Low interest rates are not new. However, what makes the current environment unique is the low level of government bond yields. Policymakers have stepped up their asset purchase programmes to help drive down long-term bond yields to record low levels. It is not just short rates which are at “The Zero” in many markets, so are bond yields.
Although we expect economic activity to rebound significantly in the second half of 2021, interest rates are unlikely to follow.
Inflation holds the key
As the economy begins to re-open, there will be upward pressure on prices and we are already seeing some bottlenecks emerge in the more buoyant goods sector.
However, this is likely to be a transitory effect as economies will go into the recovery with significant spare capacity, particularly in the labour market. For a transitory increase in prices to turn into a persistent acceleration in inflation, we would need to see wages picking up and adding a further round of cost pressure to prices. This seems unlikely with unemployment well above estimates of equilibrium around the world.
While the relationship between unemployment and wages has weakened somewhat in recent years, the signal is still one of deflationary pressure on wages for a considerable period as workers compete for jobs.
In our forecasts, the US output gap does not close until the middle of 2022 and later in the UK and eurozone. Consequently, after a brief pick-up once economies re-open later this year, inflationary pressure is likely to ebb until later in 2022.
This is not an outlook which will trouble policymakers as it comes against a backdrop where inflation is already low and central banks recognise that past policies have been too tight and deflationary to hit their inflation targets. The latter has been most clearly highlighted by the decision by the Federal Reserve to shift its inflation target to one where inflation averages 2% over the cycle.
As the economy emerges from recession, we would expect the Fed to keep rates low and policy loose for a period to achieve its new target. Such a move would also give the Fed a greater chance of reaching its maximum employment goal where a broader group of families and communities share in the benefits of economic growth.
Of course, we would not rule out a period of higher inflation, but on balance, we believe that the disinflationary trend which was established in the world economy before Covid-19 will reassert itself. One reason why is simply the level of debt in the world economy. Figures from the IMF show that government debt in the advanced economies has reached levels last seen after the Second World War.
High government debt levels will reinforce low rates
While some see high debt as a precursor to higher inflation, suspecting that the authorities will try to and succeed in devaluing their liabilities through inflation, this is not what we’ve seen in Japan.
We do see significant differences between Japan and other economies which means that they need not follow along the same deflationary path. However, looking further ahead, with debt heading above 100% of GDP in the US and UK and both countries facing significant healthcare liabilities, fiscal space will become more limited.
In this environment, the pressure on central banks to keep rates low will remain strong. Not just to maintain overall policy stimulus, but to ensure that high debt levels remain sustainable. The need to boost inflation and facilitate high budget deficits and debt mean central banks will keep policy loose as the world economy recovers.
We are in unprecedented times, but the likelihood is that low interest rates will persist long after the world economy has shaken off the pandemic. For financial markets, such an outlook will intensify the search for yield and no doubt create volatility and bubbles as investors chase returns in “the zero” environment.
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