Robin Harding has a new FT article that makes 8 claims about interest rates:
First, there is an intimate link between long-run interest rates and long-run economic growth.
There is some link, but when we get to point #4 we’ll see a problem with this claim.
Second, monetary policy is broken. In 2008-09, the Fed cut rates by 5 percentage points and it was not enough. Today it has far less room to respond to a recession.
The recession of 2008-09 was caused by tight money that depressed NGDP. The fall in NGDP caused the big drop in interest rates. Monetary policy is still highly effective, if used properly.
Third, if monetary policy is broken, fiscal policy must step in.
Fiscal policy is ineffective, due to monetary offset.
Fourth, lower interest rates make debt more sustainable.
You can’t have it both ways. Point #1 says rates are low due to weak growth. If true, then the low rates do not make debt more sustainable.
Fifth, capital stock should rise relative to output.
That’s reasoning from a price change. It’s only true if the low rates are caused by an increased propensity to save. If the capital stock “should” rise relative to output, it likely will.
Sixth, any asset in fixed supply is now more valuable, because its future cash flows can be discounted at a lower rate.
Again, this is reasoning from a price change. Perhaps rates are falling because future expected cash flows are falling. That certainly seems plausible for Japan and Europe.
Seventh, demand for housing will rise.
Not completely implausible, assuming the lower rates are not caused by a drop in the productivity of housing. But again, it’s reasoning from a price change unless one accounts for the cause of the low interest rates. Declining rates in the US during 2006-09 were partly caused by the housing slump, and thus did not boost demand for housing.
The final point is excellent:
Eighth, low interest rates make it harder to save. In particular, they make it harder to save for a pension, and harder to live off whatever capital accumulates. . . .
It is possible that this bout of low interest rates will end. Perhaps the Fed is mistaken and it will have to raise rates sharply in the future. Perhaps a burst of technological progress will raise growth and boost demand for capital.
But no one can choose to make that happen: this is not some perverse plot by Fed chair Jay Powell and ECB president Mario Draghi to make life miserable for the world’s savers. The long-run real interest rate balances the desire to save and demand to invest. Central banks are its servants not its masters.
The trend towards lower real interest rates has lasted for decades and is as likely to continue as to reverse. With central banks moving to ease, it is time to stop waiting for rates to recover and face the world as we find it.
READER COMMENTS
Thaomas
Jul 31 2019 at 9:19pm
2. The author is confusing “monetary policy” with movements in ST interest rates. The Fed just failed to buy enough stuff to keep prices rising at 2% pa and resources fully employed.
3. Recessions make the marginal costs of project inputs fall below their market prices and borrowing costs go down, so more activities with present costs and future benefits will pass an NPV test than in non-recessions. If this is “stepping in” yes it must step in.
4. Lower relative to nominal growth, yes, but “sustainability” in not the right criteria for debt. A cyclically balanced budget will result in optimal debt, whatever that is.
8. Central banks should not have targets for interest rates. Interest rates are one of many possible instruments of policy whose target should be a combination of price level growth and full employment of resources.
Market Fiscalist
Jul 31 2019 at 9:40pm
on ‘Third, if monetary policy is broken, fiscal policy must step in.’
If (by assumption) monetary policy is broken how can monetary offset
prevent fiscal policy from working?
Scott Sumner
Aug 1 2019 at 12:16pm
It can’t. But monetary policy is not broken.
Dustin
Aug 2 2019 at 12:22pm
I think you may overestimate monetary offset. I’m not a fan of active fiscal policy to guide the economy; it’s just that the CB can be rather slow and modest in how it responds to economic trends. If the CB is slow enough and modest enough, there is some room for fiscal policy to have an effect.
Alan Goldhammer
Aug 1 2019 at 7:30am
#8 – Should not this be worded differently? ‘It’s more risky to save.’ Individual and group (foundations, pension plans, etc.) investors are forced into more equity and alternative investments. I sit on the investment committee of a non-profit foundation with a significant endowment. We are constantly wrestling with how our investment portfolio should be structured so that we achieve capital appreciation while minimizing the downside risk. A portion of the portfolio is hedged to protect against the downside but that has been the weakest performer over the past 18 months. Our debate about the investment policy is complicated by the low interest rate environment and the apparent exuberance for mega-cap stocks. For those of us who are value investors, this is not a great time.
Brian Donohue
Aug 1 2019 at 10:03am
Yes, bravo on point 8. Superb.
Rob Rawlings
Aug 1 2019 at 10:37am
Question on ‘Eighth, low interest rates make it harder to save. In particular, they make it harder to save for a pension, and harder to live off whatever capital accumulates.’:
While this would be true if you did all your savings in cash – is there any evidence that this would be true if for example you save by buying stock in companies that pay dividends or rental properties (leaving aside capital growth) ?
Scott Sumner
Aug 1 2019 at 12:17pm
Rob, I believe that returns have fallen on a wide range of assets, but am not certain on that point.
Alan Goldhammer
Aug 1 2019 at 5:47pm
In terms of stocks you will have to construct a portfolio very carefully as you want to protect capital while capturing income. The yield on the S&P 500 is only 1.9% which is not great. You can move into real estate trusts and do better in terms of dividend yield. You can also add some high yield bonds as well. Even so, chances are you won’t do much better than 3-4% income on investment and you will need to balance that off against the risk of loss of capital.
You can do OK with rental properties but the upfront purchase price can be significant and of course you need to manage the property(s).
Dustin
Aug 2 2019 at 12:24pm
S&P 500. That’s the problem. With a whole world of assets, the S&P 500 isn’t the investment of choice.
TMC
Aug 1 2019 at 12:51pm
“Fiscal policy is ineffective, due to monetary offset.”
Is this always the case? I hear mention of ‘at zero bound’ things work differently, but there seems to be debate about this. I never got my head wrapped around this.
Benjamin Cole
Aug 1 2019 at 8:31pm
Ben Bernanke is certainly a sober fellow, and he recommended to Japan that they go to helicopter drops back in 2003.
Moody’s just issued a report that the US banking system is unsustainable if interest rates go to zero. As we depend upon commercial banks for the endogenous creation of money, this outlook is not encouraging.
There is a global and worsening glut of capital, and investors should get used to the idea they are as likely to lose as gain money by investing. Especially if governments and central banks don’t go all out to boost aggregate demand.
Roger McKinney
Aug 2 2019 at 9:53am
There are other more plausible reasons for low interest rates forever than the over-simplistic ones such as the money supply or the aging population. Monetary expansion creates zombie companies that banks keep on the books in order to keep themselves afloat, too. Japan, Europe and the US are chained to such zombies. New money goes to service their debt. Also, we have allowed large corporations to cartelize the economy through regulations. Econs call them oligopolies for their just cartels. Cartels don’t compete on price and see no need to grow, invent new things or any of the things that competitors do to survive. They merely want to keep profits high, and they have been for a long time.
Japan has led the US and Europe into this trap. It has suffered a generation of low growth and low interest rates due to its zombie businesses. An aging population is not their problem. They have tried every monetary scheme monetarists have dreamed up and none of them have worked. Europe has had negative rates for almost a decade with no effect. The EU and Japan have proven all monetarists wrong.
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