R-Star Decline and Monetary Hysteresis
Total Page：16
File Type：pdf, Size：1020Kb
SUERF Policy Note Issue No 137, March 2020 R-star decline and monetary hysteresis 1 By Phurichai Rungcharoenkitkul Bank for International Settlements JEL-codes: E40, E43, E52, E58. Keywords: Natural interest rate, monetary policy, monetary hysteresis. Why are global real interest rates so low for so long? Conventional theory appeals to structural factors that push down the ‘natural interest rates’ or r-star. We subject this view to a direct empirical test, by examining if real factors such as productivity growth and demographic shifts can explain real interest rate movements. Our findings, based on 19 countries over 145 years, cast doubt on this view, instead pointing to the overlooked role of monetary factors. We propose a new theoretical explanation of persistently low real rates, grounded on the interaction between monetary policy and the financial boom-bust cycle. From this ‘monetary hysteresis’ perspective, low real rates could arise endogenously from successive failures to stabilise the financial cycle. 1 I thank Claudio Borio, Daniel Rees and an anonymous SUERF editor for their useful comments, and Emese Kuruc for her research assistance. The views expressed are my own and not necessarily those of the BIS or my colleagues. www.suerf.org/policynotes SUERF Policy Note No 137 1 R-star decline and monetary hysteresis The backdrop More than a decade has lapsed since the 2008 Great Financial Crisis (GFC), and global interest rates today remain much lower than before it (Table 1). Central banks in Europe and Japan have yet to lift their policy rates off the effective lower bounds. Those engaged in large-scale asset purchases still have bloated balance sheets relative to GDP. In emerging markets, less affected by the crisis, nominal interest rates are close to their historical lows. Remarkably, low interest rates prevail despite the global economy growing at rates similar to the pre-crisis average, and major economies operating close to or even above estimates of potential.2 If the crisis has any lasting impact, it is not so much in terms of growth hysteresis but more in the form of ‘monetary hysteresis’. Pre- and post-GFC macroeconomic performances Table 1 1 GDP growth Inflation1 Short-term rates 1990-2007 2010-2019 1990-2007 2010-2019 1990-2007 2010-2019 United States 3.0 2.3 2.9 1.8 4.6 0.9 Germany 1.9 2.0 2.1 1.3 4.6 0.2 Japan 1.5 1.3 0.5 0.5 1.6 0.1 Global 3.5 3.9 3.4 2.4 5.5 2.6 1 Excluding countries with hyperinflation. Sources: BIS, IMF World Economic Outlook, national authorities, author’s calculations Subdued inflation helps explain low nominal interest rates, but only partly.3 Risks of deflation taking hold (or smaller risks of running the economy hot) may justify easier monetary policy even when there is little slack. But the global nominal interest rates have fallen by 3 ppts, much more than the 1-ppt decline in inflation during the post-GFC period (Table 1). As a result, the real (inflation-adjusted) interest rates have fallen by 2 ppts. A shift in the central bank reaction function seems to be at least part of the explanation. One influential hypothesis is that the ‘natural interest rate’, or r-star, has fallen over this period.4 R-star may be defined as the rate of interest that sustains full employment (equivalently, output at potential) and stable inflation in the medium run when all transitory shocks dissipate. According to this view, higher desired saving and/or lower desired investment have pushed down r-star, requiring the central banks to steer interest rates lower to sustain full employment and ensure stable inflation. In fact, under this hypothesis, shifts in saving- investment factors, unrelated to monetary policy, have been pushing down r-star for several decades since the 1980s (Graph 1). 2 Current unemployment rates are at or near historical lows in major economies – 3.5 percent in the US, 3.1 percent in Germany, and 2.2 percent in Japan, all below NAIRU estimates. 3 What causes low inflation remains a subject of open debate, and is beyond the scope of this article. The apparent disconnect between low price pressure and no/little economic slack has prompted many to cite non-cyclical factors such as globalisation, technology and demographics as potential factors. 4 Many governors and senior central bankers have attributed the low interest rate environment to falling natural interest rates. See Bullard (2018), Carney (2019), Lane (2019), Powell (2019), Wilkins (2020) and Williams (2018) for example. www.suerf.org/policynotes SUERF Policy Note No 137 2 R-star decline and monetary hysteresis Low r-star is often seen as the most important challenge to monetary policy since the crisis. If the nominal interest rate is subject to an effective lower bound iL, and the inflation target is a small positive number π * , the real interest rate cannot fall below iL – π*, limiting the scope for monetary easing. If r-star is close to or lower than iL – π *, there may not be enough policy space for the central bank to fulfil its mandate at all. This concern is an important consideration prompting major central banks to review their monetary policy frameworks.5 R-star re-examined R-star is indeed a central concept in how macroeconomists today think about monetary policy. It serves as the guidepost for assessing the policy stance. Monetary policy is said to be accommodative when the real interest rate is below it, and tight when above it. To many, without an r-star, it would be difficult to conceptualise, let alone gauge, an appropriate stance of monetary policy. In practice, estimating r-star empirically is far from straightforward. One difficulty is that r-star estimates are subject to significant statistical uncertainty, which limits their usefulness and makes them unfit for calibrating policy.6 More fundamentally, r-star is a theoretical concept and is inherently model-specific. To define it, one must take a position on what model is the best representation of reality. An r-star estimate is an implication of a preferred world view, and, like any theory, should be subject to independent validation. Model uncertainty translates into uncertainty about the associated r-star, both in quantifying and defining it. 5 See Federal Reserve System (2019) and ECB (2020). 6 The New York Fed President John Williams said “…at times r-star has actually gotten too much attention in commentary about Fed policy. Back when interest rates were well below neutral, r-star appropriately acted as a pole star for navigation. But, as we have gotten closer to the range of estimates of neutral, what appeared to be a bright point of light is really a fuzzy blur, reflecting the inherent uncertainty in measuring r-star.” (Williams, 2018). Former Fed Governor Kevin Warsh expressed a somewhat more critical view: “In my view, r-star is not a beacon in the sky but a chimera in the eye. The idea of a “neutral” rate is a useful fiction. It makes for an interesting academic thought experiment. In practice, though, it’s unobservable, unpredictable, imprecise and highly variable. That makes it a poor guide for policy makers.” (Warsh, 2018). www.suerf.org/policynotes SUERF Policy Note No 137 3 R-star decline and monetary hysteresis Comparing different estimates of r-star and steady-state real interest rates reveals these difficulties (Graph 2, left-hand panel). The 5-year 5-year forward rate from the TIPS market (‘TIPS 5y5y’), a market-implied measure of the steady-state real rate, hovered above 2% through the GFC and declined notably in 2011 after the euro area sovereign debt crisis set in. Meanwhile, the FOMC’s expectation of the longer-run real policy rate (‘SEP’) was close to 2% until as late as 2015, dropping quickly only from 2016 onward (right panel). Finally, an r-star estimate based on a New Keynesian model (‘HLW r*’ from Holston, Laubach and Williams (2017)) declined immediately with the onset of GFC, dropping from 2% to 0.5%, and has remained near that level since. Uneven timings of revisions are symptomatic of significant uncertainty about long-run real interest rates and their determinants. Large unanticipated revisions in all cases also sit uncomfortably with the notion that r-star should depend on slow-moving shifts in saving-investment factors. The fact that all these indicators point in the downward direction may give a false impression of robustness. In inferring r-star, the realised path of the real policy interest rate is a key observed variable, and this has been extraordinarily low in the sample. This could make the inference prone to a circularity problem: is an r-star estimate tracking monetary policy actions or the other way around? The circularity problem is even more concerning when the model used to draw inferences is subject to shortcomings. For example, the recession in 2009 clearly has to do with a rare financial crisis, which even a drastic cut in the policy interest rate could not offset. For a simple New Keynesian model, the most natural way to reconcile a deep recession with a very low rate is to deduce that r-star has declined. All these point to the need for an independent validation of the r-star hypothesis. One strategy is to look directly at what factors drive the real interest rate trends. The r-star hypothesis points to various saving-investment factors, the ‘usual suspects’ for causing declining real interest rates. Slowing productivity could subdue investment and lower r-star.