The OECD pointed out last week that the ratio of public debt/GDP will reach all time historic highs in 2014, at about 120 per cent. Taken in isolation, this could certainly viewed as a worrying fact, with bad implications for the future of real interest rates and possibly inflation. A couple of days later, however, the IMF published a fascinating chapter in its latest World Economic Outlook (WEO) on global real interest rates, showing that the global real rate has fallen from about 6 per cent in the early 1980s to about zero today.
Both of these facts are of course very well known, but placed side-by-side, they still represent a stark contrast:
They also present a conundrum for policy makers and investors. Why has the surge in public debt not resulted in a large rise in real borrowing costs for the government, and for the wider economy? And what does this tell us about the future of the risk free real rate in the global economy?
(…) The IMF says that the main reason for the drop in real rates in the 1980s and 1990s is obvious: the easing in monetary policy that occurred after the 1979-82 Volcker tightening. After 2000, the IMF identifies other forces, each of which is associated with a different school of economic thinking:
- A drop in investment demand in the advanced economies. This is very similar to the secular stagnation hypothesis, recently advanced by Larry Summers and Paul Krugman. On this view, real rates have been reduced by low rates of investment, which are in turn due to the global recession post 2008 and to the IT revolution. The latter has cut the prices of investment goods (think more computers and less steel mills), and this has cut the demand for loanable funds. The IMF says that these effects are unlikely to be reversed very rapidly in the years ahead. In fact, they expect the investment ratio in the advanced economies to stay well below pre-crash levels, while the savings ratio begins to rise moderately. Overall, this might even exert some downward pressure on real rates from here.
- An excess of savings in the emerging economies. This view is mainly associated with Ben Bernanke, who warned of a global savings glut in 2005. This shifts the supply of loanable funds to the right, also reducing real rates. The IMF says that this factor was particularly important from 2002-07, and warns that it may reverse somewhat in the next few years, exerting some upward pressure on real rates.
- A portfolio shift towards bonds and away from equities. This view, associated with John Campbell and others, suggests that the increased volatility of equities after the 2000 crash, along with a drop in the inflation risk premium on bonds as monetary policy credibility has improved, has increased the demand for bonds and depressed the real rate. Many investors seem to think that this shift will be reversed in the year ahead, with a “great rotation” away from bonds. But the riskiness of equities is not declining, and the inflation risk premium on bonds is not rising, so the chances of a major reversal in this factor also look to be limited.
The full implications of this research are profound, and they require a more complete treatment in a later blog. But three conclusions are obvious:
- If the global real long term rate rises to only 1.25 per cent in 2018, the equilibrium nominal bond yield (with inflation expectations at the 2 per cent target) will be only 3.25 per cent, suggesting that any further bear market in bonds will be limited in scale from here.
- The equilibrium real short rate in the next era should be well below the 2 per cent built into conventional monetary policy rules prior to 2008. This will restrict the extent of central bank tightening up to 2018 (assuming that Ms Yellen et al believe this research, as they probably do).
- Those of us who have been worried about the rise in public debt in Japan, the UK and the euro area periphery (not the US or the euro area as a whole) may have been exaggerating the risks that budgetary policy in these regions is in imminent danger of becoming unsustainable. More on this another time.
Complete Davies’ blog post