Wednesday, September 24, 2014

Does Canada know about the information transfer model?

Nick Rowe put up a post yesterday and to simplify the discussion, let me just quote him:
Either the bond market thinks it will take a very long time for the Bank of Canada to get back to the neutral rate [1-2% real rate], or else the bond market thinks that the neutral rate is lower than the Bank of Canada thinks it is.
First, let me say that it is probably impossible to get anything out of market fluctuations of this size. The graph at the end of Nick's post is inside the green square in this picture:


These are really tiny movements.

Now the information transfer model (ITM) is probably the best model of interest rates in existence [1] (the results for Canada are also shown in the graph above). Again, the movements Nick is talking about are swamped not only by market fluctuations, but by model error.

However, there is another possibility Nick doesn't mention in his either/or quoted above: the bond market could believe Canada will undershoot its inflation target. Why would they believe this? Maybe some people read this post and believed the model. The ITM predicts the average inflation rate going forward 30 years is about 1.6% in Canada, which means that the nominal neutral rate [2], instead of being 3% to 4%, is actually 2.6% to 3.6% -- exactly where the data is. I show both these ranges on the graph above as well (in gray and blue, respectively).

Nick will probably apoplectic about the Bank of Canada being unable to meet its 2% inflation target (if he even notices). Personally, I'd subscribe to the "it's within the model error" view.

Footnotes:

[1] That's a joke. Or hubris. Take your pick :)

[2] Add inflation to the real rate of 1-2%

PS Graphs of the inflation model projection:



4 comments:

  1. Jason, I haven't had a chance to keep up with your posts recently, but it looks like you've made a set of interesting ones...

    ReplyDelete
    Replies
    1. Thanks Tom. I'm currently working on a new one on this same subject ... it should be out sometime today.

      Delete
    2. I think he missed the point about referring to future inflation ... I don't believe that the market really has incorporated the information transfer model and is predicting below-target inflation, but low expected inflation is an explanation.

      Well, that's the last time I'll refer to market expectations as being useful ... :)

      Delete

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