Goodbye, inflation. Hello, unsustainable debt.
If you’ve spent any substantial amount of time engaged in discourse about the economy — and I, alas, have been at it for decades — you know that there’s always something to worry about.
At the start of 2023, the big worry was inflation, with many asserting that bringing inflation down to an acceptable rate would require a recession and a prolonged period of high unemployment. What we’ve seen, however, is so-called immaculate disinflation as the economy works out its pandemic-era kinks. The Fed’s usual measure of underlying inflation ran at only 2.2 percent (annualized) over the past three months, essentially back to its 2 percent target. And the latest data from the euro area suggest that immaculate disinflation is spreading across the Atlantic. It will be a while before the Fed and its counterparts abroad will dare to say it openly, but inflation is looking like a solved problem.
Now the big worry is interest rates.
The Fed and other central banks essentially control short-term interest rates and have increased them a lot in their fight against inflation. For a while, however, bond markets were basically betting that these rate hikes would be, well, transitory and that short-term rates would soon come way back down. As a result, long-term rates significantly lagged short-term rates, creating the famous inverted yield curve that many see as a sign of impending recession.
Over the past few months, however, the bond market has, in effect, capitulated, sending the signal that investors expect rates to stay high for a long time. Long-term interest rates are now higher than they have been since the 2008 financial crisis:
What’s causing this interest rate spike? You might be tempted to see rising rates as a sign that investors are worried about inflation. But that’s not the story. We can infer market expectations of inflation from breakeven rates, the spread between interest rates on ordinary bonds and on bonds indexed for changes in consumer prices; these rates show that the market believes that inflation is under control:
What we’re seeing instead is a sharp rise in real interest rates — interest rates minus expected inflation:
At this point, real interest rates are well above 2 percent, up from yields usually below 1 percent before the pandemic. And if these higher rates are the new normal, they have huge and troubling implications.
Most notably, a number of economists — including Larry Summers, Olivier Blanchard and yours truly — have argued for years that low interest rates mean that we shouldn’t worry about government debt. In particular, if the real interest rate is lower than the economy’s growth rate (r < g), debt isn’t really a burden because the ratio of debt to gross domestic product tends to fall even if the government is running deficits. Indeed, in a low-rate world, budget deficits may actually be good. As Summers wrote in 2016, “By setting yields so low and bond prices so high, markets are sending a clear signal that they want more, not less, government debt.”
But now, suddenly, real interest rates are above most estimates of the economy’s long-run growth rate. If this reversal persists, the sustainability of high debt will become a major issue for the first time in many years.
So is the low-interest era really over?
Full disclosure: I may not be an entirely trustworthy guide here. As a card-carrying member of the secular stagnation caucus — economists who believed pre-Covid that low interest rates and inadequate demand would be persistent economic issues — I have a vested interest in believing that the current rate spike is temporary. I try to avoid motivated reasoning, but you should know that it’s a risk.
Anyway, while the bond market is saying that high interest rates are here to stay, it’s not easy to see why that should be the case.
Before the pandemic, attempts to explain the decline in real interest rates since the early 2000s focused on forces leading to slowing economic growth and hence lower investment demand. In particular, many of us emphasized the big decline in growth of the working-age population:
Slow population growth means less need for new houses, less need for new shopping malls and less need for new factories and office buildings (leaving aside the effects of remote work). And Japan, which has had a falling working-age population since the 1990s and also entered a reality of very low interest rates long before the rest of the advanced world, seemed to illustrate the point. (I made the connection between demography and ultralow interest rates in a 1998 paper — I would say the best paper I ever wrote — warning that other countries could experience Japan-style problems, which they did a decade later.)
Well, we still have low population growth. So why shouldn’t we expect interest rates to go back to prepandemic levels once the Fed is done fighting inflation?
Maybe we should. The Federal Reserve Bank of New York produces regular estimates of r-star, which it defines as “the real short-term interest rate expected to prevail when an economy is at full strength and inflation is stable.” John Williams, the New York Fed’s president and one of the originators of its model, declared in a May speech that “r-star today is about where it was before the pandemic.”
But there are other models. The Richmond Fed has its own approach but reaches a very different conclusion; I wrote about this a month ago and produced this comparison:
The bond market has, in effect, been voting that Richmond is right and New York is wrong. But why? I’ve seen some efforts to point to possible fundamental factors, but they seem a bit halfhearted. Mainly, as far as I can tell, investors are looking at the economy’s resilience in the face of Fed rate hikes and concluding that this must mean that r-star has risen for some reason, even if we can’t put our finger on it.
This might be true. Or the economy’s resilience so far may reflect lags in the effect of monetary policy or other factors that won’t persist.
My instinct is to say that the bond market is overreacting to recent data and that high interest rates, like high inflation, will be transitory. But as I said, that’s what I’d like to believe, so maybe you shouldn’t trust me here.
I guess we’ll have to wait and see. And the wait may be especially difficult, because the looming government shutdown may, among other things, deprive us of a lot of important economic data.
A housekeeping note: As readers probably know, I’ve been putting out two newsletters a week, in addition to my columns. As originally conceived, the Tuesday newsletter was aimed at a relatively broad audience, while this newsletter was wonkier. In practice, however, the two newsletters haven’t looked that different. So starting next week, we’re going to consolidate them into a single letter once a week. Subscribers to this newsletter who aren’t already subscribed to the Tuesday newsletter will be automatically shifted over. The day of the week may eventually change, too, but that’s not settled yet.
