Heading into Negative Interest Rates — Real Rates and Nominal Rates
Last July I was in Bretton Woods, New Hampshire, along with a host of monetary elites, to commemorate the 75th anniversary of the Bretton Woods conference that established the post-Second World War international monetary system.
But I wasn’t just there to commemorate the past — I was there to seek insight into the future of the monetary system.
One day I was part of a select group in a closed-door ‘off the record’ meeting with top Federal Reserve and European Central Bank (ECB) officials, who announced exactly what you can expect with interest rates going forward — and why.
They included a senior official from a regional Federal Reserve bank, a senior official from the Fed’s Board of Governors, and a member of the ECB’s Board of Governors.
Chatham House rules apply, so I still can’t reveal the names of anyone present at this particular meeting or quote them directly.
But I can discuss the main points.
They essentially came out and announced that rates are heading lower, and not by just 25 or 50 basis points.
Rates were 2.25% at the time. They said they must cut interest rates by a lot going forward.
Well, that’s already happened.
The Fed cut rates last September and October (each 25 basis points), bringing rates down to 1.75%.
And now, after last week’s emergency 50-basis point rate cut, rates are down to 1.25%.
That’s a drop of one full percentage point.
If the Fed keeps cutting (which is likely), it’ll soon be flirting with the zero bound. And if the economic effects of the coronavirus don’t dissipate (very possible), the Fed could easily hit zero.
But then what?
How Negative Interest Rates Work
These central bank officials didn’t officially announce that interest rates will go negative. But they said that when rates are back to zero, they’ll have to take a hard look at negative interest rates.
Reading between the lines, they will likely resort to negative rates when the time comes.
Normally forecasting interest rate policy can be tricky, and I use several sophisticated models to try to determine where it’s heading. But these guys made my job incredibly easy. It’s almost like cheating!
The most interesting part of the meeting was the reason they gave for the coming rate cuts. They were very relaxed about it, almost as if it was too obvious to even point out.
The reason has to do with real interest rates.
The real interest rate is the nominal interest rate minus the inflation rate. You might look at today’s interest rates and think they’re already extremely low. And in nominal terms they certainly are. But when you consider real interest rates, you’ll see that they can be substantially higher than the nominal rate.
That’s why the real rate is so important. If you’re an economist or analyst trying to forecast markets based on the impact of rates on the economy, then you need to focus on real rates.
Assume the nominal rate on a bond is 4%; what you see is what you get.
But the real rate is the nominal rate minus inflation. If the nominal rate is 4% and inflation is 2%, then the real rate is 2% (4 – 2 = 2).
That difference between nominal and real rates seems simple until you get into a strange situation where inflation is higher than the nominal rate. Then the real rate is negative.
For example, if the nominal rate is 4% and inflation is 5%, then the real rate of interest is negative 1% (4 – 5 = -1).
The US has never had negative nominal rates (Japan, the eurozone, and Switzerland have), but it has had negative real rates.
By the early 1980s, nominal interest rates on long-term US Treasury securities hit 13%. But inflation at the time was 15%, so the real rate was negative 2%.
The real cost of money was cheap even as nominal rates hit all-time highs.
Nominal rates of 13% when inflation is 15% are actually stimulative. Rates of 3% when inflation is 1% aren’t. In these examples, nominal 2% is a ‘high’ rate and 13% is a ‘low’ rate once inflation is factored in.
Don’t mention the R word
What is the real rate today?
The yield to maturity on 10-year Treasury notes is currently at a record low of under 1% (it actually fell to 0.899% today before edging slightly higher).
That’s never happened before in history, which is an indication of how unusual these times are.
Meanwhile, inflation as measured by the PCE core deflator (the Fed’s preferred measure) is currently about 1.6% year-over-year, below the Fed’s 2% target.
Using those metrics, real interest rates are in the neighbourhood of -.5%.
But believe it or not, that’s actually higher than the early ‘80s when nominal rates were 13%, but real rates were -2%.
That’s why it’s critical to understand the significance of real interest rates.
And real rates are important because the central banks want to drive real rates meaningfully negative.
That’s why they must lower the nominal rate substantially, which is what these central bank officials said at Bretton Woods.
So, you can expect rates to go to zero, probably sooner or later. Then, nominal negative interest rates are probably close behind.
The Fed is very concerned about recession, for which it’s presently unprepared. And with the coronavirus, now even more so.
It usually takes five percentage points of rate cuts to pull the US out of a recession. During its hiking cycle that ended in December 2018, the Fed was trying to get rates closer to 5% so they could cut them as much as needed in a new recession. But, they failed.
Interest rates only topped out at 2.5%, only halfway to the target.
The market reaction and a slowing economy caused the Fed to reverse course and engage in easing. That was good for markets, but terrible in terms of getting ready for the next recession.
The Fed also reduced its balance sheet from US$4.5 trillion to US$3.8 trillion, but that was still well above the US$800 billion level that existed before QE1 (‘QE-lite’ has since taken the balance sheet up above US$4 trillion, and it’s probably going higher since new cracks are forming in the repo market).
In short, the Fed (and other central banks) only partly normalised and are far from being able to cure a new recession or panic if one were to arise tomorrow.
Negative Rates Bad for Cash but Good for Gold
The Fed is therefore trapped in a conundrum that it can’t escape. It needs to rate hikes to prepare for recession, but lower interest rates to avoid recession. It’s obviously chosen the latter option.
If a recession hit now, the Fed would cut rates by another 1.25% in stages, but then they would be at the zero bound and out of bullets.
Beyond that, the Fed’s only tools are negative rates, more QE, a higher inflation target, or forward guidance guaranteeing no rate hikes without further notice.
Of course, negative nominal interest rates have never worked where they’ve been tried.
They only fuel asset bubbles, not economic growth. There’s no reason to believe they’ll work next time.
But the central banks really have no other tools to choose from. When your only tool is a hammer, every problem looks like a nail.
All the best,
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