A new speech by a British policymaker suggests real interest rates will remain low
By Buttonwood
MARK Carney, governor of the Bank of England, grabbed the headlines this week with a speech that suggested British interest rates were unlikely to rise any time soon. (A bit of a victory for Andy Haldane, the Bank's chief economist, who has even suggested the next move in rates might be down.) But it is also worth reading a very thoughtful speech from a newish monetary policy committee member, Gertjan Vlieghe (formerly at the Brevan Howard hedge fund group).
Mr Vlieghe examines the case that real interest rates may remain low for a considerable period (readers may recall that Larry Summers has made a similar argument under the "secular stagnation" hypothesis). The BofE man cites three factors; debt, demography and the distribution of income. It is hard for this writer not to cheer when he reads that
Debt matters. That was a controversial statement a decade ago. It is far less controversial now. Post-crisis, we now have ample evidence that households and firms with higher debt levels reduce spending more sharply than those with lower debt levels in response in a downturn. After a drop in income, debt relative to income goes up even further, to a level that is higher than where the borrower (or the lender ) wants it – a debt overhang. The borrower wants or needs to reduce debt, and in order to achieve that, they cut back spending very sharply
Recessions in a high-debt economy last longer and are more severe than downturns in a low-debt economy. Getting out of the debt trap is tough. Debt write-offs can be organised for individual sectors but are hard for the economy as a whole. Growing one's way out of a debt crisis is better, but is slow work, since the growth rate has to exceed the real interest rate.
The Bank has done its best to help the process by cutting rates to 0.5% (and holding them for seven years) and by quantitative easing. But Mr Vlieghe argues that this approach has not been as effective as it might have been
Asset purchases were a tool to try to keep stimulating spending when policy rates could not be cut any further. However, asset purchases are an imperfect substitute for lower interest rates, as they transmit a spending impulse to the economy via different channels (wealth effects, reduced risk premia) and the impact of asset purchases – a relatively new tool – is far more uncertain. The fact that policy rates are constrained near zero may have contributed to the persistent disappointment of growth in the recovery. If we had been able to cut interest rate by several percentage points more, the deleveraging progress might have been faster, and spending might have recovered sooner. So it is the presence of the lower bound on policy rates together with a debt overhang that has the potential to create persistently weak recoveries.
The second "d" - demography - will be familiar for regular readers too. Not all the relevant factors point in the same direction. Because people live longer they need to save more. A decline in the number of workers may mean that less capital is needed. Both those factors should push down the real interest rate (higher desired savings, lower desired investment). However, as the proportion of retirees grows, savings should decline (the elderly are spending their savings pot). This could push the real rate up.
Mr Vlieghe cites research showing that the downward effect on real rates is much stronger than the upward one. And demography has a long-lasting impact.
The final "d" is distribution of income. As inequality widens, the rich have more money and they spend less (save more) of each extra dollar. Research shows that
if you increase the share of national income that has gone to the richest fifth by 7pp (change in the US since 1980), then the net effect on desired savings is an increase of around 2pp. This change alone could push real interest rates down by 0.5 percentage point (see Rachel and Smith (2015), pg 39)
He adds that
a rise in inequality could itself reinforce the rise in debt, as households at the lower end of the income and wealth distribution try to maintain consumption growth despite weaker income growth. Kumhof and Ranciere (2010) show that it has been the lower end of the wealth distribution that has driven the rise in household debt. When there is a realisation that the drop in income growth is more persistent than initially believed, the accumulated debt will be seen as too high, and households will be trying to deleverage, pushing income growth down further for a sustained period, beyond the impact of income inequality alone
And the three "d"s could interact
A high debt economy faces headwinds and needs lower interest rates. A high debt economy with adverse demographic trends needs even lower interest rates. And a high debt economy with adverse demographic trends and higher inequality … well, you get the picture.
The standard economic models do not account for these effects since they imply that debt does not matter and demographics and income distribution are not allowed for. These models are not useful for answering questions about long-term changes to real rates and growth.
All this leads Mr Vlieghe to back up his boss and conclude that
I think it is plausible that the appropriate real interest rate for the economy might be very low for years to come. So policy rates, when they rise, may not need to rise by much over the coming years. These medium-term considerations make me relatively more patient before raising rates.
Markets are clearly absorbing this lesson in a narrow sense; sterling has been taking a hit against the dollar. But investors may also be absorbing the broader lesson; that we are stuck in a low growth, low rate and thus low investment return world.
