Thursday, 20 March 2014

Overconfidence. How Westpac ended with egg on its face

One of the Behavioural Economics principles is Overconfidence. Rather than having a realistic assessment of the chance that we might be wrong, or something might go awry, we are naturally wired to be sure that we are right.

Last week, this happened to one of Australia's foremost economists, Bill Evans from Westpac.

Bill Evans, Westpac

For months now, Westpac has been declaring that Australian interest rates will keep coming down.

In September, they said...
The RBA Board will have to balance potential "bubble" risks, for which there is little evidence after 21 months, with the obvious advantage lower rates imply for a lower AUD and a boost to domestic activity. We think they are likely to opt for another cut in November.

In October was the first backtrack...
We have pushed back our timing for the next rate cut by the Reserve Bank to February next year. Our previous forecast was for one cut of 25bps in November and a second of 25bps in February. Our revised call is for a 25bp cut in February to be followed by a further cut of 25bps in May. 

By Christmas, they were still just as confident that there would be interest rate cuts. However, the signs of lower confidence were creeping in, as they pushed back the timing to May and August.

In February, more creaks were appearing in the forecast but the confidence in the language remained...
We do not expect rates to be lowered before the second half of 2014 when many of the apparent puzzles in today's statement will be resolved. Our current view is for a move in August to be followed up with a further move later in the year.

And finally, the great confession

On the 17th March, Bill Evans made the great confession.  Rates are not going down at all. No, they will go up. Let's pull apart this statement.

Westpac has revised its profile for the RBA cash rate in 2014. Previously we expected that rates would be reduced by 25bps in both August and November. The forecast is now for flat rates throughout 2014. 
- It doesn't say, "we were wrong". It doesn't say "we're not sure about this forecast either". It says, "we are still steadfastly confident in our new prediction despite the fact that the last prediction was plain wrong"

As before we do not forecast a rate hike until the third quarter of 2015 with a 25bp hike in both the September and December quarters.
- This sentence is even more extreme! It basically says, "we were right all along, and we are still right that rates are going up in 2015, but let's all just forget about the bit where we said it would go down first"

How it happens

There are two main reasons why this overconfidence takes place.

First, it's a natural human condition. Once we form a conclusion, we treat it as binary: it's either A or B. In reality, every decision is a bit of B and a bit of B, but our mental processes don't handle that at all.

The second reason is that Bill Evans was the first to call the previous rate cut cycle that the Reserve Bank started in Novermber 2011. So, once you've predicted correctly on one occasion, that provides confirmation that your predictions are going to be correct again in the future - even if you are smart enough to know your odds of being right, well, you can just ignore that!!

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