Goodbye, inflation. Hello, unsustainable debt.
If you’ve spent any substantial amount of time engaged in
discourse about the economy — and I, alas, have been at it for decades — you
know that there’s always something to worry about.
اضافة اعلان
At the start of 2023, the big worry was inflation, with many
asserting that bringing inflation down to an acceptable rate would require a
recession and a prolonged period of high unemployment. What we’ve seen,
however, is so-called immaculate disinflation as the economy works out its
pandemic-era kinks. The Fed’s usual measure of underlying inflation ran at only
2.2% (annualized) over the past three months, essentially back to its 2%
target. And the latest data from the euro area suggest that immaculate
disinflation is spreading across the Atlantic. It will be a while before the
Fed and its counterparts abroad will dare to say it openly, but inflation is
looking like a solved problem.
Now the big worry is interest rates.
The Fed and other central banks essentially control
short-term interest rates and have increased them a lot in their fight against
inflation. For a while, however, bond markets were basically betting that these
rate hikes would be, well, transitory and that short-term rates would soon come
way back down. As a result, long-term rates significantly lagged behind
short-term rates, creating the famous inverted yield curve that many see as a
sign of impending recession.
Over the past few months, however, the bond market has, in
effect, capitulated, sending the signal that investors expect rates to stay
high for a long time. Long-term interest rates are now higher than they have
been since the 2008 financial crisis.
What’s causing this interest rate spike? You might be
tempted to see rising rates as a sign that investors are worried about
inflation. But that’s not the story. We can infer market expectations of
inflation from break-even rates, the spread between interest rates on ordinary
bonds and on bonds indexed for changes in consumer prices; these rates show
that the market believes that inflation is under control.
What we’re seeing instead is a sharp rise in real interest
rates — interest rates minus expected inflation.
At this point, real interest rates are well above 2%, up
from yields usually below 1% before the pandemic. And if these higher rates are
the new normal, they have huge and troubling implications.
Most notably, a number of economists — including Larry Summers,
Olivier Blanchard and yours truly — have argued for years that low interest
rates mean that we shouldn’t worry about government debt. In particular, if the
real interest rate is lower than the economy’s growth rate (r < g), debt
isn’t really a burden because the ratio of debt to gross domestic product tends
to fall even if the government is running deficits. Indeed, in a low-rate
world, budget deficits may actually be good. As Summers wrote in 2016, “By
setting yields so low and bond prices so high, markets are sending a clear
signal that they want more, not less, government debt.”
But now, suddenly, real interest rates are above most
estimates of the economy’s long-run growth rate. If this reversal persists, the
sustainability of high debt will become a major issue for the first time in
many years.
So is the low-interest era really over?While the bond market is saying that high interest rates are
here to stay, it’s not easy to see why that should be the case.
Before the pandemic, attempts to explain the decline in real
interest rates since the early 2000s focused on forces leading to slowing
economic growth and hence lower investment demand. In particular, many of us
emphasized the big decline in growth of the working-age population.
Slow population growth means less need for new houses, less
need for new shopping malls and less need for new factories and office
buildings (leaving aside the effects of remote work). And Japan, which has had
a falling working-age population since the 1990s and also entered a reality of
very low interest rates long before the rest of the advanced world, seemed to
illustrate the point. (I made the connection between demography and ultralow
interest rates in a 1998 paper — I would say the best paper I ever wrote —
warning that other countries could experience Japan-style problems, which they did
a decade later.)
Well, we still have low population growth. So why shouldn’t
we expect interest rates to go back to pre-pandemic levels once the Fed is done
fighting inflation?
Maybe we should. The Federal Reserve Bank of New York
produces regular estimates of r-star, which it defines as “the real short-term
interest rate expected to prevail when an economy is at full strength and
inflation is stable.” John Williams, the New York Fed’s president and one of
the originators of its model, declared in a May speech that “r-star today is
about where it was before the pandemic.”
But there are other models. The Richmond Fed has its own
approach but reaches a very different conclusion: that r-star is higher than it
was pre-pandemic.
The bond market has, in effect, been voting that Richmond is
right and New York is wrong. But why? I’ve seen some efforts to point to
possible fundamental factors, but they seem a bit halfhearted. Mainly, as far
as I can tell, investors are looking at the economy’s resilience in the face of
Fed rate hikes and concluding that this must mean that r-star has risen for
some reason, even if we can’t put our finger on it.
This might be true. Or the economy’s resilience so far may
reflect lags in the effect of monetary policy or other factors that won’t
persist.
My instinct is to say that the bond market is overreacting
to recent data and that high interest rates, like high inflation, will be
transitory. But as I said, that’s what I’d like to believe, so maybe you
shouldn’t trust me here.
I guess we’ll have to wait and see. And the wait may be
especially difficult, because the looming government shutdown may, among other
things, deprive us of a lot of important economic data.
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