Low Real Interest Rates

Low Real Interest Rates Christopher Waller Executive Vice President and Director of Research Federal Reserve Bank of St. Louis Fayetteville November 6, 2017 1

Disclaimer The views I will express today are my own and do not necessarily reflect the positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.

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Motivation • The Fed’s mandate is to achieve maximal sustained employment, price stability and financial stability.

• How are we doing?

• Maximal employment is interpreted to mean unemployment is at its “natural” rate or around 4.5%.

• Price stability is PCE inflation at 2%.

• Financial stability is more ambiguous.

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Motivation • We are very close to hitting our goals!

Median Longer-Run FOMC Projections vs. Current Value Percent 5.0 4.0 3.0 Longer-Run 2.0

Current

1.0 0.0 Real GDP

Unemployment Rate

PCE Inflation

Note: Current value for real GDP is for 2017 Q3. Current value for unemployment and inflation is for September 2017. Real GDP and inflation are measured as year-over-year percent changes.

Source: Federal Reserve Summary of Economic Projections (September 2017), BEA, BLS 4

Long Run Policy • Where should we set the fed funds rate when we have achieved our goals, i.e., the gaps are zero?

• The optimal setting should be ������ = r + π*

where đ?‘–đ?‘–đ?‘“đ?‘“đ?‘“đ?‘“ is the fed funds rate, r is the “long runâ€? real interest rate and Ď€* = 2% is our desired inflation rate.

• What value should we use for r?

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Long Run Policy • Historically, the view was that r = 2% was appropriate. • Thus, when we hit our goals, we should set ������ = 4%. • Given how close we are to hitting our goals, then we are way behind in terms of raising rates since ������ = 1.0 - 1.25% at present.

• This is one argument being used to advocate for a faster path of rate hikes.

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Long Run r • Why would we believe r = 2% is appropriate?

• Fed funds (reserves) are close substitutes for U.S. government debt, hence the real return on government debt should be used as a benchmark for the fed funds rate.

• Is r = 2% some long run historical average in the data?

• Let’s take a look at the data.

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U.S. Real Yields (TIPS)

Source: Federal Reserve Board, FRED 8

The Decline in Short -Term r Short-Term Global Real Interest Rates, 1984 to the Present Percent 10 8 6 4 2 0 -2 -4

1984

1989

1994

1999

2004

2009

2014

Source: Reinhart (2017).

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The Decline in r is Global Real Long-Term Interest Rate for G10 Countries Percent 8

Real Long-Term Rate

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Median, 1991-1999

6

Median, 2000-2009

5

Median, 2010-2017

4 3 2 1 0 -1 -2 1991

1994

1997

2000

2003

2006

2009

2012

2015

Note: Last observation is for September 2017.

Source: OECD, Haver, and author's calculations.

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The Decline in r is Global Real Long-Term Interest Rate for G10 Countries Percent 8 7 6 5 4 3 2 1 0 -1 -2 1991

U.S. Foreign Excluding U.S.

The correlation between the two series is 0.85.

1994

1997

2000

2003

2006

2009

2012

2015

Note: Last observation is for September 2017.

Source: OECD, Haver, and author's calculations.

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Long Run r • From this data we can conclude that r has been in secular decline for the past 30+ years for all major economies.

• So imposing r = 2% is not a good assumption for predicting where the fed funds rate will be in the long run.

• If it is expected to stay negative or near zero, then the fed

funds rate should be set closer to đ?‘–đ?‘–đ?‘“đ?‘“đ?‘“đ?‘“ = 2% in the long run.

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Why the Decline?

• A question which the economics profession is struggling with is why the decline in r has occurred.

• One explanation that we like is that there is a “shortage of safe assets” in the world (not enough safe government debt).

• In short, the demand for safe assets is growing faster than the supply. Asset prices are bid up and the returns fall.

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Why the Decline?

What could be driving the growing demand?

1.

2.

Globalization of financial markets since the 1990’s.

3.

The rise of China, sovereign wealth funds and central bank asset holdings around the world since the late 1990’s.

4.

Global financial regulations on portfolio holdings.

Demographics; the world population is getting older and wants safe assets to ensure the principal is there in old age.

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Will the Decline Reverse Itself?

• Should we expect this secular decline to reverse course in the near future?

• If you accept the reasons above, then no.

• But why not look back even further to see how real interest rates on government debt have behaved?

• Is the last 35 years an extraordinary period?

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150 Years of Global Real Rates Short- and Long-Term Global Real Interest Rates, 1860s to the Present Percent 15

1929

10

2% 5 0 -5 World Long-Term (Hamilton, et al.)

-10 -15

World Short-Term (Reinhart) 1858 1868 1878 1888 1898 1908 1918 1928 1938 1948 1958 1968 1978 1988 1998 2008

Source: Hamilton et al. (2016), Reinhart (2017).

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This is a Really Long Run Issue!

• Near zero real interest rates on government debt has been the norm for over 70 years!

• Something clearly happened in the 1930’s that permanently lowered real interest rates.

• There was a short period of time in the late 80’s and 90’s that pushed up real rates but that disappeared in the 2000’s.

• Has the shortage of safe assets been a longer-term problem rather than a recent phenomenon?

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Long Run Shortage?

• One could argue that there has been a persistent shortage of safe assets since the 1930’s.

• The Great Depression, WWII, Korean War, Cold War were all events that induced people to clamor for safe assets and drive down their yields.

• Until the 1970’s - 80’s, Japanese/German debt obligations were not viewed as “safe assets”.

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Late 20th Century • Soviet Union collapse reduced global risk in 1990’s.

• Starting in the late 1970’s, Japanese and German debt began to be viewed as “safe”. This increased the supply of safe assets in the world.

• High and volatile inflation in the 1970’s led to lower demand for nominal government debt.

• All events would lead to higher yields on government debt.

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Going Forward • Should we expect this secular decline to reverse course in the near future?

• If you accept the reasons I listed above and the long run evidence on real interest rates, then no.

• So the best assumption going forward, is to assume that the long run real interest will be near zero or slightly above.

• This suggests the fed funds rate should be set closer to ������ = 2% - 2.5% in the long run.

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FOMC has Adopted this View.

Real Long-Term Federal Funds Rate Projection Percent 2.5

2.0

1.5

1.0

0.5

0.0 2012

2013

2014

2015

2016

2017

Note: The real rate is the median nominal rate less the longer-run projected headline PCE inflation rate.

Source: Federal Reserve Summary of Economic Projections 21

Conclusion • The FOMC’s goal variables are effectively at their target, or soon will be—i.e., the gaps are closed.

• We—and the FOMC and markets—expect real rates to remain exceptionally low for the foreseeable future.

• Although there are risks to this view, our mandate is not to raise rates for the sake of raising rates.

• But if the facts change, our policy will change.

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Questions?

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Real FFR When MP Goals “Achieved�

Time Period 1960-1969 1970-1979 1980-1989 1990-1999 2000-2009 2010-2017

Real FFR (������ – π*) 1.35

#N/A 4.10 3.48 1.86 -1.28

Note: Table displays the average real FFR, by decade, when the Fed’s distance from its goals are at or below their current (Sep. 2017) levels.

Takeaway: The real FFR associated with “normal� times has been declining since the 1980s, but was notably lower in the 1960s than from 1980-2009.

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