Stargazing

The natural interest rate – the real rate consistent with an economy at full capacity and stable inflation – has been declining over the last two decades, starkly reducing the capacity of monetary policy to steer the cycle and deliver price stability without resorting to unconventional instruments which often end up raising political or financial stability issues. Although high uncertainty prevails on these matters and we want to be cautious, we think there is a plausible case for some rebound in this equilibrium rate (r-star, or r*) post-pandemic in the US.

The drivers of r* are trend growth, which itself depends on productivity gains and the changes in working-age population, as well as the preference for saving, particularly in the form of “safe assets”. While demographic developments are unlikely to help, the jury is out on productivity post-covid, with the combination of new working practices and public investment programs focusing on infrastructure and fundamental research. “Scarring” could be limited in the US because of the speed of the recovery. True, productivity trends have been disappointing for two decades and we should remain cautious, but it just might not persist.

Where we think we can be more conclusive is on a change in the supply and demand of safe assets – in practice US public debt. Beyond the recent announcements by the US administration, the “pendulum has shifted” on public expenditure. In front of this higher issuance, we believe the “safe asset glut” from emerging countries recycling their current account surpluses has faded – provided no emerging market crisis eventually triggers another massive accumulation of official reserves.

Moreover, while the decline in r* pre-dates 2008, it has been significantly magnified by the Great Financial Crisis (GFC). The need to deal with accumulated debt in the private sector made spending less sensitive to lower interest rates. The current crisis is very different. US households are going to exit from the pandemic with much lower debt than during the GFC. They may be able to withstand a higher level of effective interest rates without triggering a deflationary slump.

We don’t posit a massive rise in r-star, given the weight of the demographic issues, but at the same time the mere possibility that the demand/supply configuration on the US bond market changes on trend should be taken into consideration by the market. This would be consistent with US effective real rates rising.