The future of interest rates is a riddle

The return of inflation has surprised many, including central bankers. So has the resulting rise in nominal interest rates. These surprises have brought with them others, in particular a mini shock to the bank.

The question, then, is: “What’s next?” Will it bring inflation down to ultra-low pre-COVID-19 levels, or will it be a long-lasting problem, like it was in the 1970s and early 1980s? What will also happen to interest rates?

As Stephen King, an adviser to HSBC, points out in We have to talk about inflationn, many were too complacent about the possibility of inflation returning. As he also points out, once inflation and especially inflationary expectations are entrenched, they become very painful to remove. Have we reached that point? Or do our institutions still have enough credibility and inflation remains transitory that we can return to low inflation at little cost?

Line chart of US interest rates, inflation, and unemployment, 1978-89 (%) showing In the 1980s, curbing US inflation required two rounds of adjustment

In my opinion, it is more likely that we will return to inflation of around 2% per year, or perhaps a little higher. This is also what the markets expect: according to he Federal Reserve Bank of Cleveland, USA Inflation forecast is 2.1%, almost exactly in line with target. This shows confidence that the goal will be met. The inflation risk premium is also estimated at 0.5 percentage points, in line with historical valuations.

There are two (overlapping) arguments why this might be too optimistic. One is that supply conditions have become more inflationary. Deglobalization and other shocks have permanently reduced the elasticity of supply of key inputs. That will raise the costs of keeping inflation low. The other is that the political economy of curbing inflation has gotten worse. So the public cares less about inflation now, in part because they don’t remember a long period of high inflation. In addition, governments want to reduce their indebtedness, which is now much higher than 15 years ago, without curbing fiscal deficits. Finally, the inflation genie is out of the bottle. Putting it back will hurt.

Line chart of 10-year expected US inflation (%) showing that US expected inflation is still close to 2 percent

I’m still not convinced. Obviously, there is no necessary link between supply and inflation, since demand also matters. As long as aggregate demand grows in line with potential output and the output structure is reasonably flexible, the specific restrictions are perfectly consistent with low headline inflation. Furthermore, those responsible for monetary policy will not want to go down in history as those responsible for the loss of monetary stability. Last but not least, they know that it will be much easier to squash inflation now than to have to adjust it again later. (See graphics.)

Suppose this is correct. Then the inflation components in nominal interest rates will not rise permanently. But what about the actual item? Real interest rates fell for a generation, before reaching negative levels during the pandemic. Since then, they have recovered sharply. What happens now?

Line chart of US real interest rates at different maturities (%) showing that US real rates have risen, but are far from extraordinary levels

in his last World economy perspectives, the IMF addresses this question by investigating the “natural interest rate,” which is defined as “the real interest rate that neither stimulates nor contracts the economy.” That is also the rate at which one would expect inflation to hold steady (absent shocks). The natural rate is not directly observable. But it can be estimated. The main conclusion of his analysis is that “once the current inflationary episode is over, interest rates are likely to return to pre-pandemic levels in advanced economies.” Following the recent shocks, real and nominal rates will fall back to where they were in 2019. In particular, he expects the effect of further aging to be moderate, as is the (opposite) effect of higher public debt.

In March, two leading macroeconomists, Olivier Blanchard and Lawrence Summers, discussed this issue in detail for the Peterson Institute for International Economics. Of the two, Blanchard was closer to the IMF position. Summers, who had reintroduced the idea of ​​”secular stagnationin the political debate in 2015, he has now changed his mind, arguing that rates will be significantly higher than in the recent past.

Line chart of US swap rates (%) showing that nominal bond yields have risen, but still to fairly modest levels

The difference is not huge. Blanchard argues that real interest rates will remain below the real rate of economic growth, which is crucial for debt sustainability. He is not suggesting that they will return to negative levels. Summers believes they will be slightly higher than the Fed’s estimate of a 0.5 percent natural rate. One reason real rates will be higher than before, they agree, is more investment in the energy transition. Another is the need to spend more on defense. Higher public debt can also raise real rates, although inflation is eroding the debt.

US Yield Curve Line Chart (%) showing US Yield Curve Suggests Tightening Will Curb Inflation

However, these two disagree on whether the persistent demand reflects temporary factors (related to Covid) or a more lasting force. They disagree on the extent to which risk aversion will keep returns on safe assets low. They disagree on whether aging will further increase savings. And they also don’t agree with the likely impact of public debt on interest rates. In all these respects, Blanchard takes a position that justifies lower natural rates and Summers another that justifies the opposite. His position is close to that taken by Charles Goodhart and Manoj Pradhan.

Germany Yield Curve line chart (%) showing the German yield curve predicts success in controlling inflation

Therefore, assume that inflation will decrease to 2-3 percent. Let us also assume an equilibrium real interest rate of 0-2 percent. So short-term nominal rates would be 2 to 5 percent and, given risk premiums, longer-term rates would be 3 to 6 percent. At the low end, debt sustainability would be simple. At the high end, it would be a challenge. This range of uncertainty is large. However, the reality could still be different.

The return of inflation has changed the world. The question is how much. It is one to which time will give its answer. My own guess is “not dramatically so”.

Follow Martin Wolf with miFT and in Twitter

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