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Andrew Norelli
PM, US Macro Strategies

Repressed and Depressed, Redux

Posted on August 28, 2014

This summer I’ve written several blog entries discussing structurally low interest rates, and some of the drivers of this potential new paradigm.  Central banks’ ultra-accommodative policies, by design, have been extraordinarily influential in creating this environment.  These policies have been stubbornly long-running, and their persistence despite unknowable long-run consequences is now eliciting vocal concern, and it’s not just coming from the conservative extremes of heterodox economics.  Eminent investors such as Stanley Druckenmiller*, a chorus of current and former FOMC members, and now the governor of the Australian central bank, Glenn Stevens**, have all essentially said that for certain economies the benefits of excessively accommodative monetary policy no longer outweigh the potential long-run consequences.  Today I want to briefly examine one of the less talked about potential consequences, which I believe may provide impetus for policy normalization where possible.   

Conventional wisdom dictates that lower interest rates stimulate spending (which in turn spurs economic growth) in at least three ways:

  • The incentive to save instead of spend is reduced, or in modern negative-real-rate incarnations, there is a penalty for saving instead of spending.  A consumer with an available $600 in her bank account can buy a smartphone today and enjoy it for a year, or accept only a puny reward of a dollar or so to forgo that purchase for a year.  Meanwhile the phone’s price could increase by more.
  • The cost of borrowing from future earnings to fund current spending is reduced.  A consumer who expects to save just a little over $600 in the next year can gladly accept the cheap embedded financing to acquire the phone on contract today with no money down, locking in the current price.
  • The wealth effect.  Asset price inflation increases household net worth, and households feel comfortable spending more and saving less.  Our consumer buys a smartphone for her teenager because she made 30% in her 401(k) last year.

These assertions seem perfectly reasonable (almost innate for Americans) and are demonstrably true historically.  Transient cyclical reductions in interest rates should result in the effects as listed.  However, to the extent interest rates and expected returns are perceived to be structurally (semi-permanently) lower, a new and opposing consideration comes into play.  The three effects listed above deal with either pulling forward future consumption, or enabling consumption that was otherwise considered unattainable.    However, society as a whole has some consistently long-term liabilities, e.g.  eldercare (retirement + healthcare) and education, which cannot be pulled forward in time, and retirement at least becomes absolutely necessary at some point in life for most people.   The amount of annual savings necessary to fund those liabilities could be considered immune to transient reductions in interest rates, but would be quite sensitive to structural reductions in interest rates.  If society in aggregate views returns on investment as permanently low, the amount of saving necessary to fund a fixed level of inflation-adjusted retirement expenditure is higher, perhaps much higher. 

Consider an extreme example: a 20-year-old exits college with student debt, and earns enough money between the ages of 20 and 30 to pay off the student loan to achieve a zero net worth at age 30.  From age 30 to 65, he earns a constant real income, i.e. earnings power increases at the pace of inflation.  All savings are invested at zero percent real return.  From age 65 to 100 he is retired with constant annual expenses and then dies penniless.  What does his savings rate need to be every year from age 30 to 65?  50%.  Five-O.  Obviously I jammed the guy with zero percent real returns and deprived him of social security, but the realities (and worries) facing young savers today are not that far off.  The combined perceptions of structurally low rates, taxes on investment returns which are high and increasing, inevitable dilution of entitlement benefits, and longer life expectancy can lead to precautionary saving.  The negative real rate penalty for saving forces more saving, not less.

Perversely, when viewing households in this framework, there should be no wealth effect.  Asset price inflation increases the present value of accumulated savings, but the worsening negative value of retirement (and/or education) liabilities more than offsets the rise.  Unless long-term expenditure is fully pre-funded, inflation-hedged, and duration-matched (together, a unicorn scenario), a household is actually less wealthy when asset price inflation causes a 401(k) balance to rise as a result of falling structural interest rates.



For further reading:  Bill White, of the OECD, has controversial but comprehensive views on this topic, summarized in his 2012 paper Ultra Easy Monetary Policy and the Law of Unintended Consequences.

Abbreviations: Fed: US Federal Reserve, QE: quantitative easing, BOJ: Bank of Japan, ECB: European Central Bank, OECD: Organization for Economic Cooperation and Development.

Christian Rolon
PM, US Rates

Only the Good Borrow Young

Posted on August 28, 2014

In the last few weeks, the Blog has covered a number of cyclical and structural trends impacting markets and the economy. For example, I’ve discussed some ways in which demographics will impact labor markets. Some researchers* have concluded that the aging of the population will also impact global savings patterns. The US will have more people above age 55 than ever before, and this is consequential, but will that be the only change? It is likely that there are other forces at play that will impact how millennials will treat borrowing, with possible broader implications. Thus, I now focus on the younger generation and how their involvement in debt markets could be much different than what we’ve seen in recent decades.

Given the role that the run-up in debt played during the recession, would millennials reflexively turn away from borrowing? We can use home ownership as a proxy for debt given that mortgages are the largest component of household debt (I’ll come back to the role of student loans). And home ownership rates for the young have declined significantly, implying some pullback. To some extent, this partly reflects: (1) general weakness in the economy that has impacted most people – irrespective of age; (2) labor market weakness that was amplified for people beginning their careers; and (3) tighter credit standards.

Homeownership rates by age













Yet while unemployment rates for those between 25 and 34 did rise disproportionately more than middle-aged workers during the recession, the difference between unemployment rates is back to historical levels. So even though high unemployment levels initially may have explained some of the relative weakness, it doesn’t explain the continued weakness.

Keep in mind that this weakness is occurring at the same time that younger generations are becoming more and more likely to extend their education. Given that employers are willing to pay more for higher-educated workers**, a better educated labor force should, all else equal, have higher lifetime earnings potential (which can be used to borrow against to purchase a car or a house). Additionally, recent college graduates are more likely to work in high-skilled sectors now than in 2007***, which should further amplify this education premium.

So despite all these positive developments, why is credit so tight for younger borrowers? This is likely due to two main factors. First, the trend towards higher education has come at a cost. Millennials have increased their reliance on student loans to finance their education. Indeed, student loans were the one form of household debt which continued to grow steadily even through the recent deleveraging cycle. This has partly been out of necessity as the cost of education has doubled since 2001. Thus, as a result of students taking on more debt to invest in their education, creditors may be hesitant to lend to them further due to high levels of existing debt.

But second, not only do millenials enter the market with higher debt burdens, they also enter the market at the wrong time. Studies show that entering the labor market during a spell of high unemployment impairs earnings potential – over the entire lifetime***. Even after labor markets recover, generations that began their careers during a downturn continue to have lower earnings. The Federal Reserve Bank of San Francisco found that this is already occurring****. Earnings for recent college graduates are trailing earnings growth for the overall labor force – even though recent grads are gravitating towards higher-skilled jobs.

Consequently, the young are saddled with higher debt burdens and lower wage growth. Unsurprisingly, a large percentage of outstanding student loans are delinquent (though it is hard to measure exactly since student loans have a grace period before payment is due). This has dragged down the credit scores for student borrowers. In turn, people with lower credit scores are less likely to demand credit and more likely to believe that they will be rejected if they do apply.

Average Risk Scores at 25 and 30













Change in Future Demand for Mortgages by Applicant Credit Score (May 2013 – February 2014)














In effect, this restricts debt’s highest-impact users – the young – from borrowing. This limited borrowing potential has long-term implications for the economy. Access to credit (in moderation) allows individuals to smooth consumption. The young in particular have limited savings to draw from in order to pay for larger purchases or when income is temporarily less than expected. Access to credit may consequently unlock demand by decreasing the need to have large rainy day funds. Thus, restricted access to credit for the young may lower the current growth trend by limiting consumption growth.

It remains to be seen whether this is the beginning of a new pattern of lower lending and income growth or if we are just seeing the other extreme of the pendulum’s swing. If the former, we may have a generation lamenting the things that they might have done, because only the good borrowed young.

* IMF World Economic Outlook 2014
** Cleveland Fed – “A College Education Saddles Young Households with Debt, but Still Pays Off” (
*** Lisa Kahn: The long-term labor market consequences of graduating from college in a bad economy
**** San Francisco Fed – “The Wage Growth Gap for Recent College Grads” (

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