The persistence of high interest rates is kind of baffling to many people who can sense- intuitively, that, as the fear of inflation recedes, so should the rates of interest in the economy. But central banks have continued to send mixed messages and continued with a path of conservative (cautious) aggression in holding on to some of the highest administered rates seen in many years. Whilst opinion is still divided about the likely longevity of high rates there is an argument building up over the likely persistence of high real interest rates and the fact that the current high positive real rates may be the new normal.
Long term observations of interest rates- and by that, I mean observations of rates and inflation over half a millennia, show empirical evidence of a decline in real interest rates over time since the Renaissance period in Europe by about 1.2% a century. The reasons offered are varied and differ over particular time blocs given the huge changes in the world since then- the opening up of the Americas, the industrial revolution, wars, scientific discoveries and advances in technology, the re-emergence and reintegration of China, and so on. But the consistent trend has been downwards which led economists to have more confidence that the current elevated situation immediately post-Covid cuts in rates, was not taking us away from a long-term downtrend.
The belief amongst economists- as late as 2022, was that rates would be low indefinitely. And why not? In the US short-term rates had been near zero for 9 out of 13 years from 2009 and even briefly negative in 2015. Japan has had rates at or below 0.5% since 1996. It was back near zero in the US and UK in 2021 and sub-zero in the Eurozone and Japan then. In fact, US yields were returning a loss after adjusting for inflation. That is, real interest rates were sub-zero then and expected by many to stay that way indefinitely. Even after the rate hike programme was begun by the Federal Reserve, real yields on dated securities stayed sub-zero until late 2022- mainly due to a more rapid rise in inflation. It is only in mid-2023 that inflation fell below the administered rate there (current Fed Funds rate is 5.25% versus the latest inflation print of 3.2%) and interest rates started offering real returns.
This emphasis on real returns is important to the discussion because the debate now is whether real rates will remain positive once inflation goes back to the target zones of central bankers. Some monetary economists have suggested in the recent past (post pandemic, pre- rate hikes) that the ‘neutral’ real interest rate had fallen below zero and that it was going to be a long-term phenomenon. But they hadn’t counted on the allure of negative real rates to governments with stagnating economies. The first main consequence is that it got many of them to push the boat out on fiscal rectitude. With ultra-low real to negative rates governments were able to ramp up fiscal spending and maintain primary budget deficits (that is, run deficits without including the interest due on outstanding debts) and still manage their debts knowing that the debt percentage of GDP would decline as the economy grew. And any rise in inflation would help that cause as the same production would reflect in a higher nominal valuation. Larry Summers, a former Treasury Secretary in the US and now President Emeritus of Harvard University, was against President Biden’s US$1.9 trillion stimulus package for the reason that it would lead to runaway inflation that would necessitate a huge jump in employment to cool demand- and that this would set the economy into a recession.
He was wrong about the need for the economy to go into recession as he was about the likely rise in joblessness needed to bring inflation down but he might have been correct about the impact on rates that came out of the growth in both monetary easing and fiscal spending. Furthermore, with the rise in interest rates Debt: GDP is expected to rise again- one of the reasons US sovereign debt faced a debt downgrade by Fitch this month.
And this may be key to whether rates are going to stay high (and real rates positive) for the longer-term. Global debt is at all-time record high at US$305 trillion (including US$162 trillion in corporate debt, $86 trillion in government debt and the balance $57 trillion in household debt) out of a global GDP of $105 trillion- a near triple leverage of annual GDP. There is now a manic need for GDP to register some growth or inflation to stay high in order for Debt: GDP to remain manageable. How can this be achieved? With high debt leverage, the ‘ask’ for returns on debt will likely keep pressure on new additions to the debt stock, especially in an environment where most central banks are looking to remove the ‘monetary accommodation’ (otherwise known as quantitative easing).
Another factor that needs to be taken into account is the argument advanced by many economists that it was the growing glut in savings- particularly from Asia, over the last 30 years that helped bring down real interest rates- as yield-chasing behaviour. But, with the absolute growth of debt coupled with moderate GDP growth expected (China and Europe particularly) the glut may vanish sooner rather than later. The inflation already witnessed has also set off demands for catch-up wage rises and a strong push towards union representation in both the US and UK- which may well feed into demand growth inflation- particularly in the smaller UK economy.
Barring China, which is facing deflationary pressures now thanks to their construction-cum-debt crisis affecting demand and Japan, facing an ageing population compressing demand, most economies still face inflationary pressures from a mix of corporate driven price rises and agricultural price hikes. The aggressive growth in outstanding debt during the low-cost era, and the withdrawal of surplus liquidity by central bankers all suggest that we are entering a sustained period of high positive real interest rates.