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Thursday, November 03, 2011

"Negative Real Interest Rates"

David Andolfatto notes that the real interest rate is near zero, even negative in some cases, and says "Surely there are public infrastructure projects that can be expected to yield a real return higher than zero? This is a great time for the U.S. treasury to borrow":

Negative real interest rates, Macromania: ...In macroeconomic theory, the nominal interest rate plays second-fiddle to the so-called real interest rate. The real rate of interest is ... a relative price. It is the price of output today measured in units of future output... So, if the risk-free annual interest rate on an inflation-indexed U.S. treasury is 2%, then one unit of output today is valued at 1.02 units of output in the future....
Economists typically focus on the real interest rate because people presumably care about output and not money (they care about money only to the extent that it may be used to purchase output). ... The higher the real interest rate, the more output is valued today vis-a-vis future output. A high real interest rate reflects the market's strong desire to have you part with your output today (in exchange for a promise of future output). Unlike the nominal interest rate, however, there is nothing that naturally prevents the real interest rate from becoming negative; see Nick Rowe. And indeed, this appears to have happened recently in the U.S. The following diagram plots the real interest rate as measured by the n-year treasury inflation-indexed security (constant maturity) for n = 5, 10, 20; see FRED.

Prior to the Great Recession, real interest rates are hovering around 2% p.a. and the yield curve is upward sloping (long rates higher than short rates), at least until early 2006 (when it flattens). Following the violent spike up in real interest rates (associated with the Lehman event), real interest rates have for the most part declined steadily since then. The 20 year rate is below 1%, the 10 year rate is basically zero, and the 5 year rate is significantly negative. What does this mean?
The decline in real rates that has taken place, especially since the beginning of 2011, is a troubling sign. ... This premium may be signaling an expected scarcity of future output. If so, then this is a bearish signal.

The decline in market real interest rates is consistent with a collapse (and anemic recovery) of investment spending (broadly defined to include investments in job recruiting). For whatever reason, the future does not look as bright as it normally does at the end of a recession. To some observers, this looks like a "deficient aggregate demand" phenomenon. To others, it is the outcome of a rational pessimism reflecting a flow of new regulatory burdens and a potentially punitive tax regime. Both  hypotheses are consistent with the observed "flight to safety" phenomenon and the consequent decline in real treasury yields.
Unfortunately, the two hypotheses yield very different policy implications. The former calls for increased government purchases to "stimulate demand," while the latter calls for removing whatever barriers are inhibiting private investment expenditure. There seems to be room for compromise though. Surely there are public infrastructure projects that can be expected to yield a real return higher than zero? This is a great time for the U.S. treasury to borrow (assuming that borrowed funds are not squandered, of course).
In the event of an impasse, can the Fed save the day? It is hard to see how. The Fed's influence on real economic activity is usually thought to flow through the influence it has (or is supposed to have) on the real interest rate. One could make the case that real interest rates are presently low in part owing to the Fed's easing policies. But this would be ignoring the fact that the Fed's easing policies were/are largely driven by the collapse in investment spending. (I am suggesting that in a world without the Fed, these real interest rates would be behaving in more or less the same way.)
In any case, real interest rates are already unusually low. How much lower should they go? Is it really the case that our economic ills, even some of them, might be solved in any significant manner by driving these real rates any lower? My own view is probably not. If there is something the Fed can do, it is likely to operate through some other mechanism. ...

David also looks at inflation expectations and concludes:

there is no evidence to suggest that inflation expectations are whirling out of control, one way or the other. I'm not sure to what extent this constitutes success. At the very least it is not utter failure.

I am more confident that David is that the Fed can still help the economy, but it can't do it on its own and too much focus on the Fed takes the pressure off of Congress to do its part to help to overcome the unemployment crisis. Members of Congress need to be worried that their own jobs are at risk if they don't do something to help the unemployed (and they shouldn't be allowed to get away with claiming that cutting the deficit by cutting social insurance programs is a means to this end). That's one of the reasons I keep calling for fiscal policy as well -- both sets of policymakers need to feel as much pressure to act as possible.

    Posted by on Thursday, November 3, 2011 at 12:33 PM in Economics, Financial System, Inflation, Monetary Policy | Permalink  Comments (21)



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