In 2021, most monetary economists believed that real interest rates would fall to zero. But things turned out differently.
In 2021, when interest rates were close to zero in the US and UK and slightly negative in the Eurozone and Japan, the consensus was that they would stay low indefinitely.
Despite aggressive monetary tightening by the US Federal Reserve and other central banks, real interest rates remained significantly negative through the end of 2022. In addition, long-term rates increased more moderately than short-term rates . In October 2022, the yield curve was inverted, signaling that financial markets expected central banks to cut short-term rates in the near future. This sentiment stemmed from the widespread expectation that both the US and global economies would enter a recession.
The Fed recently raised its key rate to 5.25%. In the United States and many other countries, real interest rates have also moved deep into positive territory.
In 2021, most monetary economists believed that the real interest rate would fall to zero. This shift was widely viewed as a long-term phenomenon, except for occasional cyclical fluctuations, such as interest rate spikes during periods of unusually loose fiscal policy. Given the Fed’s 2% inflation target, the zero real interest rate seemed to imply that the equilibrium nominal interest rate would fall to -2%.
In Europe and Japan, nominal interest rates fell slightly below zero, starting at -0.5% and at -0.75%. This was the effective lower limit. If the equilibrium real interest rate were -2% and the effective lower bound of nominal rates were close to zero or even -0.75%, the global economy would be in dire straits.
The responsibility for maintaining full employment should therefore remain with fiscal policy.
When it comes to fiscal policy, one upside of chronically low real interest rates is that they make high government debt levels more sustainable. Governments could run primary budget deficits (which exclude interest payments) and still manage their debt, as it would decline relative to GDP over time. With the rise in interest rates, however, the US sovereign debt is suddenly a problem again. The debt-to-GDP ratio should resume its upward path from here on out. This was one of the reasons Fitch Ratings downgraded US debt from its AAA credit rating on August 1st. The global rise in real interest rates has also worsened debt problems elsewhere, especially in developing countries.
In 2021, investors and economists alike had illusions that interest rates would stabilize near zero for the foreseeable future. After all, short-term rates in the US had been close to zero for nine of the previous 13 years, from 2009 to 2015 and again from 2020-21. Similarly, interest rates in the eurozone were at or below 1% since 2009 and fell below zero in 2015. In Japan, interest rates have remained below 0.5% since 1996. Such prolonged periods of low-interest rates have not been seen since the Great Depression.
Nominal and real interest rates in major countries have been declining since at least 1992. Furthermore, comprehensive analyses covering seven centuries of data on real long-term interest rates have identified a gradual but persistent decline since the Renaissance, between 0.6 and 1.6 basis points per year.
The possible explanations for the decline in real interest rates include slowing productivity growth, demographic changes, growing global demand for safe and liquid assets, rising inequality, lower capital goods prices, and a savings glut from East Asia. Other factors, such as longer lifespans and lower transaction costs, could help explain why real rates have been declining for centuries.
Nominal short-term interest rates are now above 5% and real interest rates are back in positive territory. While some monetary economists still expect interest rates to return to zero, they may have been overly influenced by the dramatic changes of 2008-21. After all, the prospect of equilibrium interest rates reaching zero or negative territory was almost unthinkable before the 2008 global financial crisis (at least outside of Japan).
Given these premises, it will be difficult to assume that interest rates will soon return to zero. But high real interest rates are bad news for fiscal policymakers, who may once again find themselves constrained by unsustainable debt-to-GDP ratios.
Original article published on Money.it Italy 2023-08-27 08:15:00. Original title: L’impennata dei tassi di interesse reali e le previsioni sbagliate degli economisti
