The Global Low Real Interest Rate Part 2
In Part 1, I established that globally low, real interest rates are a representation, at its core, of a low-level natural interest rate. Ten years after the 2008 financial crisis, we still haven’t seen much recovery of the natural interest rate (r*). The fundamentals of an economy, reflected by weak GDP growth, are the persistent and impactful factors that have been putting long-term downward pressure on the natural equilibrium rate. In Part 2 of my article, an attempt will be made to identify the specific fundamentals that are held responsible, and to explain how they affect the r*. Other than that, a discussion about the global change in account balance and its effect on the global interest rate will be recounted.
According to the Congressional Budget Office, real potential growth is currently around 2%, compared to a pace about double that amount before the 2008 financial crisis. Slowing labor productivity growth is primarily held responsible. Such lag will boost saving and depress investment. Households revising down their expectations for future income growth are likely to save more. The stagnation also makes future business opportunities less profitable, hurting investment incentives. (1)(2)
Other than that, a low unemployment rate may not depict the full picture. The U.S.’s aging population, a profound demographic shift, is another factor working against natural rate recovery. As households get closer to retirement, they unsurprisingly tend to save more. The shift also creates an expanding shortage in the labor market, which may not be urgent at this point but has the potential to become a major concern. Absorbing a large number of immigrants has been a short-term solution for years, yet it’s not a panacea without side effects. An increasing amount of immigrants has been fueling conflicts and dividing forces in the political landscape. Trump’s governance has been taking a tough attitude towards such issues, making the labor market a potential dragging force on the economic growth, hurting profitability of the market, depressing the demand of investment, and consequently forcing down the natural interest rate. (1)(3)
Particularly in the business scope, disruptive technology especially fuels uncertainty for the continued viability of long-standing business models. Investment decisions, weighing heavily on managers, are thus under significant challenges, and can be delayed. Technologies’ major contribution to industry evolution is its capability of making traditional business models more efficient, or in other words, requiring less labor and capital to achieve historical or even higher production level. As a result, new investment projects, adjusted by the corresponding amount of production they generate, are expected to cost less when compared to previous investments. Maturing industries also have fewer entries and exits. While industries are becoming more concentrated, competition shrinks, leading to diminishing incentives to increase production among the big players. All these factors are pushing down demand for investment. (1)(4)
In an attempt of quantification of the effects that all these factors might have on the U.S. long-run equilibrium rate, the FRB/US model, a large-scale estimated general equilibrium model of the U.S. economy that has been in use at the Federal Reserve Board since 1996, has discovered that the overall slowdown in growth is the primary reason for the depressed U.S. long-run equilibrium rate with a high level of conviction. (1)(5)
Prior to year 2008, it was widely conjectured that foreign developments were hurting U.S. interest rates. Former Federal Reserve Chairman Ben Bernanke used a term called “global saving glut”, referring to persistent current account surpluses of numerous emerging market economies, as these economies are constantly accumulating foreign reserves that are absorbed from developed countries such as U.S. and major Euro-zone countries. (1)
Considering the global account should be balanced, the deterioration of the U.S. deficit is matching the explosive growth of surpluses in Asian as well as OPEC from 2001 to 2006, which is an observed fact that confirms the “global saving glut” description. The corresponding up-and-down was coincident with a plummet of real interest rate in the U.S. and other major developed economies in the world during the same period, bolstering the theory that a higher foreign saving relative to lower foreign investment is likely to depress real interest rate. Therefore, it is reasonable to expect a contracting foreign saving to boost the interest rates back up. Unfortunately, this projection does not meet the reality. Over the recent period during which the U.S. deficit is shrinking, real interest rate is still walking down, suggesting that a reversal of global saving glut is failing to catch up with the falling U.S. demand for investment. (1)(6)
From a global standpoint then, the marked narrowing of the U.S. current account deficit definitely contributes to a low global interest rates over the past decade. However, the financial crisis revealed that the pace at which the U.S. absorbs global savings was unsustainable. In other words, despite its downward effect, U.S. deficit recovery is far from sufficient to be the sole reason for a globally low real interest rate level. In addition, other major factors, resulting in a sharp decline in the global real interest rate, should be long-existing before the financial crisis. A declining global real interest rate would have been even more distinctive earlier in the decade without some soothing effect from the significant deficit of U.S. and other major European developed countries. This notion is consistent with empirical evidence of the decreasing global labor force growth and productivity growth, both are the primary drivers behind the depressing global real interest rate. (1)(6)
Works Cited
“Speech by Vice Chairman Fischer on the Low Level of Global Real Interest Rates.” Board of Governors of the Federal Reserve System, https://www.federalreserve.gov/newsevents/speech/fischer20170731a.htm.
United States, Congress, “An Update to the Budget and Economic Outlook: 2019 to 2029.” An Update to the Budget and Economic Outlook: 2019 to 2029, 2019.
Gagnon, Etienne, Benjamin K. Johannsen, and David Lopez-Salido (2016). "Understanding the New Normal: The Role of Demographics (PDF)," Finance and Economics Discussion Series 2016-080. Washington: Board of Governors of the Federal Reserve System, October.
Hilsenrath, Jon, and Bob Davis (2016). "Tech Boom Creates Too Few Jobs," Wall Street Journal, October 13.
Fischer, Stanley (2016a). "Low Interest Rates," speech delivered at the 40th Annual Central Banking Seminar, sponsored by the Federal Reserve Bank of New York, New York, October 5.
Bernanke, Ben S. (2005). "The Global Saving Glut and the U.S. Current Account Deficit," speech delivered at the Homer Jones Lecture, St. Louis, April 14.
