- There is no consensus on the root causes of slow growth.
- As economists seek explanations, the secular stagnation theory has re-emerged.
- Strong evidence suggests the neutral real rate has fallen. (But is it negative? We explore this question in this continuing series over the next few weeks.)
By Marie Schofield, Chief Economist and Toby Nangle, Head of Multi Asset Allocation
The idea that economies may be undergoing a long period of slow growth has been attracting an increasing amount of attention. While primarily a developed market phenomenon, this should have more than a passing interest for all investors. True, the global financial crisis unleashed particularly strong deflationary forces, but the drivers of slower growth and lower inflation have largely been in place for some time. Some point to growing income inequality, while others lay blame on a liquidity trap for monetary policy. Still others see the unrelenting swing of demographics as the culprit, or globalization and technological advances that have slowed inflation and at the same time displaced workers. Many choose not to believe it at all, underscoring a historic output gap that is only slowly receding. If it is real, is there anything government policymakers can do to cushion or reverse its effects? We believe there are important investment implications here and plan to explore these issues through a series of articles.
In the short-run, central banks set interest rates largely with reference to where they understand an economy to be in its business cycle and when they expect inflationary pressures to emerge. But in the long run they expect that “real” rates — that is to say interest rates over and above inflation — will fluctuate around some “neutral” level, and this neutral level tends to be described in terms of estimated long-run productivity growth.
And so when Larry Summers, prominent economist and ex-policy maker, suggested that we may have entered a period of secular stagnation and that the neutral real rate in a number of advanced economies has fallen and may even be negative to the tune of -2% to -3%, the world took notice.
Secular stagnation is not a new idea. During the 1930s and 1940s it gained currency in academic circles before being beaten back by wave upon wave of strong post-war economic growth. But despite all of this evidence it never quite died a death: economists have observed time and again that all the easy inventions had already been made despite new technological breakthroughs emerging. And so it might be easy to dismiss the latest wave of interest in secular stagnation as just more evidence that you can’t keep a bad idea down.
Exhibit 1: Real fed funds and U.S. core inflation, 1980–2013
Source: Federal Reserve, December 2013
But Summers had a deeper point: that even at the peak of the booms of the past 20 years, there has been no real inflation to speak of in the United States. And so, by inference, the equilibrium real rate may well have fallen meaningfully. Exhibit 1 shows the three-year rolling real fed funds rate and three-year rolling core personal consumption expenditure deflation (the Fed’s preferred measure of inflation) over the past 30 years. Each cycle has experienced lower peaks and troughs in real rates but, despite this, inflation has been on a long-term declining trend. What has caused this disinflationary shock, and has the United States really entered a liquidity trap where even a zero-interest rate may be too high for the economy?
Over the next few weeks we will explore the nature of this disinflationary shock, looking at the patterns of domestic income and spending inequality in the United States that not only contributed to the global financial crisis, but also help define the options for policymakers on the monetary and fiscal fronts. Government policies can both help and aggravate these trends and need to be delicately balanced from a risk/reward perspective. We will then take a global perspective, examining the effects of globalization on domestic inflation and on U.S. and global industries and earnings. Following this we will analyze the impact of demographics and technological change on the U.S. economy, as well as the consequences of deregulation and reregulation. These are tectonic issues with meaningful investment implications, but we seek to bring them together and integrate them in relation to Summers’ secular stagnation hypothesis.
We are unclear as to whether the neutral real rate has truly become negative, but do believe the evidence that the neutral real rate has fallen is strong, highlighting the “low for long” inclination of U.S. rate policy. Part of this fall is due to domestic structural reasons, some of which might be addressed through policy actions while others are harder to legislate away. Part of it may relate to a global adjustment and rebalancing period lasting a century that we are but 20–30 years of the way through. Political risks will be elevated and protectionist policies will only delay the inevitable. As a result, it will be critical to assess policies across markets, as disparate outcomes are likely. Structurally lower real rates do not eradicate the possibility of bouts of inflation along the way, but when investing for the long term we do not expect long-dated real rates to revert to levels seen in the 1980s or 1990s.
* The real funds rate may be said to be neutral (“neutral real rate”) when it is at a level that, if maintained, would keep the economy at its production potential over time.