A new Bank of England paper finds a 450 bps decline in global equilibrium real interest rates over the past 35 years, due to a fundamental divergence: savings preferences surged on demographics, inequality and EM reserve accumulation, while investment spending was held back by cheapening capital goods and declining government activity. More recently, fear of secular stagnation has compounded the real rate compression.

Rachel Lukasz and Thomas D Smith (2015), “Secular drivers of the global real interest rate”, Bank of England, Staff Working Paper No. 571, December 2015

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2702441

The below are excerpts from the paper. Headings, links and cursive text have been added.

Evidence for a secular decline in equilibrium real rates

“Since the 1980s, market measures of long-term risk-free real interest rates have declined by around 450bps across both emerging and developed economies.”

LOW_RRATE01

“If we look further back, we see that real rates began the post-war period at similar levels to those seen today, before rising in the 1960s and 1970s. The low frequency of these fluctuations suggests that secular (rather than cyclical) forces are likely to be responsible for the rise and the subsequent fall in real rates seen over the second half of the 20th Century.”

LOW_RRATE02

N.B. The 1950s and 1960s have also been characterized as a period of “financial repression” (view post here), policies that have made a partial comeback in recent years.

“[The] decline in global real interest rates has largely occurred against a backdrop of low and stable inflation with little sign of demand overheating. This suggests the sustained fall in long-term market rates is symptomatic of a fall in the global neutral rate…This intuition has been formalised in econometric models, which aim to extract measures of equilibrium interest rate from observed data…This sort of exercise…finds that the U.S. normal real interest rate has declined by around 450bps since the 1960s, and by around 300bps since the 1980s.”

LOW_RRATE03

“Another line of argument is that…‘global rates are low because monetary policy is loose’… This view of the world is unlikely to be correct as the decline in actual real interest rates has occurred against a backdrop of contained inflation with little sign of exuberant demand growth.”

Rising preferences for savings

“Our analysis suggests the desired savings schedule has shifted out materially due to demographic forces (90bps of the fall in real rates), higher inequality within countries (45bps) and a preference shift towards higher saving by emerging market governments following the Asian crisis (25bps).”

“The focus of our analysis here is on changes in desired, rather than actual saving and investment. This distinction is important…For the world as a whole…actual saving and investment will always be equal by identity. But the sensitivity of desired savings and investment (the slopes of the curves) and the forces that shift them (preference shifts) will be key in determining the actual level of saving and investment and the observed real interest rate.”

“The life-cycle hypothesis suggests that changes in the age structure of the global population can affect savings behaviour over time. Consumption is fairly stable over the life cycle, but income is hump-shaped, so people of working age are those who tend to save the most. Consequently, the greater the proportion of the population that is of working age, the higher the desired level of saving in aggregate is likely to be…every 1pp fall in the dependency ratio translates to around a 0.5pp rise in national saving rates. This relationship is stable through time…Over the past 30 years the proportion of dependents has fallen from around 50% of the global population to 42%. The main driver of this decline has been a fall in the proportion of young dependents…The 8pp fall in the global dependency ratio translates to a 4pp rise in desired savings, for a given real interest rate… Overall, demographic forces…are… accounting for around 90bps of the fall in global real rates we have seen over the past 30 years.”

LOW_RRATE06

“Changes in the distribution of income can affect desired saving because the rich and poor tend to save different proportions of their income. To the extent that the rich save more, rising inequality will result in lower consumption, higher desired saving, and hence a lower equilibrium real rate…Overall, rising inequality within countries is likely to have pushed up global desired saving by around 2pp and hence account for around 45bps of the fall in the global real rate we have seen – around half as large as the effect from demographics.”

LOW_RRATE07

“Following the Asian crisis in 1998, many emerging markets significantly increased their foreign exchange reserves as a precautionary measure against the future risk of destabilising capital outflows. In tandem, the era of high oil prices prompted an increase in saving among oil producers…Using the increase in emerging markets’ current account surplus as a guide suggests the desired saving schedule has shifted to the right by 1pp as a result of the EM saving glut, which lowers the global real rate by round 25bps. This is only around half of the effect of inequality, and a quarter of the effect of demographics.”

Decreasing preferences for investment spending

“The desired investment schedule has also shifted. Here we focus on three trends that could potentially explain such a shift: the secular decline in the relative price of capital goods; a preference shift away from public investment projects; and an increase in the spread between the risk free rate and the return on capital.

“Perhaps one of the most pervasive trends that may have affected desired investment expenditure is the 30% decline in the relative price of capital goods since the 1980s. Cheaper capital means that a given investment project costs less to pursue, so investment volumes can be maintained by committing a smaller share of nominal GDP…A 30% decline in the relative price of investment lowers the steady-state nominal investment-to-GDP ratio by around 1pp…The 1pp shift in the investment schedule, together with a 30% drop in the elasticity of investment with respect to the interest rate, delivers around a 50bps fall in the real rate in the saving-investment diagram.”

LOW_RRATE08

Public investment has been on a declining trend as a share of global GDP since the 1980s…[and] lowered the global investment-to-GDP ratio by around 1pp between 1980 and 2007. Since then, public investment in emerging economies – particularly China – has accelerated rapidly, unwinding this long-term decline. However, we think much of this recent pickup is a cyclical response to weakening demand during the Global Financial Crisis. We therefore expect this to reverse and the downward secular trend to eventually reassert itself…Consequently, we think lower public investment has shifted the desired investment curve to the left by around 1pp, lowering real rates by around 20bps – a relatively small effect.”

“The interest rate that matters for firms’ investment decisions is the rate of return on capital, not the risk free rate…the rate of return on capital has fallen since the early 1990s, but not by as much as the risk free rate – the spread has increased by around 100bps…data across a variety of countries and markets supports the conclusion that the spread has increased by around 100bps since the 1980s, which corresponds to a downward shift in the desired investment schedule and a fall in the risk free real rate of around 70bps.”

What about “secular stagnation”?

“One of the most commonly cited explanations for the decline in real interest rates is that trend growth has fallen. This line of reasoning [is] at the heart of…[the] secular stagnation hypothesis.”

Growth has not changed materially since the 1980s, averaging 3 to 4% per year. In fact, if anything growth in the years before the crisis was actually a little higher than in the 1980s. Consequently, it is difficult to account for much (if any) of the pre-crisis fall in real rates by appealing to past changes in global growth, the financial crisis may have triggered a wider reassessment of growth prospects going forward.”

LOW_RRATE04

“Yet while growth may not have fallen much over the past…the financial crisis may have triggered a wider reassessment of growth prospects going forward and greater pessimism about the future could be playing an important role in driving the decline in real rates we have seen most recently. ..Slower global labour supply growth (due to demographic forces) and headwinds at the technological frontier (such as a plateau in educational attainment), may cause global growth to slow by up to 1pp over the next decade.  We think this decline could account for about 100bps of the fall in real rates we have seen recently.”

LOW_RRATE05

Consequences

“The bottom line from our analysis is that powerful global trends have driven the secular decline in the global neutral real rate, and as those trends are likely to persist, the neutral rate is likely to remain low for some time…The policy implications of permanently low real interest rates are extensive. In the face of adverse shocks, central banks are likely to run up against the zero lower bound on nominal interest rates more often, requiring the use of unconventional policy instruments.”

SHARE
Previous articleCollateral framework: risks and policies
Next articleThe root of China’s financial distortions
Ralph Sueppel is founder and director of SRSV, a project dedicated to socially responsible macro trading strategies. He has worked in economics and finance for over 25 years for investment banks, the European Central Bank and leading hedge funds. At present, he is head of research and quantitative strategies at Macrosynergy Partners.