The Macro Code #2: The structural decline of r-star
Why markets should not lose interest in r*?
Welcome to The Macro Code, an open diary on markets, macro-trends and structural changes.
If you're a market participant you can follow the Jackson Hole symposium to get a feel for market sentiment. But if you're an analyst, you might want to follow the agenda to get a feel for the latest developments in monetary economics research from top academics and economists. Believe me, it's a great opportunity to sharpen your macro perspectives!
During the panel entitled "Low interest rates and an uneven economy" an interesting paper was presented: "What explains the decline in r*? Rising income inequality versus demographic shifts" (Mian A., Straub L., and Sufi A. - 2021).
The empirical results of this research offer us a good opportunity to summarize here the structural variables that during these years have created a decline in the natural interest rate and to understand how the investment environment has been affected. Moreover, we conclude by trying to understand why markets should not lose interest in r*, especially now that taper time is approaching and some are struggling to speculate on a "new normal".
Since the GFC a large number of economists have endeavored to explain the causes and consequences of the very low level of interest rates. Until the first decade of the 2000's the concept of zero lower bound was only imprinted in textbooks for western economies, then it became reality. With the revival of some marketing-inspired slogans such as "secular stagnation" or "liquidity traps", attempts have been made to shed light on global imbalances. For instance, "secular stagnation" is a concept that dates back to the 1930s, and more specifically to the pen of economist Alvin Hansen. What does it mean? It means that at that time industrial economies were suffering from imbalances linked to an increase in the propensity to save and a decrease in the propensity to invest. In essence, these are the same dynamics observed in the aftermath of the GFC. For this reason, the keynote at the NABE Policy Conference (February 24, 2014) by Larry Summers was titled "U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound."
In a nutshell, when the propensity to save increases and investment decreases, a vicious cycle is created that lowers growth, inflation, real interest rates are crushed to the ground, and financial instability increases.
The following chart presents the growth rates of actual and potential output of the U.S. economy during the period 1960-2018. The figure shows a rather steady decline in potential growth — from more than 3% per year in the 1960s and 1970s to less than 2% per year during 2007-2018. Actual growth can be seen to fluctuate around potential growth and to follow the downward trend. Indeed, virtually all empirical studies of both actual and potential growth of the U.S. show a remarkable slowdown, which started well before the Great Financial Crisis of 2008-09 (Fernald 2014; Storm 2017; Kiefer et al. 2019; Fontanari et al. 2019). Most observers conclude that it must have been declining potential growth which forced down the rate of actual (demand-determined) growth because they have learned to believe that while demand does affect actual growth, it does not and cannot influence potential growth – the latter is said to be completely determined by ‘demography’ (labor force growth) and “technology” (productivity growth).
This stagnant environment has led to lower real interest rates. Indeed, if we look at the real interest rate on sovereign bonds, which in turn is the baseline for pricing riskier bonds and equities through the addition of various risk premia, we will see that the real return in advanced economies has undergone pronounced shifts over time.
If we look at the longer-term trend, starting from 1956 and using ex-post calculations made by the ECB (see here) we note that the real interest rates were also low during this period, since inflation turned out to be unexpectedly high. In contrast, the current low levels of the real interest rate take the form of low nominal yields, since inflation is itself low and stable.
Understanding the root causes of the low level of real interest rates is a high priority for policymakers and investors.
The downward trend in yields can be interpreted as a decline in the so-called natural or neutral interest rate (labeled r* in academia).
R*
can be defined as the inflation-adjusted short-term interest rate which prevails when the economy grows in line with its potential (namely, unemployment is at the natural rate and inflation is at the 2 percent target.
What are the causes of this declining trend in r*?
A large body of recent research investigates the reasons behind the decline in r*.
The decline in r*
To summarize the extensive literature on this hot topic, we can say that the drivers that have driven r* to a decline over time revolve around three broad driving forces.
The determinants of potential growth rates;
Demographics;
Divergent developments in returns on risky and safe financial assets.
The potential growth rate
Let's start with the potential growth rate. In a high-growth economy, it takes a higher real interest rate to encourage the volume of saving required for the high investment levels needed to sustain a fast-growing economy. There has been a sustained decline in the potential growth rate of advanced economies in recent decades. This decline can be attributed to a negative trend in total factor productivity growth and a corresponding decline in labour productivity growth.
In addition, the rate of technological innovation has had a major impact on this dynamic. For instance, the gap between the labour productivity growth of firms operating at the technology frontier in a given sector and that of firms that are lagging behind the technology frontier in that sector (non-frontier firms) has increased over time (see here).
Finally, changes in the sectoral distribution of economic activity also play an important role. In recent years, employment growth has been concentrated in the service sector, and productivity growth in services has been weaker than in other sectors, such as manufacturing and information technology. As a result, the increasing share of services in total employment mechanically implies a drag on productivity growth in the economy as a whole.
Following some empirical evidence, it can be assumed that the structural changes we have just described may account for a loss in potential output growth of about 1 percent; a calculation below the envelope suggests that these explain a decline in real equilibrium returns of similar magnitude. As for the future, it must be said that opinions on the potential economic impact of digitization, automation, and artificial intelligence are still mixed.
Demographics
It is now well-known that demographics in advanced economies are characterized by low fertility rates and rising life expectancy (especially life expectancy is rising globally, see chart below).
As a result, people now expect to enjoy many more years in retirement than they did in the 1970s. As can be seen in the chart below that measures the remaining life expectancy at the age of average labor market exit by gender; during 2018 (latest update available) the OECD average was 22.5 years for women and 17.8 years for men.
As a further consequence, the working-age population follows a downward trend.
How do these demographic trends – which are without precedent – affect the equilibrium interest rate?
The ageing of the population can depress the demand for capital. Why? Because the ratio of installed capital relative to the size of the workforce increases as the population ages.
Ageing can lower productivity growth and thereby reduce investment opportunities.
A rise in life expectancy implies longer retirement periods, then individuals and those responsible for publicly provided pensions face incentives to save more.
The mix of these three components makes a contribution to the decline in the natural interest rate (r*).
Presumably, the negative impact of aging on the natural rate of interest may be reversed as older age cohorts retire and begin to save (see here). But from a medium-term perspective, the increase in the capital-labor ratio associated with a sustained phase of increased saving and labor force contraction will weigh on the level of real interest rates for a long time (see here).
Several studies show that the downward impact on real equilibrium rates from a slowdown in fertility rates and an increase in life expectancy over the period 1980 to 2050 amounts to about 1 to 2 percentage points in both the United States and the Eurozone (for instance, see here).
Divergences between risky and safe assets
There are two trends here.
There are changes in the correlation between returns on safe assets (highly rated sovereign bonds) and broader measures of rates of return, including equity returns and returns on higher-risk debt instruments (see here).
There is also a deviation in the relationship between yields on short-term instruments and those on longer-term instruments, with term premiums much smaller than in previous periods, or even negative (see here).
As a result, corporate bond spreads have come back in line after the various post-crisis periods.
While equity risk premium estimates have increased on an aggregate basis.
In addition, the demand for short-term monetary instruments has escalated and the yield of these instruments has fallen to unprecedented negative values (as we have seen in the first chart).
What are the trends behind these dynamics?
Taking a top-down view globally, many emerging nations have accumulated low-risk assets in reserve currencies in order to limit the financial fragilities associated with a lack of foreign currency liquidity.
An aging population may contribute to changes in portfolio preferences, with a greater propensity to invest in low-risk assets as older savers seek more secure income streams as retirement approaches.
Finally, the safety premium also reflects the lingering effects of the GFC and the sovereign debt crisis. Crisis events tend to shift portfolio preferences in the direction of assets that preserve their value during difficult times, this has meant that safe assets have dramatically declined over time as we see in the chart below (the literature is still divided on this point, some argue that safe assets are scarce as supply has declined - Barclays 2012, others believe that the scarcity of safe assets is due to an increase in demand - Goldmanm, 2012).
Related to this last point, it may be interesting to look at the dynamics of demand for safe assets during the pandemic crisis.
For example, we know that traditionally US Treasuries have been a safe haven, receiving inflows from the rest of the world when risk aversion increases. This did not happen in 2020 (red), unlike 2008/09 and unlike Germany (blue) and Japan (black) which received large inflows. The graph below shows the flows registered on government bonds, in % of GDP. From the chart below we can also see a test of the resilience of a country's fiscal space: foreigners want to buy your debt in a bad shock, i.e. just when you are about to issue more debt. It happened for Germany (blue) and Japan (black) in 2020, but not for the United States (red).
As proof of the above, it is interesting to note that during the pandemic crisis, not all government bonds were appreciated as safe assets.
The graph below shows the flows recorded on government bonds, in % of GDP, during the GFC (blue) and during the Covid19 crisis (red).
Now let's go back to where we started.
As we have seen, the causes of the decline of r* are varied and many uncertainties still remain given that from 1980 to 2019 this decline was accompanied simultaneously by a number of aggregate trends, such as rising income inequality, an aging of the population, shifting patterns in global saving, and changes in how businesses invest (i.e., the sudden growth of intangible investments relative to tangibles).
The paper that we mentioned at the beginning and which was presented at Jackson Hole offers a significant contribution to mitigating these uncertainties.
Why? Because this paper clarifies that rising income inequality is the more important factor explaining the decline in r*. Saving rates are significantly higher for high-income households within a given birth cohort relative to middle and low-income households in the same birth cohort, and there has been a large rise in income shares for high-income households since the 1980s. The result has been a large rise in saving by high-income earners since the 1980s, which is the exact same time period during which r* has fallen. Differences in saving rates across the working-age distribution are smaller, and there has not been a consistent monotonic shift in income toward any given age group. Both findings challenge the view that demographic shifts due to the aging of the baby boom generation explain the decline in r*.
Key takeaways
If the inequality view is correct, then it suggests that macroeconomic forecasters should closely track the evolution of inequality when forecasting movements in r* going forward. It also suggests that inequality should play a more central role in macroeconomic models used for investments analysis.
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The Macro Code #2: The structural decline of r-star
Well, i would suggest that another viable way of reading the decline in r* could be the scarcity of "real" investments opportunities in a much broad sense (in terms, clearly, of GDP-producing investments, not financial ones). I mean...well...nowdays, with respect to booming 60s and early 2000s aorund the Globe we do really have EVERYTHING. It seems like we're in some kinda "end of history" (mutuating the expression from F. Fukuyama) in terms of goods and services avaiable to the average human being. Even in some of the poorest countries in whole world (see Africa or Asia) they have a discrete access to internet and to a smartphone with which doing lots of things as we all know. Maybe, and that's my point, a new real technological and industrial revolution could prompt a much higher r* .