Under the guidance of monetary policy, interest rates have recently reached record low levels. In August 2019, the market value of investment-grade bonds that traded at a negative yield in the United States was $17 trillion (about 30% of the total market value), and almost 70% of Euro government bonds did the same. Even some European junk bonds started to trade at a negative yield in the middle of 2019.1 While the COVID-19 pandemic has reversed the negative yield trend, the economic environment that’s produced ultra-low interest rates is still present. Rising income and wealth inequalities, slow recoveries, low inflation and long-term trends toward a shrinking population in developed economies point toward the persistence of a low growth, low interest rate environment (what’s known as “secular stagnation”). Unless economic policies are put in place to reverse the stagnationist trends, central banks will have limited willingness and ability to raise interest rates in any significant way.
Interest Rates Over Past Century
Before making any prediction about the future, it’s instructive to study what the past century tells us about the dynamics of interest rates. Several things are worth noticing from “Lessons From the Past Century,” p. 47. First, the downward trend in interest rates isn’t new. Over the past 40 years, the average rate on long-term safe debts has come down from 15% in 1981 to less than 2% in 2020. Second, interest rates on long-term safe debts are exceptionally low today; even during World War II, such interest rates didn’t go below 2% on average. The last, and most important, observation is that a key driver of interest rates in the United States is monetary policy. This is the case in any country where the government issues its own currency and issues public debt denominated in its own currency.2 Monetary policy consists of setting at least the overnight interbank rate: the federal funds rate (FFR) in the United States. One has to go back to the Great Depression to find a near-zero FFR. World War II led the Fed to expand its interest rate targeting to the entire yield curve with the rate on T-bills set at 3/8 of 1% and T-bonds purchased by the Fed at a quantity and a price consistent with the maintenance of a 2.5% yield. Following the end of the war and the 1951 Accords, the FFR rose and other rates followed until the early 1980s, when the FFR started its long decline to the present level.
Given the heavy influence of monetary policy on interest rates, any opinion about the future direction of interest rates must be made with a view of future monetary policy. One must study what could lead the Federal Open Market Committee (FOMC) to raise its FFR target. The mandate of the Fed is to promote price stability (defined as inflation around 2%) and maximum employment (defined as employment consistent with price stability). The FOMC informs its decisions by looking at a wide range of indicators including labor market conditions, inflation and inflation expectations. Short-term and long-term outlooks for these factors are pointing to interest rates that will stay low for an extended time. While the FOMC may decide to raise its FFR temporarily, the long-term trend is for the FFR and other rates to remain very low for a very long time.
Employment and Inflation
Loss of consumer confidence and lockdowns have depressed U.S. economic activity. Compared to the second quarter of 2019, real gross domestic product (GDP) has fallen by 9.5% in the second quarter of 2020. (See “Short-Term Economic Outlooks,” p. 48.) Labor market conditions worsened significantly in the second quarter. The official unemployment rose steeply to 13%, and the employment-population ratio fell in April to its lowest level ever recorded at 51.4% of the civilian population available for work actually employed. Similarly, the capacity utilization rate fell to 64.4% in the second quarter, its lowest level ever recorded since data are available. The sharp drop in economic activity, driven by a large decline in private domestic consumption, has led to a sharp decline in core inflation, well below the implicit 2% inflation target of the Fed. Given the worsening economic situation, it’s easy to understand why the FFR has fallen sharply with short-term rates matching the same trend. However, long-term rates have also fallen sharply, reflecting expectations among market participants that the FFR rate will stay low in the upcoming years.
Secular Stagnation
While COVID-19-related economic events explain the short-to-medium term interest rate dynamics, “Lessons From the Past Century” this page, points to a long-term downward trend. This trend is explained by structural changes that have led to a slower and more unstable U.S. economy. Decline in the tax burden on the wealthier households, deregulation and lax enforcement, the financialization and globalization of the economy and the decline in labor protections have destroyed shared prosperity. They’ve also led to jobless recoveries, lowered inflationary pressures and limited capital investment in the economy. As a consequence, a growing majority of households aren’t enjoying the fruits of a weakening economic prosperity. Given this stagnationist trend, one may expect interest rates to stay low over the upcoming decade and beyond. (See “Long-Term Outlook,” p. 50.)
The annual growth rate of real gross national product per capita has slowed to 2% percent or less since the 1990s. At the same time, income and wealth inequalities have soared, with the top 1% of the population recording a large increase in its share of income and wealth to the detriment of the rest of the population. In terms of income distribution, the top 1% share grew from about 12% of national income in the late 1960s to about 20% of national income in the 2010s. This gain came entirely from a loss of income share of the bottom 50% of the U.S. income earners (See “Income Shares in the United States,” p. 51). While the benefits of economic expansion used to be relatively broadly shared, since the 1980s, national income gains have gone almost entirely to the top 10%. During the last economic expansion (June 2009 to February 2020), 76.9% of the increase in national income went to the top 10% of income earners. In terms of wealth share, given that the bottom 50% of the U.S. population has little-to-no wealth, all the transfer of wealth share to the top 1% came from the 49% of the population below them. The top 1% wealth share almost doubled from 21% in the mid-1970s to 37% of national wealth in 2016 according to the World Inequality Database.
The main effect of such a lack of shared prosperity has been the disappearance of a middle class that can earn sufficient income to sustain its consumption and home purchase, both of which are key drivers of U.S. economic growth. More broadly, low income and middle income households have used debts and their savings, if any, to sustain their housing, education, casual consumption and health needs, among others. This has led to a very rapid increase in the debt-to-income ratio of the bottom 50% and middle 40% of income earners.3 Instead of income growth, debt growth and asset-price growth have become key means to sustain economic activity, which have promoted financial instability over the past half-century.4
Related to growing inequalities, another factor that’s led to stagnation is the growing joblessness of economic expansion over the past 40 years. Prior to the 1980s, it took less than two years to recover the jobs lost during a recession, but the past four expansions required more than two years. The jobs lost during the minor 2001 recession were regained after four years. The job losses of the Great Recession took six years to be eliminated. One has to go back to the Great Depression—prior to which the economic conditions were somewhat similar to the current economic situation—to see a longer period of recovery. Not only has it taken more time to recover from recessions, but also job precariousness has grown with job quality falling constantly since data is available. Jobs have become more insecure and intermittent and haven’t provided the same salary and benefits as they used to.
Finally, there’s been a marked decline in the investment dynamics of the economy. This is true not only for business investment but also for public infrastructure investment. On the business investment side, corporate profits have been large but they haven’t been used to invest in the economy, and a growing proportion of corporate profit has come from financial income.5 On the infrastructure side, investment hasn’t kept up with the needs of the economy, and maintenance has been poor, leading to a low quality infrastructure in the United States. The Infrastructure Report Card published by the American Society of Civil Engineers has constantly graded U.S. infrastructure around “D” for the past three decades, which has generated millions of job loss and thousands of dollars of income loss for U.S. households.6
Unless major changes in economic policy occur to counter the previous trends, the economy will record low growth, low inflation, growing inequalities and growing precariousness of employment for the upcoming decades. All these elements give less of an incentive to the FOMC to raise its policy rate quickly. They also point toward a more unstable economy, which gives less ability to the FOMC to raise interest rates quickly without generating financial instability. While the FOMC may start raising its FFR target, it won’t be able to do so quickly and permanently. Thus, unless there’s a dramatic shift in the way the U.S. economy is managed, the default expectation of market participants should be that interest rates continue to stay low for the upcoming decade and more. A low growth, highly leveraged economy can only accommodate so much in terms of interest rate.
Permanently Low Rates
Secular stagnation and its impact on interest rates have important implications for the sustainability of our current form of capitalism—one that’s heavily reliant on finance and money managers—and for the role of government in such an economic environment.
While a low interest rate environment makes debt servicing easier, it creates challenges for money managers (pension funds, mutual funds and others) to meet their return on equity target. This is all the more so that financial investment opportunities based on long-term income growth are far fewer than the funds available to portfolio managers. As such, it seems doubtful that a private-based retirement system is a sustainable means to achieve financial safety for retirees while at the same time promoting financial stability for the overall economy. To counter a low yield, low growth environment, money managers have focused on riskier segments of the credit market and/or have used more leverage in their financial strategies. Both strategies promote the use of leverage in the rest of the economy, increase systemic financial fragility and ultimately lead to financial instability. The most recent example is the early-2000s housing boom with its reliance on subprime mortgages, exotic mortgages and complex structured finance products that hid true leverage—all of them encouraged by the search for yield by institutional investors.
Governments of developed economies will need to tackle several major challenges; their populations are aging, trillions of dollars of infrastructure upgrade and expansion are needed and, most of all, climate change is the major socio-economic threat. Massive increases in government spending will be needed to meet these challenges, and given everything else, these increases will lead to higher fiscal deficits relative to the size of the U.S. economy. The tendency toward higher deficit, however, would be mitigated by major investments in infrastructure and greening the economy because such investments would boost economic growth and so raise tax revenues. In any case, a rapid increase in the public debt will be sustainable as long as interest rates on the public debt stay low relative to the growth rate of the economy. Some market participants may wonder about the impact of a higher public debt on interest rates. For economies that are monetarily sovereign, such as Japan, the United Kingdom and the United States, there’s no significant relation between the size of government deficits or debt and interest rates. As usual, central banks will play a major role in accommodating fiscal needs by keeping interest rates low enough to make the public debt sustainable.
Endnotes
1. See John Ainger, “Bond World Is Backing Away From All That Negativity as 2019 Ends,” Bloomberg (Dec. 23, 2019); Eric Lascelles, “Adapting Investment Strategy to the Negative Yield Environment,” RBC Wealth Management (Nov. 20, 2019); Dhara Ranasinghe, “Almost 70% of Euro Zone Bond Yields Have Sub-Zero Yields—Tradeweb,” Reuters (Oct. 3, 2019); Laura Benitez and Tasos Vossos, “Sub-Zero Yields Start Taking Hold in Europe’s Junk-Bond Market,” Bloomberg (July 9, 2019).
2. See Tanweer Akram and Huiqing Li, “What Keeps Long-Term U.S. Interest Rates so Low?” Economic Modelling (January 2017); Claudio Borio, Pite Disyatat, Mikael I. Juselius and Phurichai Rungcharoenkitkul, “Why so Low for so Long? A Long-Term View of Real Interest Rates,” BIS Working Paper, No. 685 (December 2017); Timothy P. Sharpe, “A Modern Money Perspective on Financial Crowding-out,” Review of Political Economy (November 2013); Hibiki Ichiue and Yuhei Shimizu, “Determinants of Long-Term Yields: A Panel Data Analysis of Major Countries,” Japan and the World Economy (May-August 2015).
3. Alina K. Batsher, Moritz Kuhn, Moritz Schularick and Ulrike I. Steins, “Modigliani Meets Minsky: Inequality, Debt, and Financial Fragility in America, 1950-2016,” New York Federal Reserve Bank, Staff Report No. 924 (May 2020).
4. Eric Tymoigne and L. Randall Wray, The Rise and Fall of Money Manager Capitalism: Minsky Half-Century from World War Two to the Great Recession (Routledge 2014).
5. Daniele Tori and Özlem Onaran, “The effects of financialisation and financial development on investment: Evidence from firm-level data in Europe,” Greenwich Political Economy Research Center, Working Paper 44 (November 2017).
6. American Society of Civil Engineers, Failure to Act: Closing the Infrastructure Investment Gap for America’s Economic Future (Economic Development Research Group 2016).