A Remarkable Financial Moment


The US 10 and 30 year interest rates today reached all time low levels of 1.32 percent and 2.10 percent.  Record low 10 year interest rate were also registered in Germany, France, Switzerland and Australia.  Notably Swiss 50 year interest rates are now for the first time negative.  Rates out 15 years are negative in Germany and 9 years in France.

Such rates would have seemed inconceivable a decade ago and very unlikely even a couple of years ago.  I remember my parents paying off their 30 year mortgage on the house I grew up in during 1991 and thinking that the 4.5 percent rate they paid was some kind of antique the likes of which would never be seen again.  At the beginning of this year US 10 year rates were 2.27 percent and there was a general view that they would rise sharply to perhaps 3 as the Fed began to tighten.

As Table 1 makes clear extraordinarily low rates reflect both subtarget expected inflation even over long horizons and very low real interest rates.  Note that the real interest rates exceed reported for TIPS because I have adjusted yields to reflect the 35 basis point average difference between the Consumer Price Index used in calculating TIPS coupons and the Personal Consumption Expenditures deflator targeted by the Fed.Table 1 US Interest Rates & Inflation

The Fed Funds futures market provides a window into market thinking regarding the likely path of monetary policy.  Remarkably the market does not now expect a full Fed tightening until early 2019.  This is despite all the Fed speeches expressing optimism about the economy and a desire to normalize interest rates.

I believe that these developments all reflect a growing awareness of the importance of the secular stagnation risks that I have highlighted over the last several years.  There is a growing sense that the world is demand short—that the real interest rates necessary to equate investment and saving at full employment are very low and may be often unattainable given the bounds on nominal interest rate reductions.  The result is very low long term real rates, sluggish growth expectations, concerns about the ability even over the fairly long term to get inflation to average 2 percent, and a sense that the Fed and the world’s major central banks will not be able to normalize financial conditions in the foreseeable future.

Unfortunately markets have been much more aggressive in responding to events than policymakers.  While there are some signs of recognition such as the Fed’s reduction in its estimated neutral rate from 4.5 percent to 3.0 percent during the last 2 years, the IMF’s explicit use of the term secular stagnation in its World Economic Outlook, ECB president Mario Draghi’s call for global coordination and greater use of fiscal policy, and Japan’s indicated interest in fiscal-monetary cooperation, policymakers still have not made sufficiently radical adjustments in their world view to reflect this new reality of a world where generating adequate nominal GDP growth is likely to be the primary macroeconomic policy challenge for the next decade.

Having the right world view is essential if there is to be a chance of making the right decisions.  Here are the necessary adjustments.

First, with differences between countries, neutral real interest rates are likely close to zero going forward.  Think about the USA, where growth has been relatively robust by recent standards.  Growth has averaged little more than potential for the last 1, 3 or 5 years while the real Federal Funds rate has been around -1 percent.  There is no good reason to think given sluggish investment expectations that the neutral rate will rise to be significantly positive in the foreseeable future.  The situation is worse in other countries with more structural issues and slower labor force growth.  Substantial continued reductions in Fed estimates of the real neutral rate lie ahead.

Second, as counterintuitive as it is to central bankers who came of age when the inflation of the 1970s defined the central banking challenge, our problem today is insufficient inflation.  In the United States, Europe and Japan markets are now expecting inflation that is below target even with full employment over the next 10 years.  This is despite a 70 percent rise in the price of oil.  Evidence from markets and some surveys suggests that inflation expectations are becoming unhinged to the downside.  The policy challenge with respect to credibility is exactly the opposite of what it has been historically—it is to convince people that prices will rise at target rates in the future.  This is likely to require some combination of very tight markets and mechanisms that give confidence that during the best times inflation will be allowed to exceed target levels so that over the long term they can average target levels.

Third, in a world where interest rates over horizons of more than a generation are far lower than even pessimistic projections of growth, traditional thinking about debt sustainability needs to be discarded.  In the United States, UK, Euro area and Japan the real cost of even 30 year debt will be negative or negligible if inflation targets are achieved.  Indeed, the conditions Brad Delong and I set out in 2012 for expansionary fiscal policy to pay for itself are much more easily satisfied today than they were at that time.

Fourth, the traditional suite of structural policies to promote flexibility are not especially likely to be successful in the current environment, though some structural policy approaches such as removal of restrictions on investment are still desirable.  Indeed in the presence of chronic excess supply structural reform has the risk of spurring disinflation rather than the contributing to a necessary increase in inflation.  There is in fact a case for strengthening entitlement benefits so as to promote current demand.  The key point is that the traditional OECD type recommendations cannot be right as both a response to inflationary pressures and deflationary pressures.  They were more right historically than they are today.

There is much more to be said about policy going forward.  But treatments without accurate diagnosis have little chance success.  We need to begin with a much clearer diagnosis of our current malaise than policymakers have today.  The level of interest rates provides a very strong clue.


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