A note today from CBA will raise a few eyebrows. Via Banking Day, Commonwealth Bank economist Gareth Aird argues:
“The neutral cash rate is the interest rate that would not exert expansionary or contractionary force on the economy.
Changes in productivity, the terms of trade, savings behaviour, fiscal policy, credit growth, lending margins and the exchange rate all have an impact on the estimate of the neutral cash rate.
These drivers have moved in a way that indicates a lower neutral cash rate.
A fall in productivity growth lowers the return on capital, meaning that it is less desirable to invest.
If the desire to invest is lowered, while the desire to save is unchanged, then a lower interest rate is required to balance savings and investment plans.
Over the past two years, with the terms of trade falling and weak productivity growth, the cash rate that neither exerts contractionary nor expansionary forces on the economy has been lowered.
Soft credit growth and a higher household savings ratio mean that the interest rate required to maintain economic balance is lower.”
Too right. In fact, I’d go so far as to say 3.5% is too high. Two rate hikes to 3% would stall housing and expose the economy to falling investment. As Banking Day points out, in 2004 the neutral rate was considered 5.25% to 6.25%. In 2012 it was considered 4.25%. Now it’s 3-3.5%.
That begs the question why? For that let’s turn to the ongoing discussion about “secular stagnation” started by Larry Summers and continued today by Martin Wolf at the FT:
The story, in brief, is that shifts in the balance between desired real savings and investment generated a large fall in real interest rates. These were accompanied by changes in portfolio preferences towards safe assets and the collapse in the pre-2000 equity bubble. The shift in the distribution of income towards capital and highly paid employees in high-income countries also weakened demand. The central banks then responded with aggressive monetary policies. These supported explosions of credit generally linked to house-price surges. Both imploded in the crisis. As Lawrence Summers has argued, the high-income economies seem to be worryingly unable to generate good growth in demand without extreme credit instability.
This is not a short-term story. The label “secular stagnation” looks apposite. The IMF agrees that real interest rates could remain low for a prolonged time. If governments persist with planned tightening of fiscal policies, this seems certain. If investment rates fell sharply in China, global real rates might need to fall still further. That is difficult while inflation is so low.
What might reverse this? The obvious possibility is a jump in investment in high-income countries driven by the relatively high expected returns on equity. The obstacles here are threefold. One is that chief executives are not rewarded for investing for the long term; another is that investment goods are becoming cheaper all the time; and another is that, when the future is uncertain and the economy sluggish, companies rationally prefer to wait before they invest.
Another possibility is a big fall in savings in emerging economies. But this seems unlikely, at least without a collapse in oil prices. That leaves the option of sustained fiscal deficits in high-income countries, ideally to be invested in infrastructure. Housing-related credit booms are a far worse option. Redistribution towards the spenders seems quite inconceivable.
Public spending on infrastructure is the answer. It can boost demand, increase productivity and allow the private sector to deleverage. Australia has been right to pursue that agenda at the G20.
But that means relying on politicians to make the right choices otherwise the investments don’t self-liquidate the new debt created and all that has been achieved is the exhausting of another growth bullet.
Then more government’s will need financial repression to service their debt, interest rates still wont rise, and the system will take another step towards its ultimate deflationary denouement.
