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A closer look A lower neutral rate: causes and consequences August 2016 Joshua N. Feinman Chief Global Economist Deutsche Asset Management Phone: 212-454-7964 Email: [email protected] A closer look 1 A closer look A lower neutral rate: causes and consequences Are super-low interest rates here to stay? There is a growing consensus that they are. Interest rates have been running at extraordinarily low levels —negative in real terms in virtually all advanced economies, and even in nominal terms in quite a few. And it’s not as if these rock-bottom interest rates have been fomenting inflationary booms. On the contrary, economic growth has been sluggish, well below what might have been expected to ensue from such low interest rates, while resources remain underutilized in many countries and almost all continue to struggle with below-target inflation. It’s little wonder, then, that people have pared their estimates of the “neutral” rate of interest— the real, short-term interest rate consistent with the economy operating at its potential and with inflation being stable. What’s more, it’s looking increasingly as if this lower neutral rate isn’t just a temporary artifact of the financial crisis and Great Recession, but rather a more enduring feature of the landscape. There were hints that the neutral rate may have begun to slip even before the crisis, but what has really solidified the case is that economic recoveries around much of the world have remained disappointing and incomplete for so long, even as the headwinds from the crisis have faded and interest rates have plumbed new depths. And there are sound reasons why the neutral rate may have fallen. Slower potential economic growth, the result of weaker demographics and more sluggish productivity trends that have restrained the demand for and the return on investment capital, coupled with an increased proclivity to save (partly demographic, partly perhaps reflecting lasting scars from the crisis), not only in advanced economies but in many emerging ones too, are examples of the kinds of forces that may be depressing the neutral rate. While some of these forces may yet diminish, others appear increasingly to have staying power. Financial markets certainly seem to think so. Fixed-income markets appear to be pricing in the persistence of very low short-terms rates for a long time, not only in the U.S., but especially in Europe and Japan, and yet don’t anticipate these low rates to be inflationary, suggesting that market participants have permanently lowered their estimates of the neutral rate. So too have many forecasters and policymakers, albeit perhaps not quite as far; for example, the Blue Chip consensus forecast of the level of short-term rates likely to prevail over the long run in the U.S. has declined more than 150 basis points since the financial crisis, after having already begun to edge lower in prior years, while the FOMC has trimmed its median estimate of the federal funds rate apt to prevail in the long run by 1-1/4% over the past couple of years. Model-based estimates of the neutral rate have come down too. These models aim to tease out estimates of the (unobservable) neutral rate by studying the relationships between actual interest rates, output, inflation, and estimates of potential output. Doing so is tricky, of course, and subject to considerable uncertainty. Yet most models suggest that the neutral rate has fallen sharply in the U.S., especially since the financial crisis and Great Recession.1 The precipitous contraction in output A closer look 2 in 2008 and 2009, coinciding as it did with a steep decline in real interest rates was a powerful signal that the neutral rate had declined, while the failure of inflation to fall even further was an indication that potential output had been damaged (i.e., that the collapse in output created less disinflationary slack than it would have had potential remained unscathed). During the recovery, growth has fallen well shy of what historical norms would have suggested given how low real interest rates have been, and the output gap has also closed more slowly than might have been expected given such low real rates (though more quickly than if potential output hadn’t been damaged), reinforcing the conclusion that the neutral rate remains depressed. years of much-improved economic performance— stronger growth and a convincing return to (or even beyond) full employment and targeted inflation—all coming against the backdrop of higher real interest rates, for estimates of the neutral rate to move back near historical norms. Though this can’t be ruled out, it seems unlikely given recent experience and the solid theoretical rationales for a lower neutral rate. And even if it did happen, we wouldn’t have convincing evidence of it for quite a while. So for the foreseeable future, the working hypothesis will likely remain that the neutral rate is much lower than it used to be. And that has profound consequences. Implications And it’s not just a U.S. story; the neutral rate is estimated to have declined in most other advanced economies too (e.g., Euro-area, UK, Canada).2 Again, there are wide bands of confidence around specific estimates here; different assumptions and modeling techniques lead to different point estimates of the neutral rate and alternative trajectories of just how far it fell in the immediate aftermath of the crisis, and how much (if at all) it has recovered since. Some of the differences hinge on how much weight specific models put on movements in inflation to inform their judgments about potential output and, by implication, the neutral rate. Some models, for example, view the failure of inflation to fall even further in the aftermath of the Great Recession less as a sign of damaged potential output and more the result of stable inflation expectations and downward nominal wage rigidity. As a result, they estimate an even wider opening of the output gap and steeper fall in the neutral rate at that time. But they also judge that the neutral rate has bounced back from these lows because in these models the substantial improvement in the labor market is taken as a sign that slack has been much reduced (the persistence of low inflation is deemed more the result of inertia in the inflation process). Still, even in these frameworks, the neutral rate is estimated to remain well below norms prevailing in prior cycles. And that is perhaps the key takeaway. Even allowing for alternative modeling strategies and wide confidence intervals around specific point estimates, the nearly unanimous conclusion is that the neutral rate remains far below where it was in the past. Of course, that conclusion could change. But not likely overnight. It would probably take several A lower neutral rate obviously matters for monetary policy, but it also impacts government debt dynamics and valuations of things like equities, houses, and pension liabilities—anything whose value hinges on future cash flows that have to be discounted to the present. Monetary policy The neutral rate isn’t something that monetary policymakers can influence, or pinpoint precisely, but it is something they must take into account. In that sense, it is like the economy’s potential growth rate, or its maximum, sustainable levels of output and employment—a time-varying, hardto-estimate structural parameter largely beyond the reach of monetary policy but one that factors importantly into how that policy must be calibrated. In a typical Taylor-type rule, for example, the level of short-term interest rates set by the central bank depends not only on the level of inflation relative to target and on assessments of the gap between actual and potential output, but also on estimates of the neutral rate. If those estimates decline, all else equal, so too must the rate set by the central bank, lest monetary policy implicitly tighten. Put differently, if the neutral rate has declined, actual rates may not be as accommodative as history would suggest—or, equivalently, policymakers must set rates lower than in the past to provide the same degree of accommodation. Few doubted this was true in the aftermath of the financial crisis. But it was generally expected that the crisis headwinds would fade with time, A closer look 3 lifting the neutral rate back up, at least in part, and that as it rebounded the U.S. Federal Reserve (the Fed) would need to raise rates in order to avoid overstaying an accommodative policy. As the years have passed, though, and real rates have persisted at negative levels yet the economy has not grown nearly as rapidly as might have been expected, nor slack absorbed quite as quickly nor inflation rebounded much, the view has grown that the decline in the neutral rate may be more enduring, a consequence of things like slower potential growth, increased saving propensities, and reduced investment inclinations, not only in the U.S., but globally. That means interest rates have less distance to travel to be restored to a neutral setting. This is one reason policymakers have been slow to raise rates; they’re not only wary of heightened global stresses, lingering slack, below-target inflation, and asymmetric risks near the zero bound, and hold out hope that supporting demand can help repair at least some of the damage to potential output (by enticing more people back into the labor force and encouraging firms to invest more in productivity enhancements), they also increasingly judge that the neutral rate will remain lower for longer. That doesn’t mean the Fed will never raise rates again. Virtually all estimates suggest the current policy setting is still accommodative (especially given the Fed’s enlarged balance sheet, which is holding down longer-term rates), and may become more so over time if the neutral rate edges back up, if only somewhat. Moreover, part of the reason the neutral rate is lower is that potential growth is lower—and there is only so much, if anything, that monetary policy can do about that. That means policymakers need to recalibrate on several fronts: a given real interest rate is less accommodative than in the past, but a given rate of economic growth is more likely to exceed the economy’s diminished potential and thus reduce slack, suggesting a greater need to remove accommodation. On balance, we still see the Fed as inclined to raise rates (provided the outlook continues to suggest progress toward full employment and price stability), though we continue to expect those increases to come slowly, and leave rates low by historical standards, in part because of a lower neutral rate. A higher inflation target? lower neutral rate: it argues not only for a shallower glide path of rate increases to achieve the Fed’s dual mandate, it also makes a case for bumping up the inflation target that is part of that mandate. Otherwise, encounters with the zero bound on nominal interest rates and threats of deflation may recur more frequently than they did in the past, when the neutral real rate was higher, and the Fed will have less room to cut real rates in response to adverse shocks. Keep in mind that the Fed (and most other central banks) chose 2% as an inflation target because that rate was viewed as low enough to render inflation a small consideration in people’s planning but not so low as to erode the buffer against shocks that could tip the economy into damaging deflation or cause it to bump up against the zero bound on nominal interest rates. But the size of that buffer was selected in part based on estimates of the neutral real rate. If those estimates have declined, the inflation target would need to be raised commensurately to restore the same buffer in terms of nominal interest rates and give policymakers the same scope to cut real rates to combat cyclical weakness in the economy. No change in inflation target is imminent, though; policymakers are having enough trouble getting inflation back up to 2%—raising the bar would make their task even more difficult. They might also fear that bumping up the inflation target would jeopardize their vital credibility, risking an unmooring of inflation expectations. And it’s not as if central bankers are completely out of ammunition when short-term rates hit zero; even if they are reluctant to drive rates negative, they can use other tools—including forward guidance and asset purchases—to provide stimulus, and while the efficacy of these measures may be harder to gauge than conventional rate cuts, they’ve generally been found to help. Policymakers would need to be firmly convinced that the neutral rate was a lot lower and was going to stay there before they’d even think about raising the inflation target. That seems a bridge too far, at least for now. But a higher inflation target might be contemplated sometime in the future—perhaps if the economy enters the next recession with rates not far from zero, leaving the Fed with little conventional policy ammunition— and in the meantime, provides another reason why policymakers may be a little slower to hike rates until inflation gets back to 2%, if not even a bit beyond. There is another, more controversial implication of a A closer look 4 A rise in inflation might also provide a clearer signal that slack has been exhausted and that the neutral rate may be starting to move back up. It’s not hard to imagine why policymakers would be looking for some confirmation on the inflation front. The economy’s unusual performance in recent years—abnormally low interest rates, slower-thananticipated growth yet greater-than-expected declines in labor market slack juxtaposed against persistently below-target inflation—has left many (both inside and outside the Fed) scratching their heads, less certain of many things, including the neutral rate, potential growth, and slack. That would argue for putting less weight on these hardto-estimate parameters and more emphasis on inflation itself—both to inform judgments about the neutral rate and slack, and to guide policymaking. This hardly means the Fed will wait for inflation to move convincingly to target (if not beyond) before raising rates at all; that kind of delay risks a potentially destabilizing overshoot, especially given the lags between policy, the real economy, and inflation. But it does offer yet another reason why the Fed will likely tread carefully in lifting rates, unless and until inflation shows convincing signs of picking up. Fiscal policy and debt dynamics A lower neutral rate can also impact government debt dynamics and the choices confronting fiscal policymakers. A permanently lower neutral rate, all else equal, would unambiguously improve the government’s fiscal position by lowering its cost of borrowing. But all else may not be equal. If the decline in the neutral rate is the result of a matching decline in the economy’s potential growth rate, there is little if any net benefit to government finances. Only to the extent that the fall in the neutral rate exceeds the decline in potential growth does the government gain fiscal flexibility. Fortunately, that seems to be the case; most estimates suggest that the neutral rate has fallen somewhat more than potential growth, as changes in global saving and investment inclinations have apparently had a greater impact on interest rates than growth. If so, governments will be able to run slightly larger primary budget deficits (i.e. deficits excluding interest payments) without raising the debt-to-GDP ratio, and even in countries where potential growth remains below the government’s borrowing rate, that gap would narrow, implying that slightly smaller primary surpluses would be needed to stabilize the debt ratio.3 This added room for fiscal maneuver opens a window for things like tax cuts and infrastructure spending that could help not only support aggregate demand and close remaining output gaps, but perhaps even lift potential output and the neutral rate a bit (in part by offsetting the private sector’s disinclination to invest and borrow). But the benefits here shouldn’t be oversold; a lower neutral rate is hardly a blank check for governments, and fiscal stimulus is no panacea for what’s ailing potential growth. Help on this front, if there is any at all, would likely entail structural reforms too (e.g., tax and regulatory reform, efforts to boost competition, reduce barriers to entry for new firms and disincentives for people to join the labor force, allow more high-skilled immigration, open up more international trade, etc.). Still, fiscal stimulus might help, and the decline in the neutral rate makes such stimulus more viable. Valuations The value of many assets and liabilities, particularly those that depend on expected future cash flows that have to be discounted to the present, may be affected by a lower neutral rate. Consider equities, for example. Their value hinges on expected future free corporate cash flows, discounted at an appropriate interest rate—typically, a risk-free rate plus a premium that reflects the inherent risk characteristics of equities (generally, their covariance with other things in the investor’s portfolio or, more fundamentally, with the investor’s consumption), and the willingness of investors to bear that risk. If the risk-free rate declines, all else equal, equities become more valuable; that is, for given risk characteristics and appetites, investors will be willing to pay more for the same expected future stream of free cash flows if the risk-free rate is lower. But once again, all else might not be equal. If real interest rates are lower because potential growth is lower, then free corporate cash flows will presumably not be expected to grow as rapidly. And if the lower neutral rate also reflects an increased proclivity to save borne of reduced risk appetite, then the benefit to equity valuations is further eroded. It is only to the extent that the decline in the neutral rate is greater than any decline in expected future profit growth and in risk appetite that equity valuations get a boost. And that boost would only be temporary anyway; once equity prices have A closer look 5 adjusted upward, from that point forward equity returns will actually be lower than before, reflecting the lower risk-free rate and slower expected growth of cash flows. It’s a similar story with other assets, like houses. A decline in real interest rates will lift home prices only to the extent that it exceeds any corresponding decline in expected future rents (due to slower potential growth) and diminishment of risk appetite. It’s the same for liabilities like pensions, only in the opposite direction. A lower neutral rate raises the discounted value of future pension liabilities, unless it is offset by slower expected growth in those liabilities (due, say, to slower wage growth in a world of slower potential growth). For examples of some of the research underlying these empirical estimates of the neutral rate, see: Christiano, Lawrence J., Roberto Motto, and Massimo Rostagno (2014). “Risk Shocks,” American Economic Review (January). Del Negro, Marco, Stefano Eusepi, Marc Giannoni, Argia Sbordone, Andrea Tambalotti, Matthew Cocci, Raiden Hasegawa, and M. Henry Linder (2013). “The FRBNY DSGE Model,” Federal Reserve Bank of New York Staff Reports 647 (October). Guerrieri, Luca, and Matteo Iacoviello (2013). “Collateral Constraints and Macroeconomic Asymmetries,” International Finance Discussion Papers 1082r, Board of Governors of the Federal Reserve System (June; revised July 2014). Kiley, Michael T. (2013). “Output Gaps,” Journal of Macroeconomics, vol. 37 (September). Laubach, Thomas, and John C. Williams (2015). “Measuring the Natural Rate of Interest Redux,” Hutchins Center Working Papers 15, Brookings Institution (November). 2 Holston, Kathryn, Thomas Laubach, and John C. Williams (2016), “Measuring the Natural Rate of Interest: International Trends and Determinants,” Federal Reserve Bank of San Francisco Working Paper (June). 3 For details on government debt dynamics, see, for example: Contessi, Silvio (2012). “An Application of Conventional Sovereign Debt Sustainability Analysis to the Current Debt Crises,” Federal Reserve Bank of St. Louis Review. 1 A closer look 6 This page intentionally left blank All opinions and forecasts are as of the date of this document, subject to change at any time and may not come to pass. Definitions The federal funds rate is the interest rate, set by the U.S. Federal Reserve, at which banks lend money to each other, usually on an overnight basis. The Federal Open Market Committee (FOMC) is a committee that oversees the open-market operations of the U.S. Federal Reserve. The Great Recession refers to the prolonged economic downturn in much of the world after the financial crisis of 2007-08. Inflation is the rate at which the general level of prices for goods and services is rising and, subsequently, purchasing power is falling. In economics, a Taylor rule refers to a monetary policy rule which stipulates how much a central bank should change the nominal interest rate in response to changes to inflation, output or other economic conditions. Investment products: No bank guarantee | Not FDIC insured | May lose value Deutsche Asset Management represents the asset management activities conducted by Deutsche Bank AG or any of its subsidiaries. Deutsche AM Distributors, Inc. 222 South Riverside Plaza Chicago, IL 60606-5808 www.deutschefunds.com [email protected] Tel (800) 621-1148 © 2016 Deutsche Bank AG. All rights reserved. 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