On My Mind: The Structural Shift That Wasn’t

Markets seem to be coming around to our Franklin Templeton Fixed Income CIO Sonal Desai’s view that the Fed will have to keep interest rates higher for longer, but now runaway fiscal deficits pose a further upside risk to yields in the long term, she warns. She shares her latest insights on the fiscal and monetary outlook and the implications for investors.

Policymakers meet in Jackson Hole, Wyoming, August 24-26 to discuss “Structural Shifts in the Global Economy.” The current volatility in bond markets highlights just how important it is to get these structural shifts right—and not to mistake them for structural something that is instead temporary and policy-driven.

I have long been arguing that the Federal Reserve (Fed) will have to keep interest rates higher for longer, and markets seem to be coming around to the idea. I also remain convinced that when the Fed eases policy, interest rates will not come down as much as most people think, for two reasons: First, because the equilibrium real interest rate is higher than what the Fed and a majority of analysts believe. Second, because the loose fiscal policy will keep boosting the bond supply.

R-star strikes back

Let’s start with the equilibrium real interest rate.

The Federal Open Market Committee’s (FOMC’s) forecasts still indicate a long-term nominal fed funds rate of 2.5%. Since in the long term, inflation is supposed to be back to its 2% target, this implies a real rate of just 0.5%. This is unrealistically low in my view. The long-term average of the real fed funds rate, from the 1950s to the eve of the global financial crisis (GFC), was about 2% (deflated by the contemporaneous headline Consumer Price Index CPI).1 Once inflation settles at 2%-2.5% on average, this would suggest a nominal fed funds rate of at least 4%-4.5%. And indeed, back in 2012, the FOMC’s “dot plot” forecast indicated a long-term fed funds rate of 4%-4.5%.

During the following years, dominated by zero-interest rate policy and massive rounds of quantitative easing, the Fed, together with most economists and market participants, came to believe that interest rates would be extremely low for the foreseeable future. This was the “Secular Stagnation” hypothesis, which Harvard’s Larry Summers popularized in 2013. It maintained that a structural shift driven by demographics, inequality and the accumulation of assets by central banks and sovereign wealth funds had brought about a new era of excess savings that would keep interest rates permanently depressed. Econometric analyses also suggested that the equilibrium real interest rate, dubbed r*, had declined to about 0.5% post-GFC from a previous level of about 2.5%. The Secular Stagnation hypothesis held sway for a long time: Larry Summers emphasized it again in 2020 and Olivier Blanchard early this year.

An important implication was that governments would be crazy not to deficit-spend more since they could borrow pretty much for free. And borrow they did: US federal debt held by the public jumped from 35% of gross domestic product (GDP) in 2007 to about 100% today. Lower interest rates kept the cost of debt servicing low—net interest outlays as a share of GDP were essentially the same in 2020 as in 2007, even though the debt stock had tripled.

Confidence that interest rates would stay low forever perhaps made it also seem less important to extend the maturity of government debt; close to 70% of the US government debt stock has a maturity of less than five years.2

Maturity Distribution of US Debt