Will interest rates fall back to their very low historical level and does public debt have to be aggressively consolidated?
The IMF provides a sophisticated analysis of the determination of interest rates that suggests real rates will fall yet persists in advising governments to be reticent in employing public debt.
The IMF’s April 2023 World Economic Outlook A Rocky Recovery principally attracted attention for its economic forecasts. There was some interest taken in its chapter looking at the future course of interest rates. In many respects, however, the most striking feature of the IMF’s economists’ analysis was the disjuncture between their stylised outlook for real interest rates and their recommendation that governments should energetically work to reduce public debt.
Real interest rates fell by 5 per cent after 1980.
The fall in inflation in the final part of the 20th century took most people and most economists, particularly economists working in official domestic and international institutions by surprise. The fall in nominal and real interest rates that then followed in the two decades of the 21st century in terms of its magnitude and persistence also surprised them. In the same way that the acceleration in US productivity growth and the collapse of productivity growth in advanced economies since the late 1990s took them by surprise.
So, I have no crystal ball and have no obvious suggestions about the path of future interest rates. Having said that it is possible to interrogate analysis for its coherence and its inferences for the conduct of policy.
Crystal ball or not the scale of the fall in interest rates is dramatic. The IMF economists report that ‘looking through cyclical fluctuations and term premiums, real rates have fallen steadily, by about 5 percentage points over the last four decades across all maturities’. The IMF economists also note an ‘interesting feature of these results is that the decline in the natural rate is so similar across advanced economies despite such differing trend growth components. With the exception of Japan, the natural rate dropped more than implied by the change in growth rates over the same period. This suggests that some forces other than domestic growth may be inducing common movements in the natural rate. That estimated natural rates are more similar across countries now than 40 years ago is perhaps consistent with the idea that capital market integration has progressed, at least among advanced economies’.
IMF has a cogent analysis of the determinants of real interest rates where they fall
In broad terms the IMF Economic Outlook – Chapter 2 – has an extensive and sophisticated analysis of the outlook for interest rates or as it expresses it slightly quaintly the ‘natural rate of interest’. It concludes that once inflation subsides to the sort of rates that inflation targets set for central banks interest rates will return to the historic exceptionally low rates that were generates by policy and real market influences inn the years before 2019.
The analysis of the IMF economists is worth exploring because it marshals and explains in a cogent manner the principal international factors that have shaped interest rates over the last forty years. At their heart has been the international integration of world money and capital markets.
This has led to both a lowering of interest rates and a convergence of interest rates among different economies. Among the influences has been an increase in the demand for safe usually public sector debt issues by governments and the US Treasury in particular. The combination of integrated capital market and the dominance of the appetite for so-called ‘risk free’ government debt is the principal explanation for the very low interest rates across economies as a whole. It has bene amplified by a continuing glut of savings.
This is the product of two matters that often are exhibited in the same country. Governments mainly in Asia choose to hold high levels of liquid foreign exchange reserves and portfolio assets. While their citizens choose to accumulate large financial portfolios of investment to finance health costs, assistance to adult children, retirement, and the costs attendant on old age. In the absence of developed and reliable welfare states that in advanced economies have smoothed spending over the life cycle and substituted private provision for public provision. In addition, the citizens in these Asian economies often have reservations about the governance and stability of their domestic institutions and seek opportunities for foreign investment, with a focus on the US dollar.
Part of the explanation of the very high and sustained level of the Japanese savings ratio is saving to smooth incomes in retirement, a reflection of a shorter working employment life -often ending at 55 - with employment afterward usually with much lower rates of pay; and a variety of higher costs such as higher house maintenance costs. Although fear of defective institutions and poor local governance is a much smaller part of life in Japan, what an excessive of saving over investment has resulted in Japanese capital being exported into the international markets.
The IMF analysis of interest rates includes several observations that are worth noting. These include one of the best ‘in your face’ theoretical explanations for the determination of the rate of interest. The rate of interest is determined by ‘growth in aggregate productivity. The idea is that the rate of interest paid by a borrower must compensate the lender for giving up on alternative use of those funds, known as their “opportunity cost.” Higher productivity growth increases the marginal product of capital and drives up savers’ opportunity cost, necessitating a higher interest rate to induce them to lend.’ This is among the most concise and lucid descriptions of the gravamen of the economic literature on growth and interest rates available.
The IMF’s judgement is that natural rates of interest will likely remain at low levels in advanced economies, while in emerging market economies, they are expected to converge from above toward advanced economies’ levels. These patterns will have important implications for both monetary and fiscal policy.
The factors that have lowered rates and will do so again:
No factor clearly dominates over the past 40 years, a set of common forces has driven the natural rate, explaining part of the international co-movement;
Population aging contributing negatively to the change in the natural rate;
Growth in total factor productivity (TFP) declined in all advanced economies;
Increased government borrowing can lead to higher interest rates because more saving is required to meet the increased demand for funds. However, the extent to which this occurs also depends on how much private investment is displaced by the additional public debt;
Market power and the labour share: The impact of increased market power on the natural rate is ambiguous. Increased market power typically depresses future production and investment demand, weighing down on interest rates. But it also reroutes dividends from laborers to capital owners;
International capital flows and the scarcity of safe assets: International spillovers from the integration of global capital markets may have been powerful drivers of the natural rate;
Risk aversion and leverage cycles: The quality attributed to particularly safe and liquid assets (for example, government bonds in advanced economies) gives rise to a convenience yield, which is variable and likely to increase when global stress leads to deleveraging;
Given the safe haven property of the US dollar, this is especially the case for US Treasuries whose value increases in periods of stress, providing protection to risk-averse international investors.
After inflation is gone, low interest rates will return us to secular stagnation.
The IMF’s conclusion that after the present bout of inflation has been defeated ‘natural rates will likely remain at low levels in advanced economies, while in emerging market economies, they are expected to converge from above toward advanced economies’ levels. These patterns will have important implications for both monetary and fiscal policy.
Monetary policy will have to return to the position before 2020. Central banks will have to use forward guidance in the IMF’s judgement to maintain sufficient stimulus in their economies to meet their inflation targets and avoid deflation. The IMF expects that there will be a revived interest in raising official inflation targets for central banks. In terms of fiscal policy Chapter 2 of IMF World Economic Outlook recognises there will be greater space for advanced economies to use fiscal policy.
IMF’s homilies on public debt consolidation do not appear to be properly informed by Chapter 2’s analysis.
Chapter 3 Coming Down To Earth: How to tackle Soaring Public Debt, however, appears wholly disconnected from the analysis of the outlook for interest rates in Chapter 2. If interest rates return to their exceptionally low rates there a important implications both for monetary policy and fiscal policy. The first is that as a source of stimulus monetary policy within macro-economic policy with once again be effectively neutered as a tool of demand management. Fiscal policy will have to be used in order to stabilise demand, manage the economic cycle and to respond to economic shocks. The second is that the costs of using the public sector’s balance sheet to smooth the burden of costs arising from investment and adjusting to adverse shocks such responding to an energy or trade shock is reduced. And in a macro-economic environment of secular stagnation fiscal policy and public sector debt would be an important tool to address long-term supply performance issues both in terms of financing infrastructure and other investment and the reconfiguration of incentives to improve the working of labour and product markets.
Whether central banks are going to be able to bring about a swift disinflation that vanquishes high inflation and whether a return to very low interest rates that encourage excessive leverage and the scramble for yield with its attendant asset price bubbles and zombie corporations is another question.
Maintaining more normal historical real and nominal interest rates even if inflation falls back to the low values recorded before 2019 may be desirable, given the micro-economic role of interest rates in pricing credit and capital. The secular pressures the IMF identifies driving real rates down may mean in practice higher short-term policy rates may be matched with a less steep or even somewhat flattened yield curve, particularly for public debt. Controlled inflation with highish, or to be more precise, normal nominal short-term rates with low ten, twenty and thirty year public sector bond yields would invite much more active use of public sector balance sheets and a sensible use of fiscal policy.
Warwick Lightfoot
Warwick Lightfoot is an economist who was Special Adviser to three Chancellors of the Exchequer between 1989 and 1992 and is the author of America’s Exceptional Economic Problem.