Negative Equilibrium Real Interest Rates and You

Excellent Returns

The period from 1983 until a year ago featured some of the most spectacular returns on investment ever seen. With some hiccups in each, almost every asset class, from Treasuries to stocks to real estate to commodities to corporate debt did very well.

It's pretty clear that this remarkable performance of assets was not due to a similarly awesome period of growth in the economy. While growth did become remarkably stable, it did not become any faster.

So to what can we ascribe these tremendous gains to which we all became accustomed? Most likely, to a nearly monotonic decline in real interest rates seen during the period. The "Neutral" rate in the below graphic from the FRBSF is really a smoothed average of the actual real fed funds rate. Interpret it as such.

source: FRBSF

Real Interest Rates

The real interest rate is one of the most powerful factors in asset pricing, because it's used to discount the cash flow from investments. A decline in real interest rates will cause Tobin's q to rise dramatically. Commodity prices will soar. As long as inflation doesn't pick up, the price of Treasury bonds will climb.

But indeed, shouldn't we expect a low real interest rate to lead to higher inflation as asset prices rise and economic growth accelerates? Not necessarily. This depends critically on the equilibrium real rate of interest, hereafter the "equilibrium rate."

The equilibrium rate has had a lot of definitions over the years, but it's most simply thought of as the right real interest rate to keep inflation stable.  Monetary policy keeping the real interest rate from swinging too far away from equilibrium in the wrong direction -- or even nudges it away from equilibrium in the right direction -- is a likely cause of the Great Moderation.

A critical aspect of the equilibrium rate ignored by early economic research is that it's time-variable. Its present value is very difficult to determine in real-time. Even worse, the equilibrium rate is very hard to predict, as we have limited knowledge of what should affect it.

Higher population growth and higher productivity growth should mean a higher equilibrium rate. Capital accumulation and decreasing risk premia should mean a lower equilibrium rate. I believe(and now I find, so did PIMCO) monetary policy can indirectly alter it over time. But in truth, while we have a few models, nobody really knows.

Here are some examples of these rates in action.

Inflation Rate	Interest Rate	Real Interest Rate	Equilibrium Rate	Policy Stance
12%	16%	4%	5%	Accommodative
5%	7%	2%	1%	Restrictive
2%	4%	2%	2%	Neutral
4%	2%	-2%	-1%	Accommodative
-3%	0%	3%	2%	Restrictive

While real interest rates, inflation rates, and equilibrium rates can all be negative, the nominal interest rate cannot be.

Back to reality. Refer back to the FRBSF graph above, which depicts a smoothed average of the real fed funds rate over a long period. It could be considered an approximation of the actual equilibrium if the long-term average real fed funds rate converges on the neutral rate during periods of stable inflation. During this monotonic downtrend in real rates since 1982, inflation, as measured by the GDP deflator, wages, and other metrics, declined as well, suggesting in particular that the neutral rate estimated in the 1980's is a little high. But it's close, and the trend is fairly consistent with model predictions.

Source: FRBSF

Deflation Returns

As the equilibrium rate drifted inexorably lower, the threat of excessive disinflation -- a deflationary recession -- grew more real.

To encourage economic growth, the Fed needs to push the real fed funds rate below the equilibrium rate. To curb economic growth, the real fed funds rate must rise above the equilibrium rate.

But the Fed can't directly control the real fed funds rate; it can only control the nominal rate. Because inflation responds only with a lag, that's generally sufficient to control the real rate. A lower equilibrium rate reduces the Fed's ability to be accommodative until it crunches against the zero bound.

There, monetary policy fails, and a so-called liquidity trap arises, as the Fed becomes unable to be accommodative. The fifth example above illustrates a Fed that is stuck in restrictive stance against its wishes.

So why the panic to get out of it immediately? Two reasons.

1. A higher real interest rate than the equilibrium rate -- restrictive policy -- will tend to reduce the inflation rate. As the inflation rate goes down further, policy becomes more restrictive. The fed funds rate is still 0%, but with inflation of -5%, the policy rate is now extremely restrictive.

2. If this persists long enough in a heavily indebted economy, the risk of falling into the debt-deflationary spiral discussed by Irving Fisher increases.

For that reason, an abnormally large real fed funds gap was created to prevent a collapse into deflation after the dot.com crash.  That experiment has clearly failed.  It led directly to commodity and housing bubbles, and likely indirectly to an investment bubble in China and other countries. We live in the wake of that implosion today, unable to replicate the experiment.

A Negative Equilibrium Rate?

Could the equilibrium rate in the US be negative at present?  Real interest rates have been deeply negative for long stretches of time since the 2000 bust, extending the trend set since 1983. During that time, there have been small bursts of deeply focused inflation, such as in oil, housing, and food. The general price level certainly suffered no real inflation, even despite a large fall in the dollar.

This all points to a resounding yes.  But what does that yes mean? Why would it be so? Population growth is lower, but certainly not negative.  Productivity growth remains positive too.  That leaves us with explanations similar to those proposed in Japan years ago:

1. A simple glut of pessimism exists.

2. Balance sheets are so bad, with an ever-increasing amount of debt to be serviced, that the economy is unable to invest. This is a variant of Fisher's debt-deflation story.

3. The negative equilibrium rate is structural; for whatever reason, there aren't enough good investments remaining in the economy.

I won't discuss #1 further. It simply doesn't fit the declining equilibrium rates in the heady boom years, and expectations were for significant inflation even well into this collapse.

#2 has some merits. Corporate and household balance sheets had been very good prior to the collapse, but they're looking ugly now, so we find some support. However, prior face-slaps have failed, as the government has already rushed to provide staggering liquidity to the economy and banking system repeatedly. If investment continues to fail to respond, or inflation fails to result, this argument will gradually lose its credibility.

I find #3 very compelling. 

Companies chose in aggregate to buy back stock with retained earnings rather than invest, even during the best years. It fits a gradually developed, persistent trend of the last 25 years. It explains the failures of face-slaps and recapitalization to date.  Model behaviors of monetary policy based on the Taylor Rule tend towards liquidity traps.

I think these are strong indications that negative equilibrium rates are the result of capital accumulation due to recession-fighting monetary policy.  It's also likely that this situation has been further exacerbated by the pegged currency and growth of China. 

How to Escape (drawn heavily from Krugman's innovative work)

Unfortunately, now that we've hit the zero bound, it's a virtual certainty that the excellent returns we saw in prior years will not be repeated.  A rise in equilibrium rates will not be uniformly kind to asset pricing, and it may take a long time to occur.

From a balance-sheet trap: The policy actions of the Bush and Obama administrations depend heavily on balance sheet problems being the fundamental trouble. By recapitalizing and repairing the balance sheets of banks through bank rescues or nationalization, they'll feel emboldened to lend to eager companies ready to invest profitably in their businesses. A temporary shock of demand and inflation from fiscal deficits could help the economy return to a better equilibrium.

The equilibrium real interest rate will then be higher by definition. Imagine a jump from -1% to 2%. A nominal fed funds rate of 0% and an inflation rate of 2% would flip from 1% below equilibrium to 3% below equilibrium. This could lead to a self-perpetuating increase in inflation rates if the Fed continues to peg rates at zero(though I personally suspect it would cause more capital accumulation, pushing the new equilibrium rate down).

The dollar would weaken markedly. Commodities and U.S. equities would be appealing choices.

From a structurally negative equilibrium rate: The best that fiscal and monetary policy can do in this case is make up for shortfalls in private investment and consumption by expanding the government, waiting for the causes of the depressed real interest rate to fade, and hoping the sovereign debt accrued by that point is not too severe.

All our policy actions to date would thus continue to be fairly ineffective because they don't -- and can't -- address the root issue. Deficits and monetization would persist for very long periods of time, and the best outcome we could hope for would be lessened unemployment and a little GDP growth as G expanded.

In this scenario, the interventions could also plausibly be detrimental, through several mechanisms:

• preventing destruction of capital through rescues of unprofitable companies and industries, delaying a rise in the equilibrium rate;

• calling into question the solvency of the sovereign, increasing risk premia and uncertainty;

• crowding out private investment and consumption to some degree, since perfect overlap between sovereign demand and slack resources is unlikely, and private readjustment would take time;

• worsening the trade deficit.

Holding insured cash or sovereign debt would seem to be the ideal investment, as it will gradually strengthen with negative real returns on everything else, but exactly what cash means if the sovereign itself is imperiled is a tough question. It may be that a fiat currency can be so demanded and critical to an economy that it becomes larger than the sovereign that originally issued it.

The only policy action I can imagine being beneficial in the short run in any case is one that runs counter to our every instinct: protectionism.  A deliberate collapse in trade would almost certainly raise equilibrium rates, and probably dramatically.  The arguments in favor of this are very strong, though it is and will always be a bad long-run choice.

The Monetary Policy Theory of Debt-Deflations

I believe recession-fighting monetary policy works very well in theory and practice in any one iteration.  By artificially depressing the real interest rate, increases in investment and consumption and decreases in the savings rate are forced.  This should come as no surprise: that is the entire purpose of stimulative monetary policy.  GDP and employment growth resume as a result.

But I propose that when this cycle is repeated in series, it will lead to structural oversupplies of credit and excess productive capacity.  This will force price and wage disinflation and decreases in the equilibrium real interest rate(important read) over the longer run.  Debt-deflationary spirals and instability become increasingly likely as high debt-to-GDP ratios and the zero bound inexorably are achieved.

Here are some graphs of supporting data.  We are particularly interested in the post-1982 numbers. Personal savings rates, real interest rates, non-residential investment as a percentage of GDP, total credit outstanding to GDP, the effective federal funds rate, and consumption as a percentage of GDP.  It's helpful to review these as you step through the cycle below, and I apologize again for not being good with charts.

The Proposed Process

1.  During a boom, real interest rates and investment's share of GDP naturally increase.  Household income also increases.  This income is distributed between consumption and savings.  This distribution depends on the level of real interest rates: if they're high, more will be saved, and if they're low, more will be consumed.

2.  A shock hits the economy, and the business cycle turns down.  Investment registers a particularly sharp decline, and household income declines as well.  Consumption falls less significantly.  Disinflation occurs as slack emerges in capacity utilization.

3. To forestall a deepening recession, short-term interest rates are cut to forcibly depress real interest rates.  In Hayek's parlance, this constitutes forced saving.  There is an increase in investment beyond what is supported by economic equilibrium, with an associated increase in money supply growth to fund this investment.

Over-leveraged or under-productive enterprises that would normally have been destroyed find respite from the lowered interest rates too.  They are able to continue producing goods, adding to surplus output.

In the U.S., which has a low savings rate, decreased real interest rates will also increase consumption, because the lost interest income is outweighed by benefits of cheaper credit, goods, and the wealth effect.  Thus, consumption also rises in response to the lowered real interest rates, but not as sensitively.

4.  The economy emerges from recession into a fresh boom due primarily to the resurgence in investment, and due partly to increased consumption.  Real interest rates, employment, income, inflation, and investment begin to rise again as the business cycle is reignited successfully by monetary policy.

However, we find ourselves with excess money supply and investment lingering from the prior cycle.  The artificial overhang of productive capacity and debt outstanding lead to a lower equilibrium real interest rate during this recovery.  Thereby, inflation, policy rates, and the real rate of interest fail to recover to prior cyclical highs.

As a second order effect, the lower real interest rates induce households to consume more of their income and save less during this cycle.  The savings rate rises more slowly, or even continues to fall, while consumption rises more quickly.

Investment responds to this increased consumption by growing even faster.  Total credit outstanding surges to fund this expansion, while inflation fails to respond.

Then, another shock hits the economy.

---

After this cycle is repeated enough times, we are left with very high consumption, enormous productive capacity, very low savings rates, very low inflation, very low equilibrium real interest rates, and a very large money supply.  These conditions are perfect for a debt-deflationary spiral.

Debt Deflation

A debt-deflationary spiral finally occurs when the zero bound is reached.  This section of the story has already been written by Fisher.

Recovery

Fisher's policy solutions supporting his main recommendation -- "dude, you so do not want to go there" -- are impracticable. Bernanke and the U.S. economy have ably collaborated to demonstrate that in our present disaster.

First, interest rates cannot be cut low enough.  The real interest rate rises as the economy tries to force saving.  But at the same time equilibrium real interest rates may be very low, and perhaps even negative due to the overhang of productive capacity and credit, making the liquidity trap virtually impossible to escape from. Therefore, there are few appealing investments.  Consumers will not be credit-worthy either with declining income, high debt burdens, and job losses.  It becomes very difficult to force either investment or consumption through conventional monetary policy.

Quantitative easing, encouraged by Fisher, is also probably not going to succeed because it lacks any transmission mechanism to the real economy during a liquidity trap.  Money supply is rightly thought of as a dependent variable.  As such, heroic efforts to halt a deflationary spiral by forcible money creation and liquidity provision will fail unless the money is created at incredible pace.  This would probably cause unacceptable collateral damage.

My policy prescriptions are different.  First, defaults must destroy excess money and productive capacity.  This is a painful process that will temporarily exacerbate the debt-deflation spiral and result in increased unemployment, but it is inevitable.

Secondly, future monetary policy must be consistently more constrictive, forcing declines in investment and debt outstanding during expansions.  I think it's still a useful tool, but provisioning its use by inflation and employment alone is a recipe for our current disaster.

This will be my last post for awhile.  I've got a series of contiguous business trips for my real job from now to the end of March, and expression of this theory is the reason I started the blog.  The incredibly good commentary and your readership are extremely flattering and a little addictive.  I'll continue commenting elsewhere as long as I'm welcome regardless.  If you like my ideas, please promulgate them for me, as I'm not wont to do so myself.

Bad Assets are not the Problem

I've grown extremely frustrated by the rush to save our nation's banking system, because bad assets are not the real problem. Yes, some plans, such as the nebulous cloud of something that Geithner proposed, are indeed worse than others. But even nationalization will not itself trigger credit creation or lending. We're wasting precious time answering the wrong question.

Bernanke(whom I think very highly of, even when he screws up) stated this bluntly in his testimony today, though he's said it before. He said lending is -- my rough transcription -- "no longer frozen because of subprime mortgages and bad assets, but fear about where the economy is going."

This should be blatantly obvious, but everyone's missing it and arguing about who gets screwed. Meanwhile, loans are not being extended because it makes no economic sense to borrow or lend at current interest rates with current default risks. Here's a multiple choice question to illustrate.

You are an insolvent bank. The Treasury and Fed offer you virtually limitless amounts of liquidity at nearly zero interest rates, and even give you some cash for trash. You are now flush with excess reserves, even while securities trade in the secondary markets that bear record wide yields to Treasuries. You could receive 10% interest and expect 5% loss to defaults. Do you:

A) Hoard your cash as a poor man's loan loss reserve in anticipation of future defaults;
B) Lend your cash as fast as possible in hopes the spread will fill the hole in your balance sheet.

We know the banks' answer, so in the current economic environment, apparently the return proposition sucks. Now let's add that the Fed is buying securities outright to push down interest rates. You now receive a smaller spread, and also suspect there might be an outburst of inflation triggering the Fed to crank the FFR. Does your answer improve?

Nationalization and recapitalization don't make lending more appealing. Haggling over who has to eat the carcass is important in terms of loss distribution, but it has no chance of increasing credit creation or economic growth, because it does nothing to improve the fundamental economic realities of money creation. It's a horrible, useless distraction.

Until America becomes more competitive through real devaluation of some form, and the claims on debtors are lightened through bankruptcy, things will continue to deteriorate.

Money Supply and Inflation: An Inverse Relationship?

Monetarism is a beautiful theory.  Economics is full of such beautiful theories, like Say's Law, Ricardian equivalence, Keynesian fiscal stimulus, and so forth.  These theories are generally internally consistent, predictive, and elegant.  They are also all at odds with empirical results.  That has led to the discard of some, while other ideas linger anyway.

I regularly hear that our expedition into the lands of quantitative easing and monetization will inevitably cause a rise in the dollar value of goods and services.  That makes a lot of sense intuitively: more dollars chasing fewer things.  It's certainly true in extremis.  But outside of that extreme, there's a wide variety in behavior.

Multiple authors have found that for US data series prior to 1961, there is, as expected, a strong positive correlation between M2 growth and inflation.  But after that, the relationship broke down, and an even stronger negative correlation emerged.

This breakdown makes little sense with money supply held as an independent variable.  We would expect more money to consistently lead to higher prices modulo GDP growth, by definition, but the opposite has clearly happened for half a century.

A strong inverse correlation is still correlation, so there's probably a good reason.

Perhaps we could invert the causality to make money supply a function of the inflation rate, and hence nominal interest rates.  A fall in interest rates would lead to a rise in credit outstanding as entities sought to maintain financial obligation ratios.  This would make sense in a world with a great deal of callable debt, e.g. mortgages.

This could also be a result of financial deepening and counter-cyclical monetary policy.  Agents would seek to lever up when inflation and interest rates are low, typically during recessions, anticipating future rises.  During a boom, higher inflation and interest rates deter borrowing in anticipation of rate cuts later.

These ideas are just stabs into a nebulous dark thus far, and I'd appreciate reader thoughts.

Does forcible money creation exhibit a different relationship?  Theoretically, to the extent that people believe quantitative easing will cause inflation during a liquidity trap, it could.  In practice, the inverse relationship seems to linger.  We might also see the inverse relationship persist, or suffer a strong snap back to monetaristic normalcy.  As M2 growth rates stab to new highs, the response in inflation and interest rates is unpredictable.