Last week saw the first rate hike by a developed market central bank in four years, from New Zealand’s Reserve Bank (RBNZ). The RBNZ is some way ahead of its peers in tightening, but money markets also expect the US Federal Reserve (Fed) and the Bank of England (BoE) to start hiking some time next year, and both central banks appear comfortable with those expectations.
The prospect of rate tightening in the not-so-distant future begs the question of how quickly central banks might raise rates, and how high policy rates might go in this cycle. Managing expectations about both those questions has been part of the “forward guidance” adopted by major central banks. For example, both the Fed and BoE have indicated that they expect to increase rates more gradually this time than in previous cycles. And the BoE in particular has been vocal in suggesting that at the end of the next hiking cycle, its policy rate will settle at a lower level than the historical experience would suggest.
This “normal” or “neutral” policy rate, that would be expected to prevail when the economy is at around full capacity, and inflation is around target, is an important but imprecise concept. Important, because it provides a loose anchor for the long end of the yield curve. Imprecise, because it depends on factors that are hard to pin down, like expected inflation, trend growth, and the structure of the financial system.
Over its three-hundred-year history, the Bank of England’s policy rate has averaged around 5%, and BoE policymakers were happy to cite a range of 5-5.5% for the “normal” policy rate a decade ago. But in the past month, several members of its Monetary Policy Committee have argued that even when they do start hiking, rates are unlikely to go above 3% for a considerable period. With inflation running around the BoE’s 2% target, that implies that they expect the real (i.e. inflation-adjusted) policy rate to go no higher than 1%.
The Federal Reserve still forecasts that US short rates will approach 4% over time, close to the average over the past century, and implying a real interest rate of around 2%. But its leadership has stressed that it will take many years to get there. Private sector economists’ forecasts are also for US short rate to reach around 4%, and medium-term US Treasury forward interest rates are around that same level.
Why might short term interest rates settle at lower levels than in the past? One reason is the prospect of a slowdown in trend economic growth. Trend growth is very hard to forecast, but it does appear likely that slowing labor force growth will provide a consistent headwind in the years to come. Weaker growth prospects reduce the incentive to borrow and invest, which would otherwise push up interest rates.
Perhaps the most concrete reason for lower policy rates is tighter bank lending conditions, meaning that for a given central bank policy rate, the lending rates paid by firms and households are higher. To be sure, credit conditions have eased significantly in the past few years. But bank credit is likely to remain persistently tighter than before the financial crisis, because of the appreciation that credit risk was underpriced back then, and because of more stringent bank regulation.
Finally, there is the simple empirical observation that real interest rates in advanced economies have been on a long downward trend, which predates the financial crisis. The persistent decline in long-term real interest rates over the past few decades has often been associated with the investment of Emerging Market current account surpluses – the “global savings glut” made famous by former Fed Chairman Bernanke – into developed bond markets. But these flows should have little direct effect on short-term interest rates, which are largely under the control of central banks, and which have shown the same persistent downward trend. For example, the chart illustrates this trend using the average real short-term rate in the US, UK, Euro area and Japan since 1988. In that light, an eventual move back to real short-term rates of around 2% is by no means implausible, but would represent a marked break with the recent experience.
Posted in Global rates.