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Published by: gasepy on Aug 26, 2010
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Why are long-term real interest-rates so low and does it matter? When the Inverse Plague Explains the Conundrum of Low Long-Term Interest Rates
Do China and other emerging markets hold the key to solving the persistent low long-term interest rates ‘conundrum’, famously dubbed by Alan Greenspan? The former Fed Chairman was speaking to an apparent paradox: despite seventeen consecutive nominal short-run rate hikes by the Fed since June 2004, U.S. longterm rates have remained unmoved. In fact, U.S. nominal long-term rates have trended well below their historical two-percent premium over short-term treasuries. As a result, even as inflation has edged up, long-term rates have fallen, flattening and even inverting the U.S. yield curve. rates. Faced with limited investment opportunities and wary of stagnant growth in Europe and Japan, foreign investors are funnelling capital into the U.S. Treasuries. They are being accompanied by emerging market central banks, which are accumulating reserves hand over fist to prevent an appreciation of their currencies. Bernanke’s savings glut conveniently shifts responsibility for the U.S. current and fiscal deficits from American profligacy to foreign abstemiousness. But global savings and investment levels are not yet sporting the signs of a glut: relative to output, both are below historical averages (Figure 1). Also, the bulk of U.S. securities held by foreigners is concentrated in the short end of the curve, with little effect on long-term rates. Furthermore, the conundrum is a global phenomenon, affecting Europe and Japan even if they are at different stages of the business cycle and despite the different structures of their economies. Looking to the U.S. economy, in a reversal from the 1990s, corporate America is awash in cash. Fuelled by improved productivity (from the tech era), declining capital-goods prices, and consistent profitability, U.S. corporate savings have offset half of the recent increase in U.S. government and household borrowings. These accrued earnings may be keeping long-term rates down, but even this is far from certain: only a portion of corporate savings has been channelled into securities. The rest has been used to clean up balance sheets and accumulate equity either through share repurchasing or direct investment abroad.

Just as the Black Death of the 14th century drove up inflation by decimating a third of Europe’s working-age cohort, today’s swelling formal workforce in emerging markets acts as an ‘inverse plague’, expanding the labour pool, moderating wages and dampening long-run inflation expectations. Surprisingly, this tremendous productive impetus has failed to take centre stage as a likely explanation for the conundrum. Instead, many believe that the low long-term rates are ill-omens for the global economy, anticipating a gloomier growth scenario than the consensus forecast. Others argue that the bond market has overshot; forgetting that the global credit market is extremely liquid and investors would rush in to arbitrage away any misalignment in security prices. The explanation which has gained the most currency, however, is Ben Bernanke’s ‘saving glut’ theory. Bernanke argues that excessive international savings is holding down long-term

both current and expected inflation have remained subdued. but when . 2 excess liquidity accompanies greater global output. tries to solve one paradox by raising another: why have inflation expectations remained low with strong consumer demand. high capacity utilization and rising commodity prices? This is all the more puzzling considering the massive amount of liquidity that central banks sent sloshing around the world economy following the ‘tech bubble’ in 2001. Indeed. In China alone more than 200 millions have joined non-agricultural sectors since 1987. But sooner or later one should normally see nominal longterm rates rise to preserve real return against high commodity prices and inflation expectations. by focusing on international capital flows only. ■ — Martin Philibert The answer lies in the globalization of goods production and trade. Yet. as have longterm yields. liberalized trade has stoked competition and dampened prices (Figure 2) by allowing mature markets to tap the excess labour force of emerging markets to procure not only greater quantity and quality goods. Perhaps most critically.The Inverse Plague and the Low Long-Term Rates Conundrum The notion of either a domestic or foreign savings glut keeping long-term rates down is only a partial explanation at best. This is the age of the plague inverted. If Sir Arthur Lewis’ two-tier model of economic development holds true. this migration toward nonagriculture avocations will continue to act as an immense buffer against inflation. less a conundrum. accounting for half the workforce and rising (Figure 3). but services as well. the conundrum becomes less of a riddle. Inflation results from too much money chasing too few goods. the savings glut argument. The world economy has never welcomed in its midst so many so fast.

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