Real interest rates can get back to sustainable levels

Now that’s above the 2 per cent target – but still, there is a lot of Fed credibility there.

The Fed is likely to stick to its guns to make sure those beliefs are justified. This does not mean leaving short rates at around 4 per cent (as in December) just because long-run breakeven inflation of 2.5 per cent would make the real short rate look “about right”. It would be normal to go higher than that to ensure actual inflation does indeed transition back to two-point-something.

China simply cannot bring itself to be part of the rules-based economic order if those rules are not set by China itself.

And what about bonds?

In the second Clinton presidential term the real 10-year rate was around 3.5 per cent. This reflected a strong return on capital as the benefits of businesses investing in computing technology and the internet in earlier decades led to a productivity boom without any upward trend in inflation.

But then everything changed.

Productivity gains were exhausted. “New economy” exuberance went too far. Tech lost its leadership role. Unlike previous revolutions in electricity, water, sewerage, and the internal combustion engine, it did not have the same durability.

Backing up a little, it is worth noting that central banks can drive real interest rates away from those consistent with growth fundamentals for a time. But only for temporary periods if excesses are to be avoided.

This is the main lesson of how we got into the current mess.

Cutting interest rates and lender-of-last-resort moves to avoid a financial meltdown is one thing but keeping them there and using quantitative easing to manipulate the bond market was never going to stimulate new growth leadership.

It is even perverse. Low capital return hurdles encourage bad investment ideas, leverage, and financial engineering with little value for growth.

Low interest rates and policies to push housing from 2004 are a good example. Housing was never going to be a productivity driver in filling the gap after the tech bust, and housing-related financial engineering was at the heart of the 2008 crisis.

The big tech giants such as Google, Amazon, Apple, and Meta (owner of Facebook, WhatsApp and Instagram) had also become dominant by 2004.

But like housing there was nothing on offer for productivity which began a great decline from that time. These companies focus a lot on consumption goods, convenient ways to spend your leisure time. Gimmicks and games. They are not producing capital goods that can drive cost reductions in production.

Applying demand solutions (zero rates, QE and the COVID-19 cheques) to what is essentially a supply side problem of rebuilding productivity was always going to lead to inflation if persisted with for too long. And that is exactly what came to pass.

The bond rate currently implied by short rates and expected inflation is around 5 per cent (see the chart), while the nominal bond rate was only 3.5 per cent in December. It has further to rise, even assuming inflation begins to fall back towards the long-run expected rate.

A 2.5 per cent real bond rate is realistic if trend economic growth can be sustained at a similar rate.

Experts point to the many supply side headwinds to getting there: the ageing population, exhausting gains from tertiary education, inequality, government and household debt, the costs of global warming, pandemics, and the shifting of supply chains that most benefit from technology to China after its entry into the World Trade Organisation in 2001.

Supply side vulnerability

Dealing with some of these will be the key to whether the US can transition back to sustainably higher real interest rates (a very good thing) or whether the latest rate increases and QT will go in the direction of the Yellen and Jerome Powell’s attempts from 2017.

The burst of inflation has brought home the supply side vulnerability of the US economy and should set in motion some of the things needed to deal with it.

One headwind that can be dealt with is the unreliability of China in global supply chains.

After 22 years, we learn that opening world trade to China through the World Trade Organisation did not provide the benefits predicted by economic theory.

China simply cannot bring itself to be part of the rules-based economic order if those rules are not set by China itself. This opens enormous scope to bringing manufacturing back to the West – and it is this sector rather than services where technology is a great driver of productivity gains.

Consistent with this is the need to deal with climate change. Solar wind, tidal, small modular nuclear, batteries, EVs and power grid applications together have good scope to lead of the next productivity boom.

I am an optimist on all these avenues for Western countries, and the Biden administration has taken steps in the right direction.

A 2.5 per cent real bond rate is on the horizon, and policy is much less likely to go the way of the Yellen/Powell U-turn.