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The Real Interest Rate Conundrum:

Stephen Roach

Real, or inflation-adjusted, interest rates remain near rock-bottom levels. That’s true in most major segments of the world. It’s also true for short- and long-term maturities, alike. This condition is not sustainable. The days of abnormally low real interest rates could be coming to an end. As the world economy returns to trend, a normalization of real interest rates is both appropriate and likely. This poses major risk to financial markets, as well to asset-dependent real economies that have become hooked on low real interest rates.

The real interest rate conundrum is largely made in America. The Federal Reserve is the leading actor in this saga. Fearful of a Japanese-like post-bubble carnage, the Fed slashed its policy rate by 475 basis points in 2001 in the aftermath of the bursting of the US equity bubble. Another 75 bps of rate cuts were implemented in 2002 and 2003 as the US veered dangerously toward deflation. To varying degrees, other major central banks went along for the ride. The Bank of Japan augmented its zero interest policy with extraordinary efforts at quantitative easing. Even the inflation-phobic European Central Bank took its policy rate down to “zero” in real terms and allowed excess growth in Euroland M-3 that has been above the 4.5% reference zone for the past three and a half years. And the People’s Bank of China, operating with a pegged currency, took its cue from the Fed and followed with a major monetary stimulus of its own -- fostering M-2 growth that has averaged 16.5% since 2000.

In response, real interest rates have tumbled from the short to the long end of the maturity spectrum. Nowhere is this more evident than in the United States. When “deflated” by the headline CPI, the federal funds rate is still in negative territory by about 125 bps. Using the core CPI, which excludes food and energy, the real funds rate is basically “zero.” (Note: I have long objected to stripping out important, but volatile, items in order to get a clean read on any economic trend; in the comparisons that follow -- especially the international ones, for which core inflation data are not always available -- the headline construct is used). Based on either inflation metric, US monetary policy remains in its most accommodative position since the late 1970s; the real federal funds rate has been below its post-1985 2% norm for nearly four years and has been at the zero threshold or in negative territory for more than two years. A similar downside breakout is evident for long-term US real interest rates. Adjusted for inflation, the yield on 10-year Treasuries is currently a bit below 1% (4.20% nominal yield less the latest reading of 3.5% on headline CPI inflation). That reading essentially equals the lows hit in the spring of 2003 and remains more than 250 bps below the post-1985 norm.

Real interest rate trends elsewhere in the world essentially mirror those in the United States. Short rates in both Europe and Japan remain below the inflation rate -- underscoring the extraordinary degree of monetary policy stimulus that is still in place in both regions. Long rates remain equally depressed. That’s true in Europe, where yields for 10-year German bunds (3.5%) are only 100 bps above the pan-regional European inflation rate (2.5%) and about 300 bps below the post-1985 norm. Similarly, nominal yields on 10-year Japanese government bonds (1.4%) are only about 70 bps above the now-positive Japanese CPI (+0.7% in December 2004); while that’s above the negative readings that were hit in 1998, it remains well below the 2.5% post-1985 average. Elsewhere in the developed world, it’s basically the same story. The IMF’s composite measure of world real long-term interest rates -- including not only the US, Japan, and Germany but also the higher-yielding securities of France, Italy, the UK, and Canada -- is currently at a 20-year low of around 2%. Even in the developing world, spreads relative to Treasuries are at lows last seen in the pre-crisis period of 1997-98. The world’s real interest rate cycle is, indeed, in rarefied territory.

We debate endlessly the hows and whys of fluctuations in real interest rates (for a good discussion of the broad outline of this debate see Federal Reserve Governor Roger Ferguson’s "Equilibrium Real Interest Rate: Theory and Application," 29 October 2004, and Dick Berner’s 3 January 2005 dispatch, “Critical Macro Investment Themes for 2005”). But there can be no mistaking the implications of a protracted period of low real rates -- unusual support to financial asset valuations and to those economies that convert asset appreciation into aggregate demand. Again, America leads the way in this regard. In a climate of subpar income generation -- with the current recovery in private sector real wage and salary disbursements falling ten percentage points short of the cyclical norm -- US consumers have been quick to extract “extra” purchasing power from their asset holdings in order to keep on spending. This phenomenon has been a long time in the making; it was initially concentrated in the equity wealth effect in the latter half of the 1990s; however, when that bubble popped, income-short US consumers moved seamlessly into the property-market wealth effect. It is the essence of what I have called the Asset Economy (see my 21 June 2004 dispatch, “The Asset Economy”).

In their most basic sense, asset-based economies are nothing more than a levered play on low real interest rates. And with America at the forefront of this trend, the rest of a US-centric global economy has been eager to go along for the ride. So eager, in fact, that a massive surge of foreign capital inflows into dollar-denominated securities has played a key role in subsidizing US real interest rates in recent years. That’s not without good reason. Lacking in domestic demand of its own, the non-US world has a vested interest in keeping the magic alive for America’s asset economy. Dollar-buying campaigns of Asian central banks -- especially Japan and China -- have been an important piece of this equation. Significantly, such efforts have forestalled the real interest rate pressures that normally accompany current-account adjustments. Not only has that provided interest rate support to asset-dependent demand in the US but it has also prevented an outbreak of Asian currency appreciation that might have otherwise crimped the region’s export potential.

Consequently, the role of subnormal real interests cannot be minimized as a driving force behind today’s US-centric global growth dynamic. But, at the same time, low real rates are equally culpable in producing the extreme state of imbalance that currently exists in the world economy. To the extent that low rates encourage asset-based saving, income-based saving gets minimized. In the case of the United States, this has been taken to excess -- a net national saving rate that has been pushed to a record low of 1.5% of national income since early 2002. Lacking in domestic saving, America then must import foreign saving in order to grow -- and run massive current account deficits to attract that capital. The resulting persistence of outsize trade deficits is a recipe for trade frictions and protectionist risks. Moreover, asset-based consumption also entails a bias toward ever-increasing household sector debt loads -- leverage that is manageable for only as long as real rates stay low. While low real rates may keep the party going, the celebration is hardly without consequences.

Which brings us to the endgame -- how world financial markets and the global economy are weaned from abnormally low real interest rates. This is likely to be a delicate surgical operation, to say the least. Not surprisingly, it all starts with America’s Federal Reserve -- the central bank that has nurtured the Asset Economy the most. The task is clear -- to restore the policy rate to a level that is compatible with the Fed’s multiple goals of price stability, full employment, and sustained economic growth. The recently-released minutes of the FOMC’s mid-December policy meeting send a reasonably clear signal that the central bank is about to embark on such a recalibration. By citing two sets of concerns that are goading it into action -- rising inflationary pressures and mounting speculative excesses -- the Fed is threatening to reset the anchor of the world’s real interest rate structure. In doing so, I believe that Greenspan & Co. now have their sights set on a policy rate that is in the restrictive zone. Gone are the days when the Fed can afford simply to shoot for “neutrality.”

As this realignment of US monetary policy filters through the term structure of interest rates, collateral reverberations can be expected at the long end of the yield curve. In large part, that’s because the Fed will be changing the rules of the “carry trade” and the artificial demand that bets on the “spread” create for long-duration assets. In my view, that poses especially large risks to high-yield, emerging-market, and even investment-grade debt. It also poses great risk to perhaps the biggest carry trade of them all -- the overvalued US housing market and the concomitant “refi bet” of the income-short American consumer.

There is always the risk that the asset-dependent US economy -- and by inference, the US-centric global economy -- is far more sensitive to real interest rates than might be the case for a more normal, income-based economy. If that turns out to be the case and the economy quickly weakens, then Fed tightening will undoubtedly be curtailed. That would have the effect of limiting the downside of the real economy, but at a cost of perpetuating excesses in asset markets. Therein lies the most worrisome aspect of the real interest rate conundrum -- an asset economy that won’t allow for an easy exit strategy. That should not keep central banks from acting responsibly and attempting to return real rates to more normal levels. The longer the world resists such a normalization, the more treacherous the endgame.

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