Low Interest Rates Still Look Like The New Normal

The financial crisis that ripped through the global economy in 2008-2009 ended more than a decade ago, but one of its most confounding offspring persists: low (and in some cases negative) interest rates. Some have suggested this phenomenon is largely – if not wholly – due to the Federal Reserve’s truculence in managing monetary policy. If only the central bank would raise interest rates, so the story goes, the price of money would return to the “normal” state of affairs that presided before the Great Recession. If only it were that easy.

The Fed sets interest rates, but the influence is mostly a temporary one that’s concentrated at the short-end of the yield curve.

Over the long term, the economy has a much greater influence on rates.  In fact, it’s fair to say that the economic conditions are the final arbiter of the price of money generally.

As a result, the Fed pays close attention to the equilibrium real interest rate (a.k.a. the “natural rate of interest”). This is the rate that prevails when the economy’s output matches its potential output. Also known as R-star (r*), this rate is said to be the optimal price of money for maintaining full employment and maximum output while keeping inflation steady. It is, in short, a rate with broad and deep influence over monetary policy over a medium-to-long-term horizon.

For obvious reasons, investors should keep a close eye on r* for insight on where the price of money may be headed. On that note, a recent Federal Reserve research paper reaffirmed what’s been obvious in trend lines for U.S. rates in the post-2008 era: a sustained rise in yields still appears to be a low-probability scenario for the foreseeable future.

“Real interest rates have been persistently below historical norms over the past decade, leading economists and policymakers to view the equilibrium real interest rate as likely to be low for some time,” observes Michael Kiley, a Fed economist. The downside bias is a global phenomenon, he notes in “The Global Equilibrium Real Interest Rate: Concepts, Estimates, and Challenges,” which was written in October.

In fact, analyzing the numbers through a worldwide lens suggests that “the U.S. equilibrium rate may be substantially lower than estimated in U.S.-only studies,” reports Kiley, senior adviser for research and statistics at the central bank.

Monitoring this rate deserves to be on every investor’s short list of analytical tasks, but there’s a glitch to keep in mind. The equilibrium rate isn’t directly observable and so it must be estimated with a model. There are several to choose from, but for the uninitiated the New York Fed conveniently offers regular updates that allow you to bypass the underlying analytics via a pair of models that estimate r* for the U.S. and the world’s leading economies overall. Alternatively, the regional Fed bank also provides the R code to generate the data for more timely updates or if you’re inclined to tweak the model.

The key insight here is that the Fed can adjust its target rate (Fed funds rate) above or below r* to cool the economy or provide extra fuel for growth. Watching r* also offers context for guesstimating where interest rates appear to be headed in the medium-to-long run.

With that in mind, no one will be surprised to find that r* has tumbled over the past decade, holding in the 0.5%-to-1.0% range in recent years, based on the Laubach-Williams model.

Note, too, that the trend growth line in the chart above has been edging higher since around 2016. It’s no accident that r* has drifted up too. Although there are many forces driving r*, economic activity generally is the critical input. If growth strengthens, the equilibrium rate of interest should follow, and vice versa.

As former Fed Chairman Ben Bernanke wrote a few years ago, “the state of the economy, not the Fed, ultimately determines the real rate of return attainable by savers and investors. The Fed influences market rates but not in an unconstrained way; if it seeks a healthy economy, then it must try to push market rates toward levels consistent with the underlying equilibrium rate.”

To the extent that economic activity influences r*, the recent slowdown in U.S. GDP growth implies that the equilibrium rate will remain range-bound in for the near term. Economic output increased by a moderate 2.1% in the third quarter and is expected to decelerate in Q4, according to various nowcasts. The Atlanta Fed’s GDPNow model, for instance, estimates that GDP will rise by 1.7% in the final three months of the year (based on November 27 data).

A lot can happen between now and January 30, when the Bureau of Economic Analysis publishes the first installment of the official Q4 GDP report. But even the “optimists” think slow growth is still the path of least resistance until or if incoming data offers a reason to think otherwise.

Interest rates will undoubtedly return to “normal” eventually. When? Perhaps longer than monetary hawks expect if we use r* as a baseline estimate.

By James Picerno, Director of Analytics

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