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AmericasMarch 7 2005

Low real interest rates are unsustainable

Stephen Roach worries about how the US economy can exit low real interest rates sensitively.
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Real interest rates have tumbled around the world, from the short to the long end of the maturity spectrum. This is not a sustainable development; subnormal real rates are sparking imbalances in the global economy that can only end in tears. Yet the exit strategy holds increasing peril.

The culprit is a white-hot global liquidity cycle. Fearful of a Japanese-style post-bubble carnage, the US Federal Reserve led the way with 550 basis points (bp) of monetary easing during 2001-03. Other central banks went along for the ride. The Bank of Japan augmented its zero interest policy with extraordinary efforts at quantitative easing. Even the European Central Bank took its policy rate down to zero in real terms and allowed excess growth in Euroland M-3 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, followed the Fed with a major monetary stimulus of its own – fostering M-2 growth that has averaged 16.5% since 2000.

Negative funds rate

In response, real interest rates have all but collapsed. In the US, the real federal funds rate is still in negative territory by about 100bp, marking the most accommodative policy stance since the late 1970s. The real yield on 10-year Treasuries is currently a bit below 1% – more than 250bp below the post-1985 norm. Moreover, in Europe and Japan, short rates remain below the inflation rate and long rates are equally depressed. That is especially true in Europe, where real yields for 10-year German bunds are about 300bp below the post-1985 norm. Similarly, real yields on 10-year Japanese government bonds are only about 70bp into positive territory, well below the 2.5% post-1985 average.

There is endless debate about the hows and whys of fluctuations in real interest rates. But there can be no mistaking the implications of a protracted period of low real rates: unusual support to financial asset valuations and to economies that convert asset appreciation into aggregate demand. Again, the US leads the way, with consumers quick to extract “extra” purchasing power from their asset holdings to keep on spending. First, it came from the equity wealth effect in the late 1990s but when that bubble popped, income-short consumers moved into the property market wealth effect. The result is the greatest consumption binge in US modern history. While supportive of growth, subnormal real interest 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 becomes minimised.

Savings at record low

In the case of the US, this has been taken to excess: a net national savings rate at a record low of 1.5% of national income since early 2002. Lacking in domestic savings, the US must import foreign savings so that it can grow, and must run massive current account deficits to attract that capital. This leads to the problem: how to wean world financial markets and the global economy off abnormally low real interest rates. It is likely to be a delicate operation. Here, too, it all starts with the Fed – the central bank that has nurtured the asset economy the most. The task is clear: to restore the policy rate to a more normal level. 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.

Yet there is always the risk that the asset-dependent US economy – and by inference, the US-centric global economy – is more sensitive to real interest rates than might be the case for a more normal, income-based economy. If that is so and the economy quickly weakens, Fed tightening will undoubtedly be curtailed. That would limit the downside of the real economy but perpetuate excesses in asset markets. That is the most worrying aspect of the conundrum: an asset economy that will not allow for an easy exit strategy. That should not deter central banks from acting responsibly and returning real rates to more normal levels, however. The longer the world resists normalisation, the more treacherous the endgame.

Stephen S. Roach is chief economist at Morgan Stanley

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