s a kind of snowball system. What happens to our money? Is a new crisis looming? The film ‘The Money Deluge’ casts a new and surprising light on our money in these times of zero interest rates.

The VIX and the Trump effect

March 22, 2017 Leave a comment

The VIX concept formulates a theoretical expectation of stock market volatility in the near future. The current VIX index value quotes the expected annualized change in the S&P 500 index over the next 30 days, as computed from the options-based theory and current options-market data. There has been significant financial market volatility over the last five years. A non-exhaustive list of risk events over this period includes:

  • Greece debt crisis – 2012
  • Chinese stock market shocks – August 2015 & January 2016
  • Brexit – June 2016
  • Election of Donald Trump as the US President – November 2016

Interesting to see that the Trump effect was limited when you compare it to Brexit, Chinese Stock market etc. Markets seem to be tolerant of the change in the President mainly due to:

  • Trump’s pro-business stance, which brings expectations that he’ll cut corporate tax and deregulate aspects of the economy.
  • Trump promised  increased infrastructure spending which will inject more money into the circular flow which should increase aggregate demand.

VIX

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Teaching ethics: the sub-prime crisis

February 28, 2017 Leave a comment

Teaching ethics to my Yr 10 class I have used the sub-prime crisis as an example. As with behavioural economics the conventional view of finance assumes that markets are efficient and that the price of shares, bonds and other financial instruments are a reflection of the fundamental economic values that they represent. Behavioural finance is all about understanding why and how financial markets are inefficient. If there is a difference between the market price of a share or bond and its fundamental value then in conventional economics no one can make money in financial markets by exploiting the difference.

 
Global Financial Crisis


In July 2007 a loss of confidence by US investors in the value of sub-prime mortgages caused a liquidity crisis.  Sub-prime mortgages were loans that were high risk and many mortgage holders unable to meet their  repayments. The mortgages were pooled into what was know as a Collaterised Debt Obligation (CDO) which were sliced into tranches – safe – okay – risky. Investors tended to buy safe tranches as they were rated AAA by the rating agencies. However the rating agencies were very generous in their assessment of these investments as they were paid by the banks who created the CDOs. Banks also were able to take out insurance on the CDO even if they didn’t own them. This was called a Credit Default Swap (CDS).

Timberwolf.pngThe flow chart (above) and video (below) shows how Goldman Sachs sold a CDO called Timberwolf to investors and proceeded to bet against that investment by buying insurance from AIG so that when the CDO failed they got a pay out from them. As you maybe aware AIG sold a lot of CDS’s and ultimately had to be bailed out by the US government. However a significant portion of the bailout money went to the banks that had created the problem.

Below is another very good clip from the Big Short that explains how the mortgage market brought down the financial system. Good references to CDO’s in which celebrity chef Anthony Bourdain compares fish to finance?

Credit Markets in 2017

January 24, 2017 Leave a comment

Below is an image from National Australia Bank (NAB) with regards to the prospects for credit markets in 2017 looking at various scenarios – Bearish, Bullish and Base Case.

Credit Markets 2017.png

Categories: Financial Markets
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