Now that central banks are cutting rates, the question of where they will stop comes into focus. Real rates have trended down for decades, but a very long-term view supports our thesis that rates will average higher in future than they did pre-pandemic.
Most peer central banks are already cutting rates and some are front loading the cuts. The Fed and the RBNZ have seemingly declared 50 to be the new 25, though it is not clear that the FOMC will continue at that pace. The ECB may also want to pick up the pace to offset fiscal consolidation, as Westpac economics colleague Illiana Jain points out in her piece in our latest Market Outlook report released this week.
Steep hiking phases followed by equally steep cutting phases may well be a general pattern when an inflation surge is largely driven by supply shocks that unwind of their own accord. Unlike the more organic sources of strong demand that central banks usually contend with, the demand component of the current inflation shock has also been partly self-correcting, driven as it was by pandemic-era stimulus. It should be no surprise then that the economies with some of the sharpest rate cycles – the United States and New Zealand – had ongoing fiscal stimulus after the pandemic.
While the need to reduce the restrictiveness of policy in these economies is clear, it is less obvious where policy might need to land to no longer be restrictive. The so-called neutral rate is uncertain. And as the FOMC ‘dot plot’ estimates for the long-run fed funds rate show, policy makers are even less sure about its level than in the past. While their views have diverged, all FOMC members are agreed that it is probably higher than was believed before the pandemic. This lines up with our long-standing house view that the global structure of interest rates is likely to be higher on average than it was between the GFC and the pandemic. The era of negative yields is over.
The rate that neither stimulates nor weighs on inflation at any point is also the rate that balances desired saving and investment. It will depend on whatever else is going on, including the drag or stimulus from fiscal policy. It is because of these other things that we expect a higher average rate structure. European governments need to consolidate, but as Iliana points out, by less and in a less abrupt manner than in the early 2010s. Western governments more generally are facing greater demands to spend on defence, energy transition and to meet the needs of an ageing population. The private sector, too, has more need to invest now, on energy transition and the energy demands of AI. It also has a bit more scope to do so given that Western banking systems are less constrained by the need to build up capital to meet the requirements of the Basel 3 rules. Asian economies remain an important source of saving, but not more than they were in the first two decades of the century. They might even be less of a saving source, depending on how large the stimulus is in China.
All of this is a guide to what central banks need to do to achieve their desired policy stance in the moment. It says less about where the rate structure is likely to gravitate to in the long run, when all the current shocks have played out. The answer to that question is also often labelled the ‘neutral rate’, a little confusingly. (Some researchers attach an extra star to their notation distinguish between these concepts.) This longer-term version is less of a guide to central bank decision-making now, and more of an anchor for pricing very long-term debt securities.
A plague on all your 20th century trend estimates
This long-term anchor concept still boils down to the rate that balances global saving and investment on average. But now we must consider the deeper and more structural drivers of those forces, and whether there are structural trends. A large body of research notes the downward trend in both short-term and long-term real interest rates. So far, though, there has been no consensus on the reasons for this.
Some recent research by Kenneth Rogoff, Barbara Rossi and Paul Schmelzing might provide some insights. They have compiled data on real long-term bond yields going all the way back to the year 1311, more than 700 years. An achievement in itself, their dataset shows that there has indeed been a slight downward trend over this longer period. Crucially, though, the period between the GFC and the pandemic was in fact a downward deviation from that trend. The authors therefore expect some reversion to trend in coming years. This contrasts with papers using shorter data sets, where the downward trend is less precisely estimated.
It is important not to take this purely empirical observation as gospel. We do not yet know why there is a downward trend, or what might be the cause of the recent downward deviation. There are, however, some reasonable hypotheses. Recall that these are long-term real bond yields not the short-term rates used by central bankers to set policy. The market and policy apparatus the shorter rate applied to came in many centuries later than long-term sovereign bonds. It may be that the trend comes from a trend in the term premium or risk premium, rather than from the neutral short-term rate as we think of it now. For example, it could be that as experience with long-term debt markets increased, and governments became better at keeping their financial promises, investors among Europe’s Early Modern elites became more trusting over time and demanded a smaller term/risk premium over the (unobserved) ‘true’ risk-free rate.
Some other suggestive possibilities can be inferred from the fact that there was a break upwards in the trend following the Black Death in the 1340s, when one-third to a half of the population of Europe perished. If the underlying trend in interest rates reflects people’s willingness to wait until tomorrow, their need to be compensated for waiting will reflect their beliefs about how likely it is that they will even survive until tomorrow. Events like the Black Death surely shifted that subjective belief.
More broadly, rising longevity – or more precisely, greater certainty about your adult longevity – could be one of the reasons why people have seemingly become more patient and willing to accept less compensation for waiting, that is, a lower long-term interest rate. (The authors cite other research suggesting that elite males – the segment of the population who would have cared about yields on sovereign debt back then – were less likely to die in battle from the 1400s. That would have helped start the downtrend after the increase following the Black Death.) That is a reason to expect a slow downward trend, and to not assume that a lurch down after the GFC was permanent. There is a common thread here with other literature, including work from the Bank of Canada that focused on the need to save for longer (and more certain) retirements.
The academic debate remains unresolved. For anyone thinking about pricing bonds or planning fiscal policy, though, some of the latest research suggests it would be foolhardy to assume that the low-rates world of the GFC-to-pandemic period will continue.
