As we approach the 10-year anniversary of the start of the financial crisis, one of the most stubborn legacies has been exceptionally low Western interest rates - not just the policy rate but across the term structure. The Society resisted the temptation of a mild and bright Spring evening to hear two recognised market authorities debate whether low rates were here to stay or finally on the point of normalisation.
Andrew Milligan OBE, Head of Global Strategy at Standard Life Investments, opened with the case for persistence. He began by noting that exceptional monetary policy has been both cause and indicator of the structural forces suppressing rates. Even a few years ago phenomena such as negative interest rates were inconceivable - whereas now they are perhaps the most viable option should further easing be needed. The policies themselves have not succeeded in normalising economic conditions; little evidence has emerged that such policies have been effective in economies such as Japan and the euro area - while political difficulties have resulted from the distributional implications.
At the same time, more “conventional” policies such as ultra-low positive rates and government bond purchases have created a fertile environment for capital misallocation resulting from cheap finance. The absence of structural reform from governments is one example. Andy Haldane, the Bank of England’s Chief Economist, has highlighted that misallocation may also be affecting the private sector in the form of slower rates of new firm creation.
Milligan continued by reflecting on the long-term downward trend in inflation and interest rates - this points to forces still greater (or at least older) than the financial crisis. For several decades now, each recession has left rates lower than the last; there is little reason to expect that the impact of the next recession would be any different.
The third leg of the argument is perhaps the hardest to escape: the crushing lack of productivity growth in Western economies - one which has revealed itself not in one shock but in serial downgrades of forecasts. As Haldane has observed, UK productivity growth has dropped from around 2% to nearer zero over the last few decades. Diagnoses of the productivity slump are not encouraging of a quick turnaround. Robert Gordon has argued that waves of technological change are always less impactful from one to the next. Haldane’s own prescription, of management attitude change, is almost the opposite of a quick win.
In their own analysis of the low interest rate regime, The Bank of England believes around 85% of the decline in yields can be explained through structural factors. Demographics is the biggest and best known, but the sheer breadth of this challenge is often overlooked. Human capital requirements in the modern economy have changed faster than the skills of the workforce. There are also interactions with inequality, such as the decline in UK home ownership, especially among the young. Forecasts of worsening dependency ratios in the West and China are perhaps the most alarming figures both in terms of their inevitability and their direct read through to fiscal and economic sustainability.
Cross-border flows are another important downward force on rates which is often overlooked. We underestimate the importance of official institutions’ purchases on home bond markets, together with the regulatory environment facing banks, insurers and pension schemes. There is an acknowledged shortage of high credit quality paper, which means that any additional supply is eagerly seized by investors. 20% of the global sovereign market is negative-yielding, and 30% of the euro-market.
Milligan concluded that the impact of cyclically weak demand on rates is at best moderate. Some argue that the current low yields are the result of temporarily was monetary policy. But the supply-side evidence is that policy is being correctly set.
Jari Stehn, Senior Economist at Goldman Sachs, began his response by looking at theoretical efforts to distinguish the structural drivers from more cyclical ones. He acknowledged that financial markets seem to have embraced the model of Federal Reserve researchers Holston, Laubach and Williams (HLW) that the equilibrium real rate has fallen materially - from 4% in the 1960s to zero today. There is plenty of evidence, though, which does not fit this interpretation. Unemployment rates have not just fallen, but faster than was forecast by the economist consensus. Arguably measurement issues around GDP make employment the more reliable indicator of activity. GS’ own in-house indicators suggest that global GDP growth has accelerated from around 2.5% to almost 4.5% in the space of a year.
There are empirical issues with the assumptions of the HLW model. There is very little connection between estimates of potential growth and short-term rates in real terms - a key assumption. This result is apparent over long periods (multiple countries looking back as far as the 19th Century), and when controlling for alternative explanatory factors. This longer term approach also highlights that current real interest rates are not unprecedented and have mean-reverted to higher levels in the past.
There are a number of alternative approaches, but simply easing the assumption of a 1-1 relation between potential growth and real rates produces a more benign outcome. If we also include labour market performance alongside GDP, and allow shocks to potential output to be temporary, the implication is that we have only now returned to full employment, and that equilibrium rates are in fact much more cyclical than HLW allow. The median estimate of sustainable real interest rates, from a range of studies over the last 2 years, approaches 1% more closely than 0%. HLW also accept that the uncertainty around their estimates is of the order of several percentage points.
This uncertainty has policy implications. It may be rational to wait longer before tightening monetary policy into a normalisation - but a necessary consequence is that ultimately more tightening is needed compared to a more certain baseline. This may create surprises versus market expectations.
Responding to questions, Stehn indicated that a failure of inflation to continue its apparent return to central bank targets would be a critical warning sign. Milligan noted the possibility that a lower-growth, lower-rate environment may not be a problem to be solved, but a fact to be accepted. The policy measures which might alternatively be required are indicated by the dramatic move from the Bank of Japan to manage bond yield levels across the curve - little short of classical helicopter money. Regarding the impact of modern technology, Milligan noted that it has perhaps done more to improve utility, in the form of consumer surplus, than output in a way which GDP measures can capture.
It was noticeable that both speakers took different approaches to the issue, and in doing so gave the audience a well rounded view of the enormous range of explanatory factors. Financial markets are currently precariously poised between the two points of view, indicating just how balanced the debate really is. Resolution of the discussion, much less the underlying economic challenges, still feels a distant prospect.
An audio recording of the meeting will be available soon and slides are available on request from the SBE office. Meantime, to hear an interview between the two speakers and our social media manager, George Matlock, please click here: