Not-So-Great Expectations: Why Real Interest Rates Won’t Soar by Research Affiliates

In a recent piece from Research Affiliates, Shane Shepherd, Senior Vice President, Head of Macro Research, looks at the consensus on interest rates: they are set to fly. But if, as Research Affiliates expects, savings accelerate and real GDP grows slowly, then interest rates won’t rise very much anytime soon.

Ask anyone—anyone at all—and you will get the same answer. Whether it’s an offhand remark in the elevator or a solemn pronouncement in the board room, the message comes from all sides: Interest rates will shoot up.

Granted, they all say, we’ve had false alarms before. The consensus was that interest rates would rise in 2010. Then for sure in 2011, and again in 2012, 2013, and 2014. The markets paid no attention. But Janet Yellen finally appears to have lost her patience. Following last month’s meeting, many observers perceived a subtle shift in Fed-speak1 that seemed to imply that, at the June conclave, the Federal Open Market Committee (FOMC) will nudge nominal interest rates up from the Zero Lower Bound.

But wait. Before we get ahead of ourselves, why have rates remained so low for so long?

As the Fed attempted to balance its two mandates—control inflation and maintain full employment—the slow-growth economy coming out of the Global Financial Crisis resulted in a new paradigm. The U.S. economy has registered stubbornly high unemployment and persistently low readings in the Fed’s preferred measure of inflation, the Personal Consumption Expenditures Price Index. An extended period of low rates appeared to be just the fuel our economy needed to stoke the engine of growth and put more people to work.

Or was it? A closer look at the numbers suggests this policy may not have been as effective as anticipated. Our GDP growth remains well below par. The output gap (the difference between actual and potential GDP)2 stands at 16% and shows no sign of disappearing anytime soon (see Figure 1). Rather than emerging from the 2009 recession with a period of rapid GDP expansion to make up for lost production, we have slogged through a time of slower-than-average economic growth. GDP has merely grown at an annual rate of 2.2% since 2009, and it is not accelerating; in 2014 the growth rate reached only 2.4%.

Interest Rates

What about unemployment? The official numbers show the U.S. Civilian Unemployment Rate declining from a reported high of 10.0% in 2009 to a comfy 5.5% (the number we used to call “full employment”) as of February 2015.3 But dig deeper. That number masks the fact that the labor participation rate has declined from 66.2% in 2008 to 62.8% now.4 In fact, as Figure 2 shows, most of the drop in the unemployment rate can be attributed to people leaving the workforce rather than job creation. A huge “shadow inventory” of unemployed workers hangs over the labor market, unrecognized in the official numbers.5 An improving economy could encourage many non-participants to return to job-seeking status. If the labor participation ratio were to return to its 2008 level, today’s unemployment rate would sit at 10.4%! This shadow inventory helps explain the tepid wage growth we have seen even as the job market becomes tighter, and it will likely continue to keep a lid on wage growth going forward.

Interest Rates

Fed officials, of course, are well aware of this issue6 and choose to believe that the declining trend will continue rather than reverse. Certainly some of the drop in the participation rate can be attributed to shifting workforce demographics, and it may be unrealistic to project a return to 66%. Nonetheless, it seems peculiar to disregard the fact that the participation rate held steady at 66%—only a percentage point below its all-time peak—from 2003 through 2008, and started falling only in response to the 2009 recession. Surely a combination of long-term demographic trends and cyclical pressures must be at work.

See full article online at: “Not-So-Great Expectations: Why Real Interest Rates Won’t Soar

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