ES (03.2024) R(ising) star

Question 1

[Introduction]

What recent trend in real interest rates have we observed in advanced economies?

Answer 1

Over the past two years, there has been a measurable and persistent rise in real interest rates across many advanced economies, partially reversing the secular decline that began in the early 1980s.

Question 2

[Introduction]

What is the natural rate of interest, or r, and why is it significant in economic discussions?

Answer 2

The natural rate of interest, or r*, is the real short-term interest rate that would prevail if the economy was operating at its potential and inflation was at target. It is significant because it helps economists and policymakers gauge the underlying economic conditions free from short-term disturbances.

Question 3

[Introduction]

What are the two main hypotheses discussed that explain the fluctuations in real interest rates?

Answer 3

The two main hypotheses are the savings-investment hypothesis, which attributes changes in real interest rates to global saving and investment patterns, and the monetary policy hypothesis, which suggests that monetary policy actions by central banks influence real interest rates.

Question 4

[Introduction]

How does the savings-investment hypothesis explain the decline and subsequent rise in real interest rates?

Answer 4

According to the savings-investment hypothesis, the decline in real long-term rates before the pandemic was due to

• low investment amid declining global productivity,
• high savings from an ageing population,
• and increased demand for safe assets during global financial crises.

The hypothesis implies that structural factors are the primary drivers of the natural rate of interest.

Question 5

[Introduction]

What role does the monetary policy hypothesis assign to central banks regarding real interest rates?

Answer 5

The monetary policy hypothesis argues that central banks, by providing long-run guidance on interest rates, can influence long-term interest rates and may create informational feedback loops that affect private consumption and investment decisions, potentially causing shifts in the natural rate of interest, r*.

Question 6

[Introduction]

What are the differing implications of the savings-investment and monetary policy hypotheses for the role of monetary policy in economic management?

Answer 6

The implications differ significantly:

• under the savings-investment hypothesis, monetary policy is largely reactive, adjusting to global structural changes.
• In contrast, the monetary policy hypothesis suggests that central bank actions can have proactive, long-lasting effects on economic activity and real interest rates.

Question 7

[Introduction]

What is the current debate among economists and policymakers regarding the future of real interest rates?

Answer 7

The debate centers on whether the recent rise in real interest rates is a temporary response to recent shocks or if real interest rates will stabilize at a higher level compared to the historic lows of the pre-pandemic era, challenging previous assumptions about the natural rate of interest.

Question 8

[The fall and rise in real interest rates]

How has the natural rate of interest, r*, changed in the decades leading up to the pandemic

Answer 8

The natural rate of interest, r*, has shown a persistent downward trend over the decades leading up to the pandemic, although there is some disagreement about its precise level due to high model and estimation uncertainty.

Question 9

[The fall and rise in real interest rates]

What is the relationship between real long-term rates and r* ?

Answer 9

Real long-term rates are fundamentally driven and should align closely with r* over the long run, serving as an anchor once temporary demand or supply shocks have faded and the economy returns to equilibrium.

Question 10

[The fall and rise in real interest rates]

What factors have driven the recent rise in real long-term yields?

Answer 10

The rise in real long-term yields has been driven not only by increases in spot short-term rates due to a globally synchronized monetary policy response to inflation but also by a reassessment by market participants of the expected level of future real short-term interest rates.

Question 11

[The fall and rise in real interest rates]

According to the Survey of Monetary Analysts, what are the long-term expectations for the ECB’s deposit facility rate? What does the expected level of the ECB’s deposit facility rate imply about the future natural rate of interest, r?*

Answer 11

• Respondents to the Survey of Monetary Analysts expect the ECB’s deposit facility rate to stabilize in the long run within a range of 2% to 2.5%.
• Given an expected inflation rate of 2% over the same horizon, the long-term expected level of the ECB’s deposit facility rate implies an r* of between 0% and 0.5%.

Question 12

[The savings-investment hypothesis]

What fundamental concept does the savings-investment hypothesis use to explain changes in real long-term rates and r*?

Answer 12

The savings-investment hypothesis explains changes in equilibrium real interest rates through structural shifts in savings and investments. Specifically, an increase in desired investment relative to savings puts upward pressure on real interest rates.

Question 13

[The savings-investment hypothesis]

How are real interest rates determined according to the savings-investment hypothesis in a global context? What does the concept of global r* signify in relation to domestic r*?

Answer 13

• In a world with free capital flows and no financial market frictions that prevent capital from moving freely across borders, real interest rates are determined globally, leading to a single equilibrium interest rate that clears the global capital market.
• Global r* acts as an anchor for domestic r*, indicating that domestic real interest rates are influenced by the broader global economic environment and its effects on the natural rate of interest.

Question 14

[The savings-investment hypothesis]

What are the key factors identified by the savings-investment hypothesis as driving the decline in r* before the pandemic?

Answer 14

The savings-investment hypothesis identifies slowing productivity growth and a global saving glut as key factors. Slowing productivity reduces the marginal return on capital and hence investment demand, while a saving glut, especially from emerging markets with large current account surpluses and financial crises, exerts downward pressure on r*.

Question 15

[The savings-investment hypothesis]

How have demographic changes and higher risk aversion influenced savings and investment behaviors?

Answer 15

Demographic shifts like higher life expectancy and longer retirement periods have increased desired savings. Higher risk aversion, particularly following the global financial crisis, also contributed to this increase in savings.

Question 16

[The savings-investment hypothesis]

According to recent research, what has been the major cause of the decline in global r* since the 1970s?

Answer 16

Recent research suggests that the major contributors to the decline in global r* since the 1970s have been slowing productivity growth and rising longevity, which have significantly impacted global savings and investment patterns.

Question 17

[The savings-investment hypothesis]

How does the savings-investment hypothesis explain the potential persistence of recent rises in real interest rates?

Answer 17

The hypothesis suggests considering the natural rate as having two components: a slow-moving long-run component and a more cyclical component that can deviate from its long-run trend due to structural shocks or changes, explaining the potential persistence of recent rises.

Question 18

[The savings-investment hypothesis]

What historical events demonstrate temporary but protracted reversals in the interest rate regime?

Answer 18

Historical events like the Black Death in the 1350s or extended periods of war show temporary but protracted reversals in the interest rate regime. After World War II, significant reconstruction needs also temporarily increased r* until it began to decline in the 1980s.

Question 19

[Recent shocks and structural challenges likely to put upward pressure on r*]

What current and future factors are likely to put upward pressure on the natural rate of interest, r* ?

Answer 19

Factors such as climate change and the green transition, geopolitical shifts, rapid advances in artificial intelligence, and digitalisation require high levels of investment that could put upward pressure on r*.

Question 20

[Recent shocks and structural challenges likely to put upward pressure on r*]

How might the transformation toward a climate-friendly economy affect investment needs?

Answer 20

The transformation towards a climate- and nature-preserving economy may necessitate investments comparable to those required to rebuild the European economy after the Second World War, significantly increasing investment needs.

Question 21

[Recent shocks and structural challenges likely to put upward pressure on r*]

How have disaster-related investment needs changed in the United States?

Answer 21

The frequency of billion-dollar disasters in the United States has increased significantly, from an average of three in the 1980s to 28 in 2023, indicating a rising need for extensive public and private investments in rebuilding and adaptation.

Question 22

[Recent shocks and structural challenges likely to put upward pressure on r*]

What role do artificial intelligence and digitalisation play in future investment needs?

Answer 22

Advancements in artificial intelligence and digitalisation require substantial public and private sector investments in physical and human capital to acquire new technologies and reshape business processes, especially in the EU, where investment has lagged behind the United States and China.

Question 23

[Recent shocks and structural challenges likely to put upward pressure on r*]

How are companies adapting their investment strategies in response to geopolitical risks and climate change?

Answer 23

Companies are making their supply chains more resilient by diversifying sourcing strategies, often through near-shoring or friend-shoring, which is expected to significantly increase investment over the next five years.

Question 24

[Recent shocks and structural challenges likely to put upward pressure on r*]

What is the potential long-term impact of massive investment pressures on real long-term rates?

Answer 24

Investors’ anticipation of higher private and public investment needs may have already begun to put upward pressure on real long-term rates, possibly marking the start of another protracted period where r* deviates from its long-run trend.

Question 25

[The monetary policy hypothesis]

What is the primary assertion of the monetary policy hypothesis regarding real interest rates?

Answer 25

The monetary policy hypothesis suggests that monetary policy itself may significantly influence real long-term interest rates, challenging the stable relationship between real rates and traditional determinants like savings and investment.

Question 26

[The monetary policy hypothesis]

How does the historical perspective on productivity trends challenge conventional wisdom about real interest rates?

Answer 26

Observations over several centuries reveal that despite a persistent increase in total factor productivity since the Industrial Revolution, real interest rates have shown a downward trend, suggesting other factors may be influencing these rates beyond just productivity.

Question 27

[The monetary policy hypothesis]

What conflicting effects can monetary policy have on real interest rates according to recent studies?

Answer 27

Tight monetary policy can lower investment and technological growth, potentially reducing real rates, whereas expansionary policy can lead to financial imbalances and zombification of firms, which might decrease potential growth and affect rates negatively.

Question 28

[The monetary policy hypothesis]

How does central bank communication influence real long-term interest rates?

Answer 28

Recent studies have shown that central bank communications, particularly around policy meetings like the Federal Reserve’s, have had significant impacts on US real long-term yields, indicating that statements and forward guidance can meaningfully affect market expectations and real rates.

Question 29

[The monetary policy hypothesis]

What role did self-reinforcing dynamics play in the inability of central banks to achieve inflation targets pre-pandemic?

Answer 29

The inability of central banks to return inflation to target levels before the pandemic may have been exacerbated by self-reinforcing dynamics, where monetary policy easing was seen as negative information about the economy’s long-term state, reinforcing contractionary effects and contributing to persistent declines in r*.