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Maybe Low Interest Rates Won't Last Forever

Maybe Low Interest Rates Won't Last Forever

By Thursday, 08 October 2020 08:40 AM Current | Bio | Archive

Conventional wisdom and financial markets agree: The era of near-zero interest rates will last as far as the eye can see.

Yet the prolonged era of low rates may in fact be ending, according to a provocative new book by Charles Goodhart of the London School of Economics and Manoj Pradhan of Talking Heads Macro.

Over the past decade in particular, inflation-adjusted interest rates have remained remarkably low. The 10-year yield on inflation-indexed Treasury notes at constant maturity in the U.S. fell below 1% in 2011 and fluctuated close to zero until the pandemic. The yield in the third quarter of 2020 averaged -0.9%.

Almost no one predicts a large rebound in either nominal or real interest rates. The Congressional Budget Office projects the 10-year nominal yield will not return to its 2010 level until 2030. The markets are also signaling they don’t expect the era of low rates to end any time soon: The 30-year inflation-adjusted yield, which should reflect a weighted average of the interest rates expected over three decades, has remained negative since the pandemic took hold.

So what might go wrong? First, and just to get this out of the way, I was wrong more than a decade ago to worry about an increase in rates. History has, to put it gently, not been kind to that view. By 2011, I had seen enough to know my initial fears were misplaced, and the lesson, learned the hard way, is to be more skeptical about the conventional wisdom.(1)

The dominant view, however, has swung very far in the other direction from where it was 10 years ago, from excessive worry to none at all about higher rates in the future. Now along comes The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival, by Goodhart and Pradhan, to rebut the new conventional wisdom.

The authors argue that the era of low rates was fundamentally caused by demographics and the entry of China and Eastern Europe into the global trading system. The result was that, from 1991 to 2018, the effective global labor supply more than doubled, which in turn pushed interest rates down (while also depressing inflation and wages and boosting inequality). As they write, “the rise of China, globalisation and the reincorporation of Eastern Europe into the world trading system, together with … the arrival of the baby boomers into the labour force and the improvement in the dependency ratio, together with greater women’s employment, produced the largest ever, massive positive labour supply shock.” The deflationary pressure caused by this supply produced the era of low nominal and real rates.

Goodhart and Pradhan go on to argue that the demographic sweet spot of the past three decades is now reversing, with the ratio of dependents (the elderly and the young) to workers rising in the advanced economies and in China. Indeed, working-age populations are now stagnant or falling across most of the world outside of Africa and India.

The underlying tectonic plate of aging, the authors argue, will soon reverse the previous deflationary pressures. The consequences? “The main thesis of this book,” the authors write, “is that the great demographic reversal will shortly raise inflation and interest rates.”

They address but do not find convincing the various counterarguments — for example, that Japan is already aging rapidly and hasn’t experienced a rise in rates. In Japan’s case, they note that one country aging rapidly, when it can draw upon labor in other countries, is quite different from the world as a whole doing so. They are skeptical that Africa and India can exert the same deflationary pressures in the future as China produced in the past.

The book’s conviction may be overstated, but we should thank Goodhart and Pradhan for kicking the tires on the view that low rates are here to stay, because conventional wisdom can easily blind us to other scenarios. As they say, “Once established, conventional thinking is extremely hard to dislodge, particularly at turning points. We are at such an inflexion point right now.” The first part is undoubtedly correct, even if the second part turns out to be premature.

(1) On a related note and since this history is now being re-litigated, the easy narrative that has taken hold about the 2009 stimulus seems misplaced. As I wrote in 2019, the problem with the 2009 stimulus was not that it was too small, but rather that it did not last long enough. It’s not clear that much more could have been effectively delivered in the second quarter of 2010 than the well over $100 billion included in the stimulus for that period. But it’s clear that the federal government could have spent more than the $10 billion supplied by the package in the second quarter of 2012.

Peter R. Orszag is a Bloomberg Opinion columnist. He is the chief executive officer of financial advisory at Lazard. He was director of the Office of Management and Budget from 2009 to 2010, and director of the Congressional Budget Office from 2007 to 2008.

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Conventional wisdom and financial markets agree: The era of near-zero interest rates will last as far as the eye can see.
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Thursday, 08 October 2020 08:40 AM
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