The future of interest rates is an enigma – 04/19/2023 – Martin Wolf

The return of inflation surprised many, including central bankers. So did the resulting rise in nominal interest rates. These surprises brought others with them, notably a mini-shock in the banking sector.

The question, then, is, “What now?” Will inflation drop to ultra-low pre-Covid levels, or will it be a persistent problem, as in the 1970s and early 1980s? Also, what will happen to interest rates?

As Stephen King, an adviser to HSBC, notes in “We Need to Talk About Inflation,” many have been too complacent about the possibility of inflation returning. He also observes that, once inflation and, above all, inflationary expectations are consolidated, it becomes very difficult to eliminate them. Have we reached this point? Or do our institutions still have enough credibility and inflation still transient enough that we can return to low inflation at low cost?

In my opinion, we are more likely to go back to inflation around 2% a year, or maybe a little more. It’s also what the markets expect: according to the Federal Reserve Bank of Cleveland, expected US inflation is 2.1%, almost exactly in line with the target. This demonstrates confidence that the goal will be delivered. The inflation risk premium is also estimated at 0.5 percentage points, which is in line with historical valuations.

There are two (overlapping) arguments why this might be overoptimistic. One is that supply conditions have become more inflationary. Deglobalization and other shocks have permanently reduced the supply elasticity of key inputs. This will increase the costs of keeping inflation low. The other is that the political economy of containing inflation has worsened. So the public is less concerned about inflation now, in part because it doesn’t remember a long period of high inflation. In addition, governments want to reduce their debt, which today is much higher than it was 15 years ago, without curbing fiscal deficits. Finally, the inflation genie is out of the bottle. Putting it back will hurt.

I remain unconvinced. Obviously, there is no necessary link between supply and inflation, as demand also matters. As long as aggregate demand grows in line with potential output and the structure of output is reasonably flexible, specific constraints are perfectly consistent with low overall inflation. Furthermore, monetary policy makers will not want to go down in history as those responsible for the loss of monetary stability. Last but not least, they know that it will be much easier to crush inflation now than having to squeeze it again later.

Assume this is correct. So the components of inflation in nominal interest rates will not be permanently increased. But what about the actual element? Real interest rates fell for a generation before hitting negative levels during the pandemic. Since then, they have recovered dramatically. What happens now?

In its latest World Economic Outlook, the IMF addresses this issue by investigating the “natural interest rate,” which is defined as “the real interest rate that neither stimulates nor contracts the economy.” This is also the rate at which inflation would be expected to remain stable (in the absence of shocks). The natural rate is not directly observable. But it can be estimated. The main conclusion of the IMF analysis is that “after the current inflationary episode, interest rates are likely to return to pre-pandemic levels in advanced economies”. After the recent shocks, real and nominal rates will fall back to where they were in 2019. In particular, the effect of further population aging is expected to be modest, as is the (opposite) effect of higher public debt.

In March, two leading macroeconomists, Olivier Blanchard and Lawrence Summers, debated this issue in detail for the Peterson Institute for International Economics. Of the two, Blanchard came closest to the IMF’s position. Summers, who relaunched the idea of ​​”secular stagnation” in the political debate in 2015, has now changed his mind, arguing that rates will be significantly higher than in the recent past.

The difference is not big. Blanchard argues that real interest rates will remain below the real rate of economic growth, which is crucial for debt sustainability. He does not suggest that they will return to negative levels. Summers thinks they will be slightly higher than the Fed’s estimate of a 0.5% natural rate. One reason real rates will be higher than before, they agree, is increased investment in the energy transition. Another is the need to spend more on defense. Higher public debt may also raise real rates, although inflation is eating away at the debt.

The two disagree, however, on whether the persistent demand reflects temporary (Covid-related) factors or has more lasting strength. They disagree on the extent to which risk aversion will keep returns on safe assets low. They disagree on whether an aging population will further increase savings. And they also disagree on the likely impact of public debt on interest rates. In all these respects, Blanchard takes a position that justifies lower natural rates, and Summers one that justifies the opposite. His position is close to that adopted by Charles Goodhart and Manoj Pradhan.

So, suppose inflation drops to 2% to 3%. Also assume an equilibrium real interest rate of 0 to 2%. So nominal short-term rates would be 2% to 5% and, given risk premiums, long-term rates would be 3% to 6%. At the low end, debt sustainability would be straightforward. On the higher end, it would be a challenge. This range of uncertainty is large. However, the reality could still be different.

Translated by Luiz Roberto M. Gonçalves

PRESENT LINK: Did you like this text? Subscriber can release five free hits of any link per day. Just click the blue F below.