Session 24 Economic Scenario Generators: Implications of the Persistent Low Interest Rate Environment

Transcription

1 Session 24 Economic Scenario Generators: Implications of the Persistent Low Interest Rate Environment Blair Manktelow, Principal, Property and Casualty, Eckler Ltd. Daniel Finn, Director, Risk Solutions, Conning

2 Agenda Background of Speakers Monetary Policy Rules Neutral Rate of Interest Potential Mean Path and Related Volatility Integrating Public Forecasts 2

3 Background of Speakers Blair Manktelow FCIA, FCAS Property and Casualty perspective Daniel Finn FCAS, ASA Asset-liability and integrated management advisory services to insurance companies 3

4 Background of Speakers (Cont d) Blair Manktelow s Perspective Focused on Economic Capital Modeling, DCAT, and ORSA for P&C insurance companies Apply stress tests (adverse events) to projected base scenario Five year projection period Volatility in first full year after stub year These are my opinions, not those of Eckler Ltd. 4

5 Monetary Policy Rules Federal Reserve Taylor rule and variants for Federal Funds Rate all depending on forecasts Federal Reserve Bank of Cleveland shows 7 rules: Taylor (1993) rule Core inflation in Taylor (1999) rule Inertial rule Alternative r* rule Forward-looking rule First-difference rule Low weight on output gap rule Website shows 3 different forecasts, generating 21 possible federal fund rate indication 5

6 Monetary Policy Rules (Cont d) Bank of Canada (BOC) Two main econometric models which have monetary policy rules incorporated Terms-of Trade Economic Model (ToTEM) (BOC Technical Report no. 97) Large Empirical and Semi-structural (LENS) Model (BOC Technical Report No. 102) similar structure monetary policy rule Depends on neutral rate of interest, projected inflation, and estimated output gap Reversion rate 17% per quarter Reversion level dependent on neutral rate, projected inflation and output gap 6

7 Neutral Rate of Interest BOC Discussion Paper The Neutral Rate of Interest in Canada by Rhys R. Mendes We define the neutral rate as the real policy rate consistent with output at its potential level and inflation equal to target after the effects of all cyclical shocks have dissipated. This is a medium to longer-run concept of the neutral rate. Under this definition, the neutral rate in Canada is determined by the longer-run forces that influence savings and investment in both the Canadian and global economies. BOC April 2017 Monetary Policy Report The neutral nominal policy rate in Canada is estimated to be between 2.5 and 3.5 per cent. This is more than 1.5 percentage points lower than the mid-2000s neutral rate. 7

8 Neutral Rate (Cont d) My view Reverting to historical means does not reflect longer-run forces. Current and projected demographics and expected savings behaviour are materially different than historical period both in Canada and globally. Neutral rate in the short term may be materially different from the medium to long-term value. Target a long-run reversion level within the BOC s range. 8

9 Potential Mean Path Target Estimate short term neutral rate at the level that minimizes the observed error of the BOC LENS model monetary policy rule. Use Bank of Canada estimates of historical output gap Use historical core inflation expectations from Department of Finance Survey of Private Sector Economic Forecasters Implied short term nominal neutral rate is about 1.2%. Apply LENS model monetary policy rule to project mean path over next two years Bank of Canada April 2017 Monetary Policy Report expects Output gap to be closed mid-2018 Inflation to be close to 2% 9

10 Potential Mean Path Target (Cont d) Longer term reversion target within range of % Select a mean reversion speed such that a model with a mean reversion level within the % range has a mean path over the next two years in line with the LENS model. Implies a significantly slower reversion speed than in the LENS model Project mean path beyond two years using simple mean reversion model. 10

11 Mean Path 3 Month Government of Canada 11

12 Potential Mean Path Target (Cont d) Review historical spread relationship for 5 year and long term GoC bond yields Select a mean reversion speed and reversion level in line with historical data Project mean spreads into the future Add estimated spread to short term mean path Calibrate ESG to achieve desired path 12

13 Estimating Volatility of Mean Path Review 1-year, 2-year, and 3-year movement in short, medium and long term bond yields Look at different time periods and different interest rate levels Consider target percentiles: Negative bond yields are definitely plausible for short and medium term bonds At a sufficiently adverse low percentile, values should not rise materially over time High percentiles should climb over time Compare target percentiles to historical minimums and maximums. Recognize difference in demographic and other forces. ST volatility > MT volatility > LT volatility Calibrate ESG to achieve target volatility 13

14 Integrating Publicly Available Forecasts Clients routinely compare interest rate projections to publicly available forecasts. Banks regularly forecast interest rates over the next two calendar years. Several project out further. Department of Finance Survey of Private Sector Economic Forecasters forecasts five calendar years: Can be a significant lag in release Current survey is December 2016 Most forecasts exhibit significant mean reversion. Many forecasts appear to continue to use a level of mean reversion that seems high relative to Bank of Canada neutral interest rate estimates Forecasts tend to be quite responsive to changes in the market It helps credibility if the ESG mean path is within the range of public forecasts. I prefer to look at whether the range of public forecasts is within the plausible range of the ESG projections. I use bank forecasts as a reasonability check, not as an overall target. 14

15 Comparison of Recalibrated ESG Output to Bank Forecasts 3 Month Government of Canada 15