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.
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|
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.
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.