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ANALYSIS

The economics of real rates

DUBAI, September 24, 2017

In recent years real interest rates have dropped dramatically across the world, said a report from Bank of America Merrill Lynch (BofAML), noting that underlying this decline is a decrease in neutral or equilibrium real interest rates that is permanent.

“Count us among the sceptics. Here we reinforce the views of our rates team, arguing that the long downward slide in both short and long real rates is likely to reverse,” BofAML said in its latest Global Economic Weekly.

Some commentators believe that real rates have had two regimes: high pre-crisis and low post-crisis. Such simplification ignores a number of factors that have contributed to the drop in real interest rates since the 1980s and that now suggest real rates are ready to rise. “Given the complexity of the various arguments, we take a narrative approach to discussing these factors,” the report said.

Stage one: The cost of credibility

Our story starts with the loss of anti-inflation credibility in the 1970s. Repeated inadequate tightening by central banks caused double-digit inflation. As a result, ex post real rates were unusually low for extended periods of time. However, investors extracted their revenge in the 1980s, persistently demanding high levels of inflation protection. The result was stubbornly high ex-post real rates that only retrenched gradually. For example, in the US the average real 10-year yield was 1.6 per cent in the 1970s, but 5.3 per cent in the 1980s.

Stage two: Two per cent targets

From the early 1990s to the early 2000s core inflation bounced around newly established 2 per cent or so inflation targets. During this period central banks regained their anti-inflation credibility and real rates seemed to drift down to their historical average.

Stage three: losing potential

While it was hard to spot in real time, with the benefit of hindsight it appears that US and global trend growth started to dip in the early 2000s. In theoretical models the equilibrium level of real interest rates (r-star) is often linked to trend growth in the economy. Perhaps the best-known work on equilibrium real rates is by Holston, Laubach and Williams. Using a simple framework they show that the neutral rate has fallen in four major economies, from a range of 2.2 per cent-3.5 per cent in 2000 to 0.1 per cent-1.6 per cent in 2Q 2017. In much of the discussion, this is treated as a permanent drop, with roughly half explained by the slowdown in trend growth.

Stage four: The saving glut

In the mid-2000s bond yields remained low despite rate hikes by the Fed and other central banks. Then-Fed Governor Bernanke dubbed this the “saving glut,” pointing to the surge in savings across emerging markets, with a particularly big jump in China that outstripped a sharp rise in domestic investment. At the time, China was not only expanding rapidly but also becoming increasingly integrated into the global economy.

Goodhart and Pradhan note that saving in China was boosted by the absence of a social safety net and deterioration in the family safety net due to the “one child policy.” As a result, cheap capital flowed from China into the US and other developed market economies. China also suppressed the value of the renminbi by accumulating a huge amount of FX reserves, thus constraining the supply of perceived safe assets.

Stage five: Real scars from the crises

While the saving glut focused on excess demand for fixed income assets in general, the “safe asset shortage” focused on the more narrow shortage of assets that could survive a severe financial crisis. The shortage came into focus during the great financial crisis and the European sovereign debt crisis as investors lost faith in the risk-free status of “AAA” mortgage-backed securities and the debt of a number of countries in Europe. Caballero, Farhi and Gourinchas estimate that about 40 per cent of the global supply of “safe” assets was wiped out between 2007 and 2011.

These crises also depressed real rates by inflicting structural damage on developed markets. Work by Reinhart and Rogoff and others shows that banking and real estate crises often cause deep recessions and feeble recoveries. The recent period was no exception and this helps explain why estimates of equilibrium real rates have fallen substantially in recent years.

 The final act was performed by central banks. In response to economic weakness and the collapse in r-star estimates, monetary policymakers eased aggressively and, once the effective lower bound was reached, moved to QE. The result is a further shortage of perceived safe assets.

 When the facts change, I change my mind

Several of the factors listed above are now reversing course. First, the saving glut is gradually disappearing. The saving rate in China has already fallen significantly and is likely to continue to drop as the population ages. The recent rescindment of the “one child policy” will also disincentivize saving, although this dynamic might take decades to play out. The days of reserve accumulation are also over, as China has moved from a strict dollar peg to a looser basket approach. As a result, China’s FX reserves have been roughly flat over the last year and are down nearly $1 trillion from their peak level of $4 trillion, reached in mid-2014.

 “As we noted last week, asset accumulation at the big four central banks has already slowed sharply and is likely to peak in 1Q of next year as the Fed cuts its balance sheet and the ECB and BOJ taper their asset purchases. This will ease the shortage of perceived safe assets. Meanwhile, the supply of “safe” assets will likely be boosted by a gradual rebound in budget deficits in the major economies, which could worsen substantially over time given adverse demographics. The possibility of deficit financed fiscal stimulus in the US poses further upside risk to Treasury supply,” said BofAML.

“As DM economies heal and the crisis recedes in memory, we would expect them to be less dependent on super-low policy rates. That is, we would expect r-star to rise. This is central to the Fed’s exit strategy.

“Finally, an important exception to our story is the continued weakness in trend growth. Demographic trends point to further weakening in potential growth, not just in DM but also in key EM countries like China. However, there is a critical caveat here: a careful look at the history of real rates shows a very weak correlation with trend growth in the economy. Timing is tough, but the preponderance of evidence points to rising, not falling, equilibrium real rates in the coming years.” – TradeArabia News Service




Tags: Interest rates | Bank of America Merrill Lynch |

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