(Bloomberg Opinion) — When I’m trying to understand the macroeconomy, I often find myself turning to one of my favorite things: All propositions about real interest rates are wrong.
For starters, let’s define a real interest rate, or more appropriately, a period series of real interest rates. If the long rate is published at 6%, that is the nominal long rate. The real interest rate adjusts that figure for inflation, so if the inflation rate is 4%, the real long rate is 6% minus 4%, or 2%.
Almost everything is blurry before him.
During the 1990s, a series of tax increases and changes to the federal spending trajectory narrowed the US budget deficit. The goal was to restore fiscal prudence, lower real interest rates, and boost private sector investment. It all seemed to be successful, and economists moved away from the belief that they understood not only real interest rates but many other things as well.
Alas, we didn’t. Since Bill Clinton’s presidency, the US has run rampantly large budget deficits, and racked up trillions in government debt, including most recently from the pandemic. Yet real interest rates continue to fall, often reaching negative territory, especially for short-term rates. The naive theory predicted that they should rise.
The law of demand is one of the sacred principles of economics: if the price of apples increases, the demand for apples will decrease. Yet when real interest rates rise, it’s unclear why investment demand goes down, even if the numbers were adjusted for possible reasons why real interest rates might change in the first place. This raises a deeper question: If the law of demand does not apply, how well do we understand investments and real interest rates?
The puzzle gets deeper. In economics, there has been a long-running debate about whether the US Federal Reserve, using monetary policy, can influence real rates of interest. After extensive research, it was concluded that the Fed could actually have a modest impact by supplying more liquidity to the markets. Yet the effect is so small that there may be a practical debate about whether, statistically, it exists at all.
These days, however, the real federal funds rate is less than -4% based on measures of core inflation. No one doubts that the Fed’s monetary expansion, which has brought about a lot of inflation, is a major factor behind that change. In other words, the Fed’s influence on real rates is now far more powerful than it was before.
It still gets worse. Most observers were not anticipating that expected Short rates may fall and remain below -4%. Why keep those assets at all? I don’t have a good answer to that question.
Recently the term structure of interest rates has turned inverted, which means that short term rates are higher than long term rates. Economists have debated for decades whether such a signal could be a good predictor of recession. (The theory is that lower long-term rates mean there will be lower investment demand in the future, indicating a recession.) Yet current data are unclear. So not only are real interest rates often difficult to predict, but they themselves are usually not a clear predictive signal.
There are also international versions of these puzzles. Countries with higher positive real interest rates tend to have stronger real exchange rates than standard theory predicts. When it comes to exchange rates, real interest rates are more powerful than expected – even though when it comes to investments, they are far less powerful. These puzzles remain unsolved.
This is an important question as to why there are so many puzzles surrounding real interest rates. One approach places the defect on the way the actual rates are measured. For example, if each person faces a different inflation rate based on their own spending patterns, the measured real rates may not reflect the actual real rates that individuals face. The second is that the notion of interest rates is confusing to people, and the challenge of incorporating future rates into their probabilistic decision-making is still more complex.
Still, maybe I should adjust my point a bit: no All The proposals for real interest rates are wrong. For example, it seems clear that US real rates have been falling substantially for the past century. But beyond that? If you hear the phrase “real interest rates,” cover up — and maybe even run the other way around.
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tyler cowen [email protected]