Why low interest rates will return — again and again

Talk about a pivot. The battle against soaring prices that's raged for more than a year may yet give way to something that appeared consigned to history: Low interest rates and inflation that's consistently well behaved, perhaps to a fault.

This won't happen tomorrow and inflation might not become quite so anemic as in the decade after the global financial crisis. But 18 months into the most aggressive tightening by central banks in a generation, a corrective narrative is starting to emerge. The current period of relatively high borrowing costs may be the outlier, rather than the easy money that characterised financial life in the pre-pandemic era. The idea, strange as it might seem when judged by headlines of the past year, got a lot of attention at a high-powered Singapore symposium on Friday.

There are some significant implications: Have policymakers ridiculed for the use of words like "transitory" been dealt with too harshly? Perhaps officials that began hiking late, like Reserve Bank of Australia Governor Philip Lowe, don't deserve the degree of vilification they have received. Just conceivably, Bank of Japan Governor Kazuo Ueda is doing the right thing by taking his time to remove accommodation. 

Central to the issue is whether estimates of "neutral," the inflation adjusted short-term rate that neither brakes nor juices the economy, and the closely related "natural" level, a longer-run gauge, have changed appreciably in the past few years. By some reckoning, forces that drove rates consistently lower for three decades are still broadly in place. Covid and the pent-up demand that reopening unleashed may be a blip, albeit a notable one, when viewed from this historical perspective. The idea isn't without controversy: Former Treasury Secretary Larry Summers and Olivier Blanchard, one-time chief economist at the International Monetary Fund, jousted over it in March (Summers argued much had changed; Blanchard was more circumspect). John Williams, president of the Federal Reserve Bank of New York and a research heavyweight, told a recent Fed conference that there's no evidence very low rates ended with the pandemic.

The premise received attention at the Asian Monetary Policy Forum in Singapore last week. Maurice Obstfeld, a professor at the University of California, Berkeley, and himself a former IMF chief economist, noted that the decline in long-term real interest rates was as much an Asian story as an American or European development. Real rates receded markedly in South Korea, Taiwan, Thailand and the Philippines over the decades; less so in Malaysia, Indonesia and China. He traced the long-term downtrend back to the 1990s and canvassed a range of factors behind it, including aging societies spurring demand for safe assets, slackening global growth, and the replenishing of reserves in emerging markets.

Obstfeld was skeptical the pandemic changed everything. "Real interest rates will not return to their level of three decades ago anytime soon," he wrote in a paper presented at the conference. "This could be an advantage for fiscal policy, if not driven entirely by lower global growth. Given current inflation targets, however, it will leave the effective lower bound as a recurring challenge for monetary policy. Financial instability will remain a present threat."

But what if the past few decades still don't offer sufficient perspective? In a Bank of England staff paper published in 2020, Paul Schmelzing found that long-term real rates have been inching lower since the Middle Ages. Neither wars, the rise and fall of monarchs, let alone modern totems like inflation targets, have interrupted that gradual downward slope illustrated below. 

Covid was like a wartime shock, Schmelzing, an assistant professor at Boston College and a research fellow at Stanford University's Hoover Institution, told me this week. Typically, such upheavals last between five and eight years before the gentle southbound trend in real rates reasserts itself. I asked Schmelzing whether he cringed every time he heard someone intone that the era of low rates has gone forever. "We are not at the cusp of a new era," he responded.  "I do cringe when I hear that we are, but I feel reassured when people like Williams see the same thing." 

Never mind the Fed's dot plot or zigzags in forward guidance. The really big monetary policy story may be how little has really changed.

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.