First, it generates an attitude of caution when making major decisions – moving house or job or making an investment. People will tend to look before they leap, to think twice before diving in. It creates the mind-set of the glass being half empty. Second, insecurity generates an asymmetric response to news flow. Good news will be banked or used to strengthen balance sheets. Roofs get repaired during the sunshine. But when bad news strikes, the response is immediate and defensive. There is a hunkering down, with cuts in spending and risk-taking. The exact opposite psychological traits are, of course, exhibited during a boom. Then, good news is spent and bad news borrowed against. Roof repairs are deferred, whatever the weather. The glass is half full. There is a wealth of experimental evidence documenting these psychological swings and asymmetries. Despite the recovery, evidence continues to suggest a “half-empty” mind-set. World growth has, since 2010, averaged less than 4%. Forecasts have been consistently over-optimistic by ½ percentage point per year. The evidence so far during 2015 suggests this pattern may continue. Caution is a plausible explanation for this dragging anchor. BIS central bankers’ speeches  7  The household sector has undertaken significant balance sheet repair since the crisis, dragging on spending. 8 This can be seen in the proportionately greater belt-tightening exhibited among highly-indebted consumers (Chart 15)). These debt-induced adjustments in spending have also been important among US consumers (Mian and Sufi (2014)).
Nonetheless, Table 1 suggests that the average cycle has typically been in the range 3 to 5 percentage points – towards the upper end in the period since 1970, towards the lower end in the period since 1994. Fairly sizeable degrees of interest rate headroom have been necessary in the past. An interesting thought-experiment is to assess the likelihood of future interest rates having risen sufficiently to give monetary policy the headroom necessary to cushion a recession. Chart 13 plots a set of cumulative probabilities of official interest rates exceeding a set of interest rate thresholds – 2% (the “John Bull threshold”), 3% (the average loosening cycle since the 1990s) and 5% (the average loosening cycle since the 1970s). 7 With yield curves currently low across the major advanced economies, the probabilities of interest rates exceeding these thresholds are modest. Even at a ten-year horizon, the probability of UK rates exceeding 2% is only around 50%, 3% around 40% and 5% around 20%. If financial markets’ guesses about interest rates are realistic, it is odds-against there being sufficient monetary policy headroom to cushion a typical recession. If we now compare the probabilities of interest rates being at these thresholds with the probabilities of recession, a striking conclusion emerges. Recession probabilities exceed interest rate threshold probabilities by a factor of anywhere between 1.5 and 4 (Chart 13). For example, a conservative estimate of the probability of recession over a ten-year horizon is around 80%.