Breaking new ground on neutral rates
Framing the problem this way is significant because it shows the inadequacy of shorter-term explanations of low neutral real rates such as those of Ken Rogoff that focus on the financial crisis and its aftermath. It also suggests the need to look beyond a single cause.
Second, the authors do not find that slowing growth is the main explanation for declining real rates.
Rather, they find that other factors that I and others have enumerated account for about 75 per cent of the decline in real rates. They note that since the global saving and investment rate has not changed much even as real rates have fallen sharply, there must have been major changes in both the supply of saving and demand for investment. They present thoughtful calculations assigning roles to rising inequality and growing reserve accumulation on the saving side and lower priced capital goods and slower labour force growth on the investment side. They also note the importance of rising risk premiums associated in part with an increase financial frictions. Their work is not the last word but it is an important step towards understanding which factors are behind the decline in real rates.
Third, messers Rachel and Smith use their analysis of the determinants of neutral real rates to predict their future evolution. Here, they reach the important conclusion that there is little basis for assuming a significant increase in neutral real rates going forward. This conclusion differs sharply from the “headwinds” orthodoxy prevailing in the official community. As the figure below illustrates, in the US at least the Federal Reserve and the forecasting community has been consistently far behind the curve in recognising that the neutral real rates has fallen.
If, as I suspect, the authors are right there will be much less scope to raise rates in the industrial world over the next few years than the world’s central banks suppose.
Fourth, Mr Rachel and Mr Smith recognise that their findings are highly problematic for the existing central banking order. They imply that the zero lower bound is likely to be a major issue at least intermittently in the future. After all, we will have future recessions and when we do, there will be a need to drop rates by 300 basis points or more. Perhaps quantitative easing or negative rates or forward guidance will work. I am sceptical that they will be efficacious unless the cause of the recession is again a heavily disrupted financial system for which QE can be abnormally helpful in repairing.
Mr Rachel and Mr Smith also share my concern that a world of chronic very low real rates is going to be a world of high volatility, imprudent risk taking, excessive leverage and frequent financial accident. We may be about to get a taste of this in emerging markets and US high yield markets. It is fashionable to invoke the brave new world of macroprudential policy in response. To borrow from Wilde, I fear that enthusiasm for macroprudential policy is the triumph of hope over experience. In the last wave of enthusiasm for such policies the poster-child was Spain’s countercyclical capital requirements. They did not work out so well. As best I can tell, US macroprudential policy as currently practiced has meaningfully impaired liquidity in some key markets and damaged the credit availability for small and medium sized businesses while not touching excessive flows to emerging markets and high yield corporate issuance. To work, macroprudential policy has to reduce financial vulnerabilities without to an equal extent reducing credit flows that stimulate demand. This is logically possible. I doubt that actual regulators who, after all, were proclaiming the health of the banking system in mid 2008 are capable of pulling it off consistently given the pressures they face.
There are no certainties here. It is possible that neutral real rates will rise over the next several years.
But there is a high enough chance that they will not to make contingency planning an urgent priority. That has been and is the main thrust of the secular stagnation argument.