In many ways this is perhaps my most personal essay, not because I’m about to share some deep and dark personal revelation (I can almost hear the collective sigh of relief), but rather because this essay reflects my views and mine alone. Others at GMO should not be tarred with the brush of my beliefs, and I have no doubt that many will disavow any association with the views I express here. In fact, my colleague Ben Inker’s “rebuttal” follows this piece.

In this essay I want to build on some of the ideas that were developed in my last essay specifically as they pertain to thinking about asset markets. The most obvious place to start is with the idea that the natural rate of interest is a myth. Accepting this idea has many ramifications for the way in which one conducts asset pricing.

An unanchored system: the world without a natural rate of interest

Perhaps the clearest implication from my previous essay with respect to investing is that the cash rate is potentially unanchored. That is to say, without a natural rate it isn’t obvious what cash rate one should expect to see in the long term. Or, in the parlance of GMO, what is the long-term level of cash to which we should mean revert, or, perhaps, should cash even be considered to mean revert?

In a previous piece I questioned the logic of mean reversion when it comes to cash rates (and hence bonds). If there isn’t a natural rate, then we are left trying to guess what a group of people (the Federal Reserve, for example) will think is appropriate seven years from now. Because we can’t even know for sure who is going to be on the FOMC in seven years’ time, this is an exceedingly difficult task. Pythia herself may have struggled with such a challenge.

As Exhibit 1 shows, the real rate is probably best thought of as a policy variable, set by the central bank. The breaks in the real rate series (statistically estimated) track incredibly well with the tenure of various Federal Reserve Chairmen.

[drizzle]James Montier Interest Rates

So what is one do to? One could turn to the tender mercies of history to see if any meaningful answers can be gleaned from a careful reading of the past. However, and perhaps unsurprisingly, history provides us with little comfort (consistent with my view of real interest rates as a policy variable). Exhibit 2 shows the average, median, and standard deviation across 21 countries over different time periods.

James Montier Interest Rates

The answers obtained from history depend massively on the sample period chosen. Using the longest sample period reveals an average real interest rate of -0.4% p.a., but this is coupled with a median real rate of 0.7% and a very wide distribution. I would also caution that mixing differing monetary regimes may further muddy the already opaque waters. For instance, the prevailing real rate under a system such as the gold standard is likely to be very different from that seen under a fiat currency system.

To help illustrate this point, Exhibit 2 breaks out three sub samples: 1950-2014 represents the post war period; 1970-2014 captures the period of fiat currencies; and 1980-2014 attempts to determine whether the high inflation experience of the 1970s significantly impacted the previous selection. The results reduce the standard deviations across all of the samples, but we can still see that the average ranges from 1% to 2.5% and each is very sample-specific. History really isn’t much of a guide as to a reasonable level of real rates to assume for the long term.

In a minority of cases one could turn to the predictions of the central bank itself. For instance, the Fed produces its now infamous “dots” diagram, which shows the interest rate forecasts (albeit in nominal terms) from voting members of the FOMC. This can be combined with information from, say, the inflation swap market (or the inflation forecasts from the Fed) to derive the “Fed’s view” of long-term “neutral” real interest rates. Doing such an exercise today shows the median Fed expectation for the longer term to be 3.75% nominal; using an inflation “forecast” of 2% would give a long-term real rate expectation of 1.75%.

There are three problems I can think of with doing this. The first is that the Fed is no doubt completely aware of people like me doing things like this. Thus, we can’t disentangle what the Fed wants us to believe from what the Fed really believes. That is to say, the dots may not represent the “true” belief of the Fed, but rather the belief that the Fed would like the market to think it is their true belief. Second, this estimate will not be independent of the model used by the various FOMC members, almost all of whom are seemingly wedded to so-called Dynamic Stochastic General Equilibrium models. Some of the problems inherent in such models were discussed in Part I of this series. Suffice to say, they assume what they seek to prove: a natural rate of interest based on time preference. Third, this kind of process assumes that the Fed knows more than anyone else does – a highly debatable point. Remember, this is the institution that, despite its army of PhD economists, failed to warn of either of the two most recent major economic disasters – the TMT bubble and the housing bubble.

Alternatively, one could turn to the market and ask what is implied for future cash rates from market pricing. With the help of data and models from the New York Fed (the ACM model) and the Cleveland Fed (expected inflation), one can back out the market’s implied real rate expectations. Exhibit 3 shows the average real rate expected over the short term (0 to 5 years) and the longer term (5 to 10 years). A clear difference of opinion between the market and the Fed can be observed. The market is implying a long-term real rate of 1% versus the Fed’s view of 1.75%.

James Montier Interest Rates

See full PDF below.

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