WHY LOWER FOR LONGER WILL REMAIN THE ANTHEM FOR MARKETS / THE FINANCIAL TIMES

Why lower for longer will remain the anthem for markets

Writing the obituary for the bull market in bonds has proved every premature

by: John Plender
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Alan Greenspan © Bloomberg


Do you recall Alan Greenspan’s famous conundrum? Back in 2005 the then chairman of the Federal Reserve was baffled that US bond yields continued to fall despite tighter monetary policy.

The persistent decline in real rates since then continues to baffle market observers and throw up multiple explanations.

Of course, the financial crisis has played a part. In a balance sheet constrained world, expectations of growth are inevitably lower, while the decrease in the supply of safe assets, thanks in part to central banks’ bond buying activity, has put downward pressure on yields. Yet there is much more to it than that.

This is a global phenomenon, common to both advanced and emerging market economies, that has gone on for more than 30 years. In fact, long-term real interest rates have fallen by about 450 basis points (hundredths of a per cent) over that period.

And it is not just the decline in growth expectations that explains today’s extraordinarily low yields. Changes in saving and investment behaviour are the key to understanding the underlying dynamics.

In the latest edition of the International Journal of Central Banking, Lukasz Rachel and Thomas D. Smith of the Bank of England take a fascinating stab at identifying the different components of that 450 basis point decline.

On the savings side of the equation, they identify three important trends. The first is demography, most notably slower labour force growth. The resulting decline in the workforce’s desired level of savings accounts for an estimated 90 bps of the fall in real rates.

Then there is the impact of higher inequality within countries, which reflects the fact that the rich save more of their income than the rest of the population, which adds 45 bps to the total. Increased precautionary saving by emerging market governments since the Asian crisis of 1997-8 explains another 25 bps.

On the investment side, the authors show that desired investment levels have fallen thanks to a 30 per cent fall in the relative price of capital goods since the 1980s, accounting for 50 bps of the fall in real rates, along with a preference shift away from public investment projects that explains 20 bps.

In addition, they reckon that the rising spread between the rate of return on capital and the risk-free rate has further reduced desired investment and risk free rates by 70 bps.

Finally, they argue that slower global labour supply growth and headwinds at the technological frontier, such as a plateau in educational attainment, may cause global growth to slow by up to one percentage point over the next decade and that expectations of this decline could account for about 100 bps of the fall in real rates seen recently.

All told, that provides an explanation for 400 of the 450 bps fall in long-term real interest rates. Since most of the trends they identify remain intact, the duo from the Bank of England conclude that we will be in a low-rate world for quite some time.

There are, of course, a number of heroic assumptions behind these figures. Also some omissions.

I would place more emphasis, for example, on the way lower desired investment is partly driven by incentive structures that entrench short-termism in corporate boardrooms.

And, if China and other Asian economies significantly rebalance away from investment towards consumption, the picture could look very different. That said, it is worth taking the analysis and asking what the implications for policy might be if we assume it to be correct.

The first potentially disturbing observation is that, in this low-growth, low-interest-rate world, central banks will remain dependent on unconventional measures.

It is a world in which it would make sense to place greater reliance on fiscal policy to manage the cycle. The supply potential of the economy would also need to be enhanced by structural reform.

Yet only the first of these prescriptions lies within the bounds of the politically possible.

Fiscal activism is anathema on Capitol Hill for anything bar hurricane relief and sops to vested interests. It is also out of the question in the eurozone as long as Germany calls the shots.

As for structural reform, unconventional central bank measures were meant to buy time for just that.

Nothing much happened. So the most plausible bit of the forecast is, sadly, that growth will be lower for longer.