Saturday, October 27, 2012

Frank Newman: Interest rates and ipredictions

There has been a changing of the guard at the Reserve Bank. Alan Bollard has retired after 10 years as Governor and Graeme Wheeler taken on the top job. Mr Wheeler is a former executive at the World Bank and most recently ran a consultancy in the US. 

Although the governor may have changed, the Governor’s message hasn’t. Last week Mr Wheeler left the official cash rate (OCR) at 2.5% saying it is appropriate for now. That has led to a debate about the meaning of “for now” (much like courtroom lawyers arguing about the meaning of “and”). Some say that means an imminent rise, others say a fall. Strong opinions are being advocated for both possibilities.

Those arguing for an OCR increase say it would cool the housing market. That alone is unlikely to persuade the Governor given the property market is only strong in Auckland and Christchurch and for their own reasons.

If anything, the vital signs are suggesting the OCR should fall rather than rise. The economy is flat lining and inflation is below the Reserve Bank’s 1-3% target range. A rate fall would probably lower the value of the kiwi dollar (at least in the short-term), which would bring some benefit to exporters.

Possibly the best “opinion” about the next OCR announcement on 6 December 2012 is the futures market, ipredict.

Ipredict was established in 2008. It describes itself as a “market-based political and economic forecasting system.” I would describe it more like a betting agency.

Its power is in harnessing the wisdom of crowds. Unlike an opinion poll, on this market punters actually put their money where their mouth is and take a bet on a future outcome. Because they are putting their own money at risk, they tend to be more accurate than polling where a person is randomly phoned at dinner time on a Sunday evening.

Here’s an example of how the ipredict “market” works. Essentially each contract pays out $1 should a specific event occurs, and nothing if it doesn’t. It’s a straight win – lose. How much people pay for that contract is a measure its probability of occurring. One of its contracts is the outcome of the US Presidential race.

The Obama contract last traded at 55 cents, the Romney contract 45 cents. In other words, at the time of the last trade punters believe there is a 55% chance that Obama will win. Those buying an Obama contract at 55 cents will receive $1 if Obama does win (and a profit of 45 cents per contract!).

That contract price changes continually up to election-day as the contenders battle it out during the campaign.

The contracts are particularly important when the bets relate to money matters. For example, the OCR contracts provide useful information to a property investor about interest rates. At the time of writing the various 6 December 2012 OCR contracts were trading as follows:

·         OCR up by 0.5%, trading at $0.01
·         OCR up by 0.25%, $0.01
·         OCR unchanged, $0.88
·         OCR down by 0.25%, $0.11
·         OCR down by 0.5%, $0.01

In other words those buying a contract that “Reserve Bank to not change the OCR on 6 December 2012” at 88 cents would receive $1 if that proves to be correct.

So while economists may argue the pros and cons of changes to the OCR the “market” says there is an 88% chance that the OCR will not change at the December review, and if there is a change it is more likely to be down by 0.25%. Virtually no-one believes the OCR will increase in December.

The “no change” contracts for the 31 January 2013 and 14 March 2012 OCR reviews are trading at 86% and 82% respectively.

Ipredict have contracts for inflation, unemployment, the value of the stock exchange index, chances of a recession, and others, including the future price of petrol!

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