A generation of workers are going to need to adjust to a global interest rate environment that is up to five times higher than which they are accustomed. According to a paper, Tidal Forces: Dissecting the interest rate equation , co-authored by BNY Mellon Investment Management’s chief economist, Shamik Dhar, rates are likely to settle between 4.5% and 5.5% – a range not seen since 2008 and certainly more reminiscent of 1980s and 1990s.
Inflation’s haunting effects
If and when inflation is under control, it doesn’t mean its effects won’t still be felt for years afterwards. A paper co-authored by BNY Mellon Investment Management’s chief economist, Tidal Forces: Dissecting the interest rate equation, highlights it took some 15 years to shake off the spectre of the high inflation of the 1970s.
When inflation has been high for some time, an inflationary “psychology” emerges, Shamik Dhar explains, resulting in even higher nominal interest rates required to get inflation back down.
“It took a long time to break the inflationary psychology of the 1970s, so interest rates stayed high for a long time. Arguably, it wasn’t until the late 1990s that this battle was won. And no sooner had it been won, than inflationary pressure started to move in the other direction, thanks to forces like globalisation and China’s integration into world manufacturing markets.”
Then came the financial crisis in 2008 and the extraordinary period of zero interest rates and quantitative easing programmes. He adds: “Once again, it took a long time to counter this mindset and arguably required other huge shocks – the Covid pandemic and the Russia/Ukraine war – to start to reverse it. All this suggests real interest rates are fundamentally affected by low-frequency swings in inflationary pressure and inflation psychology.”
“The 2008-19 period is extremely unusual by historic standards. According to the Bank of England database, which is the longest consistent record we have, there has never been a period in the 300 years of their records where interest rates have been so low for so long.”
Many think tanks argue that once the disruption from Covid-19 works its way through the global financial system there will be a return to lower interest rates.
However, the paper’s co-author Sebastian Vismara, senior economist on BNY Mellon’s Global Economic and Investment Analysis (GEIA) team, headed by Dhar, purports today’s situation is not just a fallout of years of quantitative easing programmes post the financial crisis, nor is it solely down to repercussions of the global pandemic.
“While any effort to provide a point estimate for interest rates in the forthcoming decade is riddled with uncertainty, we see a high probability that the global economy is transitioning into a higher interest rates regime.”
There is a myriad of factors, not the least of which is the lingering impact of inflation, higher productivity growth and climate transition costs. Add to the mix is a challenging demographics picture and high levels of government debt in the western world. In aggregate such ingredients fuel the likelihood rates will be higher for longer, the team say. This will have a corresponding effect on investment opportunities and risks, Vismara and Dhar add.
Dhar notes: “The long-term average interest rate is an enormously important economic variable: for both economic policy makers and for investors. For investors, the ‘safe rate of interest’ is the key rate off which all other assets are priced. So being able to forecast the long-term average level of interest rates is crucial for economic policy makers and financial investors.”
Inflation and rates
Dhar believes inflationary shocks may be more common going forward than they have been in the past two decades. As a consequence, he adds, the nominal interest rate required to deliver price stability may end up higher too.
In the rule of unintended consequences, the 1980s switch towards inflation targeting alongside prevailing long-term secular disinflation trends also resulted in lowered policy interest rates, the team’s analysis states.
In general inflation targets may need to be reviewed and even raised in the future, the paper asserts. “Even if targets aren’t raised de jure[1], central banks may be prepared to tolerate inflation deviations from target for longer, especially if the economic costs of hitting the inflation target rise.”
Dhar and Vismara argue it could be that inflation targeting has had its day and that political interference with central banks is on the rise. The paper reads: “There is a perfectly legitimate debate to be had about the correct level of the inflation target: after all, for much of the post-financial crisis period, many economists were arguing the target was too low at 2%, because negative demand shocks could too easily and frequently send us towards the zero bound.”
“Permanent inflationary shocks could become more common in future, especially if deglobalization and the disruption of global supply chains make negative supply shocks more common. Put another way, if globalization previously reduced underlying inflationary pressure for a long time, making it easier for central banks to hit their inflation targets at relatively low interest rates, then it is reasonable to assume that deglobalization will have the opposite impact.”
Fat tails
The past few years has seen several extraordinary events affect markets and the global economy – like a war and pandemic. Such disruptions to the normal functioning of trade and economies often result in a higher probability of extreme outcomes – something economists call fat tails.
Dhar says in a world, like today, characterised by “fat tail shocks” volatility will be more present but may be less impactful as a dampener on rates. “As the global economy undergoes several transitions - technological, demographic, geopolitical and climate-related - we expect to see changes in the risks to growth in a way that puts less downside pressure on real rates.” Dhar and Vismara’s research says the frequency and size of shocks, alongside proactive fiscal and monetary policy by authorities, mean growth is likely to see greater fluctuations but also more balance between downside and upside risks going forward.
Transitions
Today’s global transition to greener technology and energy is another force likely to impact the level of rates over the long term, argue the paper’s authors. There are many factors involved in the replacement of “polluting” capital by green capital over the coming years and many are hard to forecast. However, the impetus behind the overall trend Dhar says, leads him to conclude its impact will result in “modest upward pressure on real rates over the next 20-30 years, front-loaded into the 2030s.”
Read more about why interest rates are likely to stay higher than seen in the past 15 years. Tidal Forces: Dissecting the interest rate equation focuses on the following:
- Productivity growth
- Demographic change
- The climate transition
- Economic volatility
- Government debt and financial repression
1 Any views and opinions are those of the authors unless otherwise noted. This is not investment research or a research recommendation for regulatory purposes.
2 de jure - refers to what happens according to the law, in contrast to de facto, which is used to refer to what happens in practice or in reality.
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