Lower for Even Longer: Secular US Rates Framework in a COVID-19 World
Each year, our Global Active Fixed Income team reviews their secular framework, examining long-term trends relating to labor force dynamics, productivity, inflation, and policy orientation. The framework provides a foundation for structural portfolio allocations, with the starting point being client objectives, opportunity set and constraints. Then, on a monthly basis, the Asset Allocation Committee sets cyclical risk targets that may deviate from the structural allocations.
Developed market (DM) economies across the globe have faced dual secular headwinds of slowing labor force growth and productivity growth for years, which have driven declining trend growth — what many leading economists call “secular stagnation.” The deceleration in labor force growth is chiefly a function of declining birth rates and aging populations. The slowdown in productivity, defined as economic output per hour worked, has been driven by lack of capital investment by both the private and public sectors, as well as technology and automation channeling workers from medium (routine production) to low productivity (in-person service) jobs. These trends, well entrenched since the Global Financial Crisis (GFC), represent structural disinflationary forces and suggest continuation of the lowgrowth, low-yield environment across DM economies, including the US.
Only time will tell what longer term effects the pandemic will have on these secular downward trends. On the productivity front, we have begun and should continue to see some degree of decreased globalization and restructuring of supply chains, which may not be positive for productivity. On the other hand, we could see boosts in productivity, for example, in the services sector due to technology adaptations in response to COVID-19. We note that there has been a slight uptick in long-term productivity (10-year annualized) from 1% in the second quarter to 1.25% in the third quarter. But the question is: Will it be a sustained rise? The impacts on the labor force are assuredly negative: labor force participation has fallen significantly with vulnerable, low-income populations being hit hardest, exacerbating inequality. Women have also left the workforce disproportionately. Adverse impacts on K-12 students and higher education will also likely have longer term productivity effects. Scarring from labor market disruptions caused by COVID-19 will be with us for many years.
Negative Output Gap and the Fed’s New Inflation Framework Portend Easy Monetary Policy for Years
The pre-COVID structural disinflationary forces discussed above have been reflected in year-over-year core PCE inflation being persistently under the Federal Reserve’s (Fed) 2% target for decades, averaging 1.7% since 1995 and 1.6% since 2010. The impact of the pandemic and policy response, plus projections for an output gap that is not expected to close for many years, suggests conditions that are not necessarily supportive of sustainably higher inflation relative to the Fed’s 2% target. The output gap fell below -11% in the second quarter, almost twice the trough of the GFC, and is expected to remain negative for the remainder of the decade according to the Congressional Budget Office (CBO). The structural trends and COVID-19 response in the form of extremely accommodative monetary policy have caused the Fed to rethink its framework. In August, the Fed unveiled its Flexible Average Inflation Target (FAIT) stating its goal of 2% average inflation over time and allowing for inflation above 2% following periods of undershooting. This potentially alters the expected path for short-term rates, as well as the market’s estimate of the sensitivity of the Fed’s reaction function to future growth and inflation. For these reasons we believe that the Fed funds rate (FFR) will likely remain anchored at zero for longer than is currently being priced in the market.
If the FAIT had been implemented over the past 20 to 30 years, we estimate the FFR would have been 40–50 basis points (bps) lower on average over the period. The Fed did not explicitly define their average inflation metric, but to illustrate the point, we use a 2-year average of core PCE inflation as one possible interpretation of FAIT. We then looked back in time at the four episodes since 1990 when the Fed began to raise rates after a period of low rates or rate cuts: Q1 1994, Q2 1999, Q2 2004 and Q4 2015. Using the 2-year FAIT likely would have eliminated the 1999–2000 and 2015–2018 hikes altogether, while also delaying the 2004 hike by one year. We believe the FAIT policy unambiguously implies lower policy rates for longer. Finally, we note that the Fed initiated these rate hikes only after stronger recoveries in the output gap, north of -2%, which the CBO projects will not happen until Q3 2025.
Quantitative Easing: No Longer Unconventional Monetary Policy
In our view, quantitative easing (QE) — the purchase of longer term, typically fixed income securities by a central bank to lower rates more broadly and ease financial conditions — is here to stay for the foreseeable future and should therefore be incorporated into investment frameworks. QE has been a mainstay of monetary policy across DMs since the GFC. The combined balance sheets of the Fed, European Central Bank (ECB) and Bank of Japan (BOJ) have expanded from $4 trillion in 2008 to $15.3 trillion in 2019, and finally to $22.5 trillion as of November 2020. This undoubtedly represents a structural change in the liquidity of the system.
With policy rates at or below zero, DM central banks have increasingly looked to unconventional policies to try to combat flagging growth and low inflation. The BOJ has aggressively pursued QE, negative rates and yield curve control, in addition to the government’s expansionary fiscal policies, to combat decades of near-zero growth and deflationary pressure driven largely by an aging population, low or negative population growth rates, and restrictive immigration policies. The ECB has responded to similar trends in Europe over the past decade with QE and negative policy rates. The US appears to be heading in the same direction. As Figure 1 showed, a secular slowdown is underway in the US, with demographics playing a major role: population growth has halved from a peak of almost 1.3% in the late 1990s to 0.6% in 2020.
We believe equilibrium rates and volatility are lower in the presence of QE versus in its absence, all else equal. With the FFR at zero and no appetite to take rates negative, QE will be a primary monetary policy tool moving forward. Since 2009, the Fed’s balance sheet has grown from $0.5 trillion to over $7 trillion today. The Fed rolled out the unconventional monetary policy playbook in 2020 to great effect, having learned much during and since the GFC regarding implementation and communication around unconventional policies. As before, QE helped flatten the yield curve, dampen volatility and stabilize markets during heightened stress. The benefits at least in the shorter term are clear, while the overt costs — in particular, the runaway inflation expected with each new round of QE over the years — have failed to materialize time and again. The longer term implicit costs including zombification of companies (i.e. artificial suppression of insolvencies) and creation of asset bubbles are unsurprisingly less well understood. Finally, the larger the amount of government debt issuance in response to the pandemic, the greater the incentive for both fiscal-monetary coordination and utilization of QE to help keep rates low. For these reasons, we think the Fed will continue to lean heavily on QE well into the future.
The Difference between the Neutral Real Rate and Trend Growth
Another component of the secular rates framework is a downward adjustment to the estimate of the long-run, equilibrium neutral real interest rate (R*), which Wicksell (1936) defines as “the rate consistent with stable inflation and output remaining at equilibrium (‘potential’) level.” The neutral real rate is not observable, so the adjustment is based on estimates of the difference between the neutral real rate and trend growth, or R*–G, from academic and empirical research. Rachel and Summers (2019) found that trend growth and R* have diverged since 1980, with the gap R*–G ranging from 0% to -1.5% over the past four decades. Kogan et al (2015) examined over 200 years of data and found that R–G using the average US Treasury rate and real GDP growth had medians of -1% from 1792–2025 and -1.3% from 1947–2025. We adjust our estimate of the neutral real rate downward by 1 percentage point, consistent with long-term empirical evidence.
Putting It All Together: COVID-19 and Policy Decisions Suggest Even Lower for Even Longer
The output for our secular rates model is a range of implied nominal neutral interest rates, which the Active team uses in their fair value framework for rates. Our estimates of the current implied nominal neutral rate range from 1% to 2.25%. Below are the steps that the team takes in arriving at the implied nominal neutral rate:
Potential GDP (Trend) Growth = Labor Force Growth + Productivity Growth
We use this framework to establish estimates of the implied neutral nominal rate in base case, upside and downside scenarios. We then compare these to the current 5-year forward nominal rate, which is indicative of the market’s expectation of the level at which rates stabilize once policy has normalized to neutral levels. The resulting difference is the risk premium, which informs our assessment of longer term value.
Our secular rates framework conveys multifaceted information that can be valuable for investors beyond the actual estimates of long run fair value. Broadly speaking, the model validates the lower-for-longer environment for growth and rates, consistent with the multi-year disinflationary trends we’ve been seeing. Beyond entrenched demographic and productivity trends, we begin to see a picture of a neutral interest rate that is even lower for even longer, influenced downward by the worldwide disruption of a once-in-four-generations pandemic and subsequent policy decisions — including FAIT, QE and a FFR that we believe will be held at zero for longer than is currently priced in the market.
Despite all the disruptions of 2020, we are watchful for any positives resulting from productivity gains, technological transformations in certain sectors such as professional services, and improvements in operating models. We also remain cognizant of how policies like FAIT may influence term premium and breakeven inflation rates over a longer horizon, once the pandemic is in the rear-view mirror.
Investors should consider all of these factors together in setting their capital markets expectations and in particular the implications of Treasury yields that may remain low by historical standards for quite some time to come.
Sources: State Street Global Advisors, Federal Reserve, European Central Bank, Bank of Japan, Bloomberg.
Frey, Carl Benedikt. The Technology Trap: Capital, Labor, and Power in the Age of Automation. Princeton University Press. June 2019.
Kogan, Richard, Chad Stone, Bryann DaSilva and Jan Rejeski. “Difference Between Economic Growth Rates and Treasury Interest Rates Significantly Affects Long-Term Budget Outlook.” Center on Budget and Policy Priorities. February 27, 2015.
Rachel, Lukasz, and Lawrence Summers. “On Falling Neutral Real Rates, Fiscal Policy, and the Risk of Secular Stagnation.” Brookings Papers on Economic Activity. BPEA Conference Drafts, March 7–8, 2019.
Wicksell, Knut. Interest and Prices: A Study of the Causes Regulating the Value of Money. London, Macmillan, 1936.
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