The end of the world's Great Monetary Experiment

Following a lengthy period of highly aggressive monetary policies that have lowered real and even nominal interest rates into negative territory, the monetary policy cycle is finally beginning to tighten, a trend most notable in the US, UK, and a number of other countries.

In this article I will argue that this process will ultimately lead long- and short-term interests to exceed 300 to 400 basis points, leading to substantially higher borrowing costs for private consumers and enterprises in the years to come.

The big monetary policy experiment

The last decade has been an unprecedented monetary policy that has driven nominal and long-term real interest rates down to levels that have not been witnessed over the past 40 years, and indeed rarely seen before that. By way of example, the nominal return on a 10-year German and French government bond has been negative for most of 2020 and 2021, while the returns after inflation have been negative for government bonds in France, UK, and US since 2018 and in Germany since 2012 (figure 4). Such a prolonged period of negative real interest rates has only been experienced three times before in the US: during the American Civil war, World War I and World War II.

Note: Inflation is defined as the deflator of GDP. Long term interest rates refer to government bonds maturing in 10 years.

The basic ingredients of this experiment have been to hold short and particularly long interest rates way below the levels that equivalent economic conditions would have warranted in the past.

Indeed, as the global economy was starting fully getting back on track before the Covid-induced crisis, two questions were being increasingly raised:

• First, how quickly should central banks move towards a “normalisation” of monetary policy, specifically dropping ultralow short-term policy rates and unwinding the programme of buying-up long-term securities?
• Second, what would a normalisation imply in terms of neutral policy rates? Was the global economy experiencing a secular decline in the so-called “natural interest rate[1]”? This school of thought sees the falling real long-term rates shown in figure 1 not primarily as a result of aggressive monetary policies, but more due to changes in demographic patterns, particularly ageing, increased demand for safe assets, and reduced growth potential, notably in the OECD area.

I am squarely on the hawkish side of this argument. In particular, I find it decidedly doubtful that monetary policy is safely anchored in the perception that the natural rate of interest has been markedly reduced over the last decade. I am equally sceptical of the prudence in stimulating economic activity with negative short- and long-term real interest rates over a sustained period of time. The factors weighing on my judgement can be broken into three points:

Estimates of “neutral” interest rates are well above current rates. If we start with the premise that estimates of neutral interest rates can be taken more-or-less at face-value, we can observe that they are well above actual rates in the US and the Eurozone area, for example. To illustrate this point, I have used estimates for the US Fed that suggest that short-term real neutral interest rates are just below 100 basis points for the US and EU. This value is substantially higher than the short-term policy rates recorded for either area for a very long period in the last decade (figure 2).

Note: Data refers to the rate on 3-month, nationally traded certificates of deposits issued by commercial banks up to June 2013. Since June 2013, data refers to a 90-Day, AA Financial Commercial Paper Interest Rate.

The “calibration” issue:  Monetary policy should be at least as much concerned about longer-term economic and financial stability as attempts to fine-tune short-term inflation and economic performance. Indeed, there is a clear risk that sustained periods of low policy rates lead to asset inflation and unproductive risk-taking, creating trouble down the road. The economic crisis starting in 2008 was arguably driven, at least in part, by the US Fed being too slow in ramping up policy rates following the bursting of the tech bubble in 1999-2000, an event that was also the result of very favourable monetary conditions.

In this perspective, why keeping policy rates 200-300 basis points below neutral rates when actual inflation indicators are not far away from target levels? Just prior to the Covid-induced economic set-back, the US economy delivered rises in wage compensation of around 3% per year while core inflation rose by around 2% (figure 3). At the same time, the rate of unemployment suggested a relatively limited slack in the overall economy. Indicators of inflationary pressures were more subdued in Europe, but the difference between actual policy rates and estimated neutral rates have been even higher as shown in figure 2 above. In other words, if inflation rates are just 25-50 basis points below target, does this really justify having policy rates 200-300 basis points below natural rates? I believe this question is not only about whether monetary policies should be supportive or not: it is about the proportionality between the identified macroeconomic problem and how aggressively the perceived gap to target should be approached.

The identification problem: Estimations of the natural rate of interest use the actual short- and/or long-term rates as the variables to be explained. However, as central banks are controlling directly short-term rates, and have invested massively in long-term securities (the essence of Quantitative Easing, or “QE”) it is extremely complicated, if not impossible, to disentangle market and policy factors when attempting to understand what drives interest rates. At the end of the day, policy makers are setting the policy rates, and the estimated importance of the structural drivers are therefore to a large extent driven by the policy rates directly chosen or heavily impacted by policy makers.

Notably, it is naive to believe that market participants can use long-term macro factors to form their own view on where long-term rates should be and then “bet” against central banks by shorting long-term government bonds over an extended period of time. The investors who have done so in recent years have burnt their fingers repeatedly as monetary policies have stayed easier for a much longer time than many investors expected.

Ramifications

The cycle of tightening has begun and has still a long way to go. New factors coming such as the aftermath of the Covid and the terrible war in Ukraine will complicate policy making. But it will be hard to argue that further inflationary pressures from higher global energy prices is reducing the need for central banks to get back on track.

The higher interest rates will also lead to a reversal of the feast in capital markets over the last decade where low and falling returns from investing in new bonds have led to substantial increases in the pricing of financial assets. In my next LinkedIn article, I argue that this process has started and will continue. I will also explain how the unwinding of the monetary policy experiment will stop, and to an extent also reverse, some of the gains that the generations in or close to retirement have had over the last decade.

Am I alone in my assessment? I don’t think so, but I welcome any and all views on the subject, so please feel free to comment below.

About the author

Sigurd Næss-Schmidt is a Partner at the international economics consultancy, Copenhagen Economics, where he works primarily within the fields of Energy & Climate and Finance & Tax services. He has extensive experience in financial market regulation, taxation and energy policies with a substantial international focus. Sigurd has worked for tthe Danish Ministry of Finance, OECD in Paris and the EU Commission in Brussels and taught Economics at both Copenhagen University and Copenhagen Business School. 

Sources and remarks

• [1] The interest rate consistent with a stable inflation rate by keeping the growth of the economy close to its underlying potential.
• (Figure 1) OECD, Long-term interest-rates [https://data.oecd.org/interest/long-term-interest-rates.htm] and The World Bank: Indicators [https://data.worldbank.org/indicators]
• (Figure 2) Measuring the Natural rate of Interest: International Trends and Determinants” by Kathryn Holston, Thomas Laubach and John C. Williams, Journal of International Economics 2017.
• (Figure 3) Organization for Economic Co-operation and Development, Consumer Price Index: Harmonized Prices: Total All Items Less Food, Energy, Tobacco, and Alcohol for the Euro Area [CPHPLA01EZM661N], retrieved from FRED, Federal Reserve Bank of St. Louis.