Thursday, December 18, 2014

Real or risk-neutral wolf?

Today's Torsten Slok chart. In yesterday's chart, we saw that the market forward curve keeps forecasting a recovery that never comes. Here, we see the same pattern, over much longer time period, in the survey of professional forecasters. They're always forecasting that interest rates will rise.

I think there are deep lessons from this chart. And not the simple "economists are always wrong," or even "economic forecasts are biased." The chart offers a nice warning about how we interpret surveys.

Expectations matter a lot to modern macroeconomics. But you can't directly see expectations. So many researchers have turned to surveys to measure what people say they "expect." And they find all sorts of weird things. People "expect" stock returns to be implausibly high in booms, and low in busts. Professional forecasters "expect" interest rates always to go up.

The trouble here, I think, is that we have forgotten what "expect" means to the average person.

To the average person, "expect" means about what the upper 95% quantile means for a statistician. "Expect" is what happens if most things go right. "Risk" is all downside, the chance of something going wrong. The idea that "risk" means you  might earn a lot more money than you "expected" will leave some glazed eyes.

Statisticians developed the concept of "conditional mean." They adopted the colloquial tern "expect" to denote it. Economic survey researchers then use responses of "what do you expect?" to infer subjective conditional means.  But the average person never took a statistics class, and those that did haven't changed their use of colloquial language.

Understanding how real people use the word makes sense of a lot of surveys. I once delved in to venture capital and discovered that analysts were using 40% rate of return hurdles. This makes no sense, right? Except if you understand that "cash flow expectations" means "how much we'll make if everything goes right" -- about the 95% quantile, not the conditional mean -- then a 40% discount rate might be a reasonable rough and ready way to adjust for that.

Moreover, the average person doesn't distinguish well -- and if he or she does, the survey never asks -- whether "expect" refers to the true or the risk-neutral distribution.

The risk-neutral distribution -- probability multiplied by pain (marginal utility) -- is a wonderful concept. For many decisions, the risk-neutral probability is a good sufficient statistic: Pay attention to probable events or painful events. When someone wishes you a safe flight, they're not ignorant of the vanishing probability of a plane crash. They are multiplying low probability times the high marginal utility (pain) of the event. A rise in interest rates, to a long-term bond investor, is a painful event.

The market forecast in forward rates is exactly the risk-neutral  mean. And today's chart suggests that survey forecasters' response to "what do you expect" isn't straying far from the risk-neutral mean either. (Or, it's not straying that far from forward rates!)

In sum, next time you see a paper that uses surveys to measure "expectations," ask if the survey respondents knew the difference between "mean," "median" and "risk-neutral vs. true probability?" (Of course not.) Then you can ask why the author assumes one rather than the other.

More constructively, when using surveys, it's important to make use of the data in ways such that the precise meaning of the word doesn't matter. It  would also be interesting to develop some survey methodology that recognized the colloquial meanings of "expect" have little to do with the statistical concept.


  1. Well, interesting post. Yet I contend that we have entire generations of the economists who always expect inflation and interest rates to rise, perhaps as a vestige of the 1970s, or the general Righty Tighty obsession with inflation and gold. Pompous pettifogging and sanctimonious sermonettes about inflation have become political badges of honor, not true economics.
    This does presenting investment opportunities: mortgage REITs might be a good bet now, as inflation and interest rate fears are, as usual, overstated.

  2. Yes, we know who you mean, and as usual, you types "forget" the Krugman's whom this very blog has called out for repeatedly screaming as wrongly the opposite "deflation is coming" among his legion of wrong religion-based calls. Here's an idea, use that as an example next time?

    1. Yikes! Kindly cite an instance or two of Paul Krugman's "repeated" "religion-based" "screaming[s]" that "'deflation is coming.'" Pure fantasy. Call it Krugman derangement dementia. Props to the grumpy one for (all attempts at) dodging this.

    2. "But deflation is a huge risk — and getting out of a deflationary trap is very, very hard.
      We truly are flirting with disaster."

      "So we're really heading into Japanese-style deflation territory"

      "So tell me why we aren’t looking at a very large risk of getting into a deflationary trap, in which falling prices make consumers and businesses even less willing to spend."

      "But the risk that America will turn into Japan — that we’ll face years of deflation and stagnation — seems, if anything, to be rising."

      "What I take from this is that deflation isn’t some distant possibility — it’s already here by some measures, not far off by others."

      "Worst of all is the possibility that the economy will, as it did in the ’30s, end up stuck in a prolonged deflationary trap."

  3. So, in colloquial terms, surveys collect off-the-cuff responses about the future, whereas a market forecast is more like a 'plan', since it's pain-adjusted. Am I on the right track?

    This would lead me to believe that surveys are biased toward the more extreme outcome(s), since the surveyed don't [necessarily] have any skin in the game.

  4. I can't think why, but somehow this post reads like a clever, technically couched apologia for wrong or wrong-headed prognostics. As such it is unexceptionably apt.

  5. There are so many fundamental conceptual errors in this and the previous piece; and the graphs don't prove what you think they do. (Then again, I never met an economist who understood derivatives markets.)

    Despite the first three letters of the words being the same, forwards are not any type of forecast. (And they obviously aren't predictors!) There is no "market forecast in forward rates". The forward curve has NOT "been predicting rises in rates for years now" - it hasn't been predicting anything. The forward curve did NOT "ought to reflect where the market expects interest rates to go".

    A forward curve (as you correctly imply) is a snapshot of rates (or other prices) you can lock in today. It is a derivative, a piece of paper, a contract. The price of a forward is a function of the supply and demand for that piece of paper. By no means all of the market actors contributing to these supply/demand dynamics have any view whatsoever on where rates or prices are going. The speculators do, but the hedgers and the market-makers probably don't: or, even if they do, they wouldn't let it colour their judgement.

    Putting forward curves and forecasts on the same graph, or in the same sentence, can sometimes be amusing. But mostly it's a 'category mistake' of a rather basic nature.


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